CAPITAL BUDGETING

INTRODUCTION TO CORPORATE FINANCE First Principles of Corporate Finance

Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and should reflect the financing mix used-either owners funds (equity) or borrowed money (debt). Returns on projects should be measured on the basis of cash flows generated and the timing of these cash flows; they should also take into account both positive and negative side effects of these projects.

Choose a financing mix that maximizes the value of the firm and matches the assets being financed.

If there are not enough investments that earn the hurdle rate, return the cash to the owners of the firm. The form of returns - dividends and stock buybacks - will depend on the stockholders characteristics.

Objective : Maximize the Value of the firm.

WHAT ARE CAPITAL BUDGETING DECISIONS ?

The basic characteristic of capital budgeting (also referred to as capital expenditure) is that it involves a current outlay of funds in the hope of receiving a stream of benefits in future.

WHY ARE CAPITAL BUDGETING DECISIONS IMPORTANT ?

They have long term consequences. It is difficult to reverse capital budgeting decisions.

It involves substantial outlays.

CAPITAL

BUDGETING

PROCESS

Identification of potential investment opportunities. Assembling of investment proposals. Decision Making Preparation of Capital Budgeting and appropriations Implementation Performance Review

IDENTIFICATION OF INVESTMENT OPPORTUNITIES

Monitor External Environment To Scout For Investment Opportunities Formulate a well defined corporate strategy based on SWOT. Share corporate strategy and perspectives with people involved in capital budgeting. Motivate employees to make suggestions

ASSEMBLING OF INVESTMENT PROPOSALS

Modernisation and Replacement Decisions Expansion and Diversification New Product Investments Obligatory and Welfare Investments

KEY STEPS IN PROJECT APPRAISAL

Forecast Cost and Benefits Apply suitable investment criteria Assess the riskiness of the project Estimate the cost of capital Value the Options Consider the overall perspective.

Investment Decision Rule

It should consider all cash flows to determine true profitability It should provide unambiguous ways to separate good projects from bad projects Should help ranking of projects according to its true profitability Bigger cash flows are preferable to smaller ones and early to later ones. Should help choose among mutually exclusive projects Broader spectrum of projects.

INVESTMENT CRITERIA

Investment Criteria Discounted Cash Flow Criteria

Net Present Value Benefit Cost Ratio Internal Rate of Return

Non Discounted Cash Flow Criteria

Pay Back Period Accounting Rate of return

NET PRESENT VALUE

Net Benefit over and above the compensation for time and risk and confirms to objective of Finance. Sum of the Present Values of all cash flows discounted at an appropriate discount rate. It takes into account the time value of money It considers the cash flow stream in entirety. It follows the principle of value additivity. It is consistent with shareholders value maximisation. Problem in Mutually exclusive projects Its an absolute not a relative measure. You cannot rank projects.

BENEFIT COST RATIO

This is the Net Present Value per Rupee of outlay. Therefore it can differentiate between large and small projects. It is recommended in cases of Constrained capital budgets.

INTERNAL RATE OF RETURN

The Discount Rate that makes the Net Present Value equal to zero. Makes sense to business men who think in terms of rate of return. However if the cash flow stream changes sign there may be multiple returns. Projects of different scales cannot be ranked.

PAY BACK PERIOD

It is the length of time required to recover the initial cash outlay. It is a rough and ready method for dealing with risk. It emphasises early cash inflows , so good for firms hard pressed for liquidity.

ACCOUNTING RATE OF RETURN

It is the average rate of return given by Profit After Tax divided by Book value of Investment. It is based on accounting information. It considers entire benefits over life of project.

Why is an MBA student who has learned about DCF like a baby with a hammer?

Because to a baby with a hammer everything looks like a nail.

Where does positive NPV come from?

Projects may look attractive for two reasons:1) There are some errors in forecast 2)The company genuinely expects to earn excess profits. So increase odds in your favor by moving in areas of competitive advantages. Look at economic rents and where even advantage is absent or entry of competitors will push prices down or costs up, dont enter . When you have the market value of an asset use it..rather then over analysisgold, real estate..airplanes etc PV calculations may vary and subject to error thats life!!!!!

