CFA Level 1 ? Corporate Finance, Portfolio Management, and ...

Capital Budgeting

Know:

• All the measurements involved when evaluating a capital project
• Decision rules for accept/reject
• Why NPV and IRR give the same accept/reject decision and why they can give conflicting rankings for mutually exclusive projects

The Capital Budgeting Process as four Administrative Steps:

1. Idea Generation: this is where good project ideas are generated
2. 2.?????? Analyzing project proposals: ?this is where the analysts forecast future cash flows.
3. 3.?????? Create the firm-wide capital budget: essentially the firm here needs to prioritize the projects according to their profitability, the timing of the cash flows, available company funds, etc.? Not all projects (even if they are profitable) can or should be given the green light.? The projects that the firm selections must fit within the firm?s overall strategy.
4. 4.?????? Monitoring decisions and conducting a post-audit: the analyst needs to see how the project is going and to see if it is meeting the projections or not.? If not, why not.

Different Types of Capital Budgeting Projects

1. Replacement Projects to Maintain the Business: these usually don?t have much analysis involved.? Management just needs to decide if the existing operations should continue and if they should, whether existing procedures should be maintained.
2. Replacement Projects for Cost Reduction: should obsolete equipment that is still usable be replaced? Here there should be a fairly detailed analysis.
3. Expansion Projects: very detailed analysis is done here to determine if a projects should be undertaken that will grow the business.? Very complex examination.
4. New Product or Market Development:
5. Mandatory Projects: these could be required by the government or insurance company. Usually don?t generate any revenue.
6. Other Projects: ?for example, pet projects by management, R&D

Basic Principles of Capital Budget ? Including Choosing the Right Cash Flows

1. Capital budgeting decisions are based on cash flows, not earnings.? But you must make sure to use incremental cash flows.? These CFs are the changes in cash flows that will occur if the project is undertaken.?
   1. a.????? Sunk cost: make sure that you do not use sunk cost when determining your incremental cash flows.? Examples of sunk costs include: consulting fee paid to determine the potential demand for a new product
   2. b.????? Externalities: are the effects that choosing the project will have on other CFs from the firm.? The primary externality is cannibalization which occurs when the new projects eats the sales from an existing project. ?The analyst should subtract the lost sales of the existing project/product from the expected new sales when estimating the incremental cash flows.
   3. Cash flows are based on Opportunity Costs: these are the CFs that the firm would lose by undertaking the project.? For example, if the firm decides to build a factory on land that it already owns, it should charge the cost of th eland to the project since it could be sold if the project was not using it.
   4. The Timing of Cash Flows is Important: capital budgeting accounts for the TVM
   5. Cash flows are analyzed on an After-Tax Basis: the cash flows are evaluated based on what the firm gets to keep, not what cash they send to the government.
   6. Financing costs are reflected in the Project?s Required Rate of Return: don?t consider financing costs that are specific to the project. Use the firm?s cost of capital unless the project will return more than the cost of capital needed to fund the project will increase the value of the firm.

1. 1.?????? Independent vs. Mutually Exclusive Project
   1. a.????? Independent Projects: are projects that are unrelated to each other.? If two projects are independent and profitable, the firm should choose both
   2. b.????? Mutually Exclusive Projects: only one project can be undertaken.? Choose the more profitable one (all else equal)
   3. 2.?????? Project Sequencing
      1. a.????? Some projects need/should be undertaken in a certain order.
      2. b.????? Perhaps if one project is profitable now, another project can be taken on later
      3. 3.?????? Unlimited Funds vs. Capital Rationing
         1. a.????? If a firm has unlimited access to capital, it can take on all projects whose IRR exceeds its cost of capital
         2. b.????? If the firm has limited funds, it must ration those funds.? This means that might not be able to take on a project even though would be profitable

Calculate and Interpret: NPV, IRR, Payback Period, Discounted Payback Period, and Profitability Index (PI)

