L2 - Capital Budgeting

MSc Economics & Strategy
for Business
Corporate Finance
Lecture Notes 2
Course Overview
Primer
1. Time Value of Money 2. Analysis of Financial Statements
Company Valuation
Financing Decisions
Investment Decisions 1. DCF Method:
1. Bond Valuation
1. Capital Budgeting a. Forecast CFs
2. Equity Valuation
2. NPV/IRR/Payback b. Discount rate
3. Capital Structure
2. Relative Valuation
Imperial College Business School Imperial means Intelligent Business 2

Capital Budgeting
▪ Capital budgeting is the process used to analyse alternative investment

and decide which one to accept/reject.
▪ Capital investment decisions are usually long-term, strategic decisions,

with substantial capital expenditure e.g., build a new factory, introducing
new product.
▪ Capital investments are essential for long-term business survival.
▪ Long term decisions have a time span from 2 years and upwards.

Main Techniques
▪ Payback period: Measures the time horizon to

collect initial investment.
▪ Net present value: Discounts future expected cash

flows to today’s monetary values using an
appropriate cost of capital.
Do take time
▪ Benefit-Cost ratio: Present value of cash inflows / value of money
present value of the outflows. into account
▪ Internal rate of return: Discount rate required for a

zero NPV.

Net Present Value
▪ Net present value is the present value of the future expected cash flows minus
the initial investment.
▪ NPV measures the amount of value creation.
▪ NPV rule: : Accept projects with NPV>0, reject projects with NPV<0.
Ch. 7 5

Forecasting Cash Flows
Incremental cash flows is the amount by which he firm’s CFs are expected to
change if the project is undertaken. First, determine the incremental earnings of a
project and then use the incremental earnings to forecast the incremental CFs of
the project.
Incremental CFs = CFs with the project minus CF w/o project
Sunk costs are costs that have been or will be paid regardless of the decision
whether or not the project is undertaken (e.g. market research study). These
should not taken into account!

Depreciation and CapEx
Suppose that during the year, Global Conglomerate Corp. buys machinery for
£500,000 and pays in cash. What is the cash flow?
0
Cash outflow, not a

deduction on the
- £500,000
Income Statement
What do accountant include in the Income Statement?
-Determine useful life of machinery (e.g. 10 years)
-Depreciate the machinery over this 10-year period
-Straight-line depreciation: asset looses its service potential
0 1 2 3 10
………
Deduction on the Income Statement,
- £50k - £50k - £50k - £50k not a cash outflow
Making Adjustments
Free Cash Flow = Net Income + Depreciation – CapEx + (other adjustment) [1]

Change in Accounts Receivable
Not all revenue represent a cash inflow

▪ A customer buys a good this year but pays next year.
▪ This sale increases value of “Accounts Receivable” in the Balance Sheet
▪ The revenue from sale is included in the Income Statement, but is not a cash
inflow in the current year.
▪ So, we need to subtract the increase in Accounts Receivable from Net Income
to get cash flows.
Why the change?

Remember, Accounts Receivable is a Balance Sheet item (as of a point in time)

Change in Accounts Payable
Not all Cost of Sales represent a cash outflow

▪ The company buys a product from a supplier this year buy pays for it next
year.
▪ This purchases increases value of “Accounts Payable” in Balance Sheet.
▪ The purchasing cost is included in Income Statement but is not a cash outflow
in current year.
Why the change?

Remember, Accounts Payable is a Balance Sheet item (as of a point in time)

Change in Inventory
Not all cash outflows are represented in the Cost of Sales

▪ The company produces a product but has not sold it yet.
▪ The cost of producing this product increase value of “Inventory” in Balance
Sheet
▪ This cost is not included in Income Statement (only Cost of Sales is included)
but is a cash outflow in current year.
▪ So, we need to subtract change in Inventories from Net Income to get cash
flows.
Why the change?

Remember, Inventory is a Balance Sheet item (as of a point in time)

Net Working Capital
So, to get cash flows from Net Income we need to:

▪ Subtract change in Accounts Receivable
▪ Add change in Accounts Payable
▪ Subtract change in Inventories
Defining Net Working Capital (NWC) as:
NWC = Accounts Receivable + Inventories – Accounts Payable
Basically, Current Assets minus Current Liabilities, excluding cash & short term
borrowing.

