CHAPTER 2 LITERATURE REVIEW

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1 CHAPTER 2 LITERATURE REVIEW Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept. (Pearson Education, 2007, 178) INTRODUCTION OF CAPITAL BUDGETING Capital budgeting process consists of three elements: Coming up with proposals for investment projects Evaluate the project Deciding which ones to accept and which to reject THE NATURE OF PROJECT ANALYSIS Investment projects starts with an idea for increasing shareholder wealth by producing a new product or improving the way an existing product is produced. Investment projects are analyzed as a sequence of decisions and possible events over time starting with the original concept, gathering information relevant to assessing the costs and benefits of implementing it, and devising an optimal strategy for implementing the project overtime. 7

2 8 Capital budgeting is the process by which the firm renews and reinvents itself adapting old projects to the times and finding new ones. It involves comparing cash inflows that may spread out over many years with cash outflows that generally occur close to the present IMPORTANCE OF CAPITAL BUDGETING A number of factors combine to make capital budgeting perhaps the most important task faced by financial managers. One of the most important factors is timing. Since the results of capital budgeting decisions continue for many years, the firm loses some of its flexibility. For example, the purchase of an asset with an economic life of 10 years locks in the firm for a 10-year period. Further, because asset expansion is based on expected future sales, a decision to buy an asset that is expected to last 10 years requires a 10-year sales forecast. Finally, a firm s capital budgeting decisions define its strategic direction, because moves into new products, services, or markets must be preceded by capital expenditures. Effective capital budgeting can improve both timing and the quality of asset acquisitions. If a firm forecasts its needs for capital assets in advance, it can purchase and install the assets before they are needed.

3 9 Capital budgeting typically involves substantial expenditures, and before a firm can spend a large amount of money, it must have the funds lined up. Therefore, a firm contemplating a major capital expenditure program should plan its financing far enough in advance to be sure funds are available GENERATING IDEAS FOR CAPITAL PROJECTS A firm s growth, and even its ability to remain competitive and to survive, depends on a constant flow of ideas for new products, for ways to make existing products better, and for ways to operate at a lower cost. Accordingly, a well-managed firm will go to great lengths to develop good capital budgeting proposals. If a firm has capable and imaginative executives and amployees, and if its incentive system is working properly, many ideas for capital investment will be advanced. Some ideas will be good ones, but others will not. Therefore, procedures must be established for screening projects PROJECT CLASSIFICATIONS Analyzing capital expenditures proposals is not a costless operation, benefit can be gained, but analysis does have a cost. For certain types of projects, a relatively detailed analysis may be warranted; for others, simpler procedures should be used.

4 10 Accoringly, firms generally categorize projects and then analyze those in each category somewhat differently : 1. Replacement : maintenance of business. It consists of expenditure to replace worn-out or damaged equipment used in the production of profitable products. Replacement projects are necessary if the firm is to continue in business. The only issues here are (a) should this operation be continued and (b) should we continue to use the same production processes? The answer are usually yes, so maintenance decisions are normally made without going through an elaborate decision process. 2. Replacement : cost reduction. It includes expenditures to replace servicable but obsolete equipment. The purpose is to lower the costs of labor, materials, and other inputs such as electricity. 3. Expansion of existing products or markets. It includes the expenditures to increase output of existing products, or to expand retail outlets or distribution facilities in markets. These decisions are more complex because they require an explicit forecast of growth in demand. The go/no-go decisions is generally made at a higher level within the firm. 4. Expansion into new products or markets. These are investments to produce a new product or to expand into a geographic area not currently being served. It involve strategic

5 11 decisions that could change the fundamental nature of the business, and they normally require the expenditure of large sums with delayed paybacks. 5. Safety and/or environmental projects. Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms. These expenditures are called mandatory investments, and they often involve nonrevenue-producing projects. 6. Research and development. For many firms, R&D constitutes the largest and most important type of capital expenditure. Although it can be analyzed in the same way as tangible asset investments, the cash flows they produce are often too uncertain to warrant a standard discounted cash flow (DCF) analysis. 7. Long-term contracts. Companies are often make long-term contractual agreements to provide products or services to specific customers. For example, Company X has signed agreements to handle computer services for other companies for period of 5 to 10 years. 8. Other. This catch-all includes office buildings, parking lots, executive aircraft, and so on. DCF should be used, but how they are actually handled varies among companies.

