Value and Capital Budgeting

1
Value and Capital Budgeting

• Time Value of Money, Techniques for Capital
  Budgeting Decisions, Valuation of Cash Flow, Term
  Structure of Interest Rate

2
Capital Budgeting

• Capital Budget can be dissected into two parts
• Capital refers to operating assets in
  production.
• Budget is a plan that details projected cash
  flows during some future period.
• Therefore,
• Capital budgeting is the whole process of
  analyzing the projects and deciding which one to
  include in the capital budget.
• It is a process of evaluating specific investment
  decisions.

3
Capital Budgeting

• Need for Capital Budgeting
• A firms capital budgeting decisions must define
  its strategic direction. Planning is essential
  because launching of a new products, services or
  markets is preceded by capital expenditure.
• Results of capital budgeting decisions may be
  achieved in many years to come.
• Poor investments can lead to non-optimal
  utilisation of financial resources.

4
Capital Budgeting

• Consider a hypothetical scenario
• Sales representative reporting to his sales
  manager about the demand for a product of a
  particular type and quality.
• How would the sales manager go about tackling
  this new market potential ?

Production
Sales Manager
Marketing Research
Accounts
5
Capital Budgeting

• Capital Expenditure Types, classifications and
  decisions.
• Replacement Maintenance of business (Should we
  carry on ?).
• Replacement Cost reduction (Cut cost through
  alternatives).
• Expansion into existing and new markets (How can
  we ?).
• Expenditure on product quality and quantity
  enhancement.
• Safety and/or Environment Projects (Social
  responsibility).
• Research and Development (Product enhancement).
• Long term contracts (Securing market deals).

6
Capital Budgeting

• Techniques for Capital Budgeting
• Payback.
• Discounted Payback.
• Net Present Value.
• Internal Rate of Return.
• Modified Internal Rate of Return.
• Profitability Index.

7
Capital Budgeting
Project S has higher cash flows at the beginning
of operation. For Project T, higher cash flows
comes as years pass on. Which of these two
options are optimal from investment and revenue
point of you ?
Expected After Tax Net Cash Flow, CFt Expected After Tax Net Cash Flow, CFt
Year (t) Project S Project T
0 (1000) (1000)
1 500 100
2 400 300
3 300 400
4 100 600
8
Capital Budgeting

• Payback Period is the number of years required
  to recover the original investment.
• Initial Investment - 1000

0
1
3
2
4
Project S
Net Cash Flow -1000
500 400 300
100
Cumulative NCF -1000 -500
-100 200
300
0
3
2
1
4
Project T
Net Cash Flow -1000
100 300 400
600
Cumulative NCF -1000 -900
-600 200
400
9
Capital Budgeting
Unrecovered cost at the start of year
Year before full recovery
Pay back period
Cash flow during the year
Payback Short Term 2 (100/300) 2.33
years. Payback Long Term 3 (200/600)
3.33 years
10
Capital Budgeting

• Discounted Payback Period
• How realistic is the Payback Period method ?
• Does it account for inflation factor time vale
  of money ?
• DPP method allows for discounting of cash flows.
  The discount rate used is the projects cost of
  capital.
• Therefore, the discounted payback period is
  defined as the number of years required to
  recover the investment from the discounted cash
  flows.

11
Capital Budgeting
0
1
2
3
4
Project S
Net Cash Flow -1000
500 400 300
100
Cumulative NCF 10 -1000 455
331 225
68
C. discounted NCF -1000 -545
-214 11
79
Discounted Payback Period 2 (214/225)
2.95 years.
12
Capital Budgeting
0
1
2
3
4
Project T
Net Cash Flow -1000
100 300 400
600
Cumulative NCF 10 -1000 91
248 301
410
C. discounted NCF -1000 -909
-661 -360
50
Discounted Payback Period 3 (360/410)
3.87 years.
13
Capital Budgeting

• Net Present Value In principle, similar to the
  discounted cash flow method.
• Projects with positive NPV should be accepted. If
  not, the project must be rejected. If two
  projects have positive NPV, then the one with
  higher NPV must be accepted.
• Link Net Present Value

14
Capital Budgeting

• Internal Rate of Return is the discount rate
  that equates the present value of the projects
  cash inflows to the present value of the projects
  costs.
• Link Bonds Yield to Maturity
• Significance of IRR
• The IRR on a project is its expected rate of
  return.
• If the IRR exceeds the cost of the funds used to
  finance the project, a surplus will remain after
  paying for the capital.
• A surplus indicates that there is an increase in
  shareholder wealth

15
Capital Budgeting

• Modified Internal Rate of Return
• In MIRR, the cash flows from each projects are
  reinvested at the cost of capital.
• Recall, MIRR is the rate at which all the future
  cash flows are reinvested. Any rate above the
  MIRR is beneficial.
• Link MIRR

n
S CIFt ( 1 r ) n - t
COFt
n
t 0

S
( 1 MIRR ) n
( 1 r )t
t 0
16
Capital Budgeting

• Probability Index shows the relative
  profitability of any project or the present value
  per dollar of initial cost.
• Numerator PV of the Cash Flow.
• Denominator Initial Cost.
• Therefore,
• PI 1078.82 / 1,000 1.078

n
S
CF t / ( 1 r )t
n
t 1
PI
CF 0
17
Net Present Value, In detail

• Calculating NPV based on
• Perpetuity.
• Uneven Cash Flow Perpetuity.
• Annuity.
• a) Ordinary Annuities.
• b) Annuities Due.

18
Perpetuities and NPVs

• It is the constant stream of cash flows without
  end.
• In contrast to finite number of cash flows called
  annuities, perpetuities provide for an infinite
  unending stream of cash flows over an
  un-measurable period of time.
• Can this happen ?
• Consol Bonds issued in the UK entitles the owner
  to receive yearly interest from the British
  government forever.
• Now the obvious question ? How to value the
  consol ??

19
Perpetuities and NPVs

• PV of the Consol
• Link Perpetuities
• PV Consol _at_ 10 100 / 0.10 1000
• PV Consol _at_ 8 100 / 0.08 1250
• PV Consol _at_ 11.75 100 / 0.1175 851.07

Cash Flow
PV Consol
Interest Rate
20
Perpetuities and NPVs

• Perpetuities and Uneven Cash Flows
• Talking of annuities, the term constant payment
  is always referred to. In other words, annuities
  involve payments that are the same in every
  period.
• Are there any scope of uneven cash flow ?
• If yes, Could you think of any asset that will
  generate, hypothetically, a variable cash flow ??
  
• Common Stocks and its uneven cash flow
  dividends.

21
Perpetuities and NPVs
0
1
3
2
5
4
7
6
100 200 225 170
300 0 100
Present and Future Value of an uneven Cash flow
Link - Perpetuities
22
Perpetuities and NPVs

• Growing Perpetuities Similar to perpetuities in
  terms of its application , in growing
  perpetuities, the cash flows are expected to grow
  at some constant rate g.
• C cash flow received one period.
• r discount rate.
• g rate of growth per period.
• PV C C (1 g) C(1
  g)2 . .. C(1 g)N 1
• (1 r) (1 r)2
  (1 r)3 (1 r)N

23
Perpetuities and NPVs

• Example
• Year 1 Cash Flow 100,000.
• Rate of Interest 11 (assumed constant).
• TTM Indefinite.
• Growth Rate 5 (assumer constant).
• PV 100,000 100,000 (1.05) 100,000
  (1.05)2 100,000 (1.05) N-1
• 1.11 (1.11)2
  (1.11)3 (1.11)N

24
Annuities and FVAs

• An annuity is a level stream of regular payments
  that lasts for a fixed number of periods.
• Examples
• Pensions.
• Unspecified time based leases.
• In other words, an annuity is a series of equal
  payments made at fixed intervals for a specified
  number of period.
• Payments made at the end of one accounting period
  Ordinary or Deferred Annuity.
• Payments made typically on the 1st day of the
  accounting period Annuity Due.

25
Annuities and FVAs
Ordinary Annuities
(
)
(1 i) n 1
PMT
FVA n
i
FVA n 100 ((1 0.05)10 1)/0.05)
FVA n 552.56 Link Annuities
26
Annuities and FVAs

• Annuities Due
• Link Annuities

5
100 100 100
100
(
)
(1 i) n 1
PMT
Due FVA n
(1 i)
i
27
Amortized Loans

• One of the most important applications of
  compound interest involves loans that are paid
  off in instalments over time.
• Automobile Loans.
• Home Mortgage Loans.
• Student Loans.
• If the Loans is said to be paid in equal periodic
  (374.11) amounts, it is called amortized loans .
• Link Amortized Loans

28
Amortized Loans

• Mathematically, we can calculate the payment due
  each period from the following equation.

(
)
1 ( 1 / 1 i )n
PMT
PVA n
i
(
)
PVAn 1000 i 6 n 3 PMT ?
1 ( 1 / 1 0.06 )3
1000
PMT
0.06
1000 PMT(2.6730)
PMT 1000 / 2.6730 374.11
29
Cash Flow and Risk Estimation

• Capital Budgeting and its estimation begins with
  the identification of the relevant cash flow.
• Relevant cash flow can be defined as the specific
  set of cash flows that should be considered in
  the decision in hand.
• Capital budgeting begins with the estimation of
  projects cash flows investment outlays and
  annual net cash flow after a project goes into
  operation.
• Scope for errors-
• Capital budgeting decisions must be based on cash
  flows and not on accounting income.

30
Cash Flow and Risk Estimation

• Free Cash Flow is the cash available to all
  investors in the company both shareholders and
  bondholders after consideration for taxes,
  capital expenditure and working capital
  investment.
• Free Cash Flow
• How do you value a firm or a project ??
• Firms / Projects value depends on its free cash
  flows

NOPAT Depreciation Capital Expenditure ()
Increase (Decrease) in Working Capital Investments
31
Cash Flow and Risk Estimation

• Project Cash Flow Vs Accounting Income
• CAPEX - is incurred when a business spends money
  either to buy fixed assets or to add to the value
  of an existing fixed asset with a useful life
  that extends beyond the taxable year.
• Project Cash Flow projects require assets and
  asset purchase leads to negative capital outflow.
• Accounting Income do not show purchase of fixed
  assets as a deduction from accounting income.

32
Cash Flow and Risk Estimation

• Non Cash Charges Depreciation expenses are
  deducted to arrive at revenues. Accountants do
  not subtract the purchase price of fixed asset
  but deduct depreciation on a yearly basis.
  Depreciation itself is not a cash flow.
  Therefore it must be added back to NOPAT.
• Net Operating Working Capital New operations
  and project require additional capital. New
  operations will bring in additional account
  receivables, payables and accruals. The
  difference between the required increase in
  operating current assets and increase in
  operating current liabilities is the change in
  NOWC.

33
Cash Flow and Risk Estimation

• Interest expenses are not included in the Project
  Cash Flow
• Reasons
• Project cash flow is discounted by its cost of
  capital.
• Cost of Capital is the weighted average of cost
  of debts, preferred stocks common equity
  adjusted for projects risks.
• WACC is the rate of returns expected / necessary
  to satisfy all of the projects investors Debt
  holders, Stock holders.
• Therefore, the value of the projects by
  discounting those cash flows at the average rate
  required by all investors.
• Note We do NOT subtract interest when estimating
  project cash flow.

34
Cash Flow and Risk Estimation

• Incremental Cash Flow all those cash flows that
  occur, if and only, if we accept the project.
  These cash flows represent the firms total cash
  flow that occur as a direct result of accepting
  the project.
• Sunk Costs Sunk costs are cost that are
  incurred or occurred and the money invested is
  never recovered. Sunk costs are no incremental
  cost therefore it must not be included in the
  cash flow analysis.