ASPEK KEUANGAN Capital Budgeting

  

ASPEK KEUANGAN ASPEK KEUANGAN

Capital Budgeting

MANAJEMEN PROYEK

  Investment decisions Investment decisions y

  Objectives for this session : y

  

Review investment rules

y

  NPV, IRR, Payback y

  BOF Project BOF P j t y

  Free Cash Flow calculation y

  Sensitivity analysis, break even point y

  Inflation Investment rules Investment rules y

  Net Present Value (NPV) y

  Di t d i t l f h fl

  NPV

  y Discounted incremental free cash flows y

  Rule: invest if NPV>0 y

  Internal Rate of Return (IRR)

  IRR y

  IRR: discount rate such that NPV=0 y

  Rule: invest if IRR > Cost of capital y

  Payback period r

  Payback period y

  Numbers of year to recoup initial investment y

  No precise rule P fi bili I d (PI) y

  Profitability Index (PI) y

  PI = NPV / Investment y

  Useful to rank projects if capital spending is limited Internal Rate of Return Internal Rate of Return y

  Alternative rule: compare the internal rate of return for the project to the opportunity cost of capital project to the opportunity cost of capital y

  Definition of the Internal Rate of Return IRR : (1-period)

  IRR = Profit/Investment = (C

• - I)/I

  1

  I l IRR (125 100)/100 25% y

  In our example: IRR = (125 - 100)/100 = 25% y

  The Rate of Return Rule: Invest if IRR > r y

  In this simple setting, the NPV rule and the Rate of Return Rule lead to the same decision: y

  NPV = -I+C

• -I)/I>r ⇔ IRR>r

  1 /(1+r) >0 ⇔ C

  1 >I(1+r) ⇔ (C

  1 IRR: a general definition y

  IRR: a general definition

  The Internal Rate of Return is the discount rate such that the NPV is equal to zero. q _{25.00 30.00}

  y

• I + C /(1+IRR) ≡ 0

  1 _{V a lu e 15.00 20.00} y ^t

  In our example: _{N et P res en 10.00 5.00}

  y

• 100 + 125/(1+IRR)=0
_0.00 IRR

  y ^{0.0% 2.5% 5.0% 7.5% 10.0% 12.5% 15.0% 17.5% 20.0% 22.5% 25.0% 27.5% 30.0%}

  2 % ⇒ IRR=25%

• _{-10.00 -5.00 Discount Rate}
Internal Rate of Return IRR Internal Rate of Return IRR y

  

Can be viewed as the “yield to maturity” of the project

y

  Remember: the yield to maturity on a bond is the rate that set the present value of the expected cash flows equal to its price y

  Consider the net investment as the price of the project p p j y

  The IRR is the rate that sets the present value of the expected cash flows equal to the net investment y

  The IRR is the rate that sets the net present value equal to zero The IRR is the rate that sets the net present value equal to zero What do CFOs Use? What do CFOs Use? y y

  % Always or Almost Always % Always or Almost Always y

  Internal Rate of Return 75.6% y y

  Net Present Value N t P t V l 74.9% 74 9% y

  Payback period 56.7% y

  Discounted payback period 29.5% y

  Accounting rate of return 30.3% y

  Profitability index 11.9% y

  Based on a survey of 392 CFOs Source: Graham, John R. and Harvey R. Campbell, “The Theory and Practice of Corporate Finance: Evidence from the Field”, Journal of Financial Economics 2001 IRR Pitfall 1: Lending or borrowing? y

  IRR Pitfall 1: Lending or borrowing?

  Consider following projects:

  IRR: borrowing or lending? y

  0 1 IRR NPV(10%)

  30.00

  y

  A -100 +120 20% 9.09

  20.00

  l lue y

  B +100 -120 20% -9.09 B +100 120 20% 9 09

  10.00

  t Va n

  0.00

  se e y

  A: lending Rule IRR>r

• 10.00

  t t Pr 0% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

  1

  1

  1

  2

  2

  2

  3 y

  B: borrowing Rule IRR<r

  Ne

• 20.00
• 30.00

  Discount rate

  Project A Project B

• 500.00

  2

  4

  05 %

  4

  50 %

  4

  95 % Pr e s e nt Va lu e

  sign of cash flows

  y

  To overcome problem, use modified IRR h d

  2

  3

  3

  3

  4

  4

  4 Discount Rate Ne t

  method

  y

  Reinvest all intermediate cash flows at the cost of capital till end of project

  y

  60 %

  15 %

  Calculate IRR using the initial investment and the future value of intermediate cash flows

  Multiple Rates of Return 1000.00 1500.00 y

  IRR Pitf ll 2 M lti l R t f R t

  IRR Pitfall 2 Multiple Rates of Return y

  Consider the following project

  y

  Year 0 1 2

  y

  Year 0 1 2

  y

  CF -1,600 10,000 -10,000 2 “IRR ” +25% +400%

  2 “IRRs” : +25% & +400%

  3

  y

  This happens if more than one change in f h fl

  0.00 500.00 1000.00

  0%

  45 % 90 %

  13 5% 18 0%

  2

  25 %

  2

  70 %

• 2000.00
• 1500.00
• 1000.00

  