What is the change in NWC

Making Adjustments
Free Cash Flow = Net Income + Depreciation – CapEx – Change in NWC +

(other adjustment) [2]

Cash Flow from Financing Activities
Free cash flow to the firm (FCFF) represents the amount of cash flow from
operations available for distribution to both debt holders & equity holders.
Interest → Payout to debtholders

Cash Flow from Financing Activities
Suppose Example Inc. takes a loan today of 20,000 and repays it after five years,
incurring yearly payments of 6%:
0 1 2 3 4 5
20,000 -1,200 -1,200 -1,200 (-1,200 -20,000)
The PV of all financing cash flows should be exactly equal to zero, so they
should have no effect on firm value, and can be ignored from the calculation of
cash flows.

Making Adjustments
Ignoring interest payments, Net Income = EBIT * (1-tax rate), so our

formula becomes:
Free Cash Flow = EBIT*(1-tax rate) + Depreciation – CapEx – Change in NWC +

(other adjustment) [3]

Note!
▪ FCFF represent cash flows to both debtholders & equity holders
▪ They are different from cash flows in the cash flow statement

Statement of Cash Flows
Payments of interest
Payments to suppliers
Collections from customers
Operating Payments to employees
Activities Payments of tax
Other operating disbursements

Receipts of interest and
dividends on investments
Divestitures of businesses
Investing Acquisition of businesses
Sale of PPE & Intangibles Activities Acquisition of PPE & Intangibles
Sale of investments Purchase of investments
Issue of new shares Financing Payments of dividends

Reissue of treasury shares Activities Payments of treasury shares
Borrow money Payments of principal on debt

Preparing the Cash Flow Statement
Indirect method
Direct method
Net income
All cash flows from
cash T-account
Adjust net income to

operating cash flow by
Prepare Cash Flow 1. Non-cash items
statement (e.g. depreciation), 2
adjusting for changes
in working capital
Prepare Cash Flow

statement
Note: Indirect method is only used for the operating activities. For the investing and financing activities the
direct method is used.
The Blackberry z10 Project
Read the case (10 min)

The Blackberry z10 Project
Shortly after the release of the first iPhone in 2007, Verizon asked
Blackberry to create a touchscreen “iPhone killer”. Mr. Lazardis, the co-
founder and former CEO of Blackberry opposed the launch plan for the
touchscreen z10 and argued strongly in favour of emphasizing keyboard
devices. But the current CEO, Mr. Heins, did not take his advice and
launched the z10, with disastrous results.
Read through the case study of Blackberry and answer the following
questions:
1. What are the key costs and benefits of the z10 project?
2. What is the value of this opportunity if the discount rate that matched
the risk of the cash flows from the z10 project is 10%?
3. Should Blackberry launch the z10?

Incremental Income
With vs Without the z10 Year 0 Year 1 Year 2 Year 3 Year 4

Units sold 1.75 1.31 0.88 ?
Sales Price 180 160 140 120
Cost 70 70 70 70
(1) Revenues in year 1 include incremental erosion of (20%*200-10%*200)=20.
Revenue* 295 210 123 ?

COGS 122.5 91.9 61.6 ?
Depreciation 7.5 7.5 7.5 0
R&D 110
Selling, General & Admin 50 29.5 21 12.31 ?
EBIT 160 136 90 42 ?
Tax 64 54.2 35.8 16.7 ?
(Incremental) Net Income 96 81.3 53.8 25.1 ?

Accounts Receivable/ Payable days
We can express accounts receivable in terms of the number of days’ worth of

sales that it represents:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
Accounts Receivable Days =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
Suppose that Example Inc. has total revenue of £100 million and accounts
receivable are £20 million. How many days does it take the company to collect
payments from its customers, on average?
Suppose that accounts receivable of Global Inc. are expected to remain

outstanding for 180 days. How large are the accounts receivable if the company
if total annual revenue is £100 million?
Similarly:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
Accounts Payable Days =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡𝑠 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

Working Capital Requirements
Year 0 Year 1 Year 2 Year 3 Year 4

Inventory Units
1 0.82 0.55 0.22 0
Inventory Costs
70 57.4 38.5 15.4 0
Accounts Receivable
73.8 52.5 30.1 0
(2) Since only leftovers are sold in year 4,we assume all sales happen at the beggining of the year,
so no A/R are left at end of year 4.
NWC*
70 131.2 90.1 46.2 0
Change NWC
70 61.2 (40.2) (44.8) (46.2)
*Assume all expenses are cash settled when occurred. Hence, there are no Accounts Payable/ Other
Payables at the end of the year.

