# Unit 4 Notes: Capital Budgeting: Determining which investments a firm should undertake

Corporate Finance lecture notes for the EMBA at UNSW.

Company adds value to a business through its capital budgeting or investment decisions.

When examining an investment proposal we are interested only in the marginal or incremental cash flows associated with the project.

Incremental net cash flow of an investment proposal: the difference between the firm’s cash flows if the investment project is undertaken and the firm’s cash flows if the investment project is not undertaken.

NPV = -Initial Investment +

##### Challenging Issues

**Sunk Costs** Defined at the time of doing the NPV calculation it is any cost that have already been expended or happened in the past.

Common examples:

- Research and development cots already incurred
- Market research already done
- Feasibility studies performed
- Machines purchased but not yet installed
- Other cash outflows that can’t be recovered

**Exam tip:** Specify you are ignoring sunk costs

##### Calculating required rate of returns

Consider how firm’s assets are funded

- Debt – use yield to maturity on firm’s bonds (interest rate for the debt);
- Equity – use required return of shareholders (CAPM formula);
- Calculate weight average of cost of debt and equity

##### Costs of raising debt and equity

Cost of finance is included in the discount rate of return (r)

##### Price Inflation

Be consistent on the NPV calculation. If Revenue and Expenses

- Use current prices without inflation, use real discount rate. Real discount rate = Discount rate – inflation
- Includes inflation, use discount rate

##### Projects tie up working capital

Cash outflow at time = 0

Cash inflows at the end of the project unless stated otherwise

##### Projects have different lengths

If mutually exclusive (alternatives cannot be repeated): Compare NPVs and choose the highest.

If alternative can be repeated then for each one:

- Calculate NPV using standard method
- Calculate the present value of $1 annuity over the life of the project
- Adjusted NPV=
- Choose alternative with highest “Adjusted NPV”

##### Payback period

Length of time to recover original investment;

Management establish maximum threshold

**Rule:**

Accept if payback period < desired recovery period;

Mutually exclusive investment, select investment with lowest payback period < desired recovery period

Pros | Cons |

Simple answer in years | Ignores time value |

Easy to explain | Ignores CFs after threshold |

Can calculate in head | Problems with scale e.g. if one project has shorted payback period than the other project |

##### Internal rate of return (IRR)

Find the discount rate which makes NPV = 0

Rules:

Accept if IRR > rate of return

Mutually exclusive investment, select the highest IRR above r_{p}

Pros | Cons |

Simple answer in % | Problems with timing of cash flows. It does not take the ordering of inflows and outflows into account. In others it can’t distinguish between borrowing and lending. |

Easy to explain | Multiple % answers. For each change of sign of successive cash flow through time E.g. clean up cost. |

Decision often same as NPV | Problems with scale |

##### Depreciation

It is not a cash flow – accounting tool for allocating cost of an asset as it is used up.

Need for NPV because it influences tax cash flow. It is tax deductible, the reduction in tax is a benefit and it is a cash flow.

First calculate deprecated value of asset

Depreciation =

Cost = purchase price + installation price + sales tax + delivery charges

Second calculate gain or loss on sale

Gain on sale = Disposal price – Book value > 0. It is taxable (-ve cash flow) in the period the sale takes effect

Loss on sale = Disposal price – Book value < 0. It is claimed as deduction (+ve cash flow ) in the period the sale takes effect

##### NPV Template

0 | 1..n-1 | Final year n | |

Annual Revenue (+)[=R] | |||

Annual Expenses (-)[=E] | |||

Investment Cash flow [=I] (initial cost (-ve) includes +sales, +deliver, +install);Salvage value (+ve) | +Salvage value (at end of life) | ||

Changes in Working Capital (-)[=ΔWC = CA-CL]Add (+ve) WC back in at the end of project | -WC | +WC | |

Depreciation over the life of the asset (-)Asset cost includes sales tax, delivery charges, setup install | |||

Check for any gain or loss on sale.Book value = Original Cost – Depreciation x Years Gain (-ve) /Loss (+ve) on sale [=G_{t}] = Sold Price – Book Value | |||

Tax cash flow (-)T_{t} = τ (R_{t} + E_{t} + D_{t} + G_{t}) x -1 | |||

After Tax cash flow[X_{t}=R_{t} – E_{t} – I_{t} – T_{t}] | |||

Calculate PV of cash flow |

WC is after-tax amount; do not include it when determining tax payable

##### Decision Criteria

- Accept an investment if NPV > 0
- Reject an investment if NPV < 0
- Indifferent between accepting or rejecting an investment if NPV = 0
- Accept the investment with the
**highest positive NPV**if you must decide between**mutually exclusive investments**(i.e. must choose one, select A or Investment B) - Accept any investment if the investment have positive NPV between
**independent investments**(can be A, B, both A and B or neither if negative NPV) - Accept the investment with the
**highest Annual Equivalent Cash Flow (AE)**if you must decided between**mutually exclusive investments with different life spans**: