Capital Budgeting Projects

Capital Budgeting
Capital Budgeting
Projects
Capital Budgeting Projects

To evaluate a project, we must consider
how a project changes a firms overall cash
flows today and in the future and then
decide whether they add value to the firm.
A conventional capital budgeting project
would include:
a large up-front investment
periodic cash inflows for a definite time period
a salvage value at project termination

Only relevant cash flows for a project
are considered a relevant cash flow is
a change in the firms overall cash flow
that comes about as a direct result of
the decision to take that project.
Because relevant cash flows are defined
in terms of changes in or increments to
the firms existing cash flow, they are
called incremental cash flows.

In valuing projects or firms, and making
investment decisions, it is the after-tax
incremental cash flows that are relevant
to the financial manager or acquiring
firm executive.

Financing Costs:
In performing capital budgeting
analysis, we separate the investment
decision from the financing decision
Essentially this is equivalent to measuring
the FCF (from assets) to the firm.
Using WACCAT in the valuation of a project
implicitly includes the value of the interest
tax shield from debt financing.

Sunk Costs:
In addition to financing costs being
irrelevant to capital budgeting decisions,
so are sunk costs:
Sunk costs are not incremental and should not
be considered as part of the investment
analysis.
Common sunk costs are market research and
product research and development.
Keep in mind, however, a firm who invests in
such activities needs to recover the cost over
the long-run.

Cost Allocation:
In managerial accounting we are taught how to
allocate the cost of resources to products based
on the products use of the resource measured using cost drivers:
While the purposes of these allocations is logical, in
capital budgeting we remain only concerned with
whether it is an incremental cash flow or not.
If a cost will be incurred by the firm with or without
the project, the cost is irrelevant.
However, over the long-run, like sunk costs, the cost
of headquarters (a cost center) needs to be paid
for.

Spillover Effects:
Spillover effects can be positive or
negative and are relevant in capital
budgeting decisions:
A positive spillover effect may occur when a
complementary product is introduced to the
market by the firm - a computer products
retailer expands to offer in-house servicing.
A negative spillover effect may occur when
products are substitutes - product
cannibalization occurs; this may result in a
product not being introduced to the market.

In a competitive market, product
cannibalization will occur whether the firm
innovates and offers new products or not; as
such, the spillover effect can be considered
immaterial to the analysis - Procter and
Gamble.
On the other hand, in a non-competitive
(patent or government-legislated protected)
market, cannibalization is relevant during the
period of non-competition - pharmaceuticals
with patents.

Opportunity Costs:
Opportunity costs are relevant and need
to be valued at market rates:
An owner-operator needs to value his/her
services to the business at the market rates cooks make $10/hour, junior administrators
- $12/hour, executives - $50/hour.
Land being considered for development by a
firm would value the land at its current
market value not its historical cost.

Other categories that are relevant
capital budgeting decisions are:
Government Intervention examples include
taxes, CCA, ITC, grants, subsidized loans.
Net Working Capital generally there is a
cash outflow at time zero and a cash inflow
at project termination.
Inflation when using a nominal discount
rate, future cash flows need to be adjusted
for inflation.
1.
2.
3.
4.
5.
The following are general cash flow

categories in performing capital budgeting
analysis:
After-tax operating income excluding CCA.
Periodic changes to NWC.
Initial investment.
Salvage value including terminal losses
and recaptures (if applicable).
CCA tax shield.
Pro Forma FS and Project Cash Flows

To evaluate a proposed project, we
need to:
1. Prepare pro forma financial statements
We need to estimate unit sales, the selling
price per unit, the variable costs per unit, and
the fixed costs relevant to the project.
We also need to estimate the total investment
required including the investment in NWC.

2. Forecast project cash flows
From the pro forma FS, we need to calculate
the net cash flows each period for the project
Project cash flows come from three sources:
1. Operations
2. Changes in NWC
3. Changes in investment
Operating cash flow = EBIT + depreciation

taxes where taxes are calculated assuming
there is no interest expense.

3. Evaluate the investment
Using the NPV and other criteria, we can
evaluate the cash flows from the project to
determine whether to accept or reject the
project proposal.
Preparing Pro Forma Statements

Suppose we want to prepare a set of pro forma
financial statements for a project for Desmond
Enterprises. In order to do so, we must have
some background information. In this case,
assume:
Sales of 10,000 units/year @ $5/unit.
Variable cost per unit is $3.
Fixed costs are $5,000 per year.
The project has no salvage value.
Project life is 3 years.
Project cost is $21,000. Depreciation is $7,000/year.
Additional net working capital is $10,000.
The firms required return is 20%.
The tax rate is 34%.

Pro Forma Financial Statements
Projected Income Statements
Sales
$50,000
Variable Costs 30,000
Contribution Margin $20,000
Fixed costs
5,000
Depreciation
7,000
EBIT
$ 8,000
Taxes (34%)
2,720
Net income
$ 5,280

Now lets use the information from the
previous example to do a capital budgeting
analysis.
Project operating cash flow (OCF):
EBIT
Depreciation
Taxes
OCF
$ 8,000
+7,000
-2,720
$12,280

Project Cash Flows
0
OCF
$12,280 $12,280 $12,280
Chg. NWC -10,000
10,000
Cap. Sp.
-21,000
Total
-31,000 $12,280 $12,280 $22,280

Capital Budgeting Evaluation:
NPV = -31,000 + 12,280/1.201 + 12,280/1.202 +
$22,280/1.203
= $655
IRR = 21%
Payback =
2.3 years
Should the firm invest in this project? Why or

not?
How Do We Mitigate Forecasting Risk?

