CLASS 3 CAPITAL BUDGETING

Bridge Program 2005 Finance module

Finance, Bridge Program 2005

Contents
1 2 Investment criteria Financial statement analysis 2.1 Income Statement . . . . . . . . . . . . . . . . . . 2.2 Balance-sheet items . . . . . . . . . . . . . . . . . 2.3 A recipe . . . . . . . . . . . . . . . . . . . . . . . . Assignment 3 More capital budgeting applications 4 8 9 14 17 18 23

3 4

Finance, Bridge Program 2005

Recap
The NPV rule. Annuities and perpetuities. Mortgage calculations and after-tax eects. Examples of applications of NPV rule. In this class we will further apply the NPV rule through several examples and the assignment, as well as discuss other investment criteria (IRR), and review a bit of accounting.

Finance, Bridge Program 2005

1 Investment criteria
Basic idea of DCF analysis (NPV rule): Forecast incremental cash ows from a project (rm) in the future. In particular, forecast cash ows from operations and cash ows from investing, i.e. ignore cash ows from nancing (class 7 will deal with why we ignore nancing cash ows). This is mostly Accounting. Discount these cash ows at appropriate discount rate.

First 3 lectures are about the mechanics of discounting. Next 4 lectures are about where the discount rate comes from.

Finance, Bridge Program 2005

The NPV rule

States that we should undertake a project if and only if its NPV is positive. Why is this optimal, i.e. why should we not invest in negative NPV projects? If NPV < 0, then you could put your money in alternative investment (with same risk) and earn higher cash ows. No other alternative investment criteria is optimal (unless it reduces to NPV).

Finance, Bridge Program 2005

Alternative investment criteria

What is the Internal Rate of Return of a project? It is the discount rate y such that its NPV, when using y as a discount rate, is equal to zero. Namely it is the rate y for which
T

NPV = CF0 +
t=1

CFt =0 t (1 + y)

IRR rule: undertake projects if IRR is greater than cost of capital (expected return on assets of similar risk). What is the payback period? The time it takes to get back the initial investment (in dollar terms - with or without discounting the actual cash ows).

Finance, Bridge Program 2005

Pitfalls with other investment criteria

Relying solely on IRR can cause problems, which are avoided with the NPV rule: It does not account for scale of project. This can be dangerous when considering mutually-exclusive projects. If the term-structure is not at, what rate do we compare the IRR to? Nevertheless it is the only other alternative criteria that is worth looking at (its a nice statistic). The payback rule suers from these and many other problems.

Finance, Bridge Program 2005

2 Financial statement analysis

Financial accounting is the language of business. Finance uses Accounting statements (and forecasts) in order to compute the cash ows that a given rm/project will generate. Important note: we will make no distinction between projects and rms. View rms simply as a collection of projects, or a project as a very small rm. The following slides are a rough summary of relevant accounting issues for Finance (more on the book in chapters 9 and 30).

Finance, Bridge Program 2005

2.1 Income Statement

Calculates prots. Examples of items in an income statement: Sales (revenues). Cost of goods sold. SG&A expenses. Depreciation expenses. Interest expenses. Taxes. Net income (prots). EBITDA, EBIT.

Are prots the same as cash ows? No! Depreciation and timing issues throw things o.
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Depreciation
Depreciation creates a gap between prots and cash ows as a result of dierent conventions. In Finance we care about cash ows, so we should always ignore depreciation charges (per se). In Accounting they care about measuring the protability of a business, therefore they use the convention of expensing large capital investments over their useful life. Should we then ignore depreciation altogether? No! Depreciation matters since it aects the taxes that a rm pays (since it reduces paper prots).
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Example 1 (basic cash ow estimation)

Consider a project that yields increased sales of $3m per year for 10 years, with COGS being 70% of sales. It requires an initial investment of $3m. The initial investment is depreciated to zero using the straight-line method over 10 years. Assume a tax rate of 50%, and a discount rate of 10%. What are the cash ows from this project? What is its NPV?
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Basic cash ow estimation

Sales COGS Depreciation EBIT Prots (after tax) Depreciation CF The NPV is then 0.6 NPV = 3 + 0.1 1 1 1.110 = 0.68 > 0 3.0 -2.1 -0.3 =0.6 =0.3 +0.3 =0.6

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Basic cash ow estimation

Useful shortcut: CF = EBITDA(1 ) + (Depreciation) where denotes the rms tax rate. The last term in the above equation is usually referred to as depreciation tax shield. In our example: CF = 0.9(1 0.5) + 0.5(0.3) = 0.45 + 0.15 = 0.6

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2.2 Balance-sheet items

My own name for things such as deferred taxes and working capital items. What are working capital items? Current assets: inventory, accounts receivable. Current liabilities: accounts payable. These items will aect cash ows: recording a sale in income statement will increase our estimate of cash ows, but if we dont get paid for it until next year (accounts receivable increase) we should adjust our cash ow projections!
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Illustration
Firm makes sale of $1m to be paid in equal installments over the next 4 quarters. In this case accountants book sale and increase the account receivables balance. This balance is reduced through the next 4 quarters to zero. From a Finance perspective we only want to account for positive cash ows of $0.25m every quarter. Quarter Balance in AR CF 0 1 0 1 0.75 0.25 2 0.50 0.25 3 0.25 0.25 4 0 0.25

