Capital Budgeting and Project Valuation

Chapter 2

Overview
Different Investment criteria
Payback period NPV IRR

Project Valuation. Determining relevant Cash Flow Additional factors (options)

Capital budgeting methods used by companies

Graham-Harvey, page 197;
IRR: 75.7% (Hurdle rate 56.94%) NPV: 74.9% Payback: 56.74% Sensitivity analysis: 51.54% Real options: 26.59%

The difference between independent and mutually exclusive projects

Projects are:
Independent, if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

Normal and Abnormal Cash Flows

Normal cash flow project:
One change of signs
For example, cost (negative CF) followed by a series of positive cash inflows

Abnormal Cash Flow project:

Two or more changes of signs
Most common: Cost (negative CF), then string of positive CFs, then cost to close project Nuclear power plant, strip mine.
5

Inflow (+) or Outflow (-) in Year n 0 + 1 + + + + 2 + + + + 3 + + + 4 + + + + 5 + + N N NN

6

N N

NN NN

What is the payback period?

The number of years required to recover a projects cost, or How long does it take to get our money back?

Payback for Project L (Long: large CFs in later years)

0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 30/80 2 60 -30

2.375 3
80 50

= 2.375 years

Project S (Short: CFs come quickly)

0 CFt -100

1 70 -30

1.6 2
50 0 20

3 20 40

Cumulative -100 PaybackL

= 1 + 30/50 = 1.6 years

The payback rule

Accept the projects with the payback period shorter than a predetermined time Strengths:
Provides an indication of a projects risk and liquidity Easy to calculate and understand

Weaknesses:
Ignores the TVM Ignores CFs occurring after the payback period
10

Discounted Payback: Uses discounted rather than raw CFs

0 10% 1 2 2.7 3 CFt PVCFt -100 -100 10 9.09 -90.91 60 49.59 80 60.11

Cumulative -100 Discounted = 2 payback

-41.32 0 18.79

+ 41.32/60.11 = 2.7 years

Recover invest. + cap. costs in 2.7 years.

11

NPV Method

CFt NPV = t . t =0 (1 + k )
n

Definition: NPV is the sum of the PVs of all project cash flows The logic of NPV:
NPV = PV inflows Cost = Net gain in wealth

Accept project if NPV > 0 Choose between mutually exclusive projects on basis of higher NPV, because this project adds most value
12

Whats Project Ls NPV?

Project L: 0 -100.00 9.09 49.59 60.11 18.79 = NPVL NPVS = $19.98.
13

10%

1 10

2 60

3 80

Using NPV method, which project(s) should be accepted?

If S and L are independent, accept both; NPV > 0 If Projects S and L are mutually exclusive, accept S because NPVS > NPVL

14

Steps for NPV valuation

Estimate CFs (inflows & outflows) Assess riskiness of CFs Determine k = WACC (adj.)
WACC: Weighted Average Cost of Capital

Find NPV and/or IRR

15

Internal Rate of Return: IRR IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0
0 CF0 Cost 1 CF1 2 CF2 Inflows 3 CF3

16

Rationale for the IRR Method

If IRR > WACC = k, then the projects rate of return is greater than its cost - some return is left over to boost stockholders returns IRR Acceptance Criteria
If IRR > k, accept project If IRR < k, reject project Example: WACC = 10%, IRR = 15% Profitable
17

What is Project Ls IRR?

0
IRR = ?

1 10

2 60

3 80

-100.00 PV1 PV2 PV3 0 = NPV

10 60 80 100 + + + =0 2 3 1 + IRR (1 + IRR ) (1 + IRR )

IRRL = 18.13%. IRRS = 23.56%.

18

Decisions on Projects S and L using IRR

If S and L are independent, accept both IRRS > k = 10%, IRRL > k = 10% If S and L are mutually exclusive, accept S because IRRS > IRRL

19

Comparing NPV and IRR rules NPV: Enter k, solve for NPV
CFt t = NPV . t =0 (1 + k )
n

IRR: Enter NPV = 0, solve for IRR

CFt t = 0. t = 0 (1 + IRR )
n
20

Comparing NPV and IRR rules NPV and IRR always lead to the same accept/reject decision for independent projects with normal cash flows:
NPV ($) IRR > k and NPV > 0 Accept. k > IRR and NPV < 0. Reject.

