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Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
Capital budgeting
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Capital budgeting

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Capital budgeting

Capital budgeting

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  • 1. CAPITAL BUDGETING
  • 2. CAPITAL BUDGETING <ul><li>Investors require stock price appreciation. </li></ul><ul><li>To increase stock price, companies must become more profitable in order to increase the value of the firm’s stock. </li></ul><ul><li>Accordingly, [Financial] managers must make certain that new investments will increase the value of the firm. </li></ul>
  • 3. CAPITAL BUDGETING <ul><li>A. Motives for Capital Investment </li></ul><ul><ul><li>1. Renewal: Modernize, Overhaul, Retrofit </li></ul></ul><ul><ul><li>2. Replacement: Replace worn out equipment </li></ul></ul><ul><ul><li>3. Expansion: Adding physical capacity </li></ul></ul><ul><ul><li>4. Other: A variety of corporate objectives. </li></ul></ul><ul><ul><li>Primary Objective: Increase value of firm! </li></ul></ul>
  • 4. CAPITAL BUDGETING <ul><li>B. How Projects Are Evaluated; </li></ul><ul><ul><li>1. Companies have a variety of opportunities: investment opportunity set. </li></ul></ul><ul><ul><li>2. Data is collected on each attractive opportunity. </li></ul></ul><ul><ul><li>3. Companies select the best opportunities. </li></ul></ul><ul><ul><li>4. Fund as many investments as they have capital to invest. </li></ul></ul><ul><ul><ul><li>Diversify investments in order to diversify risks. </li></ul></ul></ul><ul><ul><li>5. Periodically reevaluate decisions in order to make decisions relative to continuance or abandonment (analysis). </li></ul></ul>
  • 5. CAPITAL BUDGETING <ul><li>C. Learning Objectives </li></ul><ul><ul><li>Learn relevant decision rules. </li></ul></ul><ul><ul><li>Learn basic analytical methodology </li></ul></ul><ul><li>D. Business Objectives </li></ul><ul><ul><li>Minimize the probability of losses </li></ul></ul><ul><ul><li>Recall that many new products / ventures fail and failures are expensive. </li></ul></ul><ul><ul><li>We want to make the most informed decision. </li></ul></ul>
  • 6. CAPITAL BUDGETING <ul><li>E. The Data Inputs; What Information Is Necessary? </li></ul><ul><ul><li>1. Type of project; new investment or replacement? </li></ul></ul><ul><ul><li>2. Expected economic life of the project (in years). </li></ul></ul><ul><ul><li>3. Initial outlay of cash required to finance project. </li></ul></ul><ul><ul><li>4. Identifying timing and magnitude of future cash flows. </li></ul></ul><ul><ul><li>5. Are projects; </li></ul></ul><ul><ul><li>Mutually exclusive? i.e. we can choose A or B </li></ul></ul><ul><ul><li>Independent? i.e., we can choose A and B </li></ul></ul>
  • 7. CAPITAL BUDGETING <ul><li>The Hurdle Rate </li></ul><ul><ul><li>Capital investments subject to one important constraint: </li></ul></ul><ul><ul><ul><li>Investment must earn a rate of return greater than the cost of capital (WACC). </li></ul></ul></ul><ul><ul><li>The hurdle rate is the market derived weighted average of investor required rates of return on company’s stocks and bonds. </li></ul></ul>
  • 8. CAPITAL INVESTMENT DECISION RULES <ul><li>A. Payback Period </li></ul><ul><ul><li>1. How long will it take to recover the initial outlay from After-Tax Cash Flows (ATCF)? </li></ul></ul><ul><ul><li>2. Many smaller companies are asked for this information by banks before getting loans. </li></ul></ul><ul><ul><li>3. Problem: Ignores the time value of money. </li></ul></ul>
  • 9. CAPITAL INVESTMENT DECISION RULES <ul><li>B. Net Present Value: NPV >> 0 </li></ul><ul><ul><li>* Note my use of the much greater than symbol (>>) rather than the text’s (  ). If I am going to put capital at risk - I don’t want to just breakeven ! </li></ul></ul><ul><li>C. Internal Rate of Return: IRR > k a </li></ul><ul><ul><li>1. IRR is the discount rate which makes NPV = zero. </li></ul></ul><ul><ul><li>2. The assumed reinvestment rate for cash flows. </li></ul></ul><ul><ul><li>3. If NPV greater than zero, then IRR is greater than k a . </li></ul></ul>
  • 10. CAPITAL INVESTMENT DECISION RULES <ul><li>D. NPV Profile </li></ul><ul><ul><li>1. To create a profile, calculate net present value at different discount rates. </li></ul></ul><ul><ul><li>2. The rate for a zero NPV is the IRR for the project. </li></ul></ul><ul><li>E. Problem of Multiple IRR </li></ul><ul><ul><li>1. When signs change more than once. </li></ul></ul><ul><ul><li>2. Cartesian Rule of Signs; number if solutions. </li></ul></ul>
  • 11. CAPITAL INVESTMENT DECISION RULES <ul><li>F. Modified Internal Rate of Return </li></ul><ul><ul><li>The NPV and IRR models assume that ATCF are reinvested at the WACC or the IRR, respectively. </li></ul></ul><ul><ul><li>A problem with the IRR is that it may be unattainable over the long run. </li></ul></ul><ul><ul><li>The MIRR is that rate which takes the terminal value (TV) of the reinvested cash flows and computes the discount rate that makes the TV equal to the initial outlay . See text for MIRR model example. </li></ul></ul>
  • 12. FIVE STEP CAPITAL BUDGETING PROCESS <ul><li>Proposal Generation: Schedule the Investment Opportunity Set. </li></ul><ul><li>Analysis: Evaluate Each Opportunity. </li></ul><ul><li>Decision Making: Select best of the Opportunity Set. </li></ul><ul><li>Implementation: Assure Project Development Compliance </li></ul><ul><li>Control: Performance Assessment </li></ul>
  • 13. ANCILLARY CONSIDERATIONS IN CAPITAL BUDGETING <ul><li>Fisher's Separation Theorem (1930) </li></ul><ul><li>An extension of the Fisher Separation theorem suggests that we separate the investment decision from the financing decision. </li></ul><ul><li>The implication is that investment projects should be considered independently of the financing decision. This is a convenient fiction. </li></ul><ul><li>Not so obvious, we must consider where our capital is coming from and the impact it will have on the capital structure of the firm. </li></ul>
  • 14. CAPITAL BUDGETING MODEL <ul><li>The “Macro” Model; details of changes in cost structure (VC and FC)* </li></ul><ul><li>Chg In Sales Revenue (  S) </li></ul><ul><li>minus Chg In Variable Costs (Direct Labor, Materials) (  VC) </li></ul><ul><li>minus Chg In Fixed Costs (Sell., General, Admin. Expenses) (  FC) </li></ul><ul><li>Chg in Earnings Before Depreciation & Taxes (  EBDT) </li></ul><ul><li>minus Chg In Depreciation (Plus New, Minus Old ) (  DEPR) </li></ul><ul><li>Chg In Earnings Before Taxes (  EBT ) </li></ul><ul><li>minus Chg In Taxes T * (  EBT) </li></ul><ul><li>Chg in Earnings After Taxes (  EAT) </li></ul><ul><li>Plus Chg In Depreciation (  DEPR ) </li></ul><ul><li>Chg In After-Tax Cash Flow  ATCF {= (1 - T)  EBT +  DEPR} </li></ul><ul><li>* This model ignores the effect of debt financing. See Lecture Notes. </li></ul>

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