Corporate Finance - Capital Budgeting

11:45 AM

Capital Budgeting
Reading 36 of CFAI Materials

Learning objectives look to contain quite a bit of repetition from quantitative methods section

Intro

• Capital budgeting is 1 year or more in timeframe
• Can ultimately decide future of corporation
• Mistakes are costly
• Close relationship to portfolio mgmt
• Used in a variety of contexts - mergers, refinancing, etc

Capital budgeting process

• Step 1 Generating ideas
• Step 2 Analyze individual proposals - forecast CFs and evaluate profitability
• Step 3 Plan capital budget - put into context of whole, evaluate timing, prioritize
• Step 4 Monitor and post-audit - compare plan to actual

Categories

• Replacement projects - replacing worn out equipment, evaluating new equipment choices, etc
• Expansion - more complex/uncertain than replacement
• New products/services - even more uncertain than expansion - will involve more people
• Regulatory/safety/environment
• Other - some projects are not easy to analyse with NPV etc.  R&D is an example as are pet projects (e.g. should CEO get a plane)

Principles

• Decisions are based on cash flows, not net income.  Intangibles ignored - if they are real, they should result in cash at some point
• Timing of cash flows is crucial
• Cash flows are based on opportunity costs
• Taxes are fully reflected
• Financing costs are ignored
• Financing costs are reflected in the required rate of return
• Cash flows are not accounting net income
• Noncash charges like D&A skew net income
• Concept of economic income versus accounting income (return to later)

Unless an investment earns more than the cost of funds from its suppliers of capital the investment should not be undertaken

Further concepts

• Sunk cost - one that has already occured - cannot change and therefore should not affect future decisions
• Opportunity cost - what is a resource worth in its next best use
• Incremental cash flow - cash flow with a decision minus cash flow without the decision
• Externality - effects of project on other parts of company or outside company
• E.g. cannibalization
• Conventional vs. nonconventional cash flows
• Conventional - outflow followed by series of inflows
• Nonconventional - can flip back and forth pos/neg
• Independent vs. mutually exclusive projects (obvious)
• Project sequencing - investing creates option to invest in other projects
• Unlimited funds vs. capital rationing
• Unlimited funds assumes company can raise as much capital as it needs to fund good projects
• Rationing is when company has fixed amount of funds to invest

Covered NPV rule and IRR rule

• Invest if NPV > 0, do not invest if NPV < 0
• Positive NPV investments are wealth increasing, negative are wealth decreasing
• IRR - discount rate that makes NPV = 0
• Invest if return is greater than your discount rate

Payback period

• Calculate how many yrs it takes to pay back
• For partial years assume linear cash flow
• Ignores time value of money and ignores pmts after payback is completed
• Simplicity is an advantage, and may indicate project liquidity
• No decision rule - must use in conjunction with NPV/IRR

Discounted payback period

• Same but uses discounted cash flows - partially addresses the problem with payback
• If a project has negative NPV, will not have a discounted payback period
• Still ignores cash flows after payback has been reached
• There might be negative CFs after payback has been reached too

Average Accounting Rate of Return

• AAR = avg net income / avg book value
• Ex you have a 5 yr project and an asset worth 200,000 depreciating to 0
• Average the 5 net incomes, and average the asset, and divide to get the return
• Advantage: easy to calculate
• Disadvantage: based on accounting, not cash flows, and doesn't account for TVM
• No conceptually sound cutoff for what is a good AAR
• Analysts should know it but rely more on NPV and IRR

Profitability Index

• PI = present value future cash flows / initial investment = 1 + NPV / initial investment
• Invest if PI > 1, do not invest if PI < 1
• Indicates value you are receiving for one unit of currency invested

NPV Profile

• Shows NPV graphed as a function of various discount rates

Ranking conflicts b/w NPV and IRR

• Differing cash flows can cause conflicts between NPV and IRR rankings
• When they differ and two projects are exclusive, defer to NPV
• Both approaches assume you can reinvest at a certain rate - NPV uses discount rate and is more reliable
• Scale can also be a factor - a small project may have high IRR but lower overall NPV
• NPV shows amount of wealth gained

Multiple IRR Problem and No IRR Problem

• IRR profiles can be parabolic and might either touch 0 NPV twice or not at all
• No IRR does not necessarily mean a bad investment - NPV might be very high
• For conventional projects - outlays followed by inflows - multiple IRR problem cannot occur
• Nth degree polynomial might had n solutions - but does not mean that you WILL have n solutions

Impact of a project on stock price is not straightforward

End of reading

12:45 pm

1 hour