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MODULE 1MBA & PGDM-Advanced Capital BudgetingSYLLABUSCash Flow Measurement: dependence and independence of cash flows in evaluating projects, Measures of risk and returns, Inflation in capital budgeting, Real vs. nominal discount rates, Bias in cash flow estimates, Total risk for multiple investment. Measuring cash flow for acquisition. Use of Excel for estimating cash flows & decision making.

9/18/20152MBA & PGDM-Advanced Capital BudgetingCapital Budgeting and Estimating Cash FlowsThe Capital Budgeting ProcessGenerating Investment Project ProposalsEstimating Project After-Tax Incremental Operating Cash FlowsMBA & PGDM-Advanced Capital BudgetingWhat is Capital Budgeting?The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

MBA & PGDM-Advanced Capital BudgetingThe Capital Budgeting ProcessGenerate investment proposals consistent with the firms strategic objectives.Estimate after-tax incremental operating cash flows for the investment projects.Evaluate project incremental cash flows.MBA & PGDM-Advanced Capital BudgetingThe Capital Budgeting ProcessSelect projects based on a value-maximizing acceptance criterion.Reevaluate implemented investment projects continually and perform postaudits for completed projects.MBA & PGDM-Advanced Capital BudgetingClassification of Investment Project Proposals1. New products or expansion of existing products2. Replacement of existing equipment or buildings3. Research and development4. Exploration5. Other (e.g., safety or pollution related)MBA & PGDM-Advanced Capital BudgetingScreening Proposals and Decision Making1. Section Chiefs2. Plant Managers3. VP for Operations4. Capital Expenditures Committee5. President6. Board of DirectorsAdvancementto the nextlevel depends on cost and strategicimportance.MBA & PGDM-Advanced Capital BudgetingEstimating After-Tax Incremental Cash FlowsCash (not accounting income) flowsOperating (not financing) flowsAfter-tax flowsIncremental flowsBasic characteristics of relevant project flowsMBA & PGDM-Advanced Capital BudgetingEstimating After-Tax Incremental Cash FlowsIgnore sunk costsInclude opportunity costsInclude project-driven changes in working capital net of spontaneous changes in current liabilitiesInclude effects of inflationPrinciples that must be adhered to in the estimationMBA & PGDM-Advanced Capital BudgetingSound investment decisions should be based on the net present value (NPV) rule. Problems to be resolved in applying the NPV ruleWhat should be discounted? In theory, the answer is: We should always discount cash flows.What rate should be used to discount cash flows? In principle, the opportunity cost of capital should be used as the discount rate.11MBA & PGDM-Advanced Capital Budgeting CASH FLOWS VERSUS PROFIT Cash flow is not the same thing as profit, at least, for two reasons. First, profit, as measured by an accountant, is based on accrual concept.

Second, for computing profit, expenditures are arbitrarily divided into revenue and capital expenditures.

12MBA & PGDM-Advanced Capital BudgetingINCREMENTAL CASH FLOWSEvery investment involves a comparison of alternatives:

When the incremental cash flows for an investment are calculated by comparing with a hypothetical zero-cash-flow project, we call them absolute cash flows.The incremental cash flows found out by comparison between two real alternatives can be called relative cash flows.

The principle of incremental cash flows assumes greater importance in the case of replacement decisions.13MBA & PGDM-Advanced Capital BudgetingExampleSuppose a firm is considering replacing an equipment at book value of Rs. 5000 and market value of Rs. 3000. New equipment will require an initial cash outlay of Rs 10,000, and is estimated to generate cash flows of Rs 8,000, Rs 7,000 and Rs 4,500 for the next 3 years. The book value of old machine is a sunk cost. Market value is opportunity cost. Thus, on an incremental basis the net cash outflow of new equipment is: Rs 10,000 Rs 3,000 = Rs 7,000.Also, The differences of the cash flows of new equipment over the cash flows of old equipment are incremental cash flows.

