Week 6 Chapter 12 & 13

PowerPoint to accompany
Week 6
Chapter 12
& 13
Chapter 12
Capital
budgeting: cash-
flow
identification
issues and
project ranking
conflicts
Guidelines for identifying
a project’s incremental
costs & benefits
 Think incrementally
 Cash flows diverted from existing products
 Incidental or synergistic benefits
 Allowance for working-capital requirements
 Consider incremental expenses not just benefits
 Sunk costs are not incremental cash flows
 Account for opportunity costs
 Are overheads truly incremental?
 Consistency in the treatment of inflation
 Ignore interest payments and financing flows
Petty, Keown, Scott, Martin, Martin, Burrow, Nguyen: Financial Management 5e © 2009 Pearson Education Australia
Applying Discounted
Cash Flow Techniques
Required steps:
 Identify incremental cash flows

 Identify the discount rate
 Calculate NPV, PI and IRR
Categorising Cash
Flows
 Initial outlay
 Year 0
 Annual incremental cash flows

 Years 1 to final year-1
 Terminal cash flows

 Final year
Cash flows - example
We are developing an extra fast-food outlet. Costs and
income flows are:
 $2 million site acquisition and development costs
 $400,000 plant & equipment straight line depreciable over 5
years
 Sales in year 1 of $600,000, $700,000 per year thereafter
 Cost of labour & materials = 40% of sales
 Policy is to sell outlet in 3 years, estimated sale price is 20%
more than initial cost
 Sales in a similar outlet of ours to decline by 10% or by
$70,000 due to loss of experienced staff to new venture
 Other costs: $150,000 annually
 Investment in working capital = 10% of annual sales
 Tax Rate = 47%
Example cont’d
Cash flows in year 0

Initial development costs -$2,000,000
(10%) ($600,000-$70,000)
Incremental working capital -$53,000
Net cash flow, after tax -$2,053,000
Net cash flow, pre tax -$2,053,000
Example cont’d
Sales $530,000
Less: Cost of sales 212,000
Gross profit 318,000
Less: Operating costs 150,000
Depreciation 80,000
Net profit before tax 88,000
Less: Tax 41,360
Net profit after tax 46,640
Add: Depreciation 80,000
Operating cash flow after tax 126,640
Incremental working capital -17,000
Net cash flow, after tax 109,640
Net cash flow, pre tax 151,000
Example cont’d
Sales $700,000
Depreciation 80,000
Less: Tax 89,300
Incremental working capital 0
Net cash flow, after tax 180,700
Net cash flow, pre tax 270,000
Example cont’d
Sales $700,000
Depreciation 80,000
Less: Tax 89,300
Proceeds of sale 2,400,000
Recovery of working capital 70,000
Net cash flow, after tax 2,650,700
Net cash flow, pre tax 2,740,000
Example cont’d
Pre tax cash flows
-$2,053,000 $151,000 $270,000 $2,740,000
0 1 2 3
After tax cash flows
-$2,053,000 $109,640 $180,700 $2,650,700
0 1 2 3
Capital availability
 Suppose that you have found 6 capital investment

projects for your company which all satisfy NPV, IRR
and PI criteria.
 Problem: the Chief Finance Officer has given you a

limited capital budget
How do you decide which projects to select?
Capital rationing
The firm limiting the dollar
size of its capital budget
 Why?
 Temporary adverse market conditions
 Shortage of qualified project managers
 Intangible considerations
Capital rationing cont’d
Cut-off criterion Cut-off criterion

with capital without capital
IRR (%)
rationing rationing
Required rate
of return
A B C D E F G H
$X Dollars
Budget constraint
Capital rationing cont’d
 Decision criterion
Select the set of projects with the highest net
present value, subject to the capital constraint
 All discounted cash flow criteria will give the same

accept/reject decision
 BUT conflict in ranking may arise
 Please refer to pages 1-4
Problems with project
ranking
1. The size disparity problem for mutually exclusive
projects of unequal size
2. The time disparity problem with mutually exclusive

projects
3. The unequal life-span problem with mutually

exclusive projects
The size disparity
problem
 The NPV decision may not agree with the IRR or PI
decisions
 If there is no capital rationing:

 Select the project with the largest NPV
 If there is capital rationing:

 Select the set of projects having the largest sum of
NPVs consistent with the capital constraint
The time disparity
problem
 Occurs when two projects of equal size have
significantly different cash flow patterns over their life-
times
 NPV and PI calculations assume cash flows are
reinvested at the required rate of return
 IRR assumes reinvestment occurs at the IRR
 Problem: the NPV or PI decision may not agree with the
IRR
 Solution: select the project with the largest NPV
The unequal life-span
problem
Example
Suppose our firm has to choose between 2
machines. They differ in terms of economic life and
capacity. Our required return is 14%. The after-tax
cash flows are:
Year Machine Machine
1 2
0 (45,000) (45,000) How do we
1 20,000 12,000 decide which
2 20,000 12,000 machine to
3 20,000 12,000
4 12,000 choose?
5 12,000
6 12,000
problem cont’d
Answer
Step 1. Calculate NPVs
 NPV1 = $1,432.64
 NPV2 = $1,664.01
 Does this mean machine 2 is better?

 No! The two NPVs can’t be compared!
problem cont’d
Answer
Step 2. Calculate the equivalent annual annuities
 We assume each project can be replaced an infinite number of times in
the future, and then convert each NPV to its equivalent annuity
 The projects’ EAAs can be compared to determine which is the best
project
Using tables: EAA = NPV / PVIFA i,n
Using calculator: PV = - NPV, i = R, n, FV = 0,
COMP PMT, EAA = PMT
problem cont’d
Step 2. (cont’d)
Using tables: EAA = NPV / PVIFA i,n
EAA 1 =NPV 1 / PVIFA 14%,3
=1432.64/ 2.322
= $616.99
EAA 2 =NPV 2 / PVIFA 14%,3
=1664.01/ 3.889
= $427.88
problem cont’d
Step 2. (cont’d)
Using a calculator: PV = - NPV, i = R, n, FV = 0,
COMP PMT, EAA = PMT
Machine1 Machine2
PV = -1432.64 PV = -1664.01
n=3 n=6
i = 14 i = 14
EAA1 = $617.08 EAA2 = $427.91
problem cont’d
Answer
Step 3. Decision
We’ve reduced a problem with different time horizons to
a choice between two annuities
Choose the project with the highest EAA
Choose machine 1
problem cont’d
Answer
Step 4. Convert back to NPV∞
Assuming infinite replacement, the EAAs are actually
perpetuities
NPV∞ ,i = EAA i / R
NPV∞,1 = EAA 1 / R = 617.08 / 0.14 = $4,407.71

NPV∞,2 = EAA 2 / R = 427.91 / 0.14 = $3,056.50
This doesn’t change the choice of project, it just yields

comparable NPVs
Impact on inflation on
capital budgeting
 Increased inflation will cause the required rate of
return to increase
 Anticipated cash inflows, cash outflows, and salvage

values could all be affected
 Inflation must be accounted for in a consistent

fashion
End of Chapter 12
Chapter
13
Risk in capital
budgeting
Risk and the investment
decision
1. What is the relevant risk in terms of

capital-budgeting decisions?
2. How should risk be incorporated into

capital-budgeting analysis?
Relevant risk for capital
budgeting
Project’s stand-alone risk
Firm can diversify Contribution-to-firm risk

away
with other projects
Investors can Systematic risk

diversify away
with other shares
Relevant
Risk and the required
rate of return
 Can the existing required rate of return be used to
assess the required rate of return on a firm’s new
investment projects?
 Is the new project likely to have the same risk as the

firm’s existing projects?
The firm’s existing required rate of return can be used

for a new project only if the new project bears the
existing level of operating risk and financial risk
Incorporating risk into
the NPV model
Σ
n
ACFt
NPV = - IO
( 1 + k* )t
t =1
 Method 1: Adjust the cash flows (ACFs)

 Method 2: Adjust the discount rate (k)
 Certainty-equivalent approach
 Risk-adjusted discount rate
Risk-adjusted discount
rates
 Simply adjust the discount rate (k) to reflect higher
risk
 Riskier projects will use higher risk-adjusted discount

rates
 Calculate NPV using the new risk-adjusted discount

rate
Risk-adjusted discount
rates
Σ
n
ACFt
NPV = - IO
( 1 + k* )t
t =1
 How do we determine the appropriate risk-adjusted

discount rate (k*) to use?
 Many firms set up risk classes to categorise different
types of projects
Risk classes
(Refer to example 13.1
pages 423- 424)
Risk RADR
class k* Project type
1 12% Replacement equipment

