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- 2. OUTLINE • Choice between mutually exclusive projects of unequal life • Optimal timing decision • Determination of economic life • Interrelationship between investment and financing aspects • Inflation and capital budgeting • International capital budgeting • Investment in capabilities
- 3. Choice between Mutually Exclusive Projects of Unequal Life For a proper comparison of the two alternatives, that have different lives, we have to convert the present value of costs into a uniform annual equivalent (UAE) figure – this is also called an equivalent annual cost (EAC) figure. The UAE is a function of the present value of cost, the life of the asset, and the discount rate. The UAE is simply: PV Cost PVIFAr,n
- 4. Uniform Annual Equivalent 12,000 12,000 12,000 PV of costs of machineA: 12,000 12,000 75,000 + + + + + = 118,260 (1.12) (1.12)2 (1.12)3 (1.12)4 (1.12)5 PV costs of machine B : 15,000 15,000 15,000 50,000 + + + = 86,030 MachineA: (1.12) (1.12)2 UAE = 118,260 (1.12)3 118,260 PVIFA12%,5 Machine B: UAE = 86,030 PVIFA12%,3 3.605 86,030 2.402 = 32,804 = 35,816 = =
- 5. Optimal Timing In real life, an investment is rarely a “now or never” proposition. Typically, it can be undertaken now or at some point of time in future. Given this option, the issue of optimal timing assumes significance. Under conditions of certainty, the optimal timing may be determined by using the following procedure. 1. Examine alternative dates (t) when the investment can be made. 2. Estimate the net future value as of each alternative date and convert the same to its current value. 3. Choose the timing that has the highest current value
- 6. Determination of Economic Life The economic life of an asset is conceptually defined as the period after which the asset should be replaced to minimise the sum of operating and maintenance costs and capital costs expressed on an annual basis. Put differently, it is the replacement cycle that minimises the uniform annual equivalent total cost, UAE (TC) of operating and owning the asset. The UAE (TC) is simply the sum of the uniform annual equivalent operating and maintenance cost, UAE (OM), and the uniform annual equivalent capital cost, UAE (CC). That is, UAE (TC) = UAE (OM) + UAE (CC) (13.1)
- 7. S UAE (CC) Replacement Period (in years) Annualised Cost Costs over the Life of a Machine
- 8. Interrelationship between the Investment and Financing Aspects • WACC is the right discount rate for a project that is a carbon copy of the firm’s existing business. • A project may have financing effects that differ from those of the existing investments of the firm. It may have a different debt capacity or be entitled to certain subsidies or have some special financial features. In such cases the recommended method is to calculate the adjusted NPV (orAPV for short).
- 9. Adjusted Present Value (APV) APV is calculated by first estimating the base-case NPV and then adjusting it to reflect the financing side effects of the project. The base-case NPV is the NPV of the project under the following assumptions: • • The project is financed entirely by equity. There is no financing side effect like issue cost or subsidy The present value of financing side effects is equal to: • Present value of positive financing side effects like tax shield on debt and availability of subsidies. • Present value of negative financing side effects like issue costs and financial distress costs associated with excessive leverage.
- 10. Illustration Investment Net cash inflow Opportunity cost of capital Issue cost of equity Debt available Repayment of debt Tax rate : Rs. 5 million : Rs.1 million per year for 8 years : 15 percent : 5 percent : Rs.2.4 million at 14 percent : 8 equal annual instalments. First instalment will be paid at the end of first year : 40 percent
- 11. Illustration = -512,700 Base – case NPV: 8 1,000,000 -5,000,000 + t=1 (1.15)t The base-case NPV has to be adjusted for two factors: (i) issue cost, and (ii) tax-shield associated with debt.
