Online classes : Capital Budgeting Analysis

The Overall Process

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Capital Expenditures

Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples includepurchase of new equipment, expansion of production facilities, buying another company, acquiring new technologies, launching a research & development program, etc., etc., etc. Capital expenditures often involve large cash outlays with major implications onfuture values of company. Additionally, once we commit to making a capital expenditure it is sometimes difficult to back-out. Therefore, we need to carefully analyze and evaluate proposed capital expenditures.

The Three Stages of Capital Budgeting Analysis

Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. We are trying to answer following question:

Will future benefits of this project be large enough to justifyinvestment given risk involved?

It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values infuture. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluating a project. We will include three stages within Capital Budgeting Analysis:

Decision Analysis for Knowledge Building
Option Pricing to Establish Position
Discounted Cash Flow (DCF) for makingInvestment Decision

KEY POINT - Do not force decisions to fit into Discounted Cash Flows! You need to go through a three-stage process: Decision Analysis, Option Pricing, and Discounted Cash Flow. This is one ofbiggest mistakes made in financial management.

Stage 1: Decision Analysis

Decision-making is increasingly more complex today because of uncertainty. Additionally, most capital projects will involve numerous variables and possible outcomes. For example, estimating cash flows associated with a project involves working capital requirements, project risk, tax considerations, expected rates of inflation, and disposal values. We have to understand existing markets to forecast project revenues, assess competitive impacts of project, and determine life cycle of project. If our capital project involves production, we have to understand operating costs, additional overheads, capacity utilization, and start-up costs. Consequently, we can not manage capital projects by simply looking at numbers; i.e. discounted cash flows. We must look atentire decision and assess all relevant variables and outcomes within an analytical hierarchy.

In financial management, we refer to this analytical hierarchy asMultiple Attribute Decision Model (MADM). Multiple attributes are involved in capital projects and each attribute indecision needs to be weighed differently. We will use an analytical hierarchy to structure decision and derive importance of attributes in relation to one another. We can think of MADM as a decision tree which breaks down a complex decision into component parts. This decision tree approach offers several advantages:

We systematically consider both financial and non-financial criteria.
Judgements and assumptions are included withindecision based on expected values.
We focus more of our attention on those parts of the decision that are important.
We include the opinions and ideas of others intodecision. Group or team decision making is usually much better than one person analyzing the decision.

Therefore, our first real step in capital budgeting is to obtain knowledge aboutproject and organize this knowledge into a decision tree. We can use software programs such as Expert Choice or Decision Pro to help us build a decision tree.

Simple Example of a Decision Tree:

Stage 2: Option Pricing

uncertainty about our project is first reduced by obtaining knowledge and working decision through a decision tree. second stage in this process is to consider all options or choices we have or should have forproject. Therefore, before we proceed to discounted cash flows we need to build a set of options into our project for managing unexpected changes.

In financial management, consideration of options within capital budgeting is called contingent claims analysis or option pricing. For example, suppose you have a choice between two boiler units for your factory. Boiler A uses oil and Boiler B can use either oil or natural gas. Based on traditional approaches to capital budgeting,least costs boiler was selected for purchase, namely Boiler A. However, if we consider option pricing Boiler B may be best choice because we have a choice or option on what fuel we can use. Suppose we expect rising oil prices innext five years. This will result in higher operating costs for Boiler A, but Boiler B can switch to a second fuel to better control operating costs. Consequently, we want to assessoptions of capital projects.

Options can take many forms; ability to delay, defer, postpone, alter, change, etc. These options give us more opportunities for creating value within capital projects. We need to think of capital projects as a bundle of options. Three common sources of options are:

1. Timing Options: ability to delay our investment inproject.
2. Abandonment Options: ability to abandon or get out of a project that has gone bad.
3. Growth Options: ability of a project to provide long-term growth despite negative values. For example, a new research program may appear negative, but it might lead to new product innovations and market growth. We need to considergrowth options of projects.

Option pricing isadditional value that we recognize within a project because it has flexibilities over similar projects. These flexibilities help us manage capital projects and therefore, failure to recognize option values can result in an under-valuation of a project.

Stage 3: Discounted Cash Flows

So we have completedfirst two stages of capital budgeting analysis: (1) Build and organize knowledge within a decision tree and (2) Recognize and build options within our capital projects. We can now make an investment decision based on Discounted Cash Flows or DCF.

Unlike accounting, financial management is concerned withvalues of assets today; i.e. present values. Since capital projects provide benefits intofuture and since we want to determine present value ofproject, we will discount future cash flows of a project to present.

Discounting refers to taking a future amount and finding its value today. Future values differ from present values because oftime value of money. Financial management recognizes time value of money because:

1. Inflation reduces values over time; i.e. $ 1,000 today will have less value five years from now due to rising prices (inflation).
2. Uncertainty in future; i.e. we think we will receive $ 1,000 five years from now, but a lot can happen overnext five years.
3. Opportunity Costs of money; $ 1,000 today is worth more to us than $ 1,000 five years from now because we can invest $ 1,000 today and earn a return.

