FINA2303 Topic 03 Capital Budgeting

Topic 3: Investment Decision Rules
and Capital Budgeting
Learning Outcomes
introduction
to capital budgeting
investment
decision rules
net present value (NPV) rule
payback rule
internal rate of return (IRR) rule
choosing between projects with differences in
scale
equivalent annual annuity (EAA) rule for
evaluating projects with different lives
Topic 3 Investment Decision Rules and Capital Budgeting
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Learning Outcomes
capital
budgeting decision
capital budgeting process
incremental free cash flows
tax depreciation vs. accounting depreciation
(extra)
post
audit or financial control
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Introduction to Capital Budgeting

also
known as project appraisal/analysis

investment decision from perspective of a firm
with focus on its mix of long-term assets
spending on long-term assets is known as capital
expenditures (CapEx) which are scare and
valuable resources of a firm
a firm is required to prepare a 3- to 5-year capital
budget on annual basis to project future capital
expenditures (long-term financial planning)
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Introduction to Capital Budgeting

issues
to consider in capital budgeting

type of project: a project is any decision that
results in using scare resources of a business
independent/stand-alone projects:
.
mutually exclusive projects:
.
cash flows to consider: relevant cash flows
what discount rate or cost of capital to use:
weighed average cost of capital (WACC) (topic
7)
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Investment Decision Rules

with
scarce and valuable capital for investment, a

firm has to find a consistent and reliable decision
rule for evaluating projects
net
present
value rule
payback
rule
internal
rate of
return
rule
equivalent
annual
annuity rule
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Net Present Value Rule

net
present value (NPV): difference between

present value of an investments benefits (cash
inflows) and present value of its costs (cash
outflows)
application of valuation principle
estimate cash flows by a project
estimate discount rate or cost of capital
(reflecting
and
)
calculate present value of cash flows
NPV = present value of benefits present
value of costs (in terms of cash flows)
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decision
rule
independent projects:
.
.
other issues
NPV profile: a graph of a projects NPV over a
range of discount rates
internal rate of return (IRR): discount rate that
renders NPV equal to zero (common mistake:
IRR is different from the IRR rule discussed
later)
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difference
between IRR and cost of capital is

the amount of estimation error without altering
original decision (sensitivity analysis - a
technique used in project risk analysis)
advantages
correspond directly to impact of the project on
firms value
direct application of valuation principle
disadvantages
rely on accurate estimate of discount rate
can be time-consuming to compute
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Example: NPV Rule

Consider
a stand-alone project with the following

future cash flows in the coming three years and
the discount rate is 10%. Should a firm accept
the project under the NPV rule?
2
1
3
0
year
-$1,000
$500
$400
$250
$500
$400
$250
NPV =
+
+
$1,000
2
3
1 + 10% (1 + 10%)
(1 + 10%)
= $26.95
As NPV < 0, the decision is to reject the project.
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Example: NPV Profile

NPV
$200
amount of estimation error if
cost of capital = 10%
$160
$120
$80
$40
region of acceptance:
NPV > 0 when r < IRR
discount rate
$0
($40) 0%
($80)
2%
4%
6%
8%
IRR = 8.27%
10% 12% 14% 16%

region of rejection:
NPV <0 when r > IRR
($120)
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Payback Rule
payback
period: the amount of time required for

an investment to generate cash flows sufficient to
recover its initial investment
assume that cash flows are received evenly over
a year so as to consider a fraction of a year in the
calculation
decision rule
.
.
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Payback Rule
advantages
simple
to compute
favors liquidity
disadvantages
no guidance as to correct payback cutoff
ignore cash flows after cutoff completely
ignore time value of money
biased against long-term projects such as
research and development or new projects
not necessarily consistent with maximizing
shareholder wealth
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Example: Payback Rule

Suppose
that there are two mutually exclusive

projects A and B with following future cash flows.
Which project be accepted under the payback
period rule?
year
-$2,000
$1,000
$1,500
-$2,000
$500
$1,000
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$10,000
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Example: Payback Rule

assume
that the firm receives the cash flows

smoothly over a year
$2,000 $1,000
payback( A ) = 1 +
= 1.67 years
$1,500
$2,000 - $500 - $1,000
payback(B) = 2 +
= 2.05 years
$10,000
As project A has the shorter payback period, the decision
is to accept project A.
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Discounted Payback Rule

discounted
payback period: the amount of time

required for an investment to generate present
value of cash flows sufficient to recover its initial
investment
still subject to most disadvantages of payback
rule except considering time value of money
decision
rule
.
.
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Example: Discounted Payback Rule

Suppose
that there are two mutually exclusive

projects A and B with following future cash flows.
Which project be accepted under the payback
period rule?
year
-$2,000
$1,000
$1,500
-$2,000
$500
$1,000
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$10,000
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timeline
of present value of discounted cash

flows is as follows:
year
-$2,000
$909.09
$1,239.67
-$2,000
$454.55
$826.45 $7,513.15
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assume
that the firm receives the discounted

cash flows smoothly over a year
$2,000 $909.09
payback( A ) = 1 +
= 1.88 years
$1,239.67
$2,000 - $454.55 - $826.45
payback(B) = 2 +
= 2.10 years
$7,513.15
As project A has the shorter discounted payback period, the
decision is to accept project
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Internal Rate of Return Rule

internal
rate of return (IRR): discount rate that

makes NPV of a project zero
decision rule
.
.
notice: cut-off rate is usually set at cost of
capital
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in
many cases, NPV rule and IRR rule give the

same conclusion
however, due to some disadvantages of IRR rule,
they may have conflicting conclusions
advantage
related to the NPV rule and usually yield the
same decision
disadvantages
hard to compute
delayed investment (can be misleading if
inflows come before outflows)
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multiple
solutions lead to ambiguity (solution:

modified internal rate of return, MIRR not
discussed)
incorrect decisions in comparing mutually
exclusive projects (ranking problem)
difference in scale
difference in timing of cash flows (solution:
equivalent annual annuity, EAA)
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Example: IRR Rule

Two
mutually exclusive projects have the

following cash flow patterns. The cost of capital is
25%. Which project should be accepted under the
IRR rule? Under the NPV rule?
year
-$200
$150
$150
-$200
$100
$200
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Example: IRR Rule

