07 33172

Corporate Finance
Topic 3 – Discounted-Cash-
Flow Analysis and Capital
Budgeting

Objective
Explain and use discounted-cash-flow
analysis (net-present-value versus
alternative investment rules) for the
evaluation of real investment
projects (capital
1
budgeting)
 Illustrating the Investment
Decision (1)
• Consider an investor who has an initial
endowment of income of $40,000 this
year, and a further $55,000 next year.
OPPORTUNITY
• Suppose that he faces
Text
a 10-percent COST OF CAPITAL
market interest rate, but is also offered
the following investment.
Cash inflows 20% RETURN ON $30,000
0 INVESTMENT
Time
1
Cash outflows
-$25,000 2
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 Illustrating the Investment
Decision (2)
• One choice available is to consume
$15,000 now; invest the remaining
$25,000 in the financial markets at 10%;
consume $82,500 next year.
• A better alternative would be to invest in
the project instead of the financial
markets. He could consume $15,000
now; invest the remaining $25,000 in the
project at 20%; consume $85,000 next
year. 3
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 Illustrating the Investment
Decision (3)
• Additional consumption next year from
investing now in the project rather than
in the financial markets = $85,000 -
$82,500 = $2,500.
• PV now of additional $2,500 next year =
$ଶ,ହ଴଴
= $2,272.73.
ଵା଴.ଵ଴

$ଷ଴,଴଴଴
• NPV of the project = -$25,000 + =
ଵା଴.ଵ଴
+$2,272.73. 4
07 33172 – Topic 3
 Capital Budgeting: Procedural
Outline
• Form ideas on how to increase
shareholders’ equity
• Plan how to implement the ideas
• Gather information on timing and
magnitude of costs and benefits
• Perform Discounted Cash Flow (DCF)
analysis, applying Net Present Value
(NPV) criterion
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 Capital Budgeting and DCF
• Recall the objective of a firm
– Maximization of the market value of
shareholders’ equity
– Requires computing the NPV of the project’s
expected cash flows, and undertaking only
those with positive NPV
– DCF analysis should be used to make
decisions such as:
• Whether to enter a new line of business
• Whether to invest in equipment to reduce
costs
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 NPV Rule (1)
• The criterion used
– find the present value of all future (net) cash flows, and
subtract the initial investment to obtain the NPV
• Estimating NPV:
– 1. Estimate future cash flows: how much? and when?
– 2. Estimate discount rate
– 3. Estimate initial costs
• A project’s NPV is
– the amount by which the project is expected to increase
the wealth of the firm’s current shareholders
• As a general (minimum acceptance) criterion
– Invest in proposed projects with positive NPV
• Ranking Criteria: Choose the highest NPV 7
07 33172 – Topic 3
 NPV Rule (2)

C1 C2 Cn
NPV  ....  Co
1 k (1 k) 2
(1 k) n

• where:
– C1, C2, …, Cn are the expected future cash flows from
the project at time 1, 2, …, n
– k is the discount rate reflecting the riskiness of the
project’s expected future cash flow stream
– C0 is the initial (i.e. at time 0) capital outlay on the
project
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07 33172 – Topic 3
 NPV Rule (3)
• Accepting positive NPV projects benefits
shareholders.
 NPV uses cash flows
 NPV uses all the cash flows of the project
 NPV discounts the cash flows properly
• Reinvestment “assumption”: the NPV rule
“assumes” that all cash flows can be reinvested
at the discount rate.