Present values are calculated by referring to tables or we can use calculators and spreadsheets for discounting. discount rate we will use isopportunity costs of investment; i.e. rate of return we require on any other project with similar risks.

If we were to receivesame cash flows year after year into future, then we could use present value tables for an annuity.

We now understand discounting of cash flows (DCF) and three reasons why we discount future cash flows: Inflation, Uncertainty, and Opportunity Costs.

Calculating the Discounted Cash Flows of Projects

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In capital budgeting analysis we want to determineafter tax cash flows associated with capital projects. We are concerned with all relevant changes or differences to cash flows once we invest inproject.

Understanding "Relevancy"

One question that we must ask in capital budgeting is what is relevant. Here are some examples of what is relevant to project cash flows:

1. Depreciation: Capital assets are subject to depreciation and we need to account for depreciation twice in our calculations of cash flows. We deduct depreciation once to calculate taxes we pay on project revenues and we add back depreciation to arrive at cash flows because depreciation is a non-cash item.

2. Working Capital: Major investments may require increases to working capital. For example, new production facilities often require more inventories and higher salaries payable. Therefore, we need to considernet change in working capital associated with our project. Changes in net working capital will sometimes reverse themselves at end of project.

3. Overhead: Many capital projects can result in increases to allocated overheads, such as computer support services. However, subjective nature of overhead allocations may not make any difference at all. Therefore, you need to assessimpact of your capital project on overhead and determine if these costs are relevant.

4. Financing Costs: If we plan on financing a capital project, this will involve additional cash flows to investors. best way to account for financing costs is to include them within our discount rate. This eliminatespossibility of double-counting financing costs by deducting them in our cash flows and discounting at our cost of capital which also includes our financing costs.

We also need to ignore costs that are sunk; i.e. costs that will not change if we invest in project. For example, a new product line may require some preliminary marketing research. This research is done regardless ofproject and thus, it is sunk. concept of sunk costs and relevant costs applies to all types of financing decisions.

So far, we have covered present values and relevancy within capital budgeting. We now can proceed to calculate present value of relevant cash flows. Once we have determined present value of cash flows, we will have a basis for comparing our initial investment. Both values (future cash flows and initial investment) will be expressed in current values. net of these two amounts will tell us how much value we will create or destroy by investing in a project.

We will receive $ 5,788 of cash flow each year by investing in this new assembly machine. Since we have a salvage value, we have a terminal cash flow associated with this project.

Calculating the Present Value of Cash Flows

Our next step is to calculate present values of our two cash flow streams. We will use our cost of capital to discountcash flows. We will assume that our cost of capital is 12%. We will use present value tables in Exhibits 1 and 2 for findingappropriate discount factor per life of our cash streams and 12% cost of capital.

Calculating Net Investment

Now that we have current value of $ 22,709 for our cash flows, we need to compare this to our investment amount. Our investment istotal cash outlay we must make today and it includes:

All cash paid out to invest in the project and place it into service, such as installation, transportation, etc.
Net proceeds fromdisposal of any old equipment that will be replaced by the new equipment.
Any taxes paid and/or tax benefits received from making investment.

So we now have a current value for our cash flows of $ 22,709 and a total net investment of $ 24,100. These amounts are derived by looking at three different types of cash flows:

1. Relevant cash flows during life ofproject.
2. Terminal cash flows at end of project.
3. Initial cash flows (net investment).

Asset Management Ratios

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We have completed our three main stages of capital budgeting analysis, including calculation of discounted cash flows. next step is to apply some economic criteria for evaluatingproject. We will use three criteria: Net Present Value, Modified Internal Rate of Return, and Discounted Payback Period.

Net Present Value

first criterion we will use to evaluate capital projects is Net Present Value. Net Present Value (NPV) istotal net present value of project. It represents total value added or subtracted fromorganization if we invest in this project. We can refer back to our previous example and calculate Net Present Value.

IfNet Present Value is positive, we should proceed and make investment. If Net Present Value is negative (as iscase in Example 10), then we would not make investment.

Modified Internal Rate of Return

Besides determiningNet Present Value of a project, we can calculate rate of return earned by project. This is calledInternal Rate of Return. Internal Rate of Return (IRR) is one ofmost popular economic criteria for evaluating capital projects since managers can identify with rates of return. Internal Rate of Return is calculating by finding discount rate wherebyNet Investment amount equals total present value of all cash inflows; i.e. Net Present Value = 0. If we have equal cash inflows each year, we can solve for IRR easily.