$150
$150
+
; IRR( A ) = 31.87%
$200 =
2
1 + IRR( A ) [1 + IRR( A )]
$100
$200
+
; IRR(B) = 28.08%
$200 =
2
1 + IRR(B) [1 + IRR(B)]
As IRR(A) > IRR(B), the decision is to accept project A.
$150
$150
NPV ( A ) =
+
$200 = $16
2
1 + 25% (1 + 25%)
$100
$200
NPV (B) =
+
$200 = $8
2
1 + 25% (1 + 25%)
As NPV(A) > NPV(B), the decision is to accept project A.
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Problem 1: Delayed Investment

Consider
a project that you receive the payment

of $500,000 upfront in year 0. To get it done, you
have to incur costs of $150,000, $200,000 and
$250,000 in years 1, 2 and 3 respectively. Given
that the cost of capital is 6%, should the project
be accepted under the IRR rule?
year
0
$500K
-$125K
-$150K
-$175K
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$150K
$200K
$250K
$500K =
2
3
1 + IRR (1 + IRR)
(1 + IRR)
IRR = 8.90%
As IRR > 6%, the decision is to accept project.
$150K
$200K
$250K
NPV =
+ $500K
2
3
1 + 6% (1 + 6%)
(1 + 6%)
= $29.41K
As NPV < 0, the decision is to reject project.
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NPV
$80
$60
$40
$20
$0
($20) 0%
($40)
($60)
cost of capital
= 6%
2%
4%
6%
region of rejection:
NPV <0 when r < IRR
region of acceptance:
NPV > 0 when r > IRR
8%
10%
12% 14% 16%

discount rate
IRR = 8.90%
($80)
($100)
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Problem 2: Multiple Solutions

Descartes
rule of sign: whenever there is a

change in sign in a polynomial, there is an
additional solution
Consider
a project with the following cash flow

pattern. The cost of capital is 12%.
year
0
-$75
$200
-$128
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$200
$128
$75 =
1 + IRR (1 + IRR)2
IRR = 6.67% or 60%
As 60% > 12%, the decision is to accept project.
As 6.67% < 12%, the decision is to reject project.
$200
$128
NPV =
$75 = $1.53
2
1 + 12% (1 + 12%)
As NPV > 0, the decision is to accept project.
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NPV
$5
cost of capital = 12%
$4
$3
IRR =
$2
6.67%
$1
$0
($1) 0%
10% 20% 30%
($2)
($3)
($4)
($5)
IRR =
60%
discount rate
40%
50%
60%
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70%
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80%
Problem 3: Differences in Scale

ranking
of mutually exclusive projects can be

different between IRR and NPV due to difference
in scale (the size of initial investment)
law of diminishing marginal return (what is it?)
Consider two mutually exclusive projects with the
following cash flow patterns both at a discount
rate of 12%. Which project should be accepted
according to (1) the IRR rule; and (2) the NPV rule?
year 0
1
2
3
A
B
-$100
-$50
$45
$23
$45
$23
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$45
$23
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$45
$45
$45
$100 =
+
+
; IRR( A ) = 16.65%
2
3
1 + IRR( A ) [1 + IRR( A )] [1 + IRR( A )]
$23
$23
$23
$50 =
+
+
; IRR(B) = 18.01%
2
3
1 + IRR(B) [1 + IRR(B)] [1 + IRR(B)]
As IRR(A) < IRR(B), the decision is to accept project B.
$45
$45
$45
NPV ( A ) =
+
+
$100 = $8.08
2
3
1 + 12% (1 + 12%)
(1 + 12%)
$23
$23
$23
NPV (B) =
+
+
$50 = $5.24
2
3
1 + 12% (1 + 12%)
(1 + 12%)
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at
a discount rate of 12%, NPV(A) of $8.08 >

NPV(B) of $5.24 and the decision is to accept
project A
IRR(B) of 18.01% > IRR(A) of 16.65% and the
decision is to accept project B
there is a conflict between the two investment
decision rules and the problem lies on the fact
that IRR does not reflect the project risk and
there is a difference in scale
cross-over rate: the discount rate makes the NPV
of two mutually exclusive projects the same, e.g.
15.28% in the example
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NPV
$40
cross-over rate
= 15.28%
$30
cost of capital
= 12%
$20
$10
IRR(B) =
18.01%
IRR(A) =
16.65%
NPV(A) = $8.08
NPV(B) = $5.24
$0
0%
2%
4%
6%
8% 10% 12% 14% 16% 18% 20%
($10)
discount rate
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Problem 4: Timing in Cash Flows

ranking
of mutually exclusive projects can be

different between IRR and NPV due to different
timing in cash flows
Consider two mutually exclusive projects with the
following cash flow patterns both at a discount
rate of 20%. Which project should be accepted
according to (1) the IRR rule; and (2) the NPV rule?
year
-$60
$50
$50
-$60
$90
$30
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$50
Page 35

$50
$50
$50
$60 =
+
+
; IRR( A ) = 64.67%
2
3
1 + IRR( A ) [1 + IRR( A )] [1 + IRR( A )]
$90
$30
$60 =
+
; IRR(B) = 78.08%
2
1 + IRR(B) [1 + IRR(B)]
As IRR(A) < IRR(B), the decision is to accept project B.
$50
$50
$50
NPV ( A ) =
+
+
$60 = $45.32
2
3
1 + 20% (1 + 20%)
(1 + 20%)
$90
$30
NPV (B) =
+
$60 = $35.83
2
1 + 20% (1 + 20%)
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at
a discount rate of 20%, NPV(A) of $45.32 >

NPV(B) of $35.83 and the decision is to accept
project A
IRR(B)
of 78.08% > IRR(A) of 64.67% and the

decision is to accept project B
there
is a conflict between the two investment

decision rules and the problem lies on the fact
that IRR does not reflect the project risk and
there is a difference in timing of cash flows
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NPV
cost of capital
= 20%
$100
$80
$60
NPV(A) = $45..32
$40
NPV(B) = $35.83
IRR(A) = IRR(B) =
64.67% 78.08%
$20
$0
($20)
0%
20%
40%
60%
80%
100%
discount rate
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Equivalent Annual Annuity Rule

equivalent
annual annuity (EAA): level annual

cash flow that has same present value as cash
flows of a project
assume that project can be replicated
indefinitely and convert cash flows into an
annual annuity
propose to deal with problem of differences in
timing of cash flows of mutually exclusive
projects or projects with different lives
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decision
rule
.
important considerations
required life: the life of a machine is more than
the years to use
replacement cost: a change in technology may
reduce the replacement cost in the future
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year 0
-C0
C1
C2
EAA
EAA
.....
N-2
N-1
CN-2
CN-1
CN
EAA
EAA
NPV
EAA
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Example: EAA Rule