We accept investment opportunities with a
NPV > 0 since the market value of a project
exceeds its costs; positive NPV projects
create value for its owners. However, NPV
is based on projected cash flows, not
actual.
As such, there is forecasting risk inherent in
our analysis the risk that we make a bad
decision because of errors in the projected
cash flows.

1. Sources of Value
We should be able to point to something
specific as a source of value:
Is our product or service better than the
competitions?
Can we manufacture it at a lower cost?
Can we distribute it more effectively?
Can we identify an underdeveloped market?
Do we have relationships with government
officials that provide us with a competitive
advantage.

Keep in mind:
a. Positive
NPV projects are rare in a highly

competitive environment.
b. Positive NPV investments are probably not
all that common and certainly limited for
any given firm.

2. Scenario Analysis
Scenario analysis is the determination of
what happens to NPV estimates when we
ask what-if questions; we change several
variables simultaneously.
If we find most scenarios have positive
NPVs, this gives us confidence in
proceeding with the project; however, if
many of the scenarios are negative, we
may want to investigate further.

Consider developing a continuum of
scenarios from worst case to best case and
identity the break-even point where NPV
= 0.
From this we can estimate the probability of
the NPV being greater-than zero.

3. Sensitivity Analysis
Sensitivity analysis investigates what
happens to NPV when only one variable is
changed.
This helps us isolate the source(s) of
forecasting risk.
For example, gold mines are sensitive to
the price of gold, the level of
concentration, and the productivity of the
factors of production.

However, through effective geological
studies and experienced operations
management, the forecasting risk for the
last two variables can be minimized, unlike
the market price of gold.
As such, we may want to graph the
relationship of various gold prices and NPV
to determine how low gold prices can go
before we fail to make our required return
on investment.
Special Capital Budgeting Cases

1. Evaluating Cost Cutting Proposals
One decision we frequently face is whether to
upgrade existing facilities to make them more
cost effective.
The issue is whether the cost savings are large
enough to justify the necessary capital
expenditure.
As always, the initial step in making this decision
is to identify the relevant incremental cash flows.
Remember, a reduction in operating expenses
increases net income and taxes.

2. Replacing an Asset
Companies often need to decide whether
it is worthwhile to enhance productivity
by replacing existing equipment with
newer models or more advance
technology.
This analysis is more complex because
you are going to replace existing
equipment.

In this situation, the initial investment (C) is
calculated by taking the initial investment of
the new asset and subtracting todays
disposal value of the old asset.
The salvage value (S) is calculated by taking
the salvage value of the new asset and
subtracting the salvage value of the old asset.
Of course, this technique only works if the
lives of both assets are equal.

3. Evaluating Equipment with Different Lives
Often we need to consider among different
possible systems, equipment, or procedures
with different lives here we are trying to
minimize costs.
To do this, we place projects on a common
horizon for comparison.
This approach is used when two special
circumstances exist:
1.
2.
The possibilities under consideration have different

economic lives.
We need whatever we buy more or less indefinitely.

One technique we use is the equivalent
annual cost (EAC):
EAC = PV of Costs
[1 (1+r)-n]/r
We choose the alternative with the
smallest EAC since it has the smallest
effective annual
cost.

4. Setting the Bid Price
Here we want to establish a bid price that
will guarantee us a minimum return on
investment.
To do this we work backwards by setting the
NPV equal to zero and solve for the bid price
using our required rate of return.
At this (solved for) bid price, if you get the
contract, you will earn your required rate of
return and, at the same time, avoid
underbidding.
Additional Considerations in Capital Budgeting

Managerial Options
In our capital budgeting analysis thus far, we
have more or less ignored the possibility of
future managerial actions.
In reality, however, depending on what actually
happens in the future, there are always ways to
modify a project these opportunities are called
managerial options
Pre-planned managerial options is a form of
contingency planning what will we do if our
assumptions are not realized and adjustments
to our plan need to be made?

Managerial options include:
1. The option to expand
2. The option to abandon
3. The option to wait
4. The tax option
5. Strategic options
Test the water by sticking a toe in before diving
By ignoring options, NPV is underestimated.
The damage might be small for a highly
structured, very specific proposal, but it might
be large for an exploratory proposal.

Market Valuation
McConnell and Muscarella (1985) document a
significantly positive stock price reaction to
corporate announcements of plans to increase
capital investment spending (including R&D)
and a negative reaction to investment
spending cuts.
Such announcements are a mechanism used
by management to send signals to the market
regarding the health and prospects of the firm.
Applying the Tax Shield Approach

Time savings are possible by using a
formula that replaces the detailed
calculation of yearly CCA.
The formula is based on the idea that
tax shields from CCA continue into
perpetuity as long as there are assets
remaining in the CCA class.

Formula:
PV of tax shield on CCA =
CdTc x 1+.5k SdTc x 1 d+k
1+k
d+k
(1+k)n
where:
C = total capital cost of asset added to
pool
d = CCA rate for the asset class
Tc =
companys marginal tax rate
k = discount
rate
S = salvage or disposal value n = asset
life in years

Two points regarding the salvage value:
1. If the asset pool contains many assets,
the disposal of an individual asset will
require the actual salvage value be used
for S.
If the UCC for the asset is more the salvage
value, CCA will continue to be taken on the
difference indefinitely into the future.
If the UCC for the asset is less than the
salvage value, CCA will be reduced as a result
of the difference indefinitely into the future.

2. If the asset pool contains only one
asset, the disposal of the asset will
require that the UCC be used for S as
the asset pool will be closed.
In this case, if the UCC is greater than the
salvage value, a terminal loss is recognized
not enough CCA was taken over the life
of the asset.
If the UCC is less than the salvage value, a
recapture is recognized too much CCA
was taken over the life of the asset.

Capital Budgeting Projects

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