14MBA & PGDM-Advanced Capital BudgetingCOMPONENTS OF CASH FLOWSInitial InvestmentNet Cash FlowsDepreciation and TaxesNet Working CapitalChange in accounts receivableChange in inventoryChange in accounts payableFree Cash FlowsTerminal Cash FlowsSalvage ValueSalvage value of the new asset Salvage value of the existing asset now Salvage value of the existing asset at the end of its normal Tax effect of salvage valueRelease of Net Working Capital15MBA & PGDM-Advanced Capital Budgeting

Initial Investment

Initial investment is the net cash outlay in the period in which an asset is purchased. A major element of the initial investment is gross outlay or original value (OV) of the asset, which comprises of its cost (including accessories and spare parts) and freight and installation charges. Original value is included in the existing block of assets for computing annual depreciation.16MBA & PGDM-Advanced Capital BudgetingExample of Initial Investment17

Wattle Extract Project: Initial InvestmentMBA & PGDM-Advanced Capital BudgetingNet Cash FlowsConsist of annual cash flows occurring from the operation of an investment, but it is also be affected by changes in net working capital and capital expenditures during the life of the investment.

The computation of the after-tax cash flows requires a careful treatment of non-cash expense items such as depreciation.Depreciation, calculated as per the income tax rules influences cash flows indirectly by way of depreciation tax shield. 18

MBA & PGDM-Advanced Capital BudgetingCalculation of Depreciation For Tax Purposes Two most popular methods of charging depreciation are: straight-line Diminishing balance or written-down value (WDV) methods. For reporting to the shareholders, companies in India could charge depreciation either on the straight-line or the written-down value basis. No choice of depreciation method and rates for the tax purposes is available to companies in India. Depreciation is computed on the written down value of the block of assets and rates are specified. 19MBA & PGDM-Advanced Capital Budgeting

Net working capital

It is the difference between change in current assets (e.g., receivable and inventory) and change in current liabilities (e.g., accounts payable) to profit. Increase in net working capital should be subtracted from and decrease added to after-tax operating profit.

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MBA & PGDM-Advanced Capital BudgetingFree Cash FlowsIt is the cash flow available to service both lenders and shareholders, who have provided, respectively, debt and equity, funds to finance the firms investments. It is this cash flow, which should be discounted to find out an investments NPV.

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MBA & PGDM-Advanced Capital BudgetingTerminal Cash Flow: Salvage ValueSalvage value is a terminal cash flow. Salvage value may be defined as the market price of an investment at the time of its sale.No immediate tax liability (or tax savings) arises on the sale of an asset because the value of the asset sold is adjusted in the depreciable base of assets.

22MBA & PGDM-Advanced Capital BudgetingEffects of Salvage ValueSalvage value of the new asset: It will increase cash inflow in the terminal (last) period of the new investment.

Salvage value of the existing asset now: It will reduce the initial cash outlay of the new asset.

Salvage value of the existing asset at the end of its normal life: It will reduce the cash flow of the new investment of in the period in which the existing asset is sold.

23MBA & PGDM-Advanced Capital BudgetingRelease of Net Working CapitalBesides salvage value, terminal cost flows will also include the release of net working capital. It is reasonable to assume that funds initially tied up in net working capital at the time the investment was undertaken would be released in the last year when the investment is terminated.24MBA & PGDM-Advanced Capital BudgetingCALCULATION OF DEPRECIATION FORTAX PURPOSESTwo most popular methods of charging depreciation are: Straight-line and diminishing balanceWritten-down value (WDV) methods

In India, depreciation is allowed as deduction every year on the written-down value basis in respect of fixed assets as per the rates prescribed in the Income Tax rules. Depreciation is computed on the written down value of the block of assets.25MBA & PGDM-Advanced Capital BudgetingDepreciation baseIn the case of block of assets, the written down value is calculated as follows:The aggregate of the written down value of all assets in the block at the beginning of the year Plus the actual cost of any asset in the block acquired during the year Minus the proceeds from the sale of any asset in the block during the year Thus, in a replacement decision, the depreciation base of a new asset will be equal to: Cost of new equipment + Written down value of old equipment Salvage value of old equipment26MBA & PGDM-Advanced Capital BudgetingCash Flow Estimates for New ProductsIt depends on forecasts of sales and operating expenses.Sales forecasts require information on the quantity of sales and the price of the product.Anticipation of the competitors reactions.

