Corporate Finance #23 - Capital Budgeting

Question 1

List the principles of capital budgeting

Answer 1

LOS 23.a

Project decision is based on:

• incremental after-tax cash flows, not accounting income.
  
  • sunk costs - not included
  • externalities - included
  • opportunitiy costs - included (e.g. assets already owned)
• Timing of after-tax cash flows
• Based on opportunity cost
• Financing costs already reflected in required rate of return
• Treat all projects as if all equity financed

Question 2

List the three stages of project cash flows

Answer 2

LOS 23.a

1. Initial investment (outlay, CF₀)
2. After-tax operating cash flows over project’s life (CF_{1 to T})
3. Terminal year cash flow (TNOCF, CF_T)

Question 3

List the equations for the 3 stages of of project cash flows

Answer 3

LOS 23.a

**Outlay = FCInv + NWCInv**
FCInv = cost of fixed capital (including shipping and installation)
NWCInv = d(non-cash OpCA) - d(non-cash OpCL); invent, acct recv

CF_t = (S - C)(1 - T) + TD
or: CF_t = (S - C - D)(1 - T) + D
C = Op cash exp; TD = “tax savings” or “tax sheild”; T = marginal tax rate

**TNOCF = Sal<sub>T</sub> + NWCInv - T(Sal<sub>T</sub> - BT)**
Sal<sub>T</sub> = pre-tax cash proceeds from sale of fixed capital; B<sub>Y</sub> = BV of sold fixed capital

Question 4

Project categories and their differences

Answer 4

LOS 23.a

Expansion - expand the business; include opportunity costs; may need to pick the project(s) that maximize ROA (NPV)

Maintenance Replacement - decide whether to continue with existing operations and, if so, whether existing processes should be mantained

Cost Reduction Replacement - determine whether equipment should be replaced or not

New Product/Market - many unknown variables

Mandatory - e.g. required by government agency or insurance company; no choice but shows effects (cost) of implementing

Others - pet projects, high-risk R&D projects; difficult to analyze using capital budgeting process

Question 5

Explain how inflation affects capital budgeting analysis.

Answer 5

LOS 23.b

Discount rate - real WACC would be lowered by the inflation rate:
WACC_real = WACC_nominal - R_inflation

Affects profitability - If inflation higher than expected, future cash flows are worth less, so NPV is lowered

Reduces tax savings (tax sheild) - higher than expected lowers the depreciation charge

Decreases payments to bondholders - higher than expected inflation shifts wealth to issuing firms at bondholders’ expense

May affect revenues and costs differently - alters ATCFs

Question 6

Describe two ways to evaluate mutually exclusive projects with unequal lives

Answer 6

LOS 23.c

Least common multiple of lives “replacement chain” - compute NPV for the two projects, then combine and discount iterations of each of the two projects to compute NPV for comparison

Equivalent annual annuity (EAA) - using calculated NPV for each project, compute the effective annuity payment over each project’s time span that equals the each project’s NPV. Higher payment is the more valuable project.

Question 7

Describe Capital Rationing and how to choose projects under limited capital resources

Answer 7

LOS 23.c

Capital rationing - the allocation of limited fixed capital to a set of available projects that maximizes shareholder wealth.

Hard capital rationing - available capital to managers cannot be increased

Soft capital rationing - additional capital can be allocated to managers if shareholder wealth can be increased as result.

Question 8

Explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to assess the stand-alone risk of a capital project

Answer 8

LOS 23.d

sensitivity analysis - change one input variable (+/-) to see how the base case is effected. Note the high and low influence input (independent) variables

scenario analysis - construct probable scenarios and assign values to many input variables. One could compute a weighed average of the scenario outcomes

Monte Carlo simulation - assign a probability distribution to each input variable and run many random input scenarios. Compute NPV mean, NPV standard deviation, and NPV correlation with each input variable

Question 9

Explain and calculate the discount rate (using market risk methods) to use in valuing a capital project

Answer 9

LOS 23.e

Important points:

• Project beta is appropriate for measuring project /asset risk when a company (or its shareholders) are diversified.
• CAPM (or SML) is used to setermine discount rate for the asset/project.

R_project = R_F + B_project [E(R_MKT) - R_F

• Using a project’s beta to determine project-specific discount rate (also called “hurdle rate”) is important when the project’s risk is different from the company’s overall risk.

Question 10

Considerations and effects of using company’s WACC vs. the project’s hurdle rate as input to capital budgetnig decisions

Answer 10

LOS 23.e

If WACC > hurdle rate: Using WACC will overstate required rate of return and understate NPV.

If WACC < hurdle rate: Using WACC will understate required rate of retrun and overstate NPV.

Question 11

Describe real options

Answer 11

LOS 23.f

Real options are like financial call/put options except real options are based on real assets (and not financial assets) and are contingent on future events. Real options ALWAYS add value to a project.