IRR

k (%)
21

Potential problems with IRR

Hard to evaluate projects with alternating cash flows. Which IRR to choose? Ranking problems: Project with highest IRR is not always the best Ergo, IRR might lead to a wrong choice from mutually exclusive projects

22

Why the project with highest IRR is not always the best:
Abnormal cash flows Different risks for different projects
Impossible to compare a risky project (IRR =15%; k=12%) with a safe project (IRR = 12%; k = 10%)

Size (scale) differences

Smaller project frees up funds at t = 0 for investment. The higher k, the more valuable these funds, so high k favors small projects

Timing differences
Project with faster payback provides more CF for early reinvestment. Implicit reinvestment rate assumption
23

NPV ($)
60 50

. 40 .
30 20 10 0 -10 5

Crossover Point = 8.7%

.
L
10

k 0 5 10 15 20

NPVL 50 33 19 7 (4)

NPVS 40 29 20 12 5

.
15

.
20

IRRS = 23.6%

.
23.6

Discount Rate (%)

IRRL = 18.1%
24

Mutually Exclusive Projects

NPV
L

k < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT k > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT

S k 8.7 k

IRRS

IRRL

%
25

Reinvestment Rate Assumptions

NPV assumes reinvest at k (opportunity cost of capital) IRR assumes reinvest at IRR Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects

26

Modified IRR (MIRR)

Managers like IRR (easier to compare rates than NPVs). Can we give them a better IRR rule? Modified IRR (MIRR) rule works correctly with projects that have alternating CFs or different time horizon MIRR is the discount rate that causes the PV of a projects terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC to the final date of the longest project Thus, MIRR assumes cash inflows are reinvested at WACC

27

How to use MIRR

Identify the longest project. Its horizon, T, will be used to calculate the terminal value (TV) for all projects in question Calculate each projects TV as a sum of FVs of all CFs (except the original investment, I) compounded at WACC to the final date of the longest project Find each projects MIRR as
TV MIRR = I
1 T

1
28

MIRR for Project L (k = 10%)

0 -100.0
10%

1 10.0
10%

2 60.0
10%

3 80.0 66.0 12.1 158.1 TV inflows

MIRR = 16.5%

-100.0 PV outflows

$158.1 $100 = (1 + MIRRL)3 MIRRL = 16.5%

29

Why use MIRR versus IRR?

MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs Managers like rate of return comparisons, and MIRR is better for this than IRR

30

Why is NPV better than MIRR?

Allows to compare the projects of different risk (different WACC) Allows to compare the projects of different scale In MIRR we implicitly use NPV concept! Problem with NPV?
Sensitive to WACC
31

Steps for NPV valuation

1 2

Draw the time line define the forecast horizon Identify all relevant free cash flows over the forecast horizon (next slide)
(FCF here = operating CF + investment CF)

3 4 5

For each cash flow item write the relevant time period and discount factor Calculate PV of this cash item; repeat 3 and 4 Calculate NPV by adding all PVs together
32

Identify all relevant FCFs over the forecast horizon

Recover FCF from accounting data
Estimate cash flow on an incremental basis Disregard sunk costs Treat depreciation properly

Adjust for changes in working capital requirements

33

Fundamental Principles of Project Evaluation

Relevant cash flows - the incremental cash flows associated with the decision to invest in a project The incremental cash flows for project evaluation consist of any and all changes in the firms future cash flows that are a direct consequence of taking the project Stand-alone principle - evaluation of a project based on the projects incremental cash flows

34

Incremental Cash Flows

When is a cash flow incremental?

Sunk costs? Opportunity costs? Side effects? Net working capital? Financing costs? Other issues?

35

Special issues:

Treat inflation consistently Ignore financing costs (interest) in calculating cash flows Dont forget about depreciation tax shield Use Equivalent Annual Cost (EAC) method to compare projects with different lengths

36

Free Cash Flow

FCF = NOPAT(All equity) + Depreciation NWC - CapEx

Alternatively

FCF = EBITDA x (1-tax rate) + Depreciation x tax rate - NWC - CapEx

37

Example - Thorelle exercise

Sales Cost of goods sold Labour costs Other operating expenses Gross operating surplus Depreciation Operating income Net working capital Investments 1998 600 200 1999 1500 450 350 20 680 200 480 2000 1575 473 364 20 719 150 569 2001 1654 496 379 20 759 100 659 2002 1736 521 394 20 802 50 752

2003 1823 547 409 20 847 50 797 2003 766 50

1999 630 150

2000 662 100

2001 695 50

2002 729 50

You estimate that at the end of 2003 the lab will be sold at 4,000 WACC = 10%; Tax rate = 40% Which cash flows should you take into account in order to value your investment? At what price would you buy this laboratory? At this price, what is the IRR?
38

Example - Thorelle exercise

Thorelle Exercise 1998 Gross operating margin - Taxes - Investment - Change in NWC* Depreciation tax shield Sale of asset Cash Flow PV (10 %) NPV 1999 680 -272 -150 -30 80 2003 847 -338.8 -50 729 20 4000 308 359.4 412.4 417.2 5207.2 280 297.024793 309.842224 284.953214 3233.26151 3605.08174 359.4 412.4 417.2 5207.2 2000 719 -287.6 -100 -32 60 2001 759 -303.6 -50 -33 40 2002 802 -320.8 -50 -34 20

-200 -600

-800 -800

IRR=

-4405.08174 10%

308

Assume that all NWC is recovered at the end of 2003

39

Equivalent Annual Cost Method (EAC)

Helpful to compare repeated projects with different lengths Principle: PV(full cost)=PV(equivalent annual cost or rent) Example: Choose between machines A and B with the same production capacity
A has economic life of 3 years, costs 4,500 and requires 2,200 annually for maintenance; B has economic life of 5 years, costs 10,000 and requires 1,200 annually for maintenance assume r=10%

40

Equivalent Annual Cost Method (EAC)

We can solve it by calculating EAC or rent cost (R) for each machine
1. We calculate the PV of each machine 2. We find annual rents such that PV(R)=PV( machine) 3. We compare R(A) and R(B)

41

Machine A 4,500 2,200 2,200 2,200 PV(A)=4,500+2,200A(3years; 10%)=9,971.4 PV(A)=A(3years; 10%) R(A); Machine B 10,000 1,200 R(A)=9,971.4/2.487=4,009.41 1,200 1,200 1,200 1,200

PV(B)=10,000+1,200A(5 years; 10%)=14,549.2 PV(B)=A(5 years; 10%) R(A); R(B)= 14,549.2 /3.791=3,837.83 R(A)>R(B) !
42

The basic problem: How reliable is our NPV estimate?

Projected vs. Actual cash flows Estimated cash flows are average of possible outcomes each period The possibility of a bad decision due to errors in cash flow projections What If analysis
Scenario analysis Sensitivity analysis
43

What-If Analyses:
Base case estimation Scenario analysis
Posit best- and worst-case scenarios and calculate NPVs

Sensitivity analysis
How does the estimated NPV change when one of the input variables changes?

Simulation analysis
Vary several input variables simultaneously, then construct a distribution of possible NPV estimates
44

MeasureX Balance Sheet

Thousands of dollars Assets Cash Others Accounts Receivable Inventories Net Fixed Assets Total Assets Liabilities & Equity Accounts Payable Accrued Taxes Short-term liabilities Long-term Bank debt Equity (a) Reserves Total Equity Total Liabilities Number of shares in 000 1996 2,790 80 6,930 2,590 4,400 16,790 1,590 90 980 5,910 8,040 180 8,220 16,790 5,760 % Sales 1997 3,030 130 9,600 5,220 6,780 24,760 3,000 560 1,480 10,720 8,170 830 9,000 24,760 5,825 % Sales 1998 % Sales 3,470 240 18,550 6,170 10,820 39,250 2,850 3,830 2,000 17,246 8,240 5,084 13,324 39,250 5,950
45

19% 7%

17% 9%

0.2% 17.4% 5.8%

4%

5%

2.7% 3.6% 1.9%

MeasureX Income Statement

Thousands of dollars Sales Cost of Goods Sold Gross Margin R&D Other EBITDA Depreciation EBIT (Operating Income) Financial Expenses Exceptional items Earnings Before Taxes Taxes *
Net Income

1996 36,160 22,970 13,190 4,220 7.820 1.150 620 530 300 -150 80 30

1997

1998 106,370 61,695 44,675 10.770 24.250 9.655 1.570 8.085 1.280 - 360 6.445 2.191

36.5% 11.7% 21.6% 3.2% 1.5% 0.8% 38% 0.1%

50

55,440 36,260 19,180 34.6% 5,290 9.5% 11.190 20.2% 2.700 4.9% 1.050 1.650 3.0% 530 1.0% -120 1.000 350 35%
650

42.0% 10.1% 22.8% 9.1% 7.6% 1.2% 34%

1.2%

4.254

4.0%

46

MeasureX Project 1
What is Project 1 relevant Cash Flow?
Investment? EBITDA? Depreciation? Changes in the NWC?

What is the relevant range for the cost of capital?

47

MeasureX Project 1
Pro je c t 1: Ne w pro duc t 1998 10,000 1999 2,000 1998 S a le s Gros s ma rgin S ta rt-up e xpe ns e s Re s e a rch & Admin EBITDA NWC Ope ra ting CF Inve s tme nt Flow be f. Ta xe s Ta x on EBIT P roje ct flows IRR 42% 15% 22% 10,000 -10,000 -10,000 20.571% NP V 3,908.83 1,838.61 169.44 0.17 - 1 192 1999 20,000 8,400 500 3,000 4,900 4,400 500 500 986 -486 2000 2,000 2000 25,000 10,500 3,750 6,750 1,100 5,650 5,650 1,615 4,035 2001 2,000 2001 25,000 10,500 3,750 6,750 0 6,750 6,750 1,615 5,135 2002 2,000 2002 16,000 6,720 2,400 4,320 -1,980 6,300 6,300 789 5,511 2003 2,000 2003 8,000 3,360 2004 0 0 2004 Inve s tme nt De pre cia tion

1,200 0 2,160 0 -1,760 -1,760 3,920 1,760 3,920 54 3,866 1,760 0 1,760

34%

WACC 10% 15% 20% 20.57% 25%

48

MeasureX Project2
Finished goods - one third of the inventory Increase in NWC is 22% of incremental sales What are the gains from going from the current level to A? What are the additional costs from going from the current level to A?

49

MeasureX Project 2
Proje ct 2: Inve ntory Inventory Inventory Mis s ed holding cos ts Level S ales 3,110 7,500 340 5,000 5,200 420 7,000 3,200 500 9,000 1,500 600 11,000 560 700 13,000 170 740 Total - Inventory NWC (inves t) 15% Inves tt A B C D E 1+WACC -1,890 -2,000 -2,000 -2,000 -2,000 121% 339 295 251 139 57 -2,229 -2,295 -2,251 -2,139 -2,057 S ales Inventory Level as a % of S ales 2.9% 4.7% 6.6% 8.5% 10.3% 12.2%

Curre nt A B C D E

O ther than inventory

2,300 2,000 1,700 940 390

Gros s margin Inventory margin holding cos ts -Taxes 42% cos ts = NOPAT 966 80 585 840 80 502 714 100 405 395 100 195 164 40 82

IRR 26.2% 21.9% 18.0% 9.1% 4.0%

NP V 5yrs NPV 10yrs

21% 373 87 -170 -725 -1009

21% 519 122 -237 -1009 -1405

P erpetuity 21% 614 144 -281 -1193 -1660

50

Managerial Options and Capital Budgeting

Generally, the exclusion of managerial options from the analysis causes us to underestimate the true NPV of a project. Why?

Options and capital budgeting

Contingency planning
1.The option to expand 2.The option to abandon 3.The option to wait

Strategic options
Toehold investments Research and development

51

Option to expand

Telecom 3 G license
Market : 50% small (0-10 min, average 5 mln), 50% big (10-50 mln, average 30 mln) in 4 years Investment: 1.5 bln Euro (capacity 10 mln) 5 bln Euro (capacity 50 mln) scalable: 2 bln (10 mln) + 4 bln in year 4 (50 mln) Variable cost margin 100 euro per customer No taxes. 25 % cost of capital. A4 years; 25%=2.362

License fee to pay?

52

Option to expand
Small investment (cant serve more than 100 mln customers) Naive approach:
Perpetuity of 500 M Euro with investment of 1.5

0 .5 1 .5 = 0 .5 . 25

Taking into account big market:

Average 500 M Euro for years 1-4 In years 5 - + 500 M Euro with probability 1/2 + 1 bln Euro with probability 1/2
4

0 . 5 A4 ; 25 %

1 + 1 . 25

0 . 75 . 25

1 . 5 = 0 . 91
53

Option to expand
Big investment
- Investment of 5 bln Euro in year 0 Average + 500 M for years 1-4 In years 5 - + 500 M Euro with probability 1/2 + 3 bln Euro with probability 1/2

1 5 + 0.5 A4; 25% + 1.25

5 +

1.75 = 0.25

1 . 75 1 . 25 A 4 ; 25 % = 2 2 . 95 = 0 . 95 . 25
54

Option to expand
Scaleable investment
Nave approach
- Investment of 2 bln Euro in year 0 - Investment of 4 bln Euro in year 4 Average + 500 M for years 1-4 In years 5 - + 500 M Euro with probability 1/2 + 3 bln Euro with probability 1/2

4 1 2 + 0.5 A4; 25% + 1.25 (1.25)4 = 2 1.64 + 4.05 = 0.41

1.75 0.25
55

Option to expand
Scaleable investment More complicated approach
- Investment of 2 bln Euro in year 0 - Investment of 4 bln Euro in year 4 ONLY IF THE MARKET IS BIG Average + 500 M for years 1-4 In years 5 - + 500 M Euro with probability 1/2 + 3 bln Euro with probability 1/2

2 + 0.5(2.36) +

= 2 + 1.18 + 0.205(2 + 8) = 1.23

1 1 0.5 3 + 4 4 2 (1.25) 0.25 0.25

56

Option to wait

Oil drilling project

Oil price per barrel:10 or 30 euros Cost 12 euros per barrel Production 1000 barrels How much to pay for 25 year lease? r=15% (A25;0.2=6.464) NPV1=(20-12)x1000xA25;0.15=51,712 NPV2=0.5(30-12)x1000xA25;0.15=58,176

57