27MBA & PGDM-Advanced Capital BudgetingSalvage Value and Tax Effects As per the current tax rules in India, the after-tax salvage value should be calculated as follows:Book value > Salvage value: After-tax salvage value = Salvage value + PV of depreciation tax shield on (BV SV)Salvage value > Book value:After-tax salvage value = Salvage value - PV of depreciation tax shield lost on (SV BV)28

MBA & PGDM-Advanced Capital BudgetingTerminal Value for a New BusinessThe terminal value included the salvage value of the asset and the release of the working capital.

Managers make assumption of horizon period because detailed calculations for a long period become quite intricate. The financial analysis of such projects should incorporate an estimate of the value of cash flows after the horizon period without involving detailed calculations.

A simple method of estimating the terminal value at the end of the horizon period is to employ the following formula, which is a variation of the dividend growth model

29MBA & PGDM-Advanced Capital BudgetingTerminal Value of New Business / New ProductsNew businesses have the potential of generating revenues and cash flows much beyond the assumed period of analysis, which is referred to as horizon period.A simple method of estimating the terminal value at the end of the horizon period is:

where NCFn+1 is the projects net cash flow one year after the horizon period, k is the opportunity cost of capital (discount rate) and g is the expected growth in the projects net cash flows. 30

MBA & PGDM-Advanced Capital BudgetingCash Flow Estimates for Replacement DecisionsThe initial investment of the new machine will be reduced by the cash proceeds from the sale of the existing machine.The annual cash flows are found on incremental basis.The incremental cash proceeds from salvage value is considered. 31MBA & PGDM-Advanced Capital Budgeting SYLLABUSCash Flow Measurement: Dependence and independence of cash flows in evaluating projects, Measures of risk and returns, Inflation in capital budgeting, Real vs. nominal discount rates, Bias in cash flow estimates, Total risk for multiple investment. Measuring cash flow for acquisition. Use of Excel for estimating cash flows & decision making.

9/18/201532MBA & PGDM-Advanced Capital BudgetingINFLATION AND CAPITAL BUDGETING Inflation is the increase in the general level of prices for all goods and services in an economyMBA & PGDM-Advanced Capital BudgetingNOMINAL VS. REALNominal values are the actual amount of money making up cash flowsReal values reflect the purchasing power of the cash flowsReal values are found by adjusting the nominal values for the rate of inflationMBA & PGDM-Advanced Capital BudgetingINFLATION EFFECTS TWO ASPECTS OF CAPITAL BUDGETING

PROJECTED CASH FLOWSDISCOUNT RATEMBA & PGDM-Advanced Capital BudgetingIF PROJECTED CASH FLOWS ARE IN REAL TERMS (WITHOUT INFLATION CONSIDERED) THE DISCOUNT RATE USED SHOULD BE A REAL RATE.

IF PROJECTED CASH FLOWS ARE IN NOMINAL TERMS (WITH INFLATION CONSIDERED) THE DISCOUNT RATE USED SHOULD BE A NOMINAL RATE.

MBA & PGDM-Advanced Capital BudgetingBOTH THE PAYMENT SERIES AND THE DISCOUNT RATE MUST BE SPECIFIED EITHER IN NOMINAL VALUES OR IN REAL VALUES, BUT NOT IN BOTH VALUES CONCURRENTLY.MBA & PGDM-Advanced Capital BudgetingThe opportunity cost of capital of a firm or project is generally market determined and is based on expected future return.It is, there fore usually expressed in nominal terms and reflects the expected rate of inflation.The opportunity cost of capital is or the discount rate is a combination of the real rate and expected inflation rate.This effect is called Fishers effect9/18/201538MBA & PGDM-Advanced Capital Budgeting Nominal discount rate (k)= (1+K) (1+)- 1

K= real discount rate = inflation rate9/18/201539MBA & PGDM-Advanced Capital Budgetingexample:The firms opportunity cost of capital, which is market determined expressed in nominal terms is 14%. Rate of inflation is 7%9/18/201540year01234Cash flow-1000030003000