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 Alternative Investment Rules
• Some popular alternatives to NPV:
– Payback period
– Internal rate of return

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 Ordinary Payback Period Rule (1)
• How long does it take the project to “pay
back” its initial investment?
• Payback Period = number of years to
recover initial costs
• Minimum Acceptance Criteria:
– set by management

• Ranking Criteria:
– set by management
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07 33172 – Topic 3
 Ordinary Payback Period Rule (2)
• Disadvantages:
– Ignores the time value of money
– Ignores cash flows after the payback period
– Biased against long-term projects
– Requires an arbitrary acceptance criteria
– A project accepted based on the payback
criteria may not have a positive NPV

• Advantages:
– Easy to understand
– Biased toward liquidity 12
07 33172 – Topic 3
 Discounted Payback Period Rule

• How long does it take the project to “pay

back” its initial investment taking the
time value of money into account?
• By the time you have discounted the
cash flows, you might as well calculate
the NPV.

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 Internal Rate of Return (IRR) Rule
• IRR: the discount rate that sets NPV to zero
• Minimum Acceptance Criteria:
• Accept if the IRR exceeds the required return.
• Ranking Criteria:
• Select alternative with the highest IRR
• Reinvestment “assumption”:
• All future cash flows “assumed” reinvested at the
IRR.
• Disadvantages:
• Does not distinguish between investing and
borrowing
• IRR may not exist or there may be multiple IRRs
• Problems with mutually exclusive investments –
ignores scale
• Advantages:
• Easy to understand and communicate 14
07 33172 – Topic 3
 IRR: Example
Consider the following project:
$50 $100 $150

t0 1 2 3
-$200
The IRR for this project is 19.44%

$50 $100 $150

NPV  0  200   
(1  IRR) (1  IRR ) 2 (1  IRR )3
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 NPV Payoff Profile for this
Example
If we graph NPV versus discount rate, we can see the IRR as
the x-axis intercept.
Discount Rate NPV $120.00
0% $100.00 $100.00
4% $71.04 $80.00
8% $47.32
$60.00
12% $27.79
$40.00
NPV
16% $11.65
IRR = 19.44%
20% ($1.74) $20.00
24% ($12.88) $0.00
28% ($22.17)
32% ($29.93)
($20.00)
-1% 9% 19% 29% 39%
36% ($36.43) ($40.00)
40% ($41.86) ($60.00)
Discount rate
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 IRR and NPV for Investment
Project

• i > IRR  NPV < 0

• i = IRR  NPV=0
• i < IRR  NPV > 0
where i is the discount rate.

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 Mutually Exclusive vs Independent
Projects
• Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring
an accounting system.
– RANK all alternatives and select the best one.

• Independent Projects: accepting or rejecting

one project does not affect the decision of the
other projects.
– Must exceed a MINIMUM acceptance criteria.

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 Ranking Mutually Exclusive
Projects

• Using the NPV method, you are unlikely

to encounter any serious problems
– Some managers, particularly those with an
engineering background, prefer to use the
IRR method
• The IRR method may be made to give the
correct answer, but this requires considerable
skill. Avoid it (unless your boss is an
engineer!)
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 Scale Problem

Would you rather make 100% or 50% on your

investments?
What if the 100% return is on a $1 investment
while the 50% return is on a $1,000
investment?

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Cost of capital =INTEREST/DISCOUNT RATE 15% All $ figures in $'000
Tax rate 40%
Unit sales (year 1) 4000
Sales growth rate 0%
Unit sales price $5
Unit sales price growth rate 0%
Fixed costs (year 1) $3,100
Fixed costs growth rate 0%
Variable costs % of sales revenue 75%
Depreciation $400 NPV = $1,236
Investment in P&E (year 0) $2,800
Investment in P&E (subsequent years) $0
Dividend $1,000
Working capital (year 0) $2,200
Working capital movement $0