Consider
two machines A and B with unequal

useful lives and otherwise same capacity.
Machine A costs $9,000 and will last for 3 years
while machine B costs $8,000 and will last for 2
years. The cost of capital is 6%.
year
-$9,000
$4,000
$4,000
$4,000
-$8,000
$5,000
$5,000
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Example: EAA Rule

$4,000 $4,000
$4,000
NPV ( A ) = $9,000 +
+
+
2
3
1 + 6% (1 + 6%)
(1 + 6%)
= $1,692.05
$5,000 $5,000
NPV(B) = -$8,000 +
+
2
1 + 6% (1 + 6%)
= $1,166.96
as NPV(A) > NPV(B), the decision is to buy machine A
however,
the NPV rule is not applicable here

before the two mutually exclusive projects have
different lives
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Example: EAA Rule

1
1
$1,692.05 = EAA( A ) *
* 1
3
6%
(1 + 6%)
EAA( A ) = $633.02
1
1
$1,166.96 = EAA(B) *
* 1
2
6%
(1 + 6%)
EAA(B) = $636.50
as EAA(B) > EAA(A), the decision is to buy machine B
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Corporate Financial Planning

project
future operating performance and

financial position of a firm (pro forma financial
statements/pro formas), formulate the way in
which financial goals are to be achieved (cash
and capital budgets) and establish guidelines for
change and growth in the firm (financial plan)
short-term financial planning (working capital
management)
long-term financial planning (capital budgeting,
capital structure and dividend policy)
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Corporate Financial Planning
feedback
financial
assumptions
statements and
market data
analysis
planning
current financial
pro-formas, cash
position and past
and capital
operating
budgets, financial
performance
plans
control
actual results
implementation of
financial plans
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Capital Budgeting Process

investment
proposals generated from internal

staff or external consultants
initial screening of proposals
capital budgeting exercise: investment decision
rules and preparation of capital budget
analysis of projects under consideration
working capital requirements
selection, approval and authorization
implementation of projects
post audit and feedback
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Capital Budgeting Process with NPV

Rule
pro-forma
financial
statements
sale forecasts
and budgets
estimate
discount rate
project cash
flows
reject project
feedback
post audits
determine NPV
keep records
<0
NPV>?
>0
accept project
and implement
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Steps in Evaluating a Project with NPV

Rule
talk
to sales people to forecast sales of project

talk to production and operations departments to
estimate expenses of project
estimate effects of project on asset requirements
(and sources of financing it)
prepare pro-forma financial statements of project
to forecast incremental revenue, incremental
costs, marginal tax rates, etc. through financial
modeling
estimate incremental free cash flows and their
timing
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Steps in Evaluating a Project with NPV

Rule
estimate
discount rate based on risk of project

(to be discussed in Cost of Capital)
calculate NPV
make decision
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Cash Flows and Timing of a Project

initial outlay
ongoing cash flows
terminal cash flows
purchase
equipment
incremental
revenue
sale of equipment
(net of taxes)
incremental costs
initial development
cost
increase in working
capital
shutdown costs
taxes
change in net
working capital
decrease in net
working capital
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Fundamentals of Capital Budgeting

before-tax
basis vs. after-tax basis
The
operations manager of a firm forecasts

the future cash flows of a project on a beforetax basis and estimates the before-tax
discount rate. He discounts the before-tax
future cash flows at the before-tax discount
rate to calculate the NPV of the project
because he claims that tax implications will
affect the cash flows and discount rate at the
same time and hence they offset each other.
Do you agree?
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consistency
in taking into account inflation
A
project manager estimates a stream of even

operating cash flows over time for a project
and uses market information to estimate the
discount rate and calculate the NPV of the
project. What is the problem?
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Page 53

incremental
basis
A
company has entered into a tenancy

agreement with a factory owner to lease a
factory at a specified monthly rental payment.
Now it considers to undertake a new project
that will occupy part of the space in the factory.
Should the pro rata rental payment of the
factory be included in calculating the NPV of
the project?
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Page 54

relevant
cash flows
A
firm carried out a pilot test, which cost

$300,000, to see whether a new product
would be accepted by consumers in the
market. Based on the test results, the firm
now wants to decide whether to have mass
production of the new product. Should the test
cost be included as a cash outflow in capital
budgeting?
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Page 55

A
company owns a piece of land with a market

value of $50 million. It would like to make use
of the land for a project. Should the market
value of the land be included as a cash outflow
in capital budgeting?
A
company carries out a project and it

produces a by-product from the project, e.g.
wood dust from producing timber. Should the
revenue of the by-product be included as a
cash inflow in capital budgeting?
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Page 56

A
company launches a new product. Some

customers switch from the old product to the
new one, which results in a decline of the sale
of the old product by $500,000. Should the
foregone sales of the old product be considered
as a cash outflow in capital budgeting?
A company launches a new product. After
buying the new product, some customers also
purchase some other items (cross selling).
Should the increase in sale of the other items
be considered as a cash flow in capital
budgeting?
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Page 57

flexibility
A
company has the flexibility of opening a new

store now or in the future. Is this flexibility likely
to increase, decrease or have no effect on the
NPV of the project of opening a new store?
A company has the flexibility of terminating a
project in the future given that its performance
is poor. Is this flexibility likely to increase,
decrease or have no effect on the NPV of the
project?
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Page 58
After-Tax Basis
revenue
arising from a project is taxable and tax

payment is a cash outflow
expenses incurred in a project are usually tax
deductible and tax saving is a cash inflow
in other words, have to consider the after-tax
cash flows and discount them at the after-tax
discount rate
if a firm uses different accounting methods in
preparing the financial statements (financial
reporting income before tax) and the tax return
(tax reporting taxable income), which is more
relevant in capital budgeting?
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Page 59
Consistency in Considering Inflation