Note: we can compute the cash ow by looking at the net change in the working capital item (accounts receivable in the example). Finance, Bridge Program 2005 15

Net working capital items

An increase in the balance in accounts receivable in a given period t should be accounted for as a negative cash ow (think about it as a bad thing since you get paid later on some new sales). An increase in inventory has a similar eect as an increase in accounts receivable - it creates a negative cash ow (you pay for the inventory but do not get sales). An increase in the balance in accounts payable in a given period should be accounted for as a positive cash ow (good since you get to pay for things later).

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2.3 A recipe
Cash Flows can be estimated from nancial statements as follows: EBIT = + = = Income tax Net Operating Prot Depreciation Gross Cash Flow Increase in Working Capital Capital Expenditure Cash Flow from Operations

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3 Assignment 3
Data for problem 1: Investment on information systems of $3000 (000s). Savings on operating costs of $500. Five-year life, no salvage value, straight-line depreciation. Cut inventory from 50% to 45% of sales (currently at $10000). Marginal tax rate 40%, discount rate 10%. How good is this investment?

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The incremental cash ows

Operating costs are reduced by 500 (all numbers 1000s). In after tax terms this is an increase in cash ow of 0.6(500) = +300. Depreciation generates a cash ow (which we refer as tax shield) of (Depreciation) = 0.4(600) = +240. The initial investment of $3m is just that - a negative cash ow of $3m (note the tax eect on this cost come through depreciation). The reduction of inventory, from 50 to 45% of sales, will cause an increase in cash, namely equal to 5% of sales, i.e. +500. Therefore cash ows are 300 + 240 = 540 in years 1-5, and 2500 in year 0.

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Assessing protability
Discounting the cash ows back to time 0: 540 NPV = 2500 + 0.10 1 1 1.15 = 453.

The IRR can be computed by solving 540 2500 + IRR 1 1 (1 + IRR)5 = 0.

which yields IRR = 2.62% < 10%. So according to both NPV and IRR criteria this is not a good project. The calculations in assign3sol.xls suggest that cost savings of $699.16 would make NPV = 0.

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Problem 2
Relevant data: Investment (transfer fee) of $25m, depreciated over next 5 years. 10 year contract with Mr. Behham. Increase in sales of apparel of $5m. Ticket sales increase of $1m. TV contract will be $2m higher per year for the duration of Mr. Behhams contract (starting in year 3). Behhams salary $3m. Other costs increase by $0.5m. Marginal tax rate 35%, and 10% discount rate.

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Incremental cash ows and NPV

Year Increase in revenue Increase in operating costs Depreciation Increase in EBIT Tax Income Depreciation addback Free cash ow 1 6.00 3.50 5.00 (2.50) (0.88) (1.63) 5.00 3.38 3 8.00 3.50 5.00 (0.50) (0.18) (0.33) 5.00 4.68 6 8.00 3.50 4.50 1.58 2.93 2.93

Discounting at 10% we get a negative NPV around 2.65 million. With sales of apparel of 5.66m a year (barely 10% more of the previous estimate) the NPV of the project is zero. Finance, Bridge Program 2005 22

4 More capital budgeting applications

Example 2
A rm knows (i.e. there is no risk) that the sales of a new product will grow over the next 2 years by 15% (in nominal terms), and from then on have a real growth rate of zero. Next years sales are expected to be $20m. Yearly costs are 50% of sales. Assume the rm pays no taxes. You estimate ination to be around 5%, and you know the term structure is at at 15%. If the initial investment of this project is $120m, should we undertake it?
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Example 2
How can we estimate cash ows? Use growth rate of sales of 15% over rst two-years, then sales grow at the ination rate of 5%. 1 Sales CF 20.00 10.00 2 23.00 11.50 3 24.15 12.08 4 25.36 12.68 5 26.63 13.31

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Note that starting in year 3 the cash ows are a perpetuity with constant growth rate. How much are those cash ows worth today? P V3 = 12.08 0.15 0.05 1 = 91.3 2 1.15

The value of the cash ows in years 1 and 2 is P V12 11.5 10 + = 17.39 = 1.15 1.15

The total value of the project is then V = 17.4 + 91.3 108.7 Therefore the rm should not undertake the project (108 < 120).
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Recap
The NPV rule. How to apply it using tools we have learned thus far (dealing with ination, shortcuts for computing NPVs using perpetuities and annuities). Estimating cash ows. How to decide what projects to take.

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Thursday
Topics: Statistics (fun, fun, fun). Intro to Investments (almost as much fun). Optimal investment decisions in a mean-variance framework. Suggestions: Start on the reading tonight (you have a light load for tomorrow). Work through assignment 4, and give your best at assignment 5 (the last question is on the hard side). Try to enjoy the readings and assignments - they are as good as Finance gets!
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