Concepts Description
Capital Budgeting
Capital budgeting process Process of identifying and evaluating capital projects (projects where CF to firm will be received over a period longer than a year)
Categories of capital budgeting 1. Replacement projects to maintain the business :
projects ‐ no need for detailed analysis
‐ issue : should the existing operations continue ; and should the existing processes be maintained
2. Replacement projects for cost reduction :
‐ Whether obsolete usable equipment should be replaced
‐ Fairly detailed analysis is required
3. Expansion projects :
‐ To expand a business
‐ Require explicit forecast of future demand → involve complex decision‐making process
4. New product / market development :
‐ Complex decision‐making process, with detailed analysis, due to high level of uncertainty
5. Mandatory projects :
‐ Required by gov. agency / insurance company
‐ involve safety‐related / envi concerns
‐ generate minimum revenue, but accompany new revenue‐generating projects undertaken by the company
6. Other projects
5 Principles of capital budgeting 1. Decision based in CF, not accounting income
‐ Sunk cost : not include
‐ Exernalities (effect of the project acceptance on firm's other CF) : include
2. CF are based on opportunities costs ‐ Opportunities cost : include
3. Timing of CF is important
4. CF analysed on after‐tax basis
5. Financing cost are reflected in project's required rate of return
Expansion project ‐ Method to 1. Initial investment outlay : up‐front costs of the project
calculate yearly CF Initial investment outlay = Fix cost investment (FCInv) + Net Working Capital investment (NWCInv)
(*) NWCInv must be included, because additional inventories are required to generate additional sales ;↑ sales → ↑ AR ; ↑ Inventory → ↑ AP
NWCInv = ∆Non‐cash current assets ‐ ∆Non‐debt current liabilities = ∆NWC
NWCInv > 0 → require addi ona financing → cash ou low to fund net investment in current assets (and vice versa)
End of project → no need for addi onal WC → cash inflow (ou low) equal to ini al NWC
2. After‐tax operating CF : Incremental CF over capital asset' economic life
CF = (S ‐ C ‐ D) × (1 ‐ T) +D = (S ‐ C) × (1 ‐ T) + T × D
S = Sales
C = Cash operating costs
D = Depreciation expense
T = Marginal tax rate
(*) Depreciation : non‐cash operating expense, but reduce the taxes paid by firm
3. Terminal year after‐tax non‐operating CF (TNOCF)
TNOCF = Sal + NWCInv ‐ T × (Sal ‐ B)
Sal = Salvage value of FA
B = Book value of FA
Replacement project ‐ Method to Replacement project analysis : whether to replace an existing assets with a newer / better one
calculate yearly CF 1. Initial outlay : reflect the sale of old asset
2. After‐tax operating CF : calculate incremental operating CF
∆ ∆ ∆ 1 ∆
3. Terminal year after‐tax non‐operating CF (TNOCF)
Effect of inflation on capital 1. Analysing nominal / real CF : should match type of CF with the discount rate (Nominal CF ‐ Nominal discount ratee ; Real CF ‐ Real discount rate)
budgeting analysis 2. Changes in inflation affect project profitability : Inflation higher than expected → ↓ future CF → ↓ project's value
3. Inflation reduce tax saving from depreciation
4. Inflation decrease the payment value to bondholders
5. Inflation affect sales and cost differently : due to price of output goods change differently to prices of inputs→ a er‐tax Cf may be be er or worse
Mutually exclusive projects with 2 approaches :
different lives 1. Least common multiple of lives approach
2. Equivalent annual annuity (EAA) approach (compare annual payment)
Capital rationing Capital rationing : allocaion of fixed amount of capital among a set of available projects→ maximise shareholder wealth. Choose combina on of projects it can afford to have the
greatest total NPV
Hard capital rationing : fund alocated to managers cannot be increased
Soft capital rationing : allow to ncrease allocated capital budget if can justify that additional funds will create shareholder value
Sensitivity analysis Sensitivity analysis : changing an independent input variables to see the change in dependent variable
‐ Start with base case scenario
‐ Change 1 variable by a fixed % point above and below the base case
‐ Noting the effect of this change on the project NPV
Scenario analysis Scenario analysis : risk analysis technique, that consider both the sensitivity of key output variable (NPV) to changes in key input variables
‐ Allow for changes in multiple input variables at once
‐ Create Worst case, Best case and Base case
, Simulation analysis (Monte Carlo Probability distribution of project NPV outcomes, rather than just a limited number of outcomes
simlation) ‐ Step 1 : Assume specific probability distribution for each variable input
‐ Step 2 : Simulate a random draw from the assumed distribution of each input variable
‐ Step 3 : For each et of inputs from Step 2, calcuate NPV
‐ Step 4 : Repeat Step 2 and 3 for 10,000 times
‐ Step 5 : Calculate mean standard deviation and correlation of NPV with each input variable
‐ Step 6 : Create probability distribution of NPV from 10,000 outcomes
Calculate discount rate based on
market risk method
(*) Use project‐specific discount rate, rather than overall company rate
Real option Real option : option to the right, but not the obligation, to make future decisions that change the value of capital budgeting decision made today
‐ Offer flexibility → improve project's NPV
1. Timing option : able to delay making an investment with the hope of having better information in the future
2. Abandonmen option : PV of incremental CF from exiting > PV of incremental CF from continuing→ able to abandon the project
3. Expansion option : able to make additional investments of it creates more value
4. Flexibility option : Choices regarding the operating of the project, including :
‐ Price setting option : abe to change price of a product
‐ Production flexibility option : paying OT / using different input materials / producing different variety of products
5. Fundamental option : projects that are option themselves (e.g.: cooper mine)
Calculate project's NPV with option :
Overal NPV = Project NPV (DCF) ‐ Option cost + Option value
Determine hurdle value for project's NPV wit option :
‐ Using decision tree
‐ Using option pricing models
Common capital budgeting ‐ Failing to incorporate economic responses into the analysis. E.g.: Low barrier entry→ new conpe tors → lower profitability
mistakes ‐ Misusing standardised templates. Templates are used to streamline analysis process, but may not be exact match for the project → es ma on errors
‐ Pet projects of senior management
‐ Basing investment decision on EPS or ROE → avoid posi ve LT NPV investment with ST decrease of EPS and ROE
‐ Using IRR criterion over NPV
‐ Poor CF estimation
‐ Misestimation of overhead costs. Shoud include only the incremental overhead costs related to management tim and IT support, which is difficult to quantify
‐ Using incorrect discount rate
‐ Politics involved with spending th entire capital budget → to ask for more budget next year
‐ Failure to generate alternative investment ideas
‐ Improper handling of sunk and opportunities costs
Economic income Economic income = CF + (Ending MV ‐ Beginning MV)
In which :
MV = discounted future CF
(*) Economic income rate = Economic income / Beginning MV = project's WACC
Accounting income Accounting income : reported net income result from an investment in a project
Accounting income = (EBIT ‐ Interest expense) × T ‐ After‐tax salvage value
In which :
Interest expense = % debt finance × Beginning MV × pretax cost of debt
Reasons for differ between Accounting income Economic income
accounting income and economic
income 1. Depreciation expense ‐ Based on original cost of investment ‐ Based on investment's MV (much larger than accounting depreciation)
‐ ignore when calculating economic income (already reflect in WACC)
2. Interest expense ‐ Deduct from accounting income
Economic profit Economic priofit : Measure of profit in excess of the dollar cost of capital invested in a project
Economic profit = NOPAC ‐ $WACC
NOPAT = Net operating profit after tax = EBIT × (1 ‐ T)
$WACC = WACC × Capital
Capital = $ amount of investment (FCInv)
Economic profit focuses on returns to all suppliers of capital (both debt and equity)
NPV of Economic profit = Market value added (MVA)
MVA + Capital = Company value = Project's NPV
Residual income Residual income : focuses on ROE
In which:
RI + equity investment + value of debt = company value = project's NPV
Claim valuation approach Value of company = PV of CF to debtholders + PV of CF to equityholders
In which :
CF to debtholders = interest + principal payments (discounted at cost of debt)
CF to equityholders = dividends + share repurchases = Net income + Depreciation ‐ Principal payments to debtholders (discount at cost of equity)
Capital Budgeting
Capital budgeting process Process of identifying and evaluating capital projects (projects where CF to firm will be received over a period longer than a year)
Categories of capital budgeting 1. Replacement projects to maintain the business :
projects ‐ no need for detailed analysis
‐ issue : should the existing operations continue ; and should the existing processes be maintained
2. Replacement projects for cost reduction :
‐ Whether obsolete usable equipment should be replaced
‐ Fairly detailed analysis is required
3. Expansion projects :
‐ To expand a business
‐ Require explicit forecast of future demand → involve complex decision‐making process
4. New product / market development :
‐ Complex decision‐making process, with detailed analysis, due to high level of uncertainty
5. Mandatory projects :
‐ Required by gov. agency / insurance company
‐ involve safety‐related / envi concerns
‐ generate minimum revenue, but accompany new revenue‐generating projects undertaken by the company
6. Other projects
5 Principles of capital budgeting 1. Decision based in CF, not accounting income
‐ Sunk cost : not include
‐ Exernalities (effect of the project acceptance on firm's other CF) : include
2. CF are based on opportunities costs ‐ Opportunities cost : include
3. Timing of CF is important
4. CF analysed on after‐tax basis
5. Financing cost are reflected in project's required rate of return
Expansion project ‐ Method to 1. Initial investment outlay : up‐front costs of the project
calculate yearly CF Initial investment outlay = Fix cost investment (FCInv) + Net Working Capital investment (NWCInv)
(*) NWCInv must be included, because additional inventories are required to generate additional sales ;↑ sales → ↑ AR ; ↑ Inventory → ↑ AP
NWCInv = ∆Non‐cash current assets ‐ ∆Non‐debt current liabilities = ∆NWC
NWCInv > 0 → require addi ona financing → cash ou low to fund net investment in current assets (and vice versa)
End of project → no need for addi onal WC → cash inflow (ou low) equal to ini al NWC
2. After‐tax operating CF : Incremental CF over capital asset' economic life
CF = (S ‐ C ‐ D) × (1 ‐ T) +D = (S ‐ C) × (1 ‐ T) + T × D
S = Sales
C = Cash operating costs
D = Depreciation expense
T = Marginal tax rate
(*) Depreciation : non‐cash operating expense, but reduce the taxes paid by firm
3. Terminal year after‐tax non‐operating CF (TNOCF)
TNOCF = Sal + NWCInv ‐ T × (Sal ‐ B)
Sal = Salvage value of FA
B = Book value of FA
Replacement project ‐ Method to Replacement project analysis : whether to replace an existing assets with a newer / better one
calculate yearly CF 1. Initial outlay : reflect the sale of old asset
2. After‐tax operating CF : calculate incremental operating CF
∆ ∆ ∆ 1 ∆
3. Terminal year after‐tax non‐operating CF (TNOCF)
Effect of inflation on capital 1. Analysing nominal / real CF : should match type of CF with the discount rate (Nominal CF ‐ Nominal discount ratee ; Real CF ‐ Real discount rate)
budgeting analysis 2. Changes in inflation affect project profitability : Inflation higher than expected → ↓ future CF → ↓ project's value
3. Inflation reduce tax saving from depreciation
4. Inflation decrease the payment value to bondholders
5. Inflation affect sales and cost differently : due to price of output goods change differently to prices of inputs→ a er‐tax Cf may be be er or worse
Mutually exclusive projects with 2 approaches :
different lives 1. Least common multiple of lives approach
2. Equivalent annual annuity (EAA) approach (compare annual payment)
Capital rationing Capital rationing : allocaion of fixed amount of capital among a set of available projects→ maximise shareholder wealth. Choose combina on of projects it can afford to have the
greatest total NPV
Hard capital rationing : fund alocated to managers cannot be increased
Soft capital rationing : allow to ncrease allocated capital budget if can justify that additional funds will create shareholder value
Sensitivity analysis Sensitivity analysis : changing an independent input variables to see the change in dependent variable
‐ Start with base case scenario
‐ Change 1 variable by a fixed % point above and below the base case
‐ Noting the effect of this change on the project NPV
Scenario analysis Scenario analysis : risk analysis technique, that consider both the sensitivity of key output variable (NPV) to changes in key input variables
