1 / 25

Capital Budgeting and Financial Planning

Capital Budgeting and Financial Planning. Course Instructor: M.Jibran Sheikh Contact info: jibransheikh@comsats.edu.pk. Comparing Projects of Unequal lives: Real Life Scenario.

rmiers
Download Presentation

Capital Budgeting and Financial Planning

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Capital Budgeting and Financial Planning Course Instructor: M.Jibran Sheikh Contact info: jibransheikh@comsats.edu.pk

  2. Comparing Projects of Unequal lives: Real Life Scenario If inflation is expected, then replacement equipment will have a higher price. Moreover, both sales prices and operating costs will probably change. Thus, the static conditions built into the analysis would be invalid. Replacements that occur down the road would probably employ new technology, which in turn might change the cash flows. It is difficult enough to estimate the lives of most projects, and even more so to estimate the lives of a series of projects. In real life such analysis may or may not be feasible. Use Computer Spreadsheets or other programs for analysis. TOPIC 1: Capital Investment Appraisal

  3. Economic Life versus Physical Life Economic life, which is the life of an asset that maximizes the NPV and thus maximizes shareholder wealth. Physical Life (Engineering life) number of years that an asset is expected to be in working condition. Projects are normally analysed under the assumption that the firm will operate the asset over its full physical life. However, this may not be the best course of action—it may be best to terminate a project before the end of its potential life. This possibility can materially affect the project’s estimated CFs (profitability). TOPIC 1: Capital Investment Appraisal

  4. Economic Life versus Physical Life: A comparison If assets is operated over its full physical life (3 years). No salvage value. Decision: -ive NPV. Not feasible TOPIC 1: Capital Investment Appraisal

  5. Economic Life versus Physical Life What would NPV be if the project were terminated after 2 years and we receive operating cash flows in Years 1 and 2, plus the salvage value at the end of Year 2 Decision: +ive NPV. Project is feasible. TOPIC 1: Capital Investment Appraisal

  6. Exercise: Decide whether these methods are consistent with the four criteria satisfied by NPV listed at the start of this topic. TOPIC 1: Capital Investment Appraisal

  7. Optimal Capital Budget The optimal capital budget is the set of projects that maximizes the value of the firm. Finance theory states that all projects with positive NPVs should be accepted, and the optimal capital budget consists of these positive NPV projects. However, two complications arise in practice: An increasing marginal cost of capital and Capital rationing TOPIC 1: Capital Investment Appraisal

  8. Optimal Capital Budget A) Increasing marginal cost of capital Flotation costs associated with issuing new equity or public debt can be quite high. This means that the cost of capital jumps upward after a company invests all of its internally generated funds and must raise funds from external sources. In addition, investors often perceive extremely large capital investments to be riskier, which may also drive up the cost of capital as the size of the capital budget increases. TOPIC 1: Capital Investment Appraisal

  9. Marginal cost of capital and the investment opportunity schedule to determine the optimal capital budget. TOPIC 1: Capital Investment Appraisal

  10. Marginal cost of capital and the investment opportunity schedule to determine the optimal capital budget. The intersection of the investment opportunity schedule with the marginal cost of capital curve identifies the amount of the optimal capital budget. The firm should undertake all those projects with IRRs greater than the cost of funds. This will maximize the value created. At the same time, no projects with IRRs less than the marginal cost of the additional capital required to fund them should be undertaken, as they will erode the value created by the firm. (will do in detail in topic on Cost of Capital) TOPIC 1: Capital Investment Appraisal

  11. Optimal Capital Budget B) Capital rationing The implicit assumption in simple NPV analysis is that sufficient funds are available to undertake all positive NPV projects. When demand for investable funds which exceeds funds currently available from internal sources, they are in a capital rationing situation. Capital rationing destroys value as there are value-adding projects (positive NPV) which cannot be undertaken. On the other hand, too much capital investment also destroys value since the corporation will be investing in negative NPV projects. A firm should invest up to the point that it has no more positive NPV projects and then should return excess cash to the shareholders. TOPIC 1: Capital Investment Appraisal

  12. Capital rationing • In a perfect capital market, a firm can always obtain the necessary funds for a positive NPV project. • In practice, obtaining necessary funds may be difficult due to: • asymmetric information (about the true value of the project) between the investors and the firm. • the adverse selection problem. • transaction costs associated with raising funds. • These costs reduce the NPV of the project.