Year 0 1 2 3 4 5 6 7
CF Forecast
Sales revenue $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000
Expenses:
Fixed costs $3,100 $3,100 $3,100 $3,100 $3,100 $3,100 $3,100
Variable costs $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000
Depreciation $400 $400 $400 $400 $400 $400 $400
Operating Profit DEPRECIATION TAX SHIELD $1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500
Taxes $600 $600 $600 $600 $600 $600 $600
Net Profit $900 $900 $900 $900 $900 $900 $900
Operating CF $1,300 $1,300 $1,300 $1,300 $1,300 $1,300 $1,300
Working capital -$2,200 $0 $0 $0 $0 $0 $0 $2,200
Investment in P&E -$2,800 $0 $0 $0 $0 $0 $0 $0
Investment CF -$5,000 $0 $0 $0 $0 $0 $0 $2,200
Net CF -$5,000 $1,300 $1,300 $1,300 $1,300 $1,300 $1,300 $3,500
PV (Net CF) -$5,000 $1,130 $983 $855 $743 $646 $562 $1,316

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 Depreciation and Cash Flows

• It is important to remember that when

making financial decisions only timed
cash flows are used
– depreciation is an expense, but is not a cash
expense, and must be excluded
– the tax benefit of depreciation, however, is a
cash flow, and must be included

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07 33172 – Topic 3
 Working Capital and Cash Flows

• Some cash flows do not occur on the

income statement, but involve timing
– working capital additions and reductions are
cash flows
– at the end of a project the sum of the
nominal changes in working capital is zero

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07 33172 – Topic 3
 Incremental Cash Flows

• Only the incremental cash flows should

form part of an investment decision
– Evaluate the projected cash flows, by
(category and) timing, both with and without
the project, and find the difference
– This difference is a collection of timed cash
flows, and this is what affects the wealth of
the shareholders
– Effects on other projects matter (erosion)
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07 33172 – Topic 3
 Sunk Costs and Opportunity
Costs
• Sunk Costs
– Costs that have already occurred.
– Because they are in the past, they cannot be
changed by the decision to accept or reject the
investment project.
– Thus, sunk costs are not incremental cash outflows.

• Opportunity Costs
– Potential loss in cash inflows through alternative use
of a resource.
– Opportunity costs are relevant incremental cash
outflows. 25
07 33172 – Topic 3
 Capital Budgeting and DCF
Caveats

• Problem of inflation: Use either real or

nominal value for cash flows with
matching discount rate
• Problem of taxation: Maximize net
present value of after-tax cash flows,
which means using after-tax discount
rate (equal to before-tax rate multiplied
by 1 minus tax rate)
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07 33172 – Topic 3
 Capital Budgeting and
Inflation
• When computing Net Present Value
(NPV)
– Use the nominal cost of capital to discount
nominal cash flows
• Nominal cash flows are rarely constant
– Use the real cost of capital to discount real
cash flows
(1  NominalRate)  (1  RealRate) * (1  InflationRate)

NominalRate  InflationRate
 RealRate 
1  InflationRate 27
07 33172 – Topic 3
 Sensitivity Analysis, Scenario
Analysis, Monte Carlo Simulation
• Will the project still be economical if some of
the underlying variables are inaccurate?
– Spreadsheets are an excellent tool for exploring the
influence of estimation errors on financial decisions

• Explore perturbations caused by randomness in

the model’s inputs
– This should lead to management correctly prioritizing
time to the key variables of the model
– Management will recognize dangers sooner, and will
create contingency plans to avoid their worst
consequences 28
07 33172 – Topic 3
 Project’s Sensitivity to Sales
Volume
BIG RANGE = BIG RISK. UPON FURTHER RESEARCH IF IT COMES NEAR TO
2000 U WONT DO IT BUT CLOSER TO 6000 YOU WILL

Sales Units Net CF Operations $000 NPV Project $000

2000 ($200) ($5,005)
3000 $550 ($1,885)
3604BREAK EVEN POINT $1,003 $0
4000 $1,300 $1,236
5000 $2,050 $4,356
6000 $2,800 $7,476

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07 33172 – Topic 3
 Relation Between Project’s NPV
and Sales Volume
Sensitivity of Project to Sales Volume
$10,000

$8,000

$6,000

$4,000
NPV $000

$2,000

BREAK EVEN POINT

$0
2000 2500 3000 3500 4000 4500 5000 5500 6000

($2,000)