2 15% Modification or expansion
of existing product line
3 18% Unrelated new products
4 25% Research & development
Certainty-equivalent
approach
 Adjusts the risky cash flows to certain cash flows
Risky cash x Certainty equivalent = Certain cash

flow coefficient, α flow
 For a risky project:
 $1000 x 0.5 = $500
 For a less risky project:
 $1000 x 0.9 = $900
coefficient
certain cash flow in period t

α t =
risky cash flow in period t
The greater the risk, the

smaller the CE coefficient
approach
Σ
n
α t ACFt
NPV = - IO
( 1 + i f )t
t =1
 Steps
1. Adjust all cash flows by certainty equivalent coefficients to get
certain cash flows
2. Discount the certain cash flows by the risk-free rate of interest
3. Apply normal capital budgeting criteria
(refer to example 13.3 pages 426-427)
Comparison of methods
Measurement of a
project’s systematic risk
 Use CAPM to determine the appropriate project required
rate of return
 Recall:
Rj = Rf + β j ( Rm – Rf )
(9-18)
 Problem: What value of project β should be used?
Measurement of a
project’s systematic risk
 Two possible approaches:
1. If the project has similar risk to existing projects in
the firm: use historical accounting data as a
substitute for historical price data (return of division
versus market return)
2. If the project has new risk levels: find a firm that has
similar risk to the new project and use its estimated
systematic risk as a proxy for that of the project
– Pure Play Method
Other methods for
comparing risk
1. Simulation
2. Sensitivity analysis
3. Probability trees
Simulation
1. Develop probability distributions for key factors

2. Randomly select values from these distributions
3. Combine these factors and determine an internal
rate of return
4. Continue to repeat this process until a clear portrait
of the results is obtained
5. Evaluate the resultant probability distribution
Simulation variables
Simulation cont’d
Probability of occurrence
10 20 30
Internal rate of return (%)
Sensitivity analysis
-$1,290,000 $200,000 $350,000 $1,100,000
0 1 2 3
Discount rate NPV

% $
8 68,469
10 7,521
12 -49,452
Probability trees
End of Chapter 13

Week 6 Chapter 12 &amp; 13

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Week 6 Chapter 12 &amp; 13

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PowerPoint to accompany

 Identify incremental cash flows

 Annual incremental cash flows

 Terminal cash flows

Cash flows in year 0

Pre tax cash flows

-$2,053,000 $151,000 $270,000 $2,740,000

After tax cash flows

-$2,053,000 $109,640 $180,700 $2,650,700

 Suppose that you have found 6 capital investment

 Problem: the Chief Finance Officer has given you a

How do you decide which projects to select?

Cut-off criterion Cut-off criterion

 All discounted cash flow criteria will give the same

2. The time disparity problem with mutually exclusive

3. The unequal life-span problem with mutually

 If there is no capital rationing:

 If there is capital rationing:

 Does this mean machine 2 is better?

EAA 1 =NPV 1 / PVIFA 14%,3

EAA 2 =NPV 2 / PVIFA 14%,3

EAA1 = $617.08 EAA2 = $427.91

Choose the project with the highest EAA

NPV∞,1 = EAA 1 / R = 617.08 / 0.14 = $4,407.71

This doesn’t change the choice of project, it just yields

 Anticipated cash inflows, cash outflows, and salvage

 Inflation must be accounted for in a consistent

1. What is the relevant risk in terms of

2. How should risk be incorporated into

Firm can diversify Contribution-to-firm risk

Investors can Systematic risk

 Is the new project likely to have the same risk as the

The firm’s existing required rate of return can be used

 Method 1: Adjust the cash flows (ACFs)

 Riskier projects will use higher risk-adjusted discount

 Calculate NPV using the new risk-adjusted discount

 How do we determine the appropriate risk-adjusted

1 12% Replacement equipment

Risky cash x Certainty equivalent = Certain cash

certain cash flow in period t

The greater the risk, the

 Problem: What value of project β should be used?

1. Develop probability distributions for key factors

-$1,290,000 $200,000 $350,000 $1,100,000

Discount rate NPV

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Week 6 Chapter 12 & 13

Week 6 Chapter 12 & 13