3000

3000

MBA & PGDM-Advanced Capital BudgetingIs it better to use real or nominal values?Using nominal values is more common.Market interest rates are nominal values that already contain a premium for anticipated inflation.Income tax obligations are based on nominal values.Therefore, it is usually easier to use nominal values.However, if a nominal discount rate is used, projected cash flows should reflect anticipated inflation. MBA & PGDM-Advanced Capital Budgeting SYLLABUSCash Flow Measurement: Dependence and independence of cash flows in evaluating projects, Measures of risk and returns, Inflation in capital budgeting, Real vs. nominal discount rates, Bias in cash flow estimates, Total risk for multiple investment. Measuring cash flow for acquisition. Use of Excel for estimating cash flows & decision making.

9/18/201542MBA & PGDM-Advanced Capital BudgetingReturn on a Single AssetTotal return = Dividend + Capital gain

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MBA & PGDM-Advanced Capital BudgetingDefining ReturnIncome received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment.Dt + (Pt - Pt-1 )Pt-1R =MBA & PGDM-Advanced Capital BudgetingReturn ExampleThe stock price for Stock A was Rs.10 per share 1 year ago. The stock is currently trading at Rs.9.50 per share and shareholders just received a Rs.1 dividend. What return was earned over the past year?MBA & PGDM-Advanced Capital BudgetingReturn ExampleThe stock price for Stock A was Rs.10 per share 1 year ago. The stock is currently trading at Rs.9.50 per share and shareholders just received a Rs.1 dividend. What return was earned over the past year?Rs.1.00 + (Rs.9.50 - Rs.10.00)Rs.10.00R == 5%MBA & PGDM-Advanced Capital BudgetingDefining RiskWhat rate of return do you expect on your investment (savings) this year?What rate will you actually earn?Does it matter if it is a bank CD or a share of stock?The variability of returns from those that are expected.MBA & PGDM-Advanced Capital Budgeting= (Probability of Return) (Possible Return)

ri= return for the I th possible incomePi = probability associated with ri n= number of possible incomeExpected rate of Return

MBA & PGDM-Advanced Capital BudgetingHow to Determine the Expected Return and Standard DeviationStock BW RiPi (Ri)(Pi) -.15 .10 -.015 -.03 .20 -.006 .09 .40 .036 .21 .20 .042 .33 .10 .033 Sum 1.00 .090The expected return, R, for Stock BW is .09 or 9%MBA & PGDM-Advanced Capital BudgetingDetermining Standard Deviation (Risk Measure)Standard Deviation, s, is a statistical measure of the variability of a distribution around its mean.It is the square root of variance.Note, this is for a discrete distribution.

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MBA & PGDM-Advanced Capital BudgetingHow to Determine the Expected Return and Standard DeviationStock BW RiPi (Ri)(Pi) (Ri - R )2(Pi) -.15 .10 -.015 .00576 -.03 .20 -.006 .00288 .09 .40 .036 .00000 .21 .20 .042 .00288 .33 .10 .033 .00576 Sum 1.00 .090 .01728MBA & PGDM-Advanced Capital BudgetingDetermining Standard Deviation (Risk Measure)s = S ( ri - R )2( Pi )s = .01728s = .1315 or 13.15%ni=1MBA & PGDM-Advanced Capital BudgetingIt is a measure of relative dispersion used in comparing the risk of assets with differing expected return.

Coefficient of variation

MBA & PGDM-Advanced Capital BudgetingCoefficient of Variation of BW9/18/201554

=.1315 / .09 = 1.46MBA & PGDM-Advanced Capital BudgetingDiscrete vs. Continuous Distributions

Discrete Continuous

MBA & PGDM-Advanced Capital BudgetingCertainty Equivalent (CE) is the amount of cash someone would require with certainty at a point in time to make the individual indifferent between that certain amount and an amount expected to be received with risk at the same point in time.Risk AttitudesMBA & PGDM-Advanced Capital BudgetingCertainty equivalent > Expected valueRisk PreferenceCertainty equivalent = Expected valueRisk IndifferenceCertainty equivalent < Expected valueRisk AversionMost individuals are Risk Averse.Risk AttitudesMBA & PGDM-Advanced Capital BudgetingSystematic Risk is the variability of return on stocks or portfolios associated with changes in return on the market as a whole.Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification.Total Risk = Systematic Risk + Unsystematic RiskTotal Risk = Systematic Risk + Unsystematic RiskMBA & PGDM-Advanced Capital BudgetingTotal Risk = Systematic Risk + Unsystematic RiskTotalRiskUnsystematic riskSystematic riskSTD DEV OF PORTFOLIO RETURNNUMBER OF SECURITIES IN THE PORTFOLIOFactors such as changes in nations economy, tax reform by the Congress,or a change in the world situation.MBA & PGDM-Advanced Capital BudgetingTotal Risk = Systematic Risk + Unsystematic RiskTotalRiskUnsystematic riskSystematic riskSTD DEV OF PORTFOLIO RETURNNUMBER OF SECURITIES IN THE PORTFOLIOFactors unique to a particular companyor industry. For example, the death of akey executive or loss of a governmentaldefense contract.MBA & PGDM-Advanced Capital BudgetingCAPM is a model that describes the relationship between risk and expected (required) return; in this model, a securitys expected (required) return is the risk-free rate plus a premium based on the systematic risk of the security.Capital Asset Pricing Model (CAPM)MBA & PGDM-Advanced Capital Budgeting1.Capital markets are efficient.2.Homogeneous investor expectations over a given period.3.Risk-free asset return is certain (use short- to intermediate-term Treasuries as a proxy).4.Market portfolio contains only systematic risk (use S&P 500 Indexor similar as a proxy).CAPM AssumptionsMBA & PGDM-Advanced Capital BudgetingAn index of systematic risk.It measures the sensitivity of a stocks returns to changes in returns on the market portfolio.The beta for a portfolio is simply a weighted average of the individual stock betas in the portfolio.What is Beta?MBA & PGDM-Advanced Capital BudgetingCharacteristic Lines and Different BetasEXCESS RETURNON STOCKEXCESS RETURNON MARKET PORTFOLIOBeta < 1(defensive)Beta = 1Beta > 1(aggressive)Each characteristic line has a different slope.MBA & PGDM-Advanced Capital BudgetingRj is the required rate of return for stock j,Rf is the risk-free rate of return,bj is the beta of stock j (measures systematic risk of stock j),RM is the expected return for the market portfolio.Security Market LineRj = Rf + bj(RM - Rf)MBA & PGDM-Advanced Capital BudgetingSecurity Market LineRj = Rf + bj(RM - Rf)bM = 1.0Systematic Risk (Beta)RfRMRequired ReturnRiskPremiumRisk-freeReturnMBA & PGDM-Advanced Capital BudgetingSecurity Market LineObtaining BetasCan use historical data if past best represents the expectations of the futureCan also utilize services like Value Line, Ibbotson Associates, etc.Adjusted BetaBetas have a tendency to revert to the mean of 1.0Can utilize combination of recent beta and mean2.22 (.7) + 1.00 (.3) = 1.554 + 0.300 = 1.854 estimateMBA & PGDM-Advanced Capital BudgetingLisa Miller at Basket Wonders is attempting to determine the rate of return required by their stock investors. Lisa is using a 6% Rf and a long-term market expected rate of return of 10%. A stock analyst following the firm has calculated that the firm beta is 1.2. What is the required rate of return on the stock of Basket Wonders?Determination of the Required Rate of ReturnMBA & PGDM-Advanced Capital BudgetingRBW = Rf + bj(RM - Rf)RBW = 6% + 1.2(10% - 6%)RBW = 10.8%The required rate of return exceeds the market rate of return as BWs beta exceeds the market beta (1.0).BWs Required Rate of ReturnMBA & PGDM-Advanced Capital BudgetingLisa Miller at BW is also attempting to determine the intrinsic value of the stock. She is using the constant growth model. Lisa estimates that the dividend next period will be Rs.0.50 and that BW will grow at a constant rate of 5.8%. The stock is currently selling for Rs.15.What is the intrinsic value of the stock? Is the stock over or underpriced?Determination of the Intrinsic Value of BWMBA & PGDM-Advanced Capital BudgetingThe stock is OVERVALUED as the market price (Rs.15) exceeds the intrinsic value (Rs.10).Determination of the Intrinsic Value of BWRs.0.5010.8% - 5.8%IntrinsicValue==Rs.10MBA & PGDM-Advanced Capital BudgetingSecurity Market LineSystematic Risk (Beta)RfRequired ReturnDirection ofMovementDirection ofMovementStock Y (Overpriced)Stock X (Underpriced)MBA & PGDM-Advanced Capital BudgetingSmall-firm EffectPrice / Earnings EffectJanuary EffectThese anomalies have presented serious challenges to the CAPM theory.Determination of the Required Rate of ReturnMBA & PGDM-Advanced Capital BudgetingRISK AND CAPITAL BUDGETINGRISK PERTAINS TO THE POSSIBILITY THAT THE PROJECTED CASH FLOWS WILL BE LESS THAN ESTIMATED.MBA & PGDM-Advanced Capital Budgeting