Comparison
ARR Payback NPV IRR

Balance between flexibility and consistency Leads to value maximisation

Not enough, depends on acc decisions Not necessarily

Too inflexible,

Good Balance

Good Balance

Not necessarily

Yes, if no constraint

Yes, if no compariso n No. Needs one sign change.

Works on all projects

No works on projects with in. investment

No works on projects with in. investment

Yes

COSTS AND BENEFITS Focus on cash flows and measure it on incremental

basis. Accrual Concept Revenue expenditure is charged to profits Capital Expenditure is capitalised as assets and depreciated Depreciation is charged to profit.

Consider all Incidental effects. - Contingent Costs -Cannibalisation -Revenue Enhancement Ignore Sunk costs Allocation of overheads

COMPONENTS OF CASH FLOW STREAM

Initial Flow Outlay on Plant & Machinery and F.A. + Outlay on Net Working Capital Operational Flow PAT + Depreciation Terminal Flow P.T. Salvage value of F.A. & NWC.

COMPONENTS OF CASH FLOW STREAM

Salvage Value
Salvage Value is the market value of Investment at the time of the sale. 1. SV < BV : Loss Net Proceeds: Salvage Value + Tax Credit on Loss ; SV T( SV BV) 2. SV> BV but SV < OV, Ordinary Profit Net Proceeds = Salvage Value Tax on Profits = SV T( SV BV) 3. SV > OV, Capital Gain NP = SV T ( OV BV) Tc ( SV OV)

COMPONENTS OF CASH FLOW STREAM

Net Working Capital

We assumed that all revenues and expenses are in cash. -- Changes in Accounts Receivable: Increase ( or decrease) in receivable should be subtracted from ( or added to) revenues for computing actual cash receipts . -- Increase ( or decrease ) in inventory should be added to expense for computing cash flows -- Increase ( or decrease) in accounts payable should be subtracted from ( or added to) expenses for computing cash flows. NCF = PAT + DEP - NWC --NWC is released at the termination of the project.

COMPONENTS OF CASH FLOW STREAM

Free Cash Flows
An Investment project may require some reinvestment of cash flow for maintaining its revenue generating ability. Thus, FCF = PAT + DEP - NWC -CAPEX

Investment Decisions under Inflation

Fishers Effect: Nominal Discount Rate = ( 1 + Real Discount Rate) * ( 1 + Inflation Rate) 1 -- Either convert the cash flows to nominal terms or discount rate to real terms

Complex Investment Decisions

How shall choice be made between investments with different lives? Should a firm make investment now, or should it wait and invest later? When should an existing asset be replaced? How shall choice be made between investments under capital rationing?

COMPLEX DECISIONS
Annual Equivalent Value Method Assume that each machinery is replaced in the last year of life with an identical asset. Calculate the AEV by using the formula, AEV = NPV / Annuity Factor Investment Timing and Duration Undertake the project at that point of time which maximises NPV. AEV can be used to find

BCR may be used for Capital Rationing Multi Prd. Constraints and Indivisibility

Risk Analysis in Capital Budgeting

Statistical Techniques --ENPV -- Variance -- Coefficient of Variation Conventional Techniques for Risk Analysis --Payback -- Risk Adjusted Discount Rate Certainty Equivalent Techniques Sensitivity and Scenario Analysis

REAL OPTIONS
Opportunities to respond to changing circumstances are called managerial options. They may be called as strategic options. They may be called as real options as they differentiated from financial options.

IDENTIFICATION OF OPTIONS
Investment Timing Option Can be used when demand is uncertain, Interest rates are volatile Most valuable to firms with proprietary technology, patents, licenses or other barriers to entry. Growth Options Allows a company to increase its capacity if market conditions are better, Increase the capacity, expand or diversify or introduce new products. Abandonment Options Option to reduce capacity or temporarily suspend operations. Such options are common in mining oil and timber. Flexibility Options: Permit the firm to alter operations depending on how conditions change during the life of project.

VALUING REAL OPTIONS

Use Discounted Cash Flow valuation and ignore any real options by assuming their values are zero. Use DCF valuation and include a qualitative recognition of any real options value. Use decision tree analysis. Use a standard model for Financial Option Develop a unique project specific model using Financial Engineering techniques.