CAPITAL BUDGETING Reading - 36

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What is Capital Budgeting ? • Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development

projects are worth pursuing

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Capital Budgeting Process Step 1 – Generating Investment Ideas Step 2 – Analyze Individual Proposals for cash flows and profitability Step 3 – Plan and prioritize the Capital Budget (profitable

projects) to fit in overall company strategy Step 4 – Monitor and Post Audit the project to compare the planned results

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Capital Project Classification Project Type

Reasons for undertaking the project

- Break down of equipments Replacement Projects - Modest expense and large implication of not investing - Replacing existing equipments with more efficient equipment Expansion Projects

- Expansion projects increase the size of business

New products and services

- These projects increase the scope of business

- Required by government, insurance company or external party Regulatory, safety and - They may generate no revenue as maximising project returns is environmental projects not the major objective - Some projects escape capital budgeting criteria Other - eg. Pet projects of CEO, Vijay Mallya owning an F1 team

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Basic Principles of Capital budgeting • Base decisions on cash flow and not on accounting concepts • Time the cash flows • Base cash flows using opportunity cost concept

• Analyze cash flows on an after tax basis • Ignore financing costs – e.g. interest expense as the discounting rate applied during valuation captures both cost of equity and debt

Terms Costs already incurred are called Sunk Costs. Next best use of resource is the Opportunity Cost. Cash flow realized because of decision is the Incremental Cash Flow. When cash flow change from + ve to – ve sign more than once over the

life of a project, they are Non Conventional Cash Flows.

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Project Interactions • Independent Projects

• Mutually Exclusive Projects – Projects compete with each other

– Cash flows are independent Select Both Projects Select Project A

Select Project B

Projects A and B

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Select Project A

Select Project B Projects A and B

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Project Interaction… • Project Sequencing – Sequence projects based on time and economic conditions.

• Unlimited funding – Considers that all profitable projects can be funded at required rate of return.

• Capital Rationing – If a company has several profitable projects then funds must be allocated to maximize

shareholder value.

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Investment Decision Criteria • NPV and IRR are the most important investment decision criteria used by analysts – NPV – Net Preset Value – IRR – Internal Rate of Return

• Additional investment decision criteria include – Payback Period – Discounted payback period – Average accounting rate of return (ARR) – Profitability index (PI) www.proschoolonline.com/

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Net Present Value (NPV) • Net present value is the present Value of all the future after tax cash flows minus the initial investment • Formula NPV = CF0 +

CF1 (1+r) 1

t=n

CFt

t=0

(1+r)t

NPV =

∑

+

CF2 (1+r) 2

+

CF3 (1+r) 3

+ ….. +

– Where, • CFt = after tax cash flow at time t • r = required rate of return

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CFn (1+r)n

To Remember Invest if NPV > 0 Do not invest if NPV < 0

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Net Present Value (NPV)… • Example – Following are the cash flows for a capital project. Find NPV of the project. – Discounting Rate = 10% Years Project Cash Flow

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0 -100,000

1 30,000

2 40,000

3 30,000

4 40,000

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Net Present Value (NPV)… • Solution • Discounting Rate = 10% Years Project Cash Flow

0 -100,000

1 30,000

2 40,000

3 30,000

4 40,000

40000 30000 40000 Present Value of Cash -100,000 30000 Flow (1+10%) 0 (1+10%) 1 (1+10%) 2 (1+10%) 3 (1+10%) 4 PV of Cash Flows NPV

-100,000

27,273

33,058

22,539

27,321

10,191

• Accept the project at 10% discounting rate as NPV > 0 www.proschoolonline.com/

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Internal Rate of Return (IRR) • IRR is the discount rate that makes the present value of the future after tax cash flows equal the initial investment. • Formula CF1 CF2 CF3 CFn Initial = CF0 + + + + ….. + Investment (1+IRR) 1 (1+IRR) 2 (1+IRR) 3 (1+IRR) n Initial = Investment

t=n

CFt

t=0

(1+IRR) t

∑

– Where, • CFt = after tax cash flow at time t • IRR = Internal Rate of Return • r = discounting rate www.proschoolonline.com/

To Remember Invest if IRR > r Do not invest if IRR < r

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Internal Rate of Return (IRR)… • Example – Following are the cash flows for a capital project. Find IRR of the project. – Discounting Rate = 10% Years Project Cash Flow

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0 -100,000

1 30,000

2 40,000

3 30,000

4 40,000

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Internal Rate of Return (IRR)… • Solution • Discounting Rate = 10% Years Project Cash Flow

0 -100,000

100,000

=

1 30,000

2 40,000

3 30,000

4 40,000

30000

+ 40000 + 30000 + 40000 (1+IRR%) 1 (1+IRR%) 2 (1+IRR%) 3 (1+IRR%) 4

Trial and Error Process for finding IRR Discounting Rate 10.00% 15.00% 14.00% 14.25% 14.49%

NPV 10,191 -1,072 1,027 495 0

r (10%) www.proschoolonline.com/

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Payback Period • Number of years required to recover the original investment in the project • Example Years Project Cash Flow Cumulative Cash Flow