in
principle, inflation is not an issue as long as it

is with consistent treatment
discount nominal cash flows at nominal
discount rate
discount real cash flows at real discount rate
in practice, which is better?
Fisher equation
(1+nominal discount rate) = (1+real discount
rate)*(1+expected inflation rate)
nominal cash flows = real cash
flows*(1+expected inflation rate)
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Page 60
Incremental Basis
in
capital budgeting, consider cash flows on an

incremental basis, i.e. the difference between
with a project and without a project or any
changes in future cash flows as a consequence of
taking a project
if a cash flow occurs regardless whether a firm
takes a project or not, it is not incremental and
hence should not affect its capital budgeting
decision
a firm should only take into account incremental
cash flows
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Page 61
Incremental Basis
standalone
principle: the assumption that

evaluation of a project may be based on the
projects incremental cash flows instead of
calculating the future cash flows with and without
the project
consider
project as a mini-firm and prepare

pro forma financial statements on project
estimate
the incremental cash flows through

the pro forma financial statements
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Page 62
Incremental Basis
similarly,
by comparing two mutually exclusive

projects A and B, consider the difference in the
cash flows between the two projects, known as
the incremental project (project A project B)
assuming that both projects have positive NPV
incremental
NPV = NPV of project A NPV of
project B
if incremental NPV > 0, accept project A
if incremental NPV < 0, accept project B
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Page 63
Incremental Free Cash Flows

concerned
about cash flows rather than net
income
determine
incremental free cash flow (to the

firm) from incremental earnings in capital
budgeting
free
cash flows (to the firm) = - capital

expenditures + operating cash flows - change
in net working capital
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Page 64
Steps in Estimating Incremental Free

Cash Flows
estimate
capital expenditures and salvage value

estimate incremental revenue and incremental
cost of project
determine income tax expense
forecast incremental earnings
estimate change in net working capital
prepare pro forma financial statements
covert incremental earnings to incremental cash
flows
calculate NPV of project and make decision on
project
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Page 65
Capital Expenditures vs. Operating

Expenses
capital
expenditures: upfront costs of the

investment in property, plant and equipment
recorded as fixed assets at cost and
depreciated over several financial years as
depreciation expenses
operating
expenses: costs of running the normal

operations of a firm
recorded as a cost in the financial year of
incurring it
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Page 66
Estimating Capital Expenditures

capital
expenditures: costs of buying new longterm assets, including shipping and installation
costs (cash outflow in year 0)
estimate the initial investment in property, plant
and equipment
capital expenditures as cash outflows, which
do not affect net income
depreciation expenses as non-cash items
which reduce net income, but not cash flows
difference between net income and cash flows
(quick reminder: why different?)
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Page 67

salvage
value is also known as scrap value,

residual value or disposal value
selling
proceeds from disposal of long-term asset

(cash inflow at project end)
gain/loss from disposal of asset = salvage
value book value of long-term asset where
book value is estimated through the
depreciation method used for tax reporting (is
this a cash item?)
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Page 68

but
Inland Revenue raises tax implication

about it (is this a cash item?)
tax payment on gain from disposal of asset:
cash outflow
tax saving on loss from disposal of asset:
cash inflow
incremental cash flows from disposal of longterm fixed assets = salvage value (salvage
value book value)*marginal tax rate
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Page 69
Example: Estimating Capital

Expenditures
a
company intends to buy a machine at a cost of

$1,000,000 for a project
the
machine is to be fully depreciated evenly on

straight-line depreciation method over 5 years for
tax reporting
the
salvage value of the machine in year 5 is

$50,000
M K Lai
Page 70

Expenditures
year
0
1
2
3
4
5
beginning net
book value of
machine
$1,000,000
$800,000
$600,000
$400,000
$200,000
ending net
depreciation
book value
expense
of machine
effect on
income
before tax
effect on cash
flows
$1,000,000
$800,000
$600,000
$400,000
$200,000
$0
$0
-$200,000
-$200,000
-$200,000
-$200,000
-$200,000
-$1,000,000
$0
$0
$0
$0
$33,000
$200,000
$200,000
$200,000
$200,000
$200,000
incremental cash
flow from disposal
of machine
difference between
income and cash flows
M K Lai
Page 71

Expenditures
salvage
value in year 5 = $50,000

book value of machine in year 5 = $0
gain from disposal of machine = $50,000 - $0 $50,000
tax payment on gain from disposal of machine =
($50,000-$0)*34% = $17,000
if marginal tax rate is 34%, incremental cash flow
from disposal of machine = $50,000 - ($50,000$0)*34% = $33,000
M K Lai
Page 72
Depreciation Method for Tax Reporting

so
far, assume straight line depreciation method

is used for tax reporting
may be different from the depreciation method
used for financial reporting
accelerated depreciation: recognize higher
depreciation expenses in early years and lower in
later years
Inland Revenue is likely to adopt an accelerated
depreciation method for tax reporting (why?)
M K Lai
Page 73
Depreciation Method in US
actual
tax depreciation method allowed by the

Inland Revenue Service in US is called modified
accelerated cost recovery system (MACRS) which
allows for accelerated depreciation of property
under different classifications
M K Lai
Page 74
MACRS
only for
half a year
depreciation
rate on each
year
M K Lai
Page 75
Example: MACRS
Suppose
a machine costs $12,000 and belongs

to the 5-year class in MACRS.
year
depreciati beginning
ending
MACRS %
on
book value book value
1
2
3
4
5
6
total
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
100.00%
$2,400
$3,840
$2,304
$1,382
$1,382
$691
$12,000
$12,000
$9,600
$5,760
$3,456
$2,074
$691
$9,600
$5,760
$3,456
$2,074
$691
$0
M K Lai
book
value in
IRS
records
Page 76
Depreciation Method in Hong Kong

initial
allowance (depreciation): 60% in year 1
annual
allowance (depreciation): 10%, 20% or

30% class on remaining balance from year 1
onwards
M K Lai
Page 77
Example: Depreciation Method in Hong

Kong
Suppose
a machine costs $12,000 and belongs

to the 30% class in Hong Kong.
year
1
2
3
4
5
6
7
8
9
10
beginning
initial
annual
total
ending
book value allowance allowance allowance book value
$12,000
$7,200
$1,440
$8,640
$3,360
$3,360
$1,008
$1,008
$2,352
$2,352
$706
$706
$1,646
$1,646
$494
$494
$1,152
$1,152
$346
$346
$807
$807
$242
$242
$565
$565
$169
$169
$395
$395
$119
$119
$277
$277
$83
$83
$194
$194
$58
$58
$136
M K Lai
Page 78
Estimating Incremental Revenue and

