Notes from various chapters in the core finance textbook, Financial Management, Concepts and Applications by Ramesh K.S. Rao.
Source: Financial Management, Concepts and Applications by Ramesh K.S. Rao Subject: Finance
The capital budgeting process is comprised of six stages:
Identifying long-term goals – evaluation of strategic investment proposals, which change the very character of the firm. When doing so, international markets must be taken into consideration. Also, they cannot be completely evaluated in terms of only their immediate impact on cash flows and stock price. Strategic considerations also involve timing decisions and marketing-related decisions. Also here are the evaluation of tactical investment proposals, which involve investments that would affect the firm’s cash flows an economic wealth, but not necessarily change the character of the firm.
Screening – This involves a qualitative evaluation of a proposal. Proposals can be cost-reduction, vertical revenue expansion or horizontal revenue expansion in nature.
Evaluation – this process involves using discounted cash flows to evaluate the economic profitability of the proposal. Proposals can exhibit a certain level of economic dependence, which is the extent to which two proposals are related to one-another. Complementary proposals are those where adoption of the proposals together exceeds the value of adoption of either one or the other. Substitute proposals are those where the adoption of one proposal reduces the cash flows of another proposal. Mutually Exclusive proposals are those which cannot co-exist. Independent proposals are those where the adoption of one proposal has no impact whatsoever on another proposal. Only proposals that are economically independent can be evaluated separately. All others must be evaluated collectively as a project.
Implementation – making the required arrangements to take on the new project(s). Usually involves the capital outlay.
Control – monitoring the progress of the project to obtain feedback and determine corrective action as necessary.
Project Audit – performed when the project is completed to carefully examine the reasons for its success or failure and learn from the experience to make more informed project decisions in the future.
Because it is so difficult to assign values to certain qualitative characteristics of a proposal or project, managers must examine the overall “fit” of the project with the corporate strategy and stated objectives. Managers must recognize that they have to make decisions based on incomplete information and must use their best judgment and all available information when making the qualitative assessment of a particular project.
Because proposals are usually not independent, if several proposals are under consideration, they must be grouped into a project because of their interdependence. They must be evaluated together because a decision made in one proposal could impact another proposal and therefore the entire project. The individual proposals cannot be analyzed in isolation because their effects are not isolated.
Proposals can be (1) complementary (2) substitutes (3) mutually exclusive or (4) independent.
“Incremental” in CFAT refers to the additional cash flow (positive or negative) caused by the adoption of a project. This would be increments to existing revenues, expenses and taxes.
The three classifications of cash flows are:
Initial cash flows – expenditures used to acquire PP&E when a project begins. Could include direct cash flows like capital expenditures and operating expenditures or indirect cash flows like asset sale proceeds and changes in working capital.
Operating cash flows – the net benefits (incremental cash flows after taxes) received over a project’s economic life.
Terminal cash flows – the cash flows that occur at the time a project’s useful life ends. Typically include salvage value of the asset(s) and recovery of net working capital.
Direct cash flows involve direct cash outlays for capital expenditures and operating expenses. Indirect cash flows occur indirectly as a result of the requirements of the project (salvage sales and gain/loss or changes in working capital).
When an asset is sold, in can generate either a tax loss or a tax gain (or no gain/loss) based on the value received and the depreciated value of the asset sold. This has tax implications because gains result in cash outflows for increased taxes paid and losses result in cash inflows for tax savings earned.
Capital expenditures are those where are expected to produce future benefits that extend beyond one year. These types of expenditures are capitalized as assets on the balance sheet. Operating expenditures are those that provide no benefits beyond those of the current period and are expensed through the P&L.
Depreciation matters in capital budgeting because it is a non-cash expense that affects cash flows from operations. When calculating annual incremental operating cash flows, changes in depreciation must be taken into consideration.
The payback period methodology does not consider opportunity cost (TVM) or cash flows beyond the payback period. Sometimes a “discounted payback period” is used, but this still ignores cash flows beyond the discounted payback period. In addition, the payback method completely ignores risk. The AROR methodology uses accounting figures (profits) and ignores the TVM and other market-driven considerations. AROI is somewhat better in that it uses cash flows instead of accounting profits, but does not consider the TVM.
The implication of value additivity is that as long as a project carries a positive NPV, the value of that project will accrue to the company as a whole and the company will have created economic value.
NPV and PI lead to the same accept reject decision because if NPV is positive, its PV of inflows must be greater than its PV of outflows, meaning that when you divide the former by the latter the result must be greater than one. However, when choosing between one of two projects, the PV vs. NPV choice can have some interesting consequences, primarily because the PI is a relative measure which the NPV is an absolute measure.
Given a stream of CFATs and a RRR, deciding whether or not to accept or reject a project should be a simple matter of calculating its NPV. However, operating flexibility and investment flexibility considerations must also be considered and are definitely of value.
Market imperfections like financing arrangements and labor costs in foreign countries, government regulations and patents, and general inefficiencies in the market for physical goods and services can be exploited to maintain positive NPV projects.
Operating flexibility is of value because it allows for the unexpected. The more inflexible a project, the more difficult it is to recover when changes occur during its life or become necessary for whatever reason.
For the opportunity to defer an irreversible investment, you would pay up to the NPV of the project with flexibility.