After-tax Salvage Value
In year 3, Blackberry will have:

▪ A cash inflow due to the money it receives from selling the machine
▪ A cash outflow due to the taxes that it has to pay on any capital gains realized
from the sale
Capital Gains = Sales Price – Net Book Value
Net Book Value = Acquisition Price – Accumulated Depreciation
After-tax cash flow = Sale Price – tax rate * Capital Gains
The after-tax salvage value should be added to the cash flows of Blackberry in
the year at which the sale took place. No depreciation after year 3!

From Earnings to Free Cash Flows
Free Cash Flow = EBIT* (1-tax rate) + Depreciation – CapEX – Change in NWC
+/- other adjustment
Change in NWC = Change in Accounts Receivable + Change in Inventories –

Change in Accounts Payable

Net Present Value
In order to evaluate the project we need to express cash flows in terms of money
today. Using the discount rate of 10%
0 1 2 3 4
𝐶0 𝐶1 𝐶2 𝐶3 𝐶4
𝐶1 𝐶2 𝐶3 𝐶4
NPV = 𝐶𝑜 + + + +
(1+0.1)1 (1+0.1)2 (1+0.1)3 (1+0.1)4
You may use NPV function in Excel:

NPV(discount rate, CF1, CF2…)
But be careful! It assumes that the first cash flow occurs at the end of year 1.
Sensitivity, Break-even & Scenario Analysis
Sensitivity Analysis shows how the NPV varies with a change in one of the
assumptions, holding the other assumptions constant.
Break-even Analysis
The break-even level of a parameter (input) is the level that causes the NPV of
the investment to equal zero.
Scenario Analysis considers the effect of the NPV of simultaneously changing

multiple assumptions.

Sensitivity Analysis
NPV Sensitivity
Base case: $3.3million
First Year Sales (+/- 10%) -10.70 17.37
Production Cost (+/- 10%) -12.82 19.48
Cost of Capital (+/- 1%) -1.66 8.50
Accounts Receivable (+/- 30 day outs.) -0.72 7.38
-15.00 -10.00 -5.00 0.00 5.00 10.00 15.00 20.00 25.00

Alternative Investment Decision Rules
▪ Do CFOs use the NPV rule?

▪ Researchers sent questionnaires to CFOs of large US listed firms asking them
to complete the sentence:
“To value an investment, I would always use…
NPV 75%
IRR 76%
Payback 53%
Discounted payback 28%

Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV = 0

𝐶1 𝐶2 𝐶𝑛
NPV = 𝐶𝑜 + + + …. +
(1+𝐼𝑅𝑅)1 (1+𝐼𝑅𝑅)2 (1+𝐼𝑅𝑅)𝑛
At 10% discount rate, the IRR is 3.33. We attempt 11% discount rate > NPV=(1.66)
The IRR is between 10% and 11%...
Trial & Error Formula:

Lowest discount rate + the difference in discount rate x (lowest discount rate NPV/
difference in NVP’s)
10% + (11-10)% x 3.33/(3.33+1.66) = 10.7%

The IRR can be found by plotting the NPV as a function of the discount rate.
Alternatively, it can be computed by trial and error or by using the IRR function in
Excel.
IRR(CF1, CF2,…)
IRR rule: Accept projects with IRR > required rate of return


Reasoning: If the opportunity cost of capital is lower (higher) than the IRR, the
project has positive (negative) NPV when discounted at the opportunity cost of
capital.
The IRR rule will give you the same answer with the NPV rule whenever the NPV
of a project is a declining function of the discount rate.
Situation where the IRR rule and NPV rule may be in conflict:
1. Delayed Investments
2. Nonexistence IRR
3. Multiple IRRs

Pitfalls of using IRR – Delayed Investments
Assume you have just retired as the CEO of a successful company. A major
publisher has offered you a book deal. The publisher will pay you £1 million
upfront if you agree to write a book about your experiences. You estimate that it
will take three years to write the book. The time spent writing will cause you to
give up speaking engagements amounting to £500,000 per year. You estimate
your opportunity cost to be 10%.
1. Should you accept the deal according to the IRR rule?