Incremental Cost
talk
to sales and marketing people to estimate

incremental revenue
talk
to production and operations people to

estimate incremental costs
estimate
revenue and costs on incremental basis
M K Lai
Page 79

Incremental Cost
issues
to notice
product life cycle: initial low sales (start-up),
accelerating sales (growth), level sales
(maturity) and declining sales (decline)
prices and costs increase with inflation and
decline with technological advancement
competition tends to drive profit margins down
over time
EBIT = incremental revenue incremental costs depreciation
M K Lai
Page 80

Incremental Cost
sales revenue
start-up
growth
maturity
decline
time
M K Lai
Page 81
Example: Estimating Incremental

Revenue and Incremental Cost
after
examining the issue of the $1,000,000

machine in the previous example, the financial
manager has talked to the people from different
departments and he forecasts the following
estimates:
year
incremental revenue
incremental cost
depreciation
EBIT
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$75,000 -$175,000 -$175,000 -$175,000 -$175,000 -$175,000
-$200,000 -$200,000 -$200,000 -$200,000 -$200,000
-$75,000 $150,000 $150,000 $150,000 $150,000 $150,000
M K Lai
Page 82
Determining Income Tax Expense

marginal
tax rate: the tax rate a firm will pay on

an incremental dollar of pretax income
effective tax rate: the tax rate calculated as
income tax expense divided by pretax income
statutory tax rate: the tax rate announced by the
government
which is the appropriate tax rate?
income tax expense = EBIT * tax rate
M K Lai
Page 83
Example: Determining Income Tax

Expense
if
the company in the previous example faces a

marginal tax rate of 34%, the financial manager
estimates the following:
year
incremental revenue
incremental cost
depreciation
EBIT
income tax @34%
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$75,000 -$175,000 -$175,000 -$175,000 -$175,000 -$175,000
-$200,000 -$200,000 -$200,000 -$200,000 -$200,000
-$75,000 $150,000 $150,000 $150,000 $150,000 $150,000
-$25,500
$51,000
$51,000
$51,000
$51,000
$51,000
what does a negative

income tax mean?
M K Lai
Page 84
Taxes and Negative EBIT

if
EBIT is negative in a year, are taxes still relevant?

if the company earns taxable income elsewhere
in that year, the negative EBIT from the project
can reduce the overall taxable income and
hence the tax payment for the year
if the company does not generate any taxable
income in that year or the taxable income is
less than the negative EBIT, all or part of the
negative EBIT (taxable loss) can be carried
backward to past years (tax rebate) or forward
to the coming years within a specified limit
M K Lai
Page 85
Example: Taxes and Negative EBIT

A
company plans to launch a new product. The

heavy advertising expenses associated with the
new product will result in an operating loss of
$10 million next year for the product. The
company expects to earn a taxable income of
$500 million from operations other than the new
product. The tax rate is 34%. What will be the tax
payment without the project? With the project?
M K Lai
Page 86
Example: Taxes and Negative EBIT

tax
payment without project = $500 million

*34% = $170 million
tax
payment with project = ($500--$10

million)*34% = $166.6 million
difference
in tax payment of $3.4 million is an

incremental cash inflow and hence relevant in
capital budgeting
M K Lai
Page 87
Forecasting Incremental Earnings

incremental
earnings
= (incremental revenue incremental cost
depreciation) * (1 tax rate)
= incremental EBIT * (1 tax rate)
M K Lai
Page 88
Example: Forecasting Incremental

Earnings
as
in the previous example, the financial

manager estimates the following:
year
incremental revenue
incremental cost
depreciation
EBIT
income tax @34%
incremental earnings
0
-$75,000
-$75,000
-$25,500
-$49,500
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$175,000 -$175,000 -$175,000 -$175,000 -$175,000
-$200,000 -$200,000 -$200,000 -$200,000 -$200,000
$150,000 $150,000 $150,000 $150,000 $150,000
$51,000
$51,000
$51,000
$51,000
$51,000
$99,000
$99,000
$99,000
$99,000
$99,000
M K Lai
Page 89
Estimating Change in Net Working

Capital
broad
definition: NWC = current assets current

liabilities
narrow definition: NWC = current assets
(excluding cash that can generate a market rate
of return, e.g. cash equivalents) current
liabilities (excluding short-term financing
liabilities)
change in NWC in year t = NWCt NWCt-1
increase in NWC is a cash outflow (why?)
decrease in NWC is a cash inflow (why?)
M K Lai
Page 90
Estimating Change in Net Working

Capital
cash
outflow at beginning of project (increase in

NWC in year 0) and cash inflow at project end
(decrease in NWC at project end)
but with inflation, NWC changes every year and
change in NWC occurs every year until project
end (why?)
M K Lai
Page 91
Example: Estimating Change in Net

Working Capital
as
in previous example, the financial estimates

the net working capital level associated with the
project as follows:
year
NWC
change in NWC
inflation
year
NWC
change in NWC
0
$200,000
-$200,000
1
$200,000
$0
2
$200,000
$0
3
$200,000
$0
4
$200,000
$0
5
$0
$200,000
2
$242,000
-$22,000
3
$266,200
-$24,200
4
$292,820
-$26,620
5
$0
$292,820
rate is 10%
0
$200,000
-$200,000
1
$220,000
-$20,000
M K Lai
Page 92
Preparing Pro Forma Financial

Statements
treat
project as mini-firm and prepare pro

forma financial statements for project
pro
forma financial statements or pro formas:

describe a company that is not based on actual
data but rather depicts a firms financials under a
given set of assumptions
M K Lai
Page 93
Example: Preparing Pro Forma Financial

Statements
in
the previous example, the financial manager

prepares the following financial statements:
year
Revenue
COGS
Gross profit
Selling, general and
administrative expense
Depreciation
EBIT
Income tax @34%
Net Income
year
Net working capital
Fixed assets
Equity
0
$0
$0
$0
-$75,000
$0
-$75,000
-$25,500
-$49,500
Income Statement
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$100,000 -$100,000 -$100,000 -$100,000 -$100,000
$425,000 $425,000 $425,000 $425,000 $425,000
-$75,000
-$75,000
-$75,000
-$75,000
-$75,000
-$200,000 -$200,000 -$200,000 -$200,000 -$200,000

