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Capital Budgeting
Economic concepts and finance
decision-making toolsBUS 219
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Building Blocks of Knowledge
Time value of money adollar in the future is worthless than a dollar in handnow
Net present value1. NPV = PV of cash flow
benefits Investment cost
2. Accept project if NPV > $0
Financial Statements
Cash is king
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What is this slide show about?
Ingtegrates topicsfrom several
chapters ofCorporate Finance
NPV
Discounted cash-
flow analysis Project analysis
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Capital Budgeting
Investment decisions involving capitalassets (tangible property, including
durable goods, equipment, buildings,installations, land)
Capital refers to the fixed assets of an
organization (factories, hospitals,schools, and their major equipment fitinto this category),
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Capital Budgeting (more)
A budget is a plan which explains theprojected cash flows during some future
period.A capital budget is therefore an outline of
planed expenditures on fixed assets, andcapital budgeting is the whole process of
analyzing projects and deciding whetherthey should be included in the capitalbudget
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Capital Budgeting - Public Sector
Capital budgeting is done in the public sectortoo, although it is not always referred to as
such. Economic analysisand investment analysis
are synonymous terms that one my hear.
Benefit-cost analysisand cost-effectivenessanalysis play an important role in the processof capital budgeting
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Capital budgeting decisions
are among the most
important ones made bymanagers and executives.
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Importance
Results of investments in schools andhospitals continue for many years.
Once these decisions are made, theorganization loses some of its flexibility.
Once a major piece of equipment is
purchased, the organization is lockedin to using it for the long term.
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Importance (more)
Errors in the forecast need for big ticketassets can have serious consequences(LILCO-Shoreham)
Imagine an office or hospital being built, or aschool established, and then there is notenough demand to utilize the services.
Conversely, what happens if not enough isspent. Inadequate capacity in a business,hospital or school can have disastrousresults.
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Importance (even more)
Timing is anotther reason that good capitalbudgeting is so essential.
Essential assets need to be ready to come on-line when needed. Early arrivals cause extraexpenses that will strain resources.
Funding of such major projects involves verysubstantial expenditures. Large amounts of
money are not available instantaneously in anyorganization, be it a large corporation, school
district or the federal government.
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Capital budgeting has become more
effective, and more fun, during the past
decade Used to be math and manpower intensive,
because the underlying theory needs a lot ofcalculations
Nowadays, most modern organizations areable to use computers to transform data toinformation
Capital budgeting used to take man years ofwork, mostly in manual calculations. Nowcapital budgeting is done in hours withspreadsheets
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What was once a budgetexercise becomes an
analysis of policy (PeterDrucker)
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Steps in the Capital Budgeting
Process1. Determine the economic life of the
project or alternatives you are
considering.2. Estimate theirIncremental Cash Flows
3. Determine the discount rate.
4. Calculate Net Present Value5. Apply the appropriate criterion to arrive
at an initial preference
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More Steps in the Capital
Budgeting Process6. Do Sensitivity & Scenario Analysis
7. Interpret the results of the basic analysis
and the sensitivity/scenario analysis, andmake a decision.
8. If you decide to aquire the use of anasset, evaluate: lease versus buy
9. Check to make sure you can afford yourdecision by putting it in the organizationsbudget.
10. Implement & Verify your decision.
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Capital Budgeting Decision
making Concepts you must
understand to be able toparticipate: incremental cash flows
the time value of moneyand sensitivity analysis
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Incremental Cash Flows
Two RulesAnnual cash flow, and not accounting
profits or costs, are to be used.
Depreciationand the need forWorkingCapitalare causes of major differencesbetween profits and cash flow
Only Incremental cash flowsare relevant
for evaluating investment projects. Onlythose cash flows that would result directlyfrom a decision to accept a project areconsidered
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Working Capital
The payroll needs to be paid beforerevenues from the days work are
received Working capital is the cash you need to
pay expenses before the benefits are
realized
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Taxes and Depreciation
Taxes are a fact of life, and need to beconsidered in all financial decisions
Depreciation is an expense that is not anegative cash flow; to the contrarydepreciation results in a tax shield (a
positive cash flow) that offsets taxes tosome extent
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Incremental Cash Flows Example a firm considering the establishment of a
branch office in a newly developing section ofa city
Incremental cash flowswill consist of thecosts of investment and operating the newoffice, costs that it would not have beenincurred unless the project was undertaken.It will also include the revenues derived fromthe business, benefits that would not havebeen realized otherwise.
