Capital Budgeting (Chapter 8)

1. Capital Budgeting(Chapter 8) Professor Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Fußzeile

2. The capital budgeting process involves three basic steps: • Generating long-term investment proposals; • Reviewing, analyzing, and selecting from the proposals that have been granted, and • Implementing and monitoring the proposals that have been selected. The Capital Budgeting Decision Process • Managers should separate investment and financing decisions. Fußzeile

3. Capital Budgeting Decision Techniques Accounting rate of return (ARR):focuses on project’s impact on accounting profits • Payback period: most commonly used Net present value(NPV):best technique theoretically; difficult to calculate realistically Internal rate of return(IRR): widely used with strong intuitive appeal, theoretically inappropriate. Profitability index(PI):related to NPV Fußzeile

4. A Capital Budgeting Process Should: Account for the time value of money; Account for risk; Focus on cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders’ wealth. Fußzeile

5. Need only profits after taxes and depreciation • Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows. Average annual depreciation Average annual operating cash inflows = - Average profits after taxes Accounting Rate Of Return (ARR) Can be computed from available accounting data ARR uses accounting numbers, not cash flows; no time value of money. Fußzeile

6. The payback period is the amount of time required for the firm to recover its initial investment. • If the project’s payback period is less than the maximum acceptable payback period, accept the project. • If the project’s payback period is greater than the maximum acceptable payback period, reject the project. Payback Period Management determines maximum acceptable payback period. Fußzeile

7. Net Present Value The present value of a project’s cash inflows and outflows Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk. Accept projects if NPV > 0. Fußzeile

8. Initial outlay Initial outlay -$250 -$50 Year 1 inflow Year 1 inflow $35 $18 Year 2 inflow Year 2 inflow $80 $22 Year 3 inflow Year 3 inflow $25 $130 Year 4 inflow Year 4 inflow $160 $30 Year 5 inflow Year 5 inflow $32 $175 Global Wireless • Global Wireless is a worldwide provider of wireless telephony devices. • Global Wireless evaluating major expansion of its wireless network in two different regions: • Western Europe expansion • A smaller investment in Southeast U.S. to establish a toehold Western Europe ($ millions) Southeast U.S. ($ millions) Fußzeile

9. Calculating NPVs for Global Wireless Projects • Assuming Global Wireless uses 18% discount rate, NPVs are: Western Europe project: NPV = $75.3 million Southeast U.S. project: NPV = $25.7 million Should Global Wireless invest in one project or both? Fußzeile

10. Key benefits of using NPV as decision rule: • Focuses on cash flows, not accounting earnings • Makes appropriate adjustment for time value of money • Can properly account for risk differences between projects Though best measure, NPV has some drawbacks: • Lacks the intuitive appeal of payback, and • Doesn’t capture managerial flexibility (option value) well. Pros and Cons of Using NPV as Decision Rule NPV is the “gold standard” of investment decision rules. Fußzeile

11. Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project: • IRR found by computer/calculator or manually by trial and error. The IRR decision rule is: • If IRR is greater thanthe cost of capital, acceptthe project. • If IRR is less thanthe cost of capital, rejectthe project. Internal Rate of Return Fußzeile

12. Western Europe project: IRR (rWE) = 27.8% Southeast U.S. project: IRR (rSE) = 36.7% Calculating IRRs for Global Wireless Projects Global Wireless will accept all projects with at least 18% IRR. Fußzeile

13. Calculating IRRs for Global Wireless Projects 27.91% Fußzeile

14. Advantages and Disadvantages of IRR Advantages of IRR: • Properly adjusts for time value of money (???) • Uses cash flows rather than earnings • Accounts for all cash flows • Project IRR is a number with intuitiveappeal Disadvantages of IRR • “Mathematical problems”: multiple IRRs, no real solutions • Scale problem • Timing problem Fußzeile

15. Multiple IRRs NPV ($) NPV>0 IRR NPV>0 Discount rate NPV<0 NPV<0 IRR When project cash flows have multiple sign changes, there can be multiple IRRs. With multiple IRRs, which do we compare with the cost of capital to accept/reject the project? Fußzeile

16. Modify Global Wireless’s Western Europe project to include a large negative outflow (-$355 million) in year 6. • There is no real number thatwill make NPV=0......... so noreal IRR. No Real Solution Sometimes projects do not have a real IRR solution. Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject! Fußzeile

17. Project IRR NPV (18%) The scale problem: Western Europe 27.8% $75.3 mn Southeast U.S. 36.7% $25.7 mn • Southeast U.S. project has higher IRR, but doesn’t increase shareholders’ wealth as much as Western Europe project. Conflicts Between NPV and IRR NPV and IRR do not always agreewhen ranking competing projects. Fußzeile

18. Long-term project IRR = 15% NPV Short-term project IRR = 17% Discount rate 13% 15% 17% The Timing Problem • The NPV of the long-term project is more sensitive to the discount rate than the NPV of the short-term project is. • Long-term project has higher NPV if the cost of capital is less than 13%. Short-term project has higher NPV if the cost of capital is greater than 13%. Fußzeile

19. Decision rule: Accept project with PI > 1.0, equal to NPV > 0 Project PV of CF (yrs1-5) Initial Outlay PI Western Europe $325.3 million $250 million 1.3 Southeast U.S. $75.7 million $50 million 1.5 • Both projects’ PI > 1.0, so both acceptable if independent. Profitability Index Calculated by dividing the PV of a project’s cash inflows by the PV of its outflows: Like IRR, PI suffers from the scale problem. Fußzeile

20. Some Extensions............. • The Tax Paradoxon • Tax payments affect the cash flows of a project in a negative way. On the other hand, a discount rate after tax will be smaller than a discount rate before tax. Under some circumstances fiscal policy – i.e. Tax rate policy – may determine the ranking of investments. • Inflation • We always have to make sure, that nominal cash flows must refer to nominal discount rates while real cash flows require real discoount rates. • Exchange Rates • If global financial markets are working well, the effect of different inflation rates will be perfectly substituted by a well functioning exchange rate mechanism. Fußzeile

21. The Tax Paradoxon Corporate tax will affect N.P.V.- calculation in numerous aspects: • Tax payments reduce the cash flow • Depreciation and interest on debt diminish the taxable income (don‘t confuse taxable income with cash flow • As the cash flow now reflects after tax figures, the concept of opportunity costs also has to be adjusted to after tax interest rates (rafter tax = rbefore tax x (1 – t);{t = tax rate}.

22. The Tax Paradoxon Two mutually exclusive investment proposals show the following cash flows over three years (without taxes): r = 10%s = 0%

23. The Tax Paradoxon Discounted cash flows lead to following N.P.V.s. At 10% and no taxes, Investment 2 is clearly dominant. +1,000 +700 + 100 +3,38 - 1,500

24. The Tax Paradoxon NPV 2 > NPV 1 At a given tax rate, the NPV is a continously decreasing function of the opportunity cost of capital

25. The Tax Paradoxon Considering a corporate tax rate of 40 %, the NPV result changes to:

26. The Tax Paradoxon NPV after tax can also be calculated in a step-by-step mode, i.e. The project‘s NPV consists of the NPV of the cash flows and the NPV of the tax payments:

27. The Tax Paradoxon At a given discount rate, the first cash flows NPV starts rising according to rising tax rates (Tax Paradox). A tax rate of approx. 50% would affect the ranking order .... !!! NPV after tax (rbefore tax = 10%) Tax rates

28. Inflation Effects / FX Rates Sometimes there is uncertainty about the question how to include inflationary effects. Basically nominal cash flows need to be discounted by nominal (inflated) discount rates, while cash flows which reflect the purchase power must be discounted using real rates. Following nominal cash flows do include a yearly inflation rate of 15%. The expected real rate is supposed to be 10%:

29. Inflationary Effects The use of nominal cash flows and real discount rates will not lead to a correct result. A first solution would be, to inflate the real discount rate: A second solution could mean, to deflate the nominal cash flows and use the real discount rate:

30. Inflation Effects / FX Rates After inflating the real discount rate of 10% with an inflation rate of 15%, the nominal discount rate is at: Consequently, the N.P.V. will drop to 1,231 Mio €.

31. Inflation Effects / FX Rates Another way round, we could also transfer nominal cash flows into real figures: Consequently the N.P.V. Now remains the same.

32. Inflation Effects / FX Rates Two alternative ways to avoid a wrong way of calcu-lation: All figures reflect „real“ data, i.e. real (not in - or deflated) cash flows and real discount rates (expected grow of purchasing power): All figures reflect „nominal“ data, i.e. nominal (in- or deflated) cash flows and nominal discount rates (usually inflated interest rate):

33. Inflation Effects / FX Rates Cash Flows (FC) Depreciation (straight) Tax rate 50% Disc.rate(before tax) 10% Disc.rate(after tax) 5% In the view of the foreign country based subsidiary, the N.P.V. is at 1.156.463 Mrd.

34. Inflation Effects / FX Rates The NPV can also be calculated as the sum of the cash flows present values before taxes and the present value of the tax payments: Adjusted Present Value (A.P.V.)

35. Inflation Effects / FX Rates Inflationary Effects / Foreign Exchange Rates Regarding the foreign inflation rate, the local N.P.V. drops to 546,467. Cash Flows increased but discount rate adjusted to 15,5% ( = 1,05*1,10 ).

36. Inflation Effects / FX Rates Considering the different sources of NPV it becomes clear, that it is not the PV of the operational cash flow which has changed, but the PV of tax payments. In our example the smaller NPV is exclusively caused by higher tax payments.

37. Inflation Effects / FX Rates • Inflation alone, under certain circumstances, (completely passed on to customers and suppliers, no supply- or demand-shifts) does not change the valuation of an investment. A smaller NPV then will be exclusively caused by higher tax payments (taxation of pseudo-profits). Tax authorities profit from inflation. • The investegated negative impact of inflation on the economical attractiveness of investment proposals could be avoided, if tax authorities would refrain from taxation of pseudo profits. • In the simplest way inflationary effects could be cancelled out by depreciation on the basis of higher, inflated purchase costs.

38. Inflation Effects / FX Rates If purchasing costs are continously inflated and depreciation is calculated on the basis of increasing current costs (per year + 10%) :

39. Inflation Effects / FX Rates Tax deductible depreciation based on current market prices, would neutralize the negative effects of inflation on N.P.V.

40. Inflation Effects / FX Rates What will be the effect of inflated cash flows in foreign curren-cies, if the foreign cash flows are transferred at the end of each period ? If international interest rate differences are perfectly reflected by a perfectly (unregulated) working foreign exchange rate mechanism, future exchange rates (EXR) are to be calculated using the „Fisher Equation“: in example for t1:

41. Inflation Effects / FX Rates If an exchange rate mechanism is perfectly working, the profit-ability (in terms of NPV) of real investment projects are not af-fected. Lower Cash Flows – due to impaired exchange rates – are then perfectly substituted by lower discount rates.