6 CAPITAL BUDGETING EVALUATION STEPS Once a potential capital budgeting project has been identifed, its evaluation involves the same steps that security analysts use. Here are the steps in capital budgeting evaluation : 1. The cost of the project must be determined. 2. Management estimates the expected cash flows from the project, including the salvage value of the asset at the end of its expected life. 3. The risk of the projected cash flowss must be estimated. This requires information about the probability distribution (risk) of the cash flows. 4. Given the project s risk, managemenet determines the cost of capital at which the cash flows should be discounted. 5. The expected cash flows are put on a present value basis to obtain an estimate of the asset s value. 6. The present value of the expected cash flows is compared with the required outlay. If the PV of the cash flows exceeds the cost, the project should be accepted. Otherwise, it should be rejected.

7 CAPITAL BUDGETING DECISION RULES There are six keys methods used to rank projects and to decide whether or not they should be accepted for inclusion in the capital budget : 1. Payback Period 2. Discounted Payback Period 3. Net Present Value (NPV) 4. Internal Rate of Return 5. Modified Internal Rate of Return (MIRR) 6. Profitability Index (PI) The ranking methods which will be used in this project are : 1. Net Present Value (NPV) 2. Internal Rate of Return (IRR) 3. Payback Period NET PRESENT VALUE (NPV) The net present value (NPV) method relies on discounted cash flow (DCF) techniques. To implement this approach, we proceed as follows : 1. Find the present value of each cash flow, including both inflows and outflows, discounted at the project s cost of capital.

8 14 2. Sum these discounted cas flows; this sum is defined as the project s NPV. 3. If the NPV is positve, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen. The equation for the NPV is as follows : Here CF t is the expected net cash flow at Period t, k is the project s cost of capital, and n is its life. Cash outflows (expenditures such as the cost of buying equipment or buildinf factories) are treated as negative cash flows INTERNAL RATE OF RETURN (IRR) The IRR is defined as the discount rate that equates the present value of a project s expected cash inflows to the present value of the project s costs: PV (Inflows) = PV (Investment Costs)

9 15 Or, equivalently, the IRR rate that forces the NPV to equal zero : Notice that the internal rate of return formula is simply the NPV formula, solved for the particular discount rate that forces the NPV to equal zero. Thus, the same basic equation is used for both methods, but in the NPV method the discount rate, k, is specified and the NPV is found, whereas in the IRR method the NPV is specified equal to zero, and the interest rate that forces this equality (the IRR) is calculated. Mathematically, the NPV and IRR methods will always lead to the same accept/reject decisions for independent projects. This occurs because if NPV is positive, IRR must exceed k. However, NPV and IRR can give conflicting rankings for mutually exclusive projects PAYBACK PERIOD The payback period, defined as the expected number of years required to

10 16 recover the original investment, was the first formal method used to evaluate capital budgeting projects. For example : Payback Period for Project S and L Project S : Net cash flow -1, Cumulative NCF -1, Payback s = 2.33 years Project L : Net cash flow -1, Cumulative NCF -1, Payback L = 3.33 years The shorter the payback period, the better. Therefore, if the firm required a payback of three years or less, Project S would be accepted but Project L would be rejected. If the projects were mutually exclusice, S would be ranked over L because S has the shorter payback. Mutually exclusive means that if one project is taken on, the other must be rejected.

11 Discounted Payback Period The discounted payback period is similar to the regular payback period except the expected cash flows are discounted by the project s cost of capital. Thus, the discounted payback period is defined as the number of years required to recover the investment from discounted net cash flows. For example : Discounted Payback Period for Project S and L Project S : Net cash flow -1, Discounted NCF (at 10%) -1, Cumulative NCF -1, Payback s = 2.95 years Project L : Net cash flow -1, Discounted NCF (at 10%) -1, Cumulative NCF -1, Payback L = 3.88 years Each cash inflow above is divided by (1 + k) t = (1.10) t, where t is the year in which the cash flow occurs and k is the project s cost of capital. After three years, Project S will have generated $1,011 in discounted cash inflows. Because the cost is $1,000, the discounted payback is just under three years. Project L s discounted payback is 3.88 years :