$150,000 $150,000 $150,000 $150,000 $150,000
$51,000
$51,000
$51,000
$51,000
$51,000
$99,000
$99,000
$99,000
$99,000
$99,000
Statement of Financial Position

0
1
2
3
$200,000
$200,000 $200,000 $200,000
$1,000,000
$800,000 $600,000 $400,000
$1,200,000 $1,000,000 $800,000 $600,000
M K Lai
4
$200,000
$200,000
$400,000
Page 94
5
$0
$0
$0
Estimating Incremental Free Cash Flows

from
pro forma financial statements and

incremental earnings, estimate incremental free
cash flows and apply NPV rule to make decision
on project
FCFt = -CapExt + incremental operating cash
flows - NWCt
where FCFt = incremental free cash flows (to
the firm) at time t; CapEx = capital
expenditures at time t; NWCt = change in net
working capital at time t
not all cash flows occur at the same time
M K Lai
Page 95
Estimating Incremental Free Cash Flows

operating
cash flows on incremental basis (add

back depreciation to incremental earnings)
= (incremental revenue incremental costs
depreciation)*(1-tax rate) + depreciation (topdown)
= (incremental revenue incremental
costs)*(1-tax rate) +deprecation*tax rate
(depreciation tax shield)
= incremental EBIT*(1-tax rate) + depreciation
(bottom-up) (notice: EBIT = revenue costs
depreciation)
M K Lai
Page 96
Example: Estimating Incremental Free

Cash Flows
as
in previous example, the financial manager

estimates the incremental free cash flows :
year
incremental revenue
incremental cost
depreciation
EBIT
income tax @34%
incremental earnings
add: depreciation
subtract: Capex and
disposal of machine
subtract: change in
NWC
incremental free cash
flows
0
-$75,000
-$75,000
-$25,500
-$49,500
$0
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$175,000 -$175,000 -$175,000 -$175,000 -$175,000
-$200,000 -$200,000 -$200,000 -$200,000 -$200,000
$150,000 $150,000 $150,000 $150,000 $150,000
$51,000
$51,000
$51,000
$51,000
$51,000
$99,000
$99,000
$99,000
$99,000
$99,000
$200,000 $200,000 $200,000 $200,000 $200,000
-$1,000,000
$0
$0
$0
$0
$33,000
-$200,000
$0
$0
$0
$0
$200,000
-$1,249,500
$299,000
$299,000
$299,000
$299,000
$532,000
M K Lai
Page 97
Summary of Incremental Free Cash

Flows
initial
investment: cash outflow in year 0

incremental operating cash flows: cash inflows
usually from year 1 until project end
add back depreciation as non-cash item
change in net working capital: cash outflow in
year 0 and cash inflow at project end
only change in NWC matters, not NWC itself
salvage value: cash flow from disposal of fixed
assets
gain/loss from disposal is subject to tax effect
M K Lai
Page 98
Calculating NPV and Make Decision

estimate
cost of capital/discount rate based on

the risk level of project
calculate
make
NPV
investment decision base don NPV
M K Lai
Page 99
Example: Calculating NPV and Make

Decision
as
in previous example, the financial manager

calculate the NPV and decides to reject the
project as follows:
year
0
incremental free cash
-$1,249,500
flows
discounted cash flows
-$1,249,500
@12%
NPV
-$39,461
Decision
reject project
$299,000
$299,000
$299,000
$299,000
$532,000
$266,964
$238,361
$212,822
$190,020
$301,871
M K Lai
Page 100
Overall Example
You
are the finance manager of a company. You

want to analyze a proposal for a new product. You
have prepared the forecasts shown in the
following table so that you can prepare the proforma financial statements. The project requires
an initial investment of $12 million in equipment.
The company uses the straight line depreciation
method in preparing the financial statements.
The estimated life of the equipment is 6 years
and the ending book value in year 6 is assumed
to be zero.
M K Lai
Page 101
Overall Example
The
equipment can be dismantled and sold for

net proceeds estimated at $2 million in year 6.
This is your forecast of the equipments salvage
value. In Hong Kong, there is an initial allowance
of 60% and the equipment belongs to the
category of 30% annual allowance on the
remaining balance.
The
estimated discount rate for the project is

20%.
M K Lai
Page 102
Overall Example
year (HK$'000)
1. Initial investment of equipment
2. Accumulated depreciation
3. Year-end book value
4. Net working capital
5. Total book value (3+4)
6. Salvage value of equipment
7. Sales
8. Cost of goods sold
9. Other costs
10. Depreciation
11. Income before tax (7-8-9-10)
12. Tax at 16.5%
13. Net income (11-12)
0
12,000
12,000
550
12,550
4,000
-4,000
-660
-3,340
2,000
10,000
1,289
11,289
4,000
8,000
3,261
11,261
6,000
6,000
4,890
10,890
8,000
4,000
3,583
7,583
10,000
2,000
2,002
4,002
523
837
2,200
2,000
-4,514
-745
-3,769
12,887
7,729
1,210
2,000
1,948
321
1,627
32,610
19,552
1,331
2,000
9,727
1,605
8,122
48,901
29,345
1,464
2,000
16,092
2,655
13,437
35,834
21,492
1,611
2,000
10,731
1,771
8,960
12,000
0
0
0
2,000
19,717
11,830
1,772
2,000
6,115
1,009
5,106
including the gain on selling

equipment = ($2,000-$0) = $2,000
M K Lai
Page 103
Overall Example
The
tax depreciation schedule is as follows:
year (HK$'000)
1. Initial investment of equipment
2. Initial allowance of 60%
3. Annual allowance of 30%
4. Total tax depreciation
5. Year-end tax book value
0
12,000
7,200
1,440
8,640
3,360
1,008
1,008
2,352
706
706
1,646
494
494
1,152
346
346
807
242
242
565
Topic
Topic
053 Capital
Investment
Budgeting
Decision Rules and Capital Budgeting
M K Lai
M K Lai
Page
Page
104
104
Overall Example
The
tax schedule is as follows:
year (HK$'000)
1. Sales
3. Other costs
4. Tax depreciation
5. Gain on sale of equipment
6. Taxable income
7. Tax at 16.5%
1
2
3
4
5
6
523 12,887 32,610 48,901 35,834 19,717
837
7,729 19,552 29,345 21,492 11,830
4,000
2,200
1,210
1,331
1,464
1,611
1,772
8,640
1,008
706
494
346
242
1,435
-4,000 -11,154
2,940 11,021 17,598 12,385
7,308
-660
-1,840
485
1,819
2,904
2,044
1,206
M K Lai
Page 105
Overall Example
Assume
that the company takes advantage of all

tax savings.
Projected cash flow table

year (HK$'000)
1. Sales
3. Other costs
4. Tax
5. Operating cash flow
6. Change in NWC
7. Capital spending
8. Total net cash flow
9. Discounted cash flow at 20%
10 NPV
As
4,000
-660
-3,340
-550
-12,000
-15,890
-15,890
4,629
1
2
3
4
5
6
523 12,887 32,610 48,901 35,834 19,717
837
7,729 19,552 29,345 21,492 11,830
2,200
1,210
1,331
1,464
1,611
1,772
-1,840
485
1,819
2,904
2,044
1,206
-674
3,463
9,908 15,188 10,687
4,909
-739
-1,972
-1,629
1,307
1,581
2,002
2,000
-1,413
1,491
8,279 16,495 12,268
8,911
-1,177
1,035
4,791
7,955
4,930
2,984
NPV > 0, accept the project.
M K Lai
Page 106
Special Effects on Incremental Free

Cash Flows
opportunity
cost
incidental/externality/spillover/side
sunk
effects
cost (ignored)
overhead
cost allocation (be careful)
financing
costs (excluded)
M K Lai
Page 107
Opportunity Cost
opportunity
cost: most valuable alternative

(second best project) that is given up if a
particular project is accepted
cash
outflow though it may not involve actual

cash payment
the
project and its alternative can be considered

as mutually exclusive projects, i.e. if accepting
the project, have to forego the alternative
(remember the incremental basis)
M K Lai
Page 108
Opportunity Cost
in
order to accept the project, a firm has to make

sure that the present value of all cash flows
arising from the project exceed that of the
alternative otherwise, it adds more value to the
firm by accepting the alternative hence the (net
present) value of the alternative becomes a
relevant cash outflow
M K Lai
Page 109
Incidental/Externality/Spillover/
Side Effect
externality:
relevant cash flows incidental on the
project
negative effects lead to cash outflows
erosion or cannibalization: cash flows of
new product come from those of old
products
environment: meeting environmental
standards
M K Lai
Page 110
Incidental/Externality/Spillover/
Side Effect
positive
effects lead to cash inflows

by-products: sale of side products
cross-selling: sale of new product triggers
sale of old products.
increased traffic: more customers attract
even more customers
real options: the right to make a particular
business decision
the value of a real option is usually nonnegative (why?)
M K Lai
Page 111
Real Options in Capital Budgeting

add
positive value to NPV of project

option to delay commitment: the right to time
a particular investment
option to expand: the right to start with limited
production and expand only if the product is
successful
option to abandon: the right for an investor to
cease investing in a project (drop it when it is
not successful)
M K Lai
Page 112
Sunk Cost
sunk
cost: a cost that has already been incurred

and cannot be recovered
irrelevant
for making the current decision
past
research and development expenditures
past
marketing or pilot test
fixed
overhead expenses
M K Lai
Page 113
Overhead Cost Allocation

a
firm should be careful to distinguish between

accounting overhead cost allocation and
incremental overhead cost allocation
only incremental overhead cost allocation is a
relevant cash outflow
for example
a firm has rented a warehouse for storage
now, it launches a new project which requires
the use of some storage space in the
warehouse and it has to hire new workers to
take care of the logistics of the new products
M K Lai
Page 114
Overhead Cost Allocation

in
accounting, part of the rental expense may

be allocated to the new project, but it is not
incremental and hence irrelevant
however, the wages to the newly hired workers
are relevant cash outflows in capital budgeting
because they are incremental
M K Lai
Page 115
Financing Cost
financing
costs like dividend payments, stock

repurchase, interest payments, principal
repayment are not included in capital budgeting
and hence irrelevant
especially be careful about interest expenses that
are included in calculating the net income in the
income statement
exclude interest expenses and their tax saving, i.e.
we consider the EBIT as the operating cash flows
M K Lai
Page 116
Financing Cost
separation
of investment and financing decisions

only consider cash flows from assets in
investment decision, i.e. uses of funds
cash flow implication from financing decision
(e.g. interest expenses), i.e. sources of funds
unlevered net income: net income that does not
include interest expenses associated with debt
in capital budgeting, estimate unlevered net
income of a project and determine its cash
flows
M K Lai
Page 117
Post Audit
also
known as financial control, an often ignored

but actually important step
compare actual results with the estimates in
financial planning
positive or negative deviations?
why deviations? human errors and/or
uncontrollable external factors
who is responsible?
any remedial actions
feedback to next round of capital budgeting
exercise
M K Lai
Page 118
Post Audit
uses
of post audit
1.
2.
3.
4.
M K Lai
Page 119
Post Audit
feedback
financial
assumptions
statements and
market data
analysis
planning
current financial
pro-formas, cash
position and past
and capital
operating
budgets, financial
performance
plans
control
actual results
implementation of
financial plans
M K Lai
Page 120
Conclusion
generate
the idea of a project
be
careful about assumptions in pro forma

financial statements of the project
project
use
incremental free cash flows of the project
NPV rule in making decision on the project
carry
out post audit
M K Lai
Page 121
Challenging Questions
1. How is the NPV rule related to the goal of
maximizing shareholder wealth?
2. Why does the NPV decision not depend on the
investors preferences?
3. How can you interpret the difference between
the cost of capital and the internal rate of return
(IRR) under the NPV rule?
4. Explain why choosing the option with the highest
NPV is not always correct when the options have
different lives. What additional issues should
you keep in mind when choosing among
projects with different lives?
M K Lai
Page 122
5. Which of the investment criteria in capital
budgeting does not take into account the project
risk, NPV, IRR, payback period, discounted
payback period and equivalent annual annuity?
6. What are the differences between incremental
earnings and incremental free cash flows in
capital budgeting?
7. Which of the following statements describes a
situation that is not considered as appropriate
when applying the net present value rule in
capital budgeting?
M K Lai
Page 123
A. A financial manager estimates the beforetax cash flows of a project and discounts
them at the before-tax discount rate.
B. In considering two mutually exclusive
projects, a financial manager subtracts the
cash flows of one project from those of
another project. Based on the net present
value of this net cash flow stream, he makes
a decision to choose between these two
projects.
M K Lai
Page 124
C. A financial manager includes the