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Sunk Costs
Sunk costsare cash outlays that havealready been incurred and cannot be
recovered regardless of any present orfuture decision.
Sunk costsare not incremental costs
and should not be included in capitalbudgeting analysis.
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Sunk CostExample
The firm and its branch office decision.
Suppose it hired a consulting firm two
years ago to do a site analysis. The$75,000 they paid is irrelevant, a sunkcost, because it cannot be recovered no
matter whether or not they decide tobuild their new branch office.
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Easier said than done
It may be psychologically impossible forpolicy makers to ignore sunk costsfor
future decisions, even though it isaccepted practice in higher circles. Thereis a natural tendency to continue with acourse of action, unable to see that it was
incorrect, even when there is evidence toshow the project is doomed to fail. Theterm used for this behavioral process isescalation of commitment
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Opportunity costs
Consider the firm with the branch officedecision.
Suppose they own land upon which thebranch could be built.
Should they ignore the cost of the landbecause they will not have a cash outlay to
acquire it? No, because if they dont use the land they
could sell it, for let us say $100,000.
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An opportunity costis a benefit
lost Opportunity cost is the maximum worth
of an asset among possible alternative
uses Opportunity costis thus a cash flow that
could be generated from assets the
organization already owns providedthey are not used for the project inquestion
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Externalities
Externalityis an economic term, whichcomes from the idea that we should
account for the direct effects, whetherpositive or negative, on someones
welfare that arise as a by-product of
some other persons or firms activity Synonyms are neighborhood,
interactive or spillover effects
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Externalities (more)
Consider the firms present customers who
might use the new branch office. Business
they do at the branch will reduce business atthe main office. That effect needs to beaccounted for in the analysis.
Branch office incremental revenues should be
reduced by the amount of decreasedrevenues at the main office, say $25,000/yr.
S E i C
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Summary - Economic Concepts
for use in discounted cash flow
analysis Do use
Incremental Cash inflowsand outflows
External benefits/costs
Opportunity costs Do not include
Accounting profits
Sunk costs
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Time Value of Money
What do you do with future incrementalcash flows of a project?
Calculate their Net Present Value! Start with displaying them on a time line
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Example
Firm invests $500,000 in a new branch nextyear, estimates it would return a net* of$100,000 ($500,000 in revenues offset by
$400,000 in expenses) annually beginning ayear latter. Sunk costs are not included.$100 opportunity cost is added to the initialinvestment for a first year total cost of $600,
000. $25,000/yr. external cost of the reducedrevenues at the home office should beaccounted for.
*i.e. the effects of taxes and depreciation are included
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Time Line: Incremental Cash Flows for the New Branch Office Project
Year 0 1 2 3 4 5 6 7 8 9
Cash Flow ($600k) 75k 75k 75k 75k 75k 75k 75k 75k 75k
Underlying Data & Calculations for the New Branch Office Project
Investment $500k
Opportunity Cost 100k
External Cost 25k 25k 25k 25k 25k 25k 25k 25k 25k
Operations Cost* 400k 400k 400k 400k 400l 400k 400k 400k 400k
Revenues 500k 500k 500k 500k 500k 500k 500k 500k 500k
Net Cash In (out) (600k) 75k 75k 75k 75k 75k 75k 75k 75k 75k
*Includes effects of taxes and depreciation
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The dilemma facing the firm
Do you invest something now with a promiseof a return in the future? Its not a simplecase of foregoing $600,000 and recovering
$650,000($75,000 x 9) over the next 9 years.Dollars received in the future cannot beequated to dollars spent in the near term.Money in hand has more value than a like
amount of money in the future because of theopportunity it represents. The challenge ishow to account for this time value of money.
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Calculating the Projects NPV
Determine the discount rate
Calculate the present value of each
years cash flow Sum PV of future cash flows, then
subtract the investment to get NPV
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Discount rates are estimates of an
organizations cost of capital
If you as an individual were going toinvest in a project, the alternative use of
your money would be the clue to yourcost of capital.
A firms cost of capital depends on
where it would get the cash to fund theproject.
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Firms cost of capital
If it borrowed it, the cost of capital wouldbe the after tax interest rate it pays on a
loan or the bonds it issues. If the business sold more stock to raise
the money, the cost of capital would bethe rate of return the stockholders
expect to get.
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Cost of capital
If the project is funded with cash from thebusinesss accounts, then the cost of capital
would be the estimated rate of return onalternative investments.
Often, businesses get money from all threesources. When this is the case, they
estimate their cost of capital by a weightedaverage calculation. (Chapter 12)
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Riskier Projects > Higher
Discount Rate Weighted average
cost of capital is a
good discount ratefor average riskprojects
Higher risk projects
should use a higherthan average cost ofcapital
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NPV of the Firms Project
Year 0 1 2 3 4 5 6 7 8 9
Net
Cash
Flow
$
(600)
K
75 75 75 75 75 75 75 75 75
PVFactor
7%
1.000 .935 .873 .816 .763 .713 .666 .623 .582 .544
PV
@7%
$
(600)
70 66 61 57 53 50 47 44 41
NPV $
(111)
K
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Calculating NPV
Can use the Formula
Tables (as done on the previous slide)
Calculator
Spreadsheets make it really easy
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Making an Initial Decision
Follow a criterion, or decision rule.Whichrule to followdepends upon the
circumstances. If you are in businessand yourobjective is to turn a profitandincrease shareholders wealth, the rule
is simple: you accept any project thathas a positive net present value
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Special Rule
If projects are mutually exclusive, thenyou choose among them by picking the
one with the highest positive net presentvalue
Mutually exclusive projects are ones
that would not be chosen together, likebuilding a bridge and buying ferry boatsto traverse the same route.
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Sensitivity Analysis
Nothing is certain in the future. Sincethat is where the consequences of
capital budgeting decisions occur, wemust challenge the assumptionsunderlying our calculations.
We know estimates are wrong. Its amatter of how wrong they have to be tocause us to make a bad decision.
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Definition
Sensitivity analysisin general refers to arepetition of analysis using different
values for uncertain factors. If a reasonable change in an assumed
value results in a change in preference
among choices, then the decision issaid to be sensitive to that assumptionor that variable
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How to do what if
In capital budgeting, sensitivity analysismeasures the effect of changes to aparticular variable, say annual operatingcost, on a projects present value
All variables are fixed at their expectedvalues, except one. That one variable is
then changed, often by specifiedpercentages, and the resulting effect onpresent value is noted
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Sensitivity Analysis Routine
Spreadsheets and contemporary PCtechnology make the performance of
sensitivity analysis a piece of cake.Excel is ideally suited for sensitivityanalysis. Once a model is created, it is
very easy to change the values ofvariables and obtain new results.
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Usefulness
Identify those variables which potentiallyhave the greatest impact on success orfailure
Helps policy makers focus attention onthese variables that are probably mostimportant.
The sources of the estimates of thesevariables should be further scrutinized,and alternative sources sought.
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Sensitivity Analysis
Above all else, it serves as a riskassessment tool
If a reasonable change in an estimatecauses the outcome to go from asuccess to a failure, then the decision is
risky
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How To Handle Uncertainty
Sensitivity Analysis - Analysis of the effects ofchanges in single variables (sales, costs, etc.)on a project.
Scenario Analysis - Project analysis given aparticular combination of assumptions.
Worst Case Scenario
Best Case Scenario Most Likely Scenario
Summary
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Summary
Capital budget decisions are among themost important ones a firm can make
Steps. For each project:1. Estimate economic life
2. Estimate Incremental Cash Flows
3. Determine the discount rate
4. Calculate Net Present Value5. Order preference ofallprojects based on NPV
6. Do Sensitivity & scenario analysis
7. Interpret the results of the basic analysis and thesensitivity/scenario analysis, and make a decision.
8. Decide: lease or buy
9. Plan to implement what you can afford
10. Follow up, verify and adjust
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Capital Budget Decision Process
Discountedcash-flowanalysis
NPVInitial
Choice
Criterion
StartSensitivity &
ScenarioAnalys is
End:decision
AccountingProjections(Income
Statement)
DetermineRelevant
IncrementalCash Flow s
DetermineDiscount Rate
Cost ofCapital
Do theProject?
Lease orbuy
assessts?
yes
no