- 12. Illustration Out of the total financing requirement of the project Rs.2,600,000 will come from the equity sources and Rs.2,400,000 will come in the form of debt finance. As the net equity finance required by the project is Rs.2,600,000 and the issue costs would absorb 5 per cent of the gross proceeds of the issue, the firm will have to issue Rs.2,736,842 (Rs.2,600,000 / 0.95) of equity stock in order to realise a net amount of Rs.2,600,000. The difference of Rs.136,842 is the cost of underwriting, brokerage, printing, and other issue related expenses. TheAPV after adjustment for issue cost is : APV = Base-case NPV – Issue cost = -Rs.512,700 – Rs.136,842 = -Rs.649,542
- 13. Illustration Now we consider the adjustment for the tax shield associated with debt finance. The present value of tax shield associated with Rs.2,400,000 of debt finance is calculated. From this we find that the debt finance associated with the project brings a stream of tax shields which has a present value of Rs.403,385. If we make adjustment for this also, we get : APV = Base case NPV – Issue cost + Present value of tax shield = -Rs.512,700 – Rs.136,842 + Rs.403,385 = -Rs.246,157
- 14. Y ear Interest Tax shield Debt outstanding at the beginning Present value of tax shield (at 14% discount rate) 1 2,400,000 336,000 134,400 117,869 2 2,100,000 294,000 117,600 90,552 3 1,800,000 252,000 100,800 68,040 4 1,500,000 210,000 84,000 49,728 5 1,200,000 168,000 67,200 34,877 6 900,000 126,000 50,400 22,982 7 600,000 84,000 33,600 13,440 8 300,000 42,000 16,800 5,897 Total Rs.403,385 Calculation of the Present Value of Tax Shield
- 15. Merits of APV The principle underlying APV is to divide and conquer. APV does not reflect the side effects of financing in a single calculation. Instead, it captures them in a series of calculations. This makes it more illuminating. You not only know what the APV is but also where it is coming from. This is helpful in reformulating the project. APV makes more sense for projects that have a capital structure that is different from the rest of the firm or which have a capital structure that changes significantly over time or which enjoy special concessions, incentives, and subsidies. For example, APV is eminently suitable for leveraged buyouts(LBOs) or infrastructure projects.
- 16. Adjusted Cost of Capital E V V D c r (1- T ) D + rE (13.4) Though conceptually sound, APV is not very popular because (i) it requires some sophistication to assess the financing side effects, and (ii) it involves a series of adjustments which may be cumbersome. That is why WACC, which is the cost of capital adjusted for financing effects, is more commonly used in practice. Recall that WACC is:
- 17. There are some other formulae also of adjusted cost of capital. Two of them are : Modigliani and Miller formula : r* = r (1-TL) (13.5) Miles and Ezzell formula : r* = r – L rD T 1+r (13.6) 1+ rD where r* = adjusted cost of capital r = opportunity cost of capital assuming 100 per cent equity financing T = tax rate applicable to the firm L = marginal contribution of the project to the firm’s debt capacity rD = cost of debt Adjusted Cost of Capital
- 18. Adjusted Cost of Capital Example 1 A firm is considering a project for setting up a captive power plant for which the following information has been gathered. Investment outlay : Annual post-tax savings : Life of the project : Debt capacity of the project : Interest rate of debt : Nature of debt : Tax rate of the firm : Opportunity cost of capital : Rs. 50 million Rs. 5 million Perpetual Rs. 25 million 10 percent Perpetual 40 percent 12 percent The adjusted cost of capital as per Modigliani-Miller formula is : r* = r (1-TL) = 0.12 (1- 0.4 x 0.5 ) = 0.096 or 9.6% The adjusted cost of capital as per Miles and Ezzell formula is : 1+r 1.12 r* = r – L rD T = 0.12 –0.5 x 0.10 x 0.4 x = 0.100 or 10.0% 1+ rD 1.10
- 19. Inflation and Capital Budgeting Inflation has been a persistent feature of the Indian economy. Hence, it should be properly considered in capital investment appraisal. Since the cost of capital, the discount rate, is typically expressed in nominal terms, all the cash flows should also be expressed in nominal terms. This means that (a) projected revenues and costs must reflect the inflation rates expected in future and (b) salvage values, too, must be expressed in future