Capital Budgeting

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Calculate the yearly cash flows of expansion and replacement capital projects and evaluate how the choice of depreciation method affects those cash flows
Generally, we can classify incremental cash flows for projects as initial investment outlay, operating cash flow over the project's life, and terminal year cash flow.

Expansion Project Analysis
Initial investment outlay is the upfront costs associated with the project. Components are price, which includes shipping and installation (FCInv)and investment in net working capital (NWCInv).
outlay = FCInv + NWCInv
The investment in NWC must be included in the capital budgeting decision. The investment in net working capital is defined as the difference between the changes in non-cash current assets and changes in non-cash current liabilities (i.e., those other than short-term debt). Cash is excluded because it is generally assumed not to be an operating asset.
NWCInv = change in non-cash current assets - change in non-debt current liabilities = change in NWC
If NWCInv is positive, additional financing is required and represents a cash outflow because cash must be used to fund the net investment in current assets. (If negative, the project frees up cash, creating a cash inflow.) Note that at the termination of the project, the firm will expect to receive an end of project cash inflow (or outflow) equal to initial NWC when the need for the additional working capital ends.

After tax operating cash flows are the incremental cash flows over the capital asset's economic life.
CF = (S-C-D)(1-D)+D = (S-C)(1-T)+(TD)
EBIT = (S-C-D)
S=sales, C=cash operating costs, D=depreciation expense, T=marginal tax rate
Although depreciation is a non-cash operating expense, it is an important part of determining operating cash flow because it reduces the amount of taxes paid by the firm. We can account for depreciation either by adding it back to net income from the project (as in the first cash flow formula) or by adding the tax savings caused by depreciation back to the project's after tax gross profit (as in the second formula). In general, a higher depreciation expense will result in greater tax savings and higher cash flows. This means that accelerated depreciation methods will create higher after-tax cash flows for the project earlier in the project's life as compared to the straight-line method, resulting in a higher net present value for the project. Entress is not included in operating cash flow's for capital budgeting purposes because it is incorporated into the project cost of capital.

Terminal year after tax non-operating cash flows (TNOCF). At the end of the asset's life, there are certain cash inflows that occur. These are the after-tax salvage value and the return of the net working capital.
TNOCF= Sal(t)+NWCInv-T(Sal(t)-B(t))
Sal(t) = pre-tax cash proceeds from sale of fixed capital
B(t) = Book value of the fixed capital sold

Replacement Project Analysis
There are a few key differences in the analysis of a replacement project versus an expansion project. In a replacement project analysis we have two:
1. Reflect the sale of the old asset in the calculation of the initial outlay:
outlay=FCInv+NWCInv-Sal(0)+T(Sal(0)-B(0))

2. Calculate the incremental operating cash flows as the cash flows from the new asset minus the cash flows from the old asset:
Change in cash flow= (change in sales-change in costs)(1-T)+change in (DT)

3. Compute terminal year not operating cash flow:
TNOCF = (Sal(t-new)-Sal(t-old)+NWCInv-T[(Sal(t-new)-B(t-new)-(Sal(t-old)-B(t-old)]
Explain how inflation affects capital budgeting analysis
Analyzing nominal or real cash flows. Nominal cash flows reflect the impact of inflation, while real cash flows are adjusted downward to remove inflation affects. Although either type of cash flow can be used in the capital budgeting process it is important to match the type of cash flows with the discount rate. Nominal cash flows should be discounted at a nominal discount rate, while real cash flows should be discounted at a real discount rate.

The changes in inflation affect project profitability. If inflation is higher than expected, future project cash flows are worth less, and the value of the project will be lower than expected. The opposite is also true, however. If inflation turns out to be lower than originally expected, future cash flows from the project will be worth more effectively increasing the project's value.

Inflation reduces the tax savings from depreciation. If inflation is higher than expected, the firm's real taxes paid to the government are effectively increased because the depreciation tax shelter is less valuable. This is because the depreciation charge, which is based upon the asset's purchase price, is less than it would be if we calculated at current (i.e. inflated) prices.

Inflation decreases the value of payments to bondholders. Bondholders receive fixed payments that are effectively worth less as inflation increases. This means that higher than expected inflation effectively shifts wealth to issuing firms at bondholders' expense.

Inflation may affect revenues and costs differently.
Evaluate capital projects and determine the optimal capital project in situations of 1) mutually exclusive projects with unequal lives, using either the least common multiple of lives approach or the equivalent annual annuity approach, and 2) capital rationing
When two projects are mutually exclusive, the firm may choose one project or the other, but not both. If mutually exclusive projects have different lives, and the projects are expected to be replaced indefinitely as they wear out, an adjustment needs to be made in the decision making process. There are two procedures to make this adjustment: least common multiple of lives approach, and equivalent annual annuity (EAA) approach.
See examples.