depreciation tax shield as a relevant cash
inflow in a project.
D. When calculating the corporate income
tax paid to the government in a capital
budgeting exercise, a financial manager uses
the accounting methods used in preparing
the financial statements.
M K Lai
Page 125
8. A company is considering whether to undertake a
project. In the project, the company is required to
make use of an idle machine which has no
alternative use at all. In the tax records, the net
book value of the machine is $100,000. In the
financial statements, the net book value of the
machine is $250,000. Which of the following
statements is correct with respect to the machine?
M K Lai
Page 126
A. There is no relevant cash flow associated
with the use of the machine in this project.
B. There is a relevant cash outflow of
$100,000 with the use of the machine in this
project because it is the opportunity cost.
C. There is a relevant cash outflow of
D. There is a relevant cash outflow of
M K Lai
Page 127
9. A company is carrying out a capital budgeting
exercise on an incremental project of project X
minus project Y. Which of the following items is
considered as a cash outflow for this
incremental project?
A. Project X will recognize an annual
depreciation expense of $200,000 for tax
reporting.
M K Lai
Page 128
B. In project X, it is estimated that some old
customers will switch from the old products
to the new products and there will be a drop
in the annual sales revenue of the old
products by $400,000.
C. There is an increase in net working capital
of $450,000 at the beginning of project Y.
D. There will be a tax saving on disposal of a
machine of $150,000 at the end of project Y.
M K Lai
Page 129
10.The board of directors of a company decides to
assign a particular senior manager in the
operations department to lead a new project of
improving the operational efficiency of the
company. In the capital budgeting exercise, the
board agrees that they should allocate the
salary of the senior manager as a cash outflow
to the project. The rationale is that the manager
is now 100% devoted to the project. Without the
project, he can be assigned elsewhere and this
is an opportunity cost. Do you agree?
M K Lai
Page 130
11. In order to fill the rush orders from customers, a
manufacturing company usually asks the workers
to work overtime, but the overtime pay is usually
1.1 times the normal pay on an hourly basis. With
a capital project, the company expects that there
will be a lot of rush orders from customers. In
order to give more incentives to the workers to
work overtime for the project, the company
decides to raise the overtime hourly wage rate to
1.15 times the normal hourly wage rate. Which of
the following statements is correct with respect to
the overtime pay for the project?
M K Lai
Page 131
A. The original overtime pay of 1.1 times the
normal pay for the project is relevant because it is
an incremental cash outflow.
B. The original overtime pay of 1.1 times the
normal pay for the project is irrelevant because it
is a sunk cost.
C. The additional overtime pay of 0.05 (1.15 1.1)
times the normal pay for the project is irrelevant
because it is a sunk cost.
D. The additional overtime pay of 0.05 (1.15 1.1)
times the normal pay for the project is relevant
because it is an incremental cash outflow.
M K Lai
Page 132
12.In the capital budgeting exercise on a project,
the chief financial officer of a company finds
that the company has the flexibility to give up
the project before the end of its life in the future.
Which of the following statements is correct in
respect of this flexibility to abandon?
M K Lai
Page 133
A. The flexibility may add negative value to the
net present value of the project because it
renders the initial investment of the project
worthless in the future.
B. The flexibility may add negative value to the
net present value of the project because of the
increased uncertainty.
C. The flexibility may add positive value to the
net present value of the project because it is
an opportunity cost.
D. The flexibility may add positive value to the
net present value of the project because it is a
strategic
option.
M K Lai
Page 134

FINA2303 Topic 03 Capital Budgeting

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FINA2303 Topic 03 Capital Budgeting

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Topic 3: Investment Decision Rules

and Capital Budgeting

Topic 3 Investment Decision Rules and Capital Budgeting

audit or financial control

Topic 3 Investment Decision Rules and Capital Budgeting

Introduction to Capital Budgeting

known as project appraisal/analysis

Topic 3 Investment Decision Rules and Capital Budgeting

Introduction to Capital Budgeting

to consider in capital budgeting

Topic 3 Investment Decision Rules and Capital Budgeting

Investment Decision Rules

scarce and valuable capital for investment, a

Topic 3 Investment Decision Rules and Capital Budgeting

Net Present Value Rule

present value (NPV): difference between

Net Present Value Rule

Net Present Value Rule

between IRR and cost of capital is

Example: NPV Rule

a stand-alone project with the following

Example: NPV Profile

10% 12% 14% 16%

period: the amount of time required for

Example: Payback Rule

that there are two mutually exclusive

Topic 3 Investment Decision Rules and Capital Budgeting

Example: Payback Rule

that the firm receives the cash flows

Topic 3 Investment Decision Rules and Capital Budgeting

Discounted Payback Rule

payback period: the amount of time

Topic 3 Investment Decision Rules and Capital Budgeting

Example: Discounted Payback Rule

that there are two mutually exclusive

Topic 3 Investment Decision Rules and Capital Budgeting

Example: Discounted Payback Rule

of present value of discounted cash

Topic 3 Investment Decision Rules and Capital Budgeting

Example: Discounted Payback Rule

that the firm receives the discounted

Topic 3 Investment Decision Rules and Capital Budgeting

Internal Rate of Return Rule

rate of return (IRR): discount rate that

Topic 3 Investment Decision Rules and Capital Budgeting

Internal Rate of Return Rule

many cases, NPV rule and IRR rule give the

Internal Rate of Return Rule

solutions lead to ambiguity (solution:

Topic 3 Investment Decision Rules and Capital Budgeting

Example: IRR Rule

mutually exclusive projects have the

Topic 3 Investment Decision Rules and Capital Budgeting

Example: IRR Rule

Problem 1: Delayed Investment

a project that you receive the payment

Topic 3 Investment Decision Rules and Capital Budgeting

Problem 1: Delayed Investment

Problem 1: Delayed Investment

12% 14% 16%

Problem 2: Multiple Solutions

rule of sign: whenever there is a

a project with the following cash flow

Topic 3 Investment Decision Rules and Capital Budgeting