2. Should you accept the deal according to the NPV rule?

Pitfalls of using IRR – Delayed Investments
Calculate the IRR of the project
0 1 2 3
500,000 500,000 500,000

NPV = 1,000,000 − − −
1+𝑟 1 1+𝑟 2 (1+𝑟)3
Setting NPV=0 and solving for r, we find the IRR= 23.38%, i.e. larger than the
cost of capital (10%). The IRR rule says we should accept the deal.
Calculate NPV: -£243,426 < 0

Since NPV < 0, the NPV rule indicates you should reject the deal.

NPV as a function of discount rate
When the benefits of an investment occur before the costs, the NPV is an
increasing function of the discount rate.

Pitfalls of using IRR – Multiple IRR
Suppose you inform the publisher that he needs to sweeten the deal before you
will accept it. The publisher offers £550,000 in advance and £1,000,000 in four
years when the book is published.
- Should you accept or reject the offer now?

Pitfalls of using IRR – Multiple IRR
The cash flows would now look like:
0 1 2 3 4
500,000 500,000 500,000 1,000,00

NPV = 550,000 − − − +
1+𝑟 1 1+𝑟 2 (1+𝑟)3 (1+𝑟)3
By setting the NPV=0 and solving for r, we find the IRR.

In this case, there are two IRRs: 7.164% and 33.673%.
Because there is more than one IRR, the IRR rule cannot be applied.

NPV as a function of discount rate

Pitfalls of using IRR – Non-existent IRR
Finally, you are able to get the publisher to increase his advance payment to
£750,000, in addition to the £1 million when the book is published. With these
cash flows, no IRR exists; the NPV is positive for all values of the discount rate.
Thus, the IRR rule cannot be used:

The Payback Rule
▪ Payback Period
-length of time until the accumulated cash flows equal or exceed the original
investments.
▪ Payback rule: Quicker is better
-accept if payback is less than some pre-specified number of years.
0 1 2 3 4
-5,000 1,500 2,000 2,500 2,500
What is the payback period?

The Payback Rule - Example
Consider the following 3 projects. The discount rate is 10%.
Project 𝑪𝑭𝒐 𝑪𝑭𝒐 𝑪𝑭𝒐 𝑪𝑭𝒐 Payback Period NPV
A (2,000) 500 500 5,000

B (2,000) 500 1,800 0
C (2,000) 1,800 500 0

The Payback Rule - Example
Consider the following 3 projects. The discount rate is 10%.
Project 𝑪𝑭𝒐 𝑪𝑭𝒐 𝑪𝑭𝒐 𝑪𝑭𝒐 Payback Period NPV
A (2,000) 500 500 5,000 2.2 Years 2,624

B (2,000) 500 1,800 0 1.83 Years (58)
C (2,000) 1,800 500 0 1.4 Years 50
▪ NPV rule tells us to accept projects A and C and reject project B.

▪ What if the firm uses the payback rule with a cut-off period of 2 years?

The Payback Rule
▪ Advantages
-simple to use
-it is a crude measures of liquidity
▪ Drawbacks
-how to determine cut-off? It’s arbitrary..
-bias against long-term projects
-ignores time value if money
Payback used on its own is inconsistent with maximization of shareholder value.

The Discounted Payback Rule
In practice, we should at least try to account for the time value of money.
0 1 2 3 4
-5,000 1,500 2,000 2,500 2,500
Suppose r =10%
NPV = 602.35
Discounted Payback Period = ??

The Payback Rule
Useful adjustment to Payback, with similar information about liquidity.
Beware of the pitfalls:

-arbitrary cut-off date
-bias against long-term projects.
Use it qualitatively, and jointly with NPV as a secondary method.

Benefit-Cost Ratio
The BCR is also known as the profitability index.
𝑃𝑉 𝑜𝑓 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
BCR =
𝑃𝑉 𝑜𝑓 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠
BCR rule: Accept projects with BCR>1, reject projects with BCR<1.