Net Present Value (NPV):

1. Discount Incremental cash flows at the appropriate discount rate
2. Subtract out the initial CF (assuming outflow in year zero followed by inflows)
3. Choose all projects with a positive NPV

Internal Rate of Return (IRR):

1. Essentially, IRR is the discount rate that makes NPV = zero (present value of inflows equals present value of outflows)
2. How to calculate: use your calculator J
3. Decision Rule:
   1. If IRR > Cost of Capital, accept the project
   2. If IRR < Cost of Capital, reject the project

Payback Period (PBP)

1. The number of years it takes to recover the initial cost of the investment
2. To Calculate: you just to a running total of your cash inflows.? The moment those inflows exceed your initial cash outflow; you?ve reached your PBP.
3. Problems and? Benefits
   1. A drawback to using this method is that: (1) it doesn?t take into account the TVM and (2) there is no consideration of the CFs after the PBP
   2. A benefit is that it is a good measure of the project?s liquidity

Discounted Payback Period

1. This is the same as the PBP above, except it uses the PV of CFs instead of just a running total.
2. How to Calculate:
   1. Get the PV of each cash flow. For example, the PV of a CF in year 3 of 600 with a discount rate of 10%, would be 451
   2. Using the above PV numbers compute a running total to see where the CFs go positive
   3. To get a precise figure:

i.????? (# of years before the CF goes positive) + (-negative # in the year just before CFs go positive/positive number in the year following)

Profitability Index (PI)

1. Present Value of Future Cash Flows divided by the Initial Cash Outlay
   1. = 1? + NPV/Initial Investment
   2. Decision Rule:
      1. If PI > 1.0, accept the project
      2. If PI < 1.0, reject the project

?

NPV vs. IRR when evaluating independent and mutually exclusive projects ? what are some problems associated with each?

1. 1.?????? NPV:
   1. Advantage: the key advantage here is that it is a direct measure of the expected increase in the value of the firm.
   2. Weakness: the main weakness here is that NPV does not take into account the size of the project. For example, an NPV of $100 is awesome for a project that cost $100, but not for a project that cost $1M
   3. 2.?????? IRR
      1. Advantage: is that it measures profitability as a percentage, showing the return on each dollar invested
      2. Weaknesses: (1) possibility of producing differently ranked mutually exclusive projects than NPV and (2) Multiple IRRs

????????????????????????????????????????????????????????????? i.????? Conflicting Project Rankings:

1. 1.?????? Because of CF timing projects can have different priorities (e.g. one project might have a higher NPV but a lower IRR ? IRR would say chose the other project even though this project would make the firm more valuable overall)

??????????????????????????????????????????????????????????? ii.????? Multiple or No IRR:

1. 1.?????? If the project as unconventional cash flows (e.g. cash outflows in years following the initial year) it is possible to either multiple IRRs or no IRR at all.

Various Capital Budgeting Methods Used

If thought NPV and IRR are superior methods, many financial managers used a variety of methods when evaluating capital projects. Some of these methods are delineated in the following ways.

1. Location:? European countries tended to use the payback method
2. Size of the company: the larger the company, the more likely it will use the DCF techniques such as NPV and IRR
3. Public vs. Private: private use payback more. Public use DCF methods
4. Management Education: more education (MBA) will use DCF methods

The Relationship between NPV and Stock Price

1. (in theory)A project with a positive NPV should increase the stock price by same amount (e.g. positive NPV of 250M will increase the stock price of a company with 100M shares outstanding by $2.5 per share
2. (in reality) the price of a company?s shares is reflected by the expected future earnings. Management might expect a positive NPV, but analyst might expect a negative one (or simply less positive). This alternative expectation will affect the stock price.

Source: http://www.garyjschroeder.com/2012/02/27/cfa-level-1-corporate-finance-portfolio-management-and-equity-investments-capital-budgeting/

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