($4,000)

($6,000)

Sales (Units)
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 Break-Even and Indifference
Points

• Sales volume break-even point is number of

unit sales resulting in NPV = 0
• Sales price break-even point is unit sales price
resulting in NPV= 0
• Internal Rate of Return is discount rate
resulting in NPV = 0
• Discounted payback period is the project life
resulting in NPV = 0

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07 33172 – Topic 3
PRACTICE EAC AND EAV VALUE BEFORE ATTEMPTING

Replicable Projects with

Different Lives
• Calculate Annualized Cost [Value] to
compare projects with different lives and
where cash outflows only [net cash
flows] are relevant to decision
– Equivalent annual cost (EAC) [value (EAV)]
over life of project that has a [net] present
value equal to the project’s underlying [net]
present value i.e. cash outflow only [net
cash flow] from annuity
– Choose project with lowest [highest] EAC
[EAV] 32
07 33172 – Topic 3
 Replicable Projects with Different
Lives: Example (1)

Machine CF0 CF1 CF2 CF3 PV @ 6%

A -15 -5 -5 -5 -28.37
B -10 -6 -6 -21.00
CF denotes cash outflows only

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07 33172 – Topic 3
 Replicable Projects with Different
Lives: Example (2)

• Machine A: EAC
-28.37 = EAC/0.06 * [1 – 1/(1.06)3]
EAC = -10.61

• Machine B: EAC
-21.00 = EAC/0.06 * [1 – 1/(1.06)2]
EAC = -11.45

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07 33172 – Topic 3
 Replicable Projects with Different
Lives: Example (3)
Machine CF0 CF1 CF2 CF3 PV @ 6%
A -15 -5 -5 -5 -28.37
EAC -10.61 -10.61 -10.61 -28.37

B -10 -6 -6 -21.00
EAC -11.45 -11.45 -21.00

Choose Machine A.
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07 33172 – Topic 3
 Investing in Real Options

• To date we have ignored management’s

ability to
– delay the start of a project
– expand a project
– abandon the project

• Failure to take these options into account

will result in an understated NPV
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07 33172 – Topic 3
 Using Decision Tree (yes, no)
Analysis to Evaluate Real Option
Investments: Example (1)
(Probability = 0.5)
Make the movie?
(NPV $4 Million)
Book a
Success?
(Probability = 0.5)
Make the Movie?
Buy the movie (NPV -$4 Million)
rights to book?
(Cost $1 Million)
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07 33172 – Topic 3
 Using Decision Tree (yes, no)
Analysis to Evaluate Real Option
Investments: Example (2)
– If the decision to undertake the project is
made under the assumption of a single up-
front decision then the project must always
be rejected
– But … if the company makes the logical
managerial decision at each stage, then (as
long as the cost of capital for the project is
less than 100%) the project should be
undertaken

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 Volatility and Project
Evaluation
– There is a common notion that risk in
investment decisions is something that
needs to be penalized: Risky cash flows are
often discounted at a higher rate
– But … we have just seen an investment
decision containing an option-like feature,
and options always become more valuable
with higher volatility because the downside
risk can be ridden of without sacrificing the
upside risk 39
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 Investing in Real Options:
Conclusions
• Some projects are naturally rich in valuable
managerial options (R&D), while other projects have
options that are relatively hard to find, and when
discovered, are not particularly valuable (fast-food
franchisee)
• Sometimes, management’s ability to recognize the
options in a business situation is the key that
distinguishes a winning business from its less
successful siblings

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07 33172 – Topic 3
 Practice of Capital Budgeting

• Varies by industry.
• The most frequently used technique for
large corporations is IRR or NPV.
• When it is all said and done, the
alternatives to NPV are not the NPV rule;
for those of us in finance, it makes them
decidedly second-rate.

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07 33172 – Topic 3