IRR Pitfall 3 - Mutually Exclusive

P j t Projects y

  C C

  Timing Problem C C C

  Scale Problem y

NPV IRR

  IRR S ll 10 +20 8 2 100%

  1 C

  L-S -40 +60 14.5 50% A-B 0 -80 +90 2.9 12.5%

  y

  IRR

  1 NPV 10%

  y C C

  To choose, look at incremental cash flows

  y

  IRR

  2 NPV 8%

  C C

  1 NPV 10%

  Look at incremental cash flows

  y C C

  Large -50 +80 22.7 60%

  y

  Small -10 +20 8.2 100%

  y

  IRR A -100 +20 +120 19.8 20% B -100 +100 +30 17.0 24.2%

  2 NPV 8%

  1 C

  y M t Mutually Exclusive Project - Illustration ll E l i P j t Ill t ti

  50.0

40.0 A

  30.0

  20.0 B 10.0 10 0 0.0 0.0% 2.5% 5.0% 7.5% 10.0% 12.5% 15.0% 17.5% 20.0% 22.5% 25.0% 27.5% 30.0% 32.5%

• 10.0
• 20.0
Payback Payback y

  The payback period is the number of years it takes before the cumulative forcasted cash flows equals the initial investment. l ti f t d h fl l th i iti l i t t

  Y e a r

  1

  2

  3 P a y b a c k N P V

  y Example: r

  = 1 0 % A - 1 ,0 0 0 5 0 0 5 0 0 1 ,0 0 0 2 6 1 9 B - 1 ,0 0 0 1 ,0 0 0 2 - 1 7 4 C - 1 ,0 0 0 5 0 0 5 0 0 2 - 1 3 2

  y A very flawed method, widely used y

  Ignores time value of money y

  Ignores cash flows after cutoff date g Profitability Index Profitability Index y

  Profitability Index = PV(Future Cash Flows) / Initial Investment A f l l f l h l y

  A useful tool for selecting among projects when capital budget limited. y

  The highest weighted average PI y

  The highest weighted average PI NPV Review NPV - Review y

  NPV: measure change in market value of company if project accepted accepted y

  As market value of company V = PV(Future Free Cash Flows)

  ∑

  = Δ =

  t t t r FCF

  V NPV

• Δ

  ) 1 (

  y ΔV = V with project

• V

  without project y

  Cash flows to consider: y cash flows (not accounting numbers) y do not forget depreciation and changes in WCR y incremental (with project - without project) y forget sunk costs y include opportunity costs y include all incidental effects y beware of allocated overhead costs beware of allocated overhead costs Inflation Inflation y

  Be consistent in how you handle inflation y

  Discount nominal cash flows at nominal rate y

  Discount real cash flows at real rate y

  Both approaches lead to the same result. pp y

  Example: Real cash flow in year 3 = 100 (based on price level at time 0) y y

  Inflation rate = 5% Inflation rate = 5% y

  Real discount rate = 10% Discount real cash flow using real rate Discount nominal cash flow using nominal rate

  3

  3 PV = 100 / (1.10) = 75.13 Nominal cash flow = 100 (1.05) = 115.76 Nominal discount rate = (1.10)(1.05)-1 = 15.5%

  3 PV = 115.76 / (1.155) = 75.13 Interest rates and inflation: real i t interest rate t t y

  Nominal interest rate = 10% Date 0 Date 1 y y

  Indi idual in ests Individual invests $ 1,000 $ 1 000 y

  Individual receives $ 1,100 y

  Hamburger sells for $1 $1.06 y

  Inflation rate = 6% y

  Purchasing power (# hamburgers) H1,000 H1,038 y

  Real interest rate = 3.8% (1+Nominal interest rate)=(1+Real interest rate)×(1+Inflation rate) ) ( ) y

  Approximation: Real interest rate ≈ Nominal interest rate - Inflation rate

  Investment Project Analysis: BOF BOF Big Oversea Firm is considering the project

  Year

  1

  2

  3 Initial Investment

60 Resale value

  20 Sales 100 100 Cost of sales

  50

  50 Corporate tax rate = 40% C t t t 40% Working Capital Requirement = 25% Sales Discount rate = 10% BOF: Free Cash Flow Calculation Calculation

  Year

  1

  2

  3 Sales 100 100

  C Cost of sales f l

  50

  50

  50 EBITDA

  50

  50

  50 Depreciation

  30

  30 EBIT

  20

  20 Taxes

  8

  8

  8 Net income 12 12 -8

  Net income 12 12 -8

  Depreciation D i ti

  30

  30

  30 DWCR 25 -25

  30

  CFInvestment

• 60

  20 Free Cash Flow -60

  17

  42

  37 BOF: go ahead? BOF: go ahead? y

  NPV calculation:

  17

  42

  37 NPV NPV = −

  

60

  96

  96

  

60

+ = + + + = = + + 17 17 .

  2

  3 1 .

  10 ( 1 . 10 ) ( 1 . 10 ) y

  Internal Rate of Return = 24% y

  Payback period = 2 years BOF: checking the numbers BOF: checking the numbers y

  Sensitivity analysis y

  

What if expected sales below expected value?

  Sales

  60

  70

  80 90 100

NPV -1.28

  3.53

  8.34

  13.15

  17.97

  y Break-even point y

  What is the level of sales required to break even? y

  Break even sales = 62.7

  BOF Project with inflation rate = 100% 100% Nominal free cash flows

  Year

  1

  2

  3 Sales 200 400 Cost of sales 100 200 EBITDA EBITDA 100 100 200 200 Depreciation

  30

  30 EBIT 70 170 Taxes

  28

  68

  64 Net income Net income 42 42 102 102 -64

  64 Net income 42 102 -64 Depreciation

  30

  30 Δ 50 50 -100 ΔWCR

  CFInvestment -60 160 Free Cash Flow -60

  22 82 196

  Nominal discount rate = (1+10%)(1+100%)-1 = 120% NPV = -14.65 IRR = 94%