How to calculate the different measures (NPV, IRR, BCR)
Three-step procedure:
1. Estimate the relevant cash flows
– With-without principle: record only cash flow differences that occur

because an investment is made as opposed to not made.
– The with-without principle implies that sunk costs are not part of
project cash flows.
2. Calculate a figure of merit for the investment, summarizing the

investment’s economic worth. Ch. 7 50
3. Compare the figure of merit to an acceptance criterion.

Excess Capacity
• Is the use of excess capacity free?
• If the excess capacity has no alternative use, then that is the case.
• If using the excess capacity prevents the generation of cash flows from an
alternative, then the with-without principle indicates that the foregone cash
flows should be part of the analysis to reflect the opportunity cost.

Financing Costs
• Financing costs refer to any dividend, interest, or principal payments

associated with financing an investment.
• The standard procedure is to reflect the cost of money in the discount

rate and ignore financing costs in the cash flow projections.
Ch. 7 52


L2 - Capital Budgeting

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

L2 - Capital Budgeting

Uploaded by

Copyright:

Available Formats

MSc Economics & Strategy

Imperial College Business School Imperial means Intelligent Business 2

▪ Capital budgeting is the process used to analyse alternative investment

▪ Capital investment decisions are usually long-term, strategic decisions,

▪ Capital investments are essential for long-term business survival.

Imperial College Business School Imperial means Intelligent Business 3

▪ Payback period: Measures the time horizon to

▪ Net present value: Discounts future expected cash

▪ Internal rate of return: Discount rate required for a

Imperial College Business School Imperial means Intelligent Business 4

▪ NPV measures the amount of value creation.

Imperial College Business School Imperial means Intelligent Business 5

Incremental CFs = CFs with the project minus CF w/o project

Imperial College Business School Imperial means Intelligent Business 6

Cash outflow, not a

Imperial College Business School Imperial means Intelligent Business 8

Not all revenue represent a cash inflow

Why the change?

Imperial College Business School Imperial means Intelligent Business 9

Not all Cost of Sales represent a cash outflow

Why the change?

Imperial College Business School Imperial means Intelligent Business 10

Not all cash outflows are represented in the Cost of Sales

Why the change?

Imperial College Business School Imperial means Intelligent Business 11

So, to get cash flows from Net Income we need to:

Defining Net Working Capital (NWC) as:

NWC = Accounts Receivable + Inventories – Accounts Payable

Imperial College Business School Imperial means Intelligent Business 12

Imperial College Business School Imperial means Intelligent Business 13

Free Cash Flow = Net Income + Depreciation – CapEx – Change in NWC +

NWC = Accounts Receivable + Inventories – Accounts Payable

Imperial College Business School Imperial means Intelligent Business 14

Interest → Payout to debtholders

Imperial College Business School Imperial means Intelligent Business 15

20,000 -1,200 -1,200 -1,200 (-1,200 -20,000)

Imperial College Business School Imperial means Intelligent Business 16

Ignoring interest payments, Net Income = EBIT * (1-tax rate), so our

Free Cash Flow = EBIT*(1-tax rate) + Depreciation – CapEx – Change in NWC +

NWC = Accounts Receivable + Inventories – Accounts Payable

Imperial College Business School Imperial means Intelligent Business 17

▪ FCFF represent cash flows to both debtholders & equity holders

Imperial College Business School Imperial means Intelligent Business 18

Other operating disbursements

Sale of PPE & Intangibles Activities Acquisition of PPE & Intangibles

Sale of investments Purchase of investments

Issue of new shares Financing Payments of dividends

Borrow money Payments of principal on debt

Imperial College Business School Imperial means Intelligent Business 19

Adjust net income to

Prepare Cash Flow

Read the case (10 min)

Imperial College Business School Imperial means Intelligent Business 21

Imperial College Business School Imperial means Intelligent Business 22

With vs Without the z10 Year 0 Year 1 Year 2 Year 3 Year 4

Revenue* 295 210 123 ?

Imperial College Business School Imperial means Intelligent Business 23

We can express accounts receivable in terms of the number of days’ worth of

Suppose that accounts receivable of Global Inc. are expected to remain

Imperial College Business School Imperial means Intelligent Business 24

Year 0 Year 1 Year 2 Year 3 Year 4

Imperial College Business School Imperial means Intelligent Business 25