Least common multiple of lives approach. A project where equipment will need to be replaced every few years is often called the replacement chain. The key is to analyze the entire chain and not just the first link in the chain.

Equivalent Annual Annuity (EAA) Approach
The EAA approach finds the sequence of equal annual payments with a present value that is equal to the project's NPV. There are three steps to the EAA approach.
Step 1: Find each project's NPV.
Step 2: Find an annuity with a present value equal to the project's NPV over its individual life at the WACC. Compute for PMT.
Step 3: Select the project with the highest EAA (the PMT on your calculator).

Capital rationing. Capital rationing is the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth. A firm with less capital than profitable projects should choose the combination of projects it can afford to fund that has the greatest total NPV. Note that capital rationing is not the optimal decision from the firm's perspective. More value would be created by investing in all positive NPV projects. Therefore, capital rationing violates market efficiency because society's resources are not allocated to their best use (i.e., to generate the highest return). The goal with capital rationing is to maximize the overall NPV within the capital budget, not necessarily to select the individual projects with the highest NPV.
Explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to assess the stand-alone risk of a capital project
Sensitivity analysis. Sensitivity analysis involves changing one input (independent) variable to see how sensitive the dependent variable is to the input variable. For example, by varying sales, we could determine how sensitive the projects NPBV is to changes in sales, assuming that all other factors are held constant. The key to sensitivity analysis is to only change one variable at a time.

Scenario analysis. Scenario analysis is a risk analysis technique that considers both the sensitivity of some key output variable (e.g. NPV) to changes in a key input variable (e.g. sales) and the likely probability distribution of these variables. The key difference between scenario analysis and sensitivity analysis is that scenario analysis allows for changes in multiple input variables all at once. In scenario analysis, we study the different possible scenarios, such as worst case, best case, and base case.

Simulation analysis (or Monte Carlo simulation) results in a probability distribution of project NPV outcomes, rather than just a limited number of outcomes as with sensitivity or scenario analysis.
Explain and calculate the discount rate, based on market risk methods, to use in valuing a capital project
In the CAPM, risk is separated into systematic and unsystematic components. Unsystematic, or company specific, risk can be diversified away, while systematic, or market, risk cannot be diversified away. A diversified investor is compensated for taking on systematic risk, but not unsystematic risk. In a capital budgeting context, beta, a systematic risk measure, is appropriate for measuring project or asset risk when a company is, or the company's investors are, diversified. The project's or asset's beta in conjunction with the CAPM can be used to determine the appropriate discount rate for the asset or project.

Beta risk is based on the equation of the CAPM, or the security market line, which defines a project's required rate of return.

Using a project's beta to determine discount rates is important when the risk of a project is different from the risk of the overall company. Such a project specific discount rate is also called a hurdle rate. Hurdle rates vary from project to project. Simply using the company's WACC will overstate the required return for a conservative project and will understate the required return for an aggressive project.
Describe types of real options
Real options allow managers to make future decisions that change the value of capital budgeting decisions made today. Real options are similar to financial call and put options in that they give the option holder the right, but not the obligation, to make a decision. The difference is that real options are based on real assets rather than financial assets and are contingent on future events.