  13. Capital rationing Hard and soft capital rationing "Hard" capital rationing refers to cases where the constraint on investable funds is imposed externally: the capital market (or the government) will not supply funds to the company even though company has identified positive NPV projects. Hard form is an extreme form of market failure; Short term Capital constraint is imposed internally by the firms' management, i.e."soft" capital rationing TOPIC 1: Capital Investment Appraisal

  14. Capital Rationing • If the firm has capital rationing, then its funds are limited and not all independent projects may be accepted. In this case, we seek to choose those projects that best use the firm’s available funds. PI is especially useful here. • Note: capital rationing is a different problem than mutually exclusive investments because if the capital constraint is removed, then all projects can be accepted together. • Analyze the projects on the next page with NPV, IRR, and PI assuming the opportunity cost of capital is 10% and the firm is constrained to only invest $50,000 now (and no constraint is expected in future years).

  15. Capital Rationing – Example(All $ numbers are in thousands)

  16. Capital Rationing Example: Comparison of Rankings • NPV rankings (best to worst) • A, D, C, B, E • A uses up the available capital • Overall NPV = $4,545.45 • IRR rankings (best to worst) • E, D, B, A, C • E, D, B use up the available capital • Overall NPV = NPVE+D+B=$6,181.82 • PI rankings (best to worst) • E, D, C, B, A • E, D, C use up the available capital • Overall NPV = NPVE+D+C=$6,381.82 • The PI rankings produce the best set of investments to accept given the capital rationing constraint.

  17. Capital rationing Reasons for Soft Capital Rationing: Management is unwilling to accept the borrowing constraints required by lenders [preservation of financial flexibility] Owners are unable to contribute additional equity, and are unwilling to share control with new external equity holders; Managers are "satisficers" rather than "maximisers"; Managers feel they lack the time or skills to manage new investment projects, and are unwilling or unable to hire additional management talent; Management does not believe in the project numbers. Skeptical about the project. TOPIC 1: Capital Investment Appraisal

  18. Capital rationing If a firm faces capital rationing, how should it allocate its available resources so as to optimize its investment budget? Firm's objective?to maximise shareholder wealth. Therefore the investment decision rule is to select the set of investment projects which maximise the positive NPV generated. Ranking projects by the profitability index is one way that has been suggested to ensure that the total NPV is maximized. TOPIC 1: Capital Investment Appraisal

  19. Capital rationing Funds Available: 20 million each year Which project should be selected? Simple ranking by NPV would suggest Project 1 But combination of 2 & 3 is superior. P.I will reflect this. TOPIC 1: Capital Investment Appraisal

  20. Capital rationing Suppose projects 2 and 3 were mutually exclusive. The choice of 2 would preclude 1, although the NPV of 1 is greater (because of capital rationing). Projects are said to be mutually exclusive when they cannot be undertaken simultaneously. Mutually exclusive projects means that the acceptance of one project eliminates the others from consideration. A problem with the PI is the effect of multi-period capital constraints. Suppose we have another project: TOPIC 1: Capital Investment Appraisal

  21. Capital rationing Assume the constraint of $20 million applies in both years 1 and 2. The PI rule would select 2 and 3 in period 1 (assuming they are independent). This choice then rules out project 4 in period 2. But the choice of 1 in period 1 would enable the acceptance of 4 in period 2. The NPV of 2 and 3 (35.3 + 33.4 = 68.7) is less than the NPV of 1 and 4 (50.5 + 26.1/1.12 = 73.8) TOPIC 1: Capital Investment Appraisal

  22. Remember • P.I is good for single period Capital Rationing • There are no rules of thumb for multi-period capital rationing. Different methods/Rules (Goal Seek) • Real Life – companies don’t use programs/softwares to select projects. Capital rationing TOPIC 1: Capital Investment Appraisal

  23. Valuation by multiples DCF used forecasts for the project or business; Valuation by multiples finds comparable entities and uses multiples based on current or prospective earnings. Multiples can be based on Net profit after Tax; the P/E multiple; EBIT or EBITDA; Revenue etc. When financials are unavailable multiples can be calculated on physical variables, such as sales volume, quantity of resources etc. The earnings of the company being valued are multiplied by a standard multiple, generally the average of a group of comparable companies. The average should be calculated on a weighted group basis TOPIC 1: Capital Investment Appraisal

  24. Valuation by multiples Using the P/E ratio in this way assumes that all the companies: have comparable tax rates and shareholders; have similar debt/equity ratios; are at a similar stage of capital investment; follow similar working capital and funding policies TOPIC 1: Capital Investment Appraisal

  25. Valuation by multiples More meaningful valuations by multiples may be achieved by making adjustments like these: Use a sustainable earnings concept, e.g. remove abnormal and unusual effects on reported profit. Discontinued operations can be removed; Use EBIT and EBITDA multiples to remove the effect of taxation and capital structure and Depreciation policies; Use the total value of debt plus equity (V = B + S), commonly called "enterprise value"; Make adjustments for special factors that will affect value; Tax losses or tax shelter on debt Adjust for heavy capital expenditure or depreciation adjustments Adjust for specific liabilities such as potential legal exposures TOPIC 1: Capital Investment Appraisal

More Related