Question 12

List types of real options

Answer 12

LOS 23.f

timing options - option to delay an investment with hope of having better decision-making information in the future.

abandonment option - (put) option to abandon a project if NPV_exit > NPV_continuing.

expansion option - (call) option to make additional investments if NPV_add > NPV.

flexibility option - option to change operational parameters of a project. e.g. price-setting, production-flexibility (worket overtime, change input materials, make product variations

fundamental options - projects that are options themselves because the payoff depends on the price of an underlying assets (e.g. copper mine)

Question 13

Approaches for valuing projects with real options

Answer 13

LOS 23.f

Compute NPV without option - If NPV > 0, real option will always increase NPV, so no need to compute real option value.

Add estimated value of option to project NPV:
total NPV = NPV_project - option cost + option value

decision trees - informs managers of the value of different choices.

option pricing models - e.g. Black-Scholes

Question 14

Describe common capital budgeting mistakes

Answer 14

LOS 23.g

failing to incorporate industry reaction to the project

misusing standard templates

pet projects - overly optimistic projections; less analysis

basing decisions of ROE or EPS - EPS/ROE incentives cause it

using IRR instead of NPV

poor cash flow estimation

poor overhead cost estimation - consider only incremental overhead costs related to management time and IT support

using incorrect discount rate e.g. company WACC instead of rate based on project’s risk

politics of manager spending entire annual budget

failure to generate alternative ptojects - don’t stop at “good” when there could be “better”

improper use of sunk and opportunity costs

Question 15

Economic Income (of a project)

Answer 15

LOS 23.h

Economic Income - one of two measurement alternatives to the basic discounted incremental cash flow approach used in the standard capital budgeting model (the other is Accounting Income). Like the DIATCF budgeting model, interest expense is reflected in the discount rate.

Economic inc equals after-tax cash flow plus the change in the investment’s market value, where

d(investment’s mkt value) = PV(discounted remaing ATCF) at WACC

econ inc = ATCF + (end mkt value - begin mkt value), or

econ inc = ATCF - economic deperession, where
economic depression = (begin mkt value - end mkt value)

Question 16

Accounting Income (of a project)

Answer 16

LOS 23.h

Accounting Income - one of two measurement alternatives to the basic discounted incremental cash flow approach used in the standard capital budgeting model (the other is Economic Income). Accounting Income is the reported NI on a company’s financial statements that results from an investment in a project.

NI (accounting) = (S - C - I)(1 - T) + TD (plus ATSal_T for Year_T),

where I = (begin MV)(Int%_debt)(%debt used to finance proj)

Question 17

A project’s accounting income will differ from economic income because…

Answer 17

LOS 23.h

• Accounting depreciation is based on the original cost (not market value) of the investment
• In accounting income, financing costs (e.g. interest expense) are considered as a separate line item and subtracted out to arrive at NI. In the basic capital budgeting model (and also the standard model) financing costs are reflected in the WACC.

Question 18

Market Value Added

Answer 18

LOS 23.i

market value added - the NPV based on economic profit. NPV using MVA is always the same as the valuation of NPV using the basic NPV approach.

NPV = MVA = sum[EP_t / (1+WACC)^t], where

EP_t = economic profit in year t

Question 19

Economic Profit

Answer 19

LOS 23.i

a measure of profit in excess of the dollar cost of capital invested in a project:

EP = NOPAT - $WACC, where

NOPAT = net operating profit after tax = EBIT(1 - T)
$WACC = dollar cost of capital = WACC \* capital
capital = dollar amount of investment (_initial investment reduced by depreciation each year_)

NOTE: “economic profit” and “economic income” refer to different concepts!

Question 20

Residual Income

Answer 20

LOS 23.i

residual income - focuses only on r_eturns to equityholders_ by subtracting an equity charge from the accounting NI:

residual income = NI - equity charge

or

RI_t = NL_t - r_eB_t-1, where

RI_t = residual income in period t

NI_t = net income in period t

r_e = required rate of return on equity

B_t-1 = beginning of period book value of equity.

So, NPV = sum[RI_t / (1+ r_e)^t]

Question 21

Claims Valuation Approach

Answer 21

LOS 23.i

claims valuation - based on BS concept that every asset is is financed by some combination of bedt and equity. divides operarating cash flows based on the claims of debt and equityholders that provide capital to the company, which are then added together to determine the value of the company (not the project).

• CF from debt = principle payments d(liab) + interest payments (from BS) discounted by the cost of debt.
• CF from equity = CFO (NI + deprec) - interest paid to bondholders d(liab).dividends and share repurchases discounted by cost of equity.

Question 22

Distuinguish between economic profit, residual income, and claims valuation models for capital budgeting.

Answer 22

LOS 23.i

• In theory, company valuation using EP, RI and claims valuation incomes will produce the same NPV.
• economic profit (EP) - reflects the income earned by all capital holders (NOPAT - $WACC); NPV (aka MVA) discounts EP using WACC.
• residual income (RI) - focuses on returns to equityholders (NI - r_eB_t-1); NPV discounts RI using required rate of return to equityholders (r_e).
• claims valuation - divides CFs to debt holders and equityholders, discounted by their respective costs; values the entire company, not just the project.