‐ Allow for changes in multiple input variables at once
‐ Create Worst case, Best case and Base case
, Simulation analysis (Monte Carlo Probability distribution of project NPV outcomes, rather than just a limited number of outcomes
simlation) ‐ Step 1 : Assume specific probability distribution for each variable input
‐ Step 2 : Simulate a random draw from the assumed distribution of each input variable
‐ Step 3 : For each et of inputs from Step 2, calcuate NPV
‐ Step 4 : Repeat Step 2 and 3 for 10,000 times
‐ Step 5 : Calculate mean standard deviation and correlation of NPV with each input variable
‐ Step 6 : Create probability distribution of NPV from 10,000 outcomes
Calculate discount rate based on
market risk method
(*) Use project‐specific discount rate, rather than overall company rate
Real option Real option : option to the right, but not the obligation, to make future decisions that change the value of capital budgeting decision made today
‐ Offer flexibility → improve project's NPV
1. Timing option : able to delay making an investment with the hope of having better information in the future
2. Abandonmen option : PV of incremental CF from exiting > PV of incremental CF from continuing→ able to abandon the project
3. Expansion option : able to make additional investments of it creates more value
4. Flexibility option : Choices regarding the operating of the project, including :
‐ Price setting option : abe to change price of a product
‐ Production flexibility option : paying OT / using different input materials / producing different variety of products
5. Fundamental option : projects that are option themselves (e.g.: cooper mine)
Calculate project's NPV with option :
Overal NPV = Project NPV (DCF) ‐ Option cost + Option value
Determine hurdle value for project's NPV wit option :
‐ Using decision tree
‐ Using option pricing models
Common capital budgeting ‐ Failing to incorporate economic responses into the analysis. E.g.: Low barrier entry→ new conpe tors → lower profitability
mistakes ‐ Misusing standardised templates. Templates are used to streamline analysis process, but may not be exact match for the project → es ma on errors
‐ Pet projects of senior management
‐ Basing investment decision on EPS or ROE → avoid posi ve LT NPV investment with ST decrease of EPS and ROE
‐ Using IRR criterion over NPV
‐ Poor CF estimation
‐ Misestimation of overhead costs. Shoud include only the incremental overhead costs related to management tim and IT support, which is difficult to quantify
‐ Using incorrect discount rate
‐ Politics involved with spending th entire capital budget → to ask for more budget next year
‐ Failure to generate alternative investment ideas
‐ Improper handling of sunk and opportunities costs
Economic income Economic income = CF + (Ending MV ‐ Beginning MV)
In which :
MV = discounted future CF
(*) Economic income rate = Economic income / Beginning MV = project's WACC
Accounting income Accounting income : reported net income result from an investment in a project
Accounting income = (EBIT ‐ Interest expense) × T ‐ After‐tax salvage value
In which :
Interest expense = % debt finance × Beginning MV × pretax cost of debt
Reasons for differ between Accounting income Economic income
accounting income and economic
income 1. Depreciation expense ‐ Based on original cost of investment ‐ Based on investment's MV (much larger than accounting depreciation)
‐ ignore when calculating economic income (already reflect in WACC)
2. Interest expense ‐ Deduct from accounting income
Economic profit Economic priofit : Measure of profit in excess of the dollar cost of capital invested in a project
Economic profit = NOPAC ‐ $WACC
NOPAT = Net operating profit after tax = EBIT × (1 ‐ T)
$WACC = WACC × Capital
Capital = $ amount of investment (FCInv)
Economic profit focuses on returns to all suppliers of capital (both debt and equity)
NPV of Economic profit = Market value added (MVA)
MVA + Capital = Company value = Project's NPV
Residual income Residual income : focuses on ROE
In which:
RI + equity investment + value of debt = company value = project's NPV
Claim valuation approach Value of company = PV of CF to debtholders + PV of CF to equityholders
In which :
CF to debtholders = interest + principal payments (discounted at cost of debt)
CF to equityholders = dividends + share repurchases = Net income + Depreciation ‐ Principal payments to debtholders (discount at cost of equity)