Types of real options:
>> Timing options allow the company to delay making an investment with the hope of having better information in the future.
>> Abandonment options are similar to put options. They allow management to abandon a project if the present value of the incremental cash flows from exiting the project exceeds the present value of the incremental cash flows from continuing a project.
>> Expansion options are similar to call options. Expansion options allow the company to make additional investments in a project if doing so creates value.
>> Flexibility options give managers choices regarding the operational aspects of the project. The two main forms are price setting and production flexibility options.
Price setting options allow the company to change the price of a product. For example, the company may raise prices if demand for a product is high in order to benefit from that demand without increasing production.
Production flexibility options may include paying workers overtime, using different materials as inputs, or producing a different variety of products.
>> Fundamental options are projects that are options themselves because the payouts depend on the price of an underlying asset. For example, the payoff for a copper mine is dependent on the market price for copper. If copper prices are low, it may not make sense to open a copper mine, but if copper prices are high, opening the copper mine could be very profitable.
Evaluate a capital project using real options
A manager can use a number of different approaches for evaluating the profitability of an investment with real options. Examples of different approaches include the following:
1. Determine the NPV of the project without the option. A real option adds value to a project, even if it is difficult to determine the monetary amount of that value. If the NPV of the project without the option is positive, the analyst knows that the project with the option must be even more valuable, and determining the specific value for the option is unnecessary.
2. Calculate the project NPV without the option and add the estimated value of the real option.
Overall NPV = project NPV - option cost + option value
3. Use decision trees. This method does not determine a value for that option but may allow a manager to make a more informed choice by showing the sequence of decisions made.
4. Use option pricing models.
See examples.
Describe common capital budgeting pitfalls
>> Failing to incorporate economic responses into the analysis. For example, if a profitable product is in an industry with low barriers to entry, competitors may undertake a similar project, lowering profitability.
>> Using standardized templates. Since managers may evaluate hundreds of projects in a given year, they often create templates to streamline the analysis process. However, the template may not be an exact match for the project, resulting in estimation errors.
>> Pet projects of senior management. Projects that have the personal backing of influential members of senior management may contain overly optimistic projections that make the project appear more profitable than it really is. In addition, the project may not be subject to the same level of analysis as other projects
>> Basing investment decisions on EPS or ROE. Manages whose incentive compensation is tied to increasing EPS or ROE may avoid positive long term NPV investments that have the short run effect of reducing EPS or ROE.
>> Using that IRR criterion for project decisions.
>> Poor cash flow estimation. For a complex project, it is easy to double count or fail to include certain cash flows in the analysis. For example, the effects of inflation must be properly accounted for.
>> Misestimation of overhead costs. The cost of a project should include only the incremental overhead costs related to management time and information technology support. These costs are often difficult to quantify, and over or under estimation can lead to incorrect investment decisions.
>> Using the incorrect discount rate. The required rate of return of the project should reflect the project's risk. Simply using the company's WACC as a discount rate without adjusting it for the risk of the project may lead to significant errors in estimating the NPV of the project.
>> Politics involved with spending the entire capital budget. Many managers try to spend their entire capital budgeting for the following year.
>> Failure to generate alternative investment ideas. Generating investment ideas is the most important step of the capital budgeting process. However, once a manager comes up with a good idea, they may go with it rather than coming up with an idea that is better.
>> Improper handling of sunk and opportunity costs.
Calculate and interpret accounting income and economic income in the context of capital budgeting
Accounting and economic income measures are alternatives to the basic discounted incremental cash flow approach used in the standard capital budgeting model.

A project's economic income is equal to the after-tax cash flow plus the change in the investment's market value. As with the basic capital budgeting model, interest is ignored for cash flow calculations and is instead included as a component of the discount rate.
economic income = cash flow + (ending market value - beginning market value)

The project's accounting income is the reported income on a company's financial statements that results from an investment in a project. Accounting income will differ from economic income because:
> accounting depreciation is based on the original cost (not market value) of the investment.
>> Financing costs (e.g. interest expense) are considered as a separate line item and are subtracted out to arrive at a net income. In the basic capital budgeting model, financing costs are reflected in the WACC.

See examples.
Distinguish among the economic profit, residual income, and claims valuation models for capital budgeting and evaluate a capital project using each
>> Economic profit is a measure in excess of the dollar cost of capital invested in a project. Economic profit approach focuses on returns to all suppliers of capital, which includes both debt and equity holders, and therefore the appropriate discount rate is the WACC.
EP = NOPAT - $WACC

NOPAT = net operating profit after tax = EBIT (1-tax rate)
$WACC = dollar cost of capital = WACC x capital
capital = dollar amount of investment

Once the economic profit is determined, it is easily applied to the valuation of an asset. The NPV based on economic profit is called the market value added added (MVA).
NPV = MVA = summation (EP)/(1+ WACC)

The value of the company is the NPV of the project plus the initial investment.

>> Residual income focuses on returns on equity and is determined by subtracting an equity charge from the accounting net income. The equity charge is found by multiplying the required return on equity by the beginning book value of equity.
RI = NI - (r)(beginning book value of equity)

The value of the company is the sum of the present value of the residual income plus the equity investment plus the value of debt.

>> The claims valuation approach divides operating cash flows based on the claims of debt and equityholders that provide capital to the company. These debt and equity cash flows are valued separately and then added together to determine the value of the company. The claims valuation method calculates the value of the company, not the project. This is different from the economic profit and residual income approaches, which calculate both project and company value.
Every asset is financed by some combination of debt and equity, and the claims valuation approach merely separates the cash flows provided by the asset into the proportionate debt and equity components.
The cash flows to debtholders consist of interest and principal payments and are discounted at the cost of debt.
The cash flow to equity holders are dividends and share repurchases and are discounted at the cost of equity.
The sum of the present value of each stream of cash flows will equal the value of the company.
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