IfInternal Rate of Return were higher than our cost of capital, then we would accept this project. In our example, IRR (6.43%) is less than our cost of capital (12%). Therefore, we would not invest in this project. One ofproblems with IRR is so-called reinvestment rate assumption. IRR makesassumption that every year you will be able to earn IRR each time you reinvest your cash inflows. This assumption can result in some major distortions between Net Present Value and Internal Rate of Return. We will correct this distortion by modifying our IRR calculation.

In order to eliminate reinvestment rate assumption, we will modify Internal Rate of Return so thatreinvestment rate is our cost of capital. This will give us a more accurate IRR for our project. Fortunately, we can use spreadsheets like Microsoft Excel to calculate Modified Internal Rate of Return.

Discounted Payback Period

final economic criteria we will use is Discounted Payback Period. Payback refers to number of years it takes to recover our net investment. In our previous example (Example 6), we could use a simple payback calculation as follows:

$ 24,100 / $ 5,788 = 4.2 years

However, this method does not recognizetime value of money and as we previously indicated, we must considertime value of money because of inflation, uncertainty, and opportunity costs. Therefore, we will use discounted cash flows to calculatepayback period (discounted payback period).

UnderDiscounted Payback Period, we would never receive a payback on our project; i.e. total to date present cash flows never reached $ 24,100 (net investment). If we had relied on regular payback calculation, we would falsely assume that this project does payback infourth year.

In summary, we use economic criteria that have realistic economic assumptions about capital investments. Three economic criteria that meet this test are:

Net Present Value
Modified Internal Rate of Return
Discounted Payback Period

Profitability Ratios

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Whenever we analyze a capital project, we must consider unique factors. A discussion of all of these factors is beyond scope of this course. However, three common factors to consider are:

Compensating for different levels of risks between projects.
Recognizing risks that are specific to foreign projects.
Making adjustments to capital budgeting analysis by looking atactual results.

Adjusting for Risk

We previously learned that we can manage uncertainty by initiating decision analysis and building options into our projects. We now want to turn our attention to managing risks. It is worth noting that uncertainty and risk are notsame thing. Uncertainty is where you have no basis for a decision. Risk is where you do have a basis for a decision, but you have possibility of several outcomes. wider variation of outcomes, higher risk.

In our previous example (Example 6), we used cost of capital for discounting cash flows. Our example involvedreplacement of equipment and carried a low level of risk since expected outcome was reasonably certain. Suppose we have a project involving a new product line. Would we still use our cost of capital to discount these cash flows? answer is no since this project could have a much wider variation in outcomes. We can adjust for higher levels of risk by increasingdiscount rate. A higher discount rate reflects a higher rate of return that we require whenever we have higher levels of risk.

Another way to adjust for risk is to understandimpact of risk on outcomes. Sensitivity Analysis and Simulation can be used to measure how changes to a project affect outcome. Sensitivity analysis is used to determinechange in Net Present Value given a change in a specific variable, such as estimated project revenues. Simulation allows us to simulate results of a project for a given distribution of variables. Both sensitivity analysis and simulation require a definition of all relevant variables associated withproject. It should be noted that sensitivity analysis is much easier to implement since sophisticated computer models are usually required for simulation.

International Projects

Capital investments in other countries can involve additional risks. Whenever we invest in a foreign project, we want to focus onvalues that are added (or subtracted) to Parent Company. This makes us consider all relevant risks ofproject, such as exchange rate risk, political risk, hyper-inflation, etc. For example, discounted cash flows of project are discounted cash flows of project toforeign subsidiary converted to currency of home country of Parent Company atcurrent exchange rate. This forces us to take into account exchange rate risks and its impact toParent Company.

Post Analysis

One of most important steps in capital budgeting analysis is to follow-up and compare your estimates to actual results. This post analysis or review can help identify bias and errors withinoverall process. A formal tracking system of capital projects also keeps everyone honest. For example, if you were to announce to everyone that actual results will be tracked during life of project, you may find that people who submit estimates will be more careful. purpose of post analysis and tracking is to collect information that will lead to improvements withincapital budgeting process.

Course Summary

long-term investments we make today determinesvalue we will have tomorrow. Therefore, capital budgeting analysis is critical to creating value within financial management. Andonly certainty within capital budgeting is uncertainty. Therefore, one of biggest challenges in capital budgeting is to manage uncertainty. We deal with uncertainty through a three-stage process:

1. Build knowledge through decision analysis.
2. Recognize and encourage options within projects.
3. Invest based on economic criteria that have realistic economic assumptions.

Once we have completedthree-stage process (as outlined above), we evaluate capital projects using a mix of economic criteria that adheres toprinciples of financial management. Three good economic criteria are Net Present Value, Modified Internal Rate of Return, and Discounted Payback.

Additionally, we need to manage project risk differently than we would manage uncertainty. We have several tools to help us manage risks, such as increasingdiscount rate. Finally, we want to implement post analysis and tracking of projects after we have madeinvestment. This helps eliminate bias and errors incapital budgeting process.