12 18 Discounted payback S = $215/$225 Discounted payback L = $361/$410 = 2.95 years = 3.88 years For Project S and L, the rankings are the same regardless of which payback method is used; that is, Project S is preferred to Project L, and Project S would still be selected if the firm were to require a discounted payback period of three years or less. Often, however, the regular and the discounted paybacks produce conflicting rankings ESTIMATING CASH FLOW The most important, but also the most difficult, step in capital budgeting is estimating project s cash flows. Cash flows here involve the the investment outlays and the annual net cash inflows after a project goes into operation. Many variables are involved, and many individuals and departments participate in the process. For example, the forecasts of unit sales and sales prices are normally made by the marketing group, based on their knowledge of price elasticity, advertising effects, the state of the economy, competitors reactions, and trends in consumers tastes. Similarly, the capital outlays associated with a new product are generally obtained from the engineering and product development staffs, while operating costs are estimated by cost accountants, production experts, personnel specialists, purchasing

13 19 agents, and so forth. The financial staff s role in the forecasting process includes : 1. Obtaining information from various departments such as engineering and marketing, 2. Ensuring that everyone involved with the forecast uses a consistent set of economic assumptions, and 3. Making sure that no biases are inherent in the forecasts IDENTIFYING THE RELEVANT CASH FLOW The first step in capital budgeting is to identify the relevant cash flows, defined as the specific set of cash flows that should be considered in the decision at hand. Analysts often make errors in estimating cash flows, but two cardinal rules can be implemented to minimize mistakes : 1. Capital budgeting decisions must be based on cash flows, not accounting income. 2. Only incremental cash flows are relevant PROJECT CASH FLOW VERSUS ACCOUNTING INCOME The firm receives and is able to reinvest cash flows, whereas accounting

14 20 profits are shown when they are earned rather than when the money is actually in hand. Unfortunately, a firm s accounting profits and cash flows may not be timed to occur together. For example, capital expenses, such as vehicles, plant and equipment, are depreciated over several years, with their annual depreciation substracted from profit. Cash flows correctly reflect the timing of benefits and costs, that is, when the money is received, when it can be reinvested, and when it must be paid out. In capital budgeting analysis, we use the yearly cash flows, not the accounting income. Recall that free cash flow is calculated as follows : FCF = NOPAT + Depreciation Gross Capital Expenditures Change in Working Capital = EBIT(1 T) + Depreciation Gross Capital Expenditures (Δ Current Operating Assets Δ Current Operating Liabilities) INCREMENTAL CASH FLOW In evaluating a project, we focus on those cash flows that occur if and only if we accept the project. These cash flows, called incremental cash flows, represent the change in the firm s total cash flow that occurs as a direct result of accepting the project. Three special problems in determining incremental cash flows are : 1. Sunk Costs. A sunk cost is an outlay that has already occured, hence

15 21 is not affected by the decision under consideration. Since sunk costs are not incremental costs, they should not be included in the analysis. 2. Opportunity Costs. A second potential problem relates to opportunity costs, which are cash flows that could be generated from an asset the firm already owns provided. 3. Effects on Other Parts of the Firm : Externalities. This problem involves the effects of a project on other parts of the firm CHANGES IN NET OPERATING WORKING CAPITAL Normally, additional inventories are required to support a new operation, and expanded sales tie up additional funds in accounts receivable. However, payables and accruals increase as a result of the expansion, and this reduces the cash needed to finance inventories and receivables. The difference between the required increase in current operating assets and the increase in current operating liabilites is the change in net operating working capital. If this change is positive, as it generally is for expansion projects, then additional financing, over and above the cost of the fixed assets, will be needed. Toward the end of a project s life, inventories will be used but not replaced, and receivables will be collected without corresponding replacements. As these changes occur, the firm will receive cash inflows, and as a result, the investment in

16 22 net operating working capital will be returned by the end if the project s life EVALUATING CAPITAL BUDGETING PROJECTS Cash flow analysis affect capital budgeting decisions. Conceptually, capital budgeting is straightforward. A potential project creates value for the firm s shareholders if and only if the net present value of the incremental cash flows from the project is positive. Incremental cash flows are affected by whether the project is an expansion project or replacement project NEW EXPANSION PROJECT ANALYSIS A new expansion project analysis is defined as an activity to analyze where the firm invests in new assets to increase sales REPLACEMENT PROJECT ANALYSIS A replacement project occurs when the firm replaces the existing asset with a new one. In a replacement project analysis, the company is comparing its value if it takes on the new project to its value if it continues to use the esixting asset.

17 PROJECT RISK ANALYSIS The project risk analysis is important for all financial decisions, especially for the capital budgeting decisions. Although it is intuitively clear that riskier projects have a higher cost of capital, it is difficult to estimate project risk. There are three separate and distinct types of risk that can be identified: 1. Stand-alone risk is the project s risk regarding the fact that it is but one asset within the firm s portfolio of assets and that the firm is but one stock ina typical investor s portfolio of stocks. It is measured by the variability of the project s expected returns. 2. Corporate, or within-firm, risk is the project s risk to the corporation, giving consideration to the fact that the project represents only one of the firm s portfolio of assets, hence that some of its risk effects will be diversified away. It is measured by the project s effect on uncertainty about the firm s future earnings. 3. Market, or beta, risk is the riskiness of the project as seen by a welldiversified stockholder who recognizes that the project is only one of the firm s assets and that the firm s stock is but one part of his or her total portfolio. It is measured by the project s effect on the firm s beta coefficient.

18 FINANCIAL RISKS IN FOREIGN EXCHANGE The investment of this project will be in United States Dollar (USD) as writer already mentioned above, there are some financial risks for company could be facing such as the revenue will be in Indonesian Rupiah (IDR). The financial risk that could happen to the foreign exchange exposure because of the different currencies, and it will cause a foreign gain or loss for the company. Also to reduce the foreign exchange risk, the company should execute the hedging method. The hedging techniques generally involve the derivatives, which are options and futures. With hedging, the company can enter into a futures contract which allows the company to make a transaction at a specific price at a set date in the future. Thus the company can create any budget without worrying the fluctuating commodity TECHNIQUES FOR MEASRUING MEASURING STAND- ALONE RISK The starting point for analyzing a project s stand-alone risk involves determining the uncertainty inherent in its cash flows. The nature of individual cash flow distributions, and their correlations with

19 25 one antoher, determine the nature of the NPV probability distribution and, thus, the project s stand-alone risk. There are four techniques for assessing a project s standalone risk : 1. Sensitivity Analysis Sensitivity analysis is a technique that indicates how much NPV will change in response to a given change in an input variable, other things held constant. 2. Scenario Analysis Scenario analysis brings in the probabilities of changes in the key variables, and it allows us to change more than one variable at a time. 3. Monte Carlo Simulation Monte Carlo Simulation analyze projects on gambling stratigies. Taken from the famous European casino, because it attempt into model of real-world uncertainty. 4. Real Options When valuing capital projects, net present value (NPV) analysis is the best approache. Somehow practioners and scholars have pointed out that there is a problem with NPV. Therefore there are real options to adjust the best suited for projects for being accepted, such as: Option to expand, option to abondon, and option in timely.

20 INTRODUCTION TO REAL OPTIONS As writers mentioned above, Real Options is the most suited for managers who are looking for alternative decision making tool than NPV. The indicator of NPV is negative, then the project should be rejected. However, in traditional capital budgeting theory indicate that actions can be taken after the project has been accepted and placed in operation that might cause the cash flows to increase. Implicate that this theory is a like a manager who like to gamble into a project until it see what is next what is coming. There are several options such as: Managerial options It gives manager an opportunity to change on circum conditions which can influence the result of the project. Strategic options Usually managers are often associated with large, strategic projects rather than routine maintenance projects. Real options Managers are involve with real case or situation rather than financial or assets. There are several options that manager should try to create options within projects.

21 INVESTMENT TIMING OPTIONS Other than NPV analysis being positive or negative, companies is looking for third choice which is delay the decision until later when more information is available. This investment timing option can implicate the profit and risk project could be affected GROWTH OPTIONS Growth option is when a company has a plan to increase its capacity when the market conditions are better than expected. There are several growth options which are: Increase the capacity of an existing product line Expand into new geographic markets Add new products ABANDONMENT OPTIONS Abandonment option is when evaluating a potential project, standard DCF analysis assumes that assets will be used over a specified economic life. While other projects must be operated over their full economic life, even though market

22 28 conditions might deteriorate and cause lower than expected cash flows, others can be abandoned FLEXIBILITY OPTIONS Flexibility options that permit the permit the company to alter operations depending on how conditions change during the life of the project. Typically, either inputs or outputs (or both) can be changed.

Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS

Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS 10-1 a. Capital budgeting is the whole process of analyzing projects and deciding whether