METHODS OF ACCOUNTING FOR RISK IN CAPITAL BUDGETING AREADJUSTING THE DISCOUNT RATE TO REFLECT A RISK PREMIUM.

CONVERTING THE PAYMENT SERIES TO CERTAINTY EQUIVALENTS.

PROBABILITY ANALYSIS.MBA & PGDM-Advanced Capital BudgetingADJUSTING THE DISCOUNT RATEDISCOUNT RATE COMPONENTS INCLUDE:

TIME PREFERENCEINFLATION EXPECTATIONSRISK PREMIUMMBA & PGDM-Advanced Capital BudgetingTHE RISK PREMIUM IS THE COST OF RISK BEARING.

INCREASING THE DISCOUNT RATE ADDS A COST FOR TAKING RISK BY REQUIRING A HIGHER RATE OF RETURN FOR RISK BEARING.MBA & PGDM-Advanced Capital BudgetingRisk adjusted discount rate = Risk free rate +Risk premium k=kf + kr

under CAPM, the risk premium is the difference between the market rate of return and the risk free rate multiplied by the beta of the project

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MBA & PGDM-Advanced Capital BudgetingChart20.00000109310.00000153720.00000214930.00000298790.00000412970.00000567490.00000775340.00001053210.00001422430.00001910030.00002549990.00003384770.00004466960.00005861180.00007646260.00009917540.00012789390.00016397840.00020903260.00026493060.00033384180.00041825370.00052098980.00064522160.00079447240.00097261020.00118382870.0014326130.00172368850.00206195170.00245238120.00289992770.00340938490.00398524030.00463150990.00535155820.00614790960.00702205540.00797426390.00900339990.0101067630.01127995230.01251676560.01380914170.01514715270.01651905140.01791137880.01930913260.02069599660.02205462830.02336699810.02461477260.02577973120.02684420250.02779150860.02860639960.02927546530.02978750850.03013386660.03030866960.03030867010.03013386660.02978750850.02927546530.02860639960.02779150860.02684420250.02577973120.02461477260.02336699810.02205462830.02069599660.01930913260.01791137880.01651905140.01514715270.01380914170.01251676560.01127995230.0101067630.00900339990.00797426390.00702205540.00614790960.00535155820.00463150990.00398524030.00340938490.00289992770.00245238120.00206195170.00172368850.0014326130.00118382870.00097261020.00079447240.00064522160.00052098980.00041825370.00033384180.00026493060.00020903260.00016397840.00012789390.00009917540.00007646260.00005861180.00004466960.00003384770.00002549990.00001910030.00001422430.00001053210.00000775340.00000567490.00000412970.00000298790.00000214930.00000153720

Normal Distribution

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Sheet1000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000

Normal DistributionReturnsLiklihood

Sheet2

Sheet3

Sheet4

Sheet5