0 -100,000 -100,000

1 30,000 -70,000

2 40,000 -30,000

3 30,000 0

4 40,000 40,000

As Cumulative cash flow becomes '0' in the Third year, payback period = 3 years

• Drawbacks : – Ignores time value of money – Ignores cash flows beyond payback period www.proschoolonline.com/

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Discounted Payback Period • Number of years required for cumulative discounted cash flows to recover the initial investment • Example – Discount Rate = 10% Years Project Cash Flow Cumulative Cash Flow Discounted Cash Flow Cumulative Discounted CF

0 -100,000 -100,000 -100,000 -100,000

Fraction of year between, = years 3 and 4 =

17,130 27,130 0.627

Discounted Payback Period =

4.627 years

1 30,000 -70,000 27,273 -72,727

2 40,000 -30,000 33,058 -39,669

3 30,000 0 22,539 -17,130

4 40,000 40,000 27,321 10,191

As Cumulative cash flow becomes '0' between the years 3 and 4, the discounted payback lies between

• Drawbacks : – Ignores cash flows beyond payback period – Thus it does not measure profitability www.proschoolonline.com/

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Average Accounting Rate of Return • Formula:

AAR =

Average Net Income Average Book Value

• Example: – Initial Investment = Rs.1,50,000 – Project Life = 5 years (zero salvage value) Years Sales Cash Expenses Depreciation EBT Taxes (@40%) Net Income

1 80,000 40,000 30,000 10,000 4,000 6,000

2 75,000 37,500 30,000 7,500 3,000 4,500

3 4 100,000 75,000 50,000 37,500 30,000 30,000 20,000 7,500 8,000 3,000 12,000 4,500 Average Net Income

Working Notes 5 50,000 25,000 30,000 -5,000 -2,000 -3,000 4,800

Average Book Value = (1,50,000 + 0) / 2

= 75,000 Average Net Income = 4,800

– AAR = 4,800 / 75,000 = 6.4%

• Drawbacks : – Considers Accounting income – Ignores time value of money www.proschoolonline.com/

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Profitability Index (PI) • Formula PI

=

To Remember

PV of future cash flows = Initial Investment

1

+

NPV Initial Investment

Invest if

PI > 1

Do not invest if PI < 1

• Example – Following are the cash flows for a capital project. Find PI of the project. – Discounting Rate = 10% Years Project Cash Flow

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0 -100,000

1 30,000

2 40,000

3 30,000

4 40,000

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Profitability Index (PI)… • Solution • Discounting Rate = 10% Years Project Cash Flow

0 -100,000

1 30,000

2 40,000

3 30,000

4 40,000

40000 30000 40000 Present Value of Cash -100,000 30000 Flow (1+10%) 0 (1+10%) 1 (1+10%) 2 (1+10%) 3 (1+10%) 4 PV of Cash Flows

-100,000

NPV

27,273

33,058

22,539

27,321

10,191 Profitability Index

=

1 +

10,191 = 1.1019 100,000

• Accept the project as PI > 1 www.proschoolonline.com/

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NPV Profile • Value of NPV for a given capital project at different discounting rates generates the NPV Profile • Analyse the NPV profile for the following stream of cash flows Years Project Cash Flow

Discounting Rate 0% 3% 5% 8% 10% 13% 14% 18% 20% 23% 25%

0 -100,000

NPV 40,000 31,437 23,676 16,621 10,191 4,313 0 -6,018 -10,571 -14,772 -18,656

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1 30,000

2 40,000

3 30,000

4 40,000

3%

8%

NPV Profile NPV 50,000 40,000 30,000

20,000 10,000 0 -10,000

0%

5%

10% 13% 14% 18% 20% 23% 25%

-20,000

-30,000

Discount Rate (%)

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NPV v/s IRR • Whenever NPV and IRR rank two mutually exclusive projects differently, you should choose the project based on NPV • Example Years Project A Project B

To Remember For independent projects

IRR and NPV give the same accept /reject decisions

0

1

2

3

4

NPV

IRR

-100,000 -100,000

35,000 0

35,000 0

35,000 0

35,000 165,000

10,945 12,697

14.96% 13.34%

– Project A is ranked higher by the IRR method – Project B is ranked higher by the NPV method – As the two projects are mutually exclusive we must select the project with Higher NPV i.e. Project B www.proschoolonline.com/

To Remember For mutually exclusive projects decision based on NPV has a higher precedence over IRR 21

Observations on NPV Profile • NPV profiles are downward sloping as discounting rate increases • Discount rate at which two NPV profiles are same is called Crossover Rate • A projects NPV profile intersects X axis at its IRR Years Project A Project B

Discounting Rate 0% 3% 5% 8% 10% 13% 14% 18% 20% 23% 25%

0

1

2

3

4

NPV

IRR

-100,000 -100,000

35,000 0

35,000 0

35,000 0

35,000 165,000

10,945 12,697

14.96% 13.34%

Project A NPV 40,000 31,669 24,108 17,226 10,945 5,197 974 -4,925 -9,394 -13,523 -17,344

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Project B NPV 65,000 49,482 35,746 23,552 12,697 3,009 -3,952 -13,437 -20,428 -26,728 -32,416

NPV Profile NPV

Crossover Rate

120,000 100,000 80,000 60,000 40,000 20,000 0

-20,000

0%

3%

5%

8%

10% 13% 14% 18% 20% 23% 25%

-40,000 -60,000

Discount Rate (%)

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Multiple IRR problem • Arises when we have non conventional cash flows (cash flow changing signs more than once) • Example – For a given stream of cash flows find out IRR Year Cash Flow

0 -3500

1 12000

2 -10000

For this series of cash flow we get two different values of IRR. IRR 1 = 42.68% and IRR2 = 100%. Thus IRR decision criteria fails to give an output. Multiple IRR Profile Discounting Rate 10% 25% 43% 58% 73% 88% 100% 115% 130%

NPV -855 -300 0 89 95 54 0 -82 -173

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200 0 -200

10%

25%

43%

58%

73%

88%

100% 115% 130%

-400 -600 -800 -1,000

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No IRR problem • Arises when we have non conventional cash flows (cash flow changing signs more than once) • Example – For a given stream of cash flows find out IRR Year Cash Flow

0 4000

1 -12000

2 10000

For this series of cash flow there is no value of IRR. However it is a GOOD Investment as Project yields a + ve NPV across all discoutning rates. No IRR Profile 2,500

Discounting Rate 0% 30% 60% 90% 120% 150% 180% 210% 240%

NPV 2,000 686 406 454 612 800 990 1,170 1,336

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2,000 1,500 1,000 500 0 10%

25%

43%

58%

73%

88%

100% 115% 130%

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Popularity of Capital Budgeting Methods • Location – European companies follow payback period as decision making criteria. • Size – Bigger companies more likely to use NPV as selection criteria.

• Public v/s Private Companies – Private companies more likely to use payback period. • Management – Educated managers more likely to use NPV

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NPV and Stock Prices • NPV measures the expected change in shareholder wealth from a project. • The effect of project’s NPV is determined by valuing the existing investments and adding the expected NPV of its future investments. • Formula: Estimated increase in share price

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=

Existing Market Value

+

NPV of Project Number of shares

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Remuneration / Compensation Committee • It is responsible for ensuring that compensation and other awards encourage executive management to act in ways that enhance the company’s long term profitability and value. • Investors when analyzing committee should determine whether : – Executive compensation is appropriate . – The firm has provided details to shareholders regarding compensation in public documents. – Polices and procedures for this committee are in place . – The terms and conditions of options granted to management and employees are reasonable. – The firm and the board receive shareholder approval for any share based remuneration plans. – The firm has provided loans or the use of company property to board members. www.proschoolonline.com/

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Nominations Committee The purpose of the nomination committee : – It is responsible for recruiting new board members with qualities and experience . – Creating nomination policies and procedures. – Monitors the performance ,independence skills and expertise of existing board members to determine whether they meet the current and future needs of the company and the board. – Preparing for the succession of executive management .

• Investors should review the following: – The criteria for the new board members. – Expertise and background of existing board members. – The attendance records of the board members at regular and special meetings. www.proschoolonline.com/

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Voting rules • The ability to vote ones share is fundamental right of the share ownership. If the company makes it difficult for shareowners to vote or express their views , it could affect the company’s performance. • Investors should consider whether the company: – Allows proxy voting by some remote mechanism. – Limits the ability to vote shares by requiring the presence at annual general meeting. – Coordinating the timings of the AGM at different locations but on the same day in order to prevent the shareholders from casting their rights.

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Voting Rules . . • Confidential voting : Investors should determine if shareholders are able to cast confidential votes to encourage unbiased voting . Thus investors should consider : – – – –

The firm uses third party to tabulate shareowner votes. Third party agent retains voting records. The third party agent is subject to an audit to ensure accuracy. Shareholders are entitled to vote only if they are present.

• Cumulative voting: It enables shareholders to vote in a manner that enhances the likelihood that their interests are represented on the board. – Investors should consider whether the company has a significant minority shareowner group that might be able to use cumulative voting to serve it s own interests.

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Takeover Defenses • Take over defenses are provisions that make a company less attractive to a hostile bidder or more difficult to acquire. • When reviewing a company’s anti takeover measures investors should : – Inquire whether the company is required to receive shareowner approval for takeover measures. – Inquire whether the company has received any formal acquisition interest in the past. – Inquire whether the firm may use its cash to pay off a hostile bidder . Shareholders should take steps to discourage the board doing the activity.

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Take over Defenses . . • Take over defenses include: – Golden parachutes is the provision where large severance packages for top managers who lose their jobs as a result of a takeover. – Poison pills are the provisions that grant rights to existing shareholders in the event a certain percentage of a company’s shares are acquired – Greenmail is the provision for the use of corporate funds to buy back the shares of a hostile acquirer at a premium to their market value.

• Their effect is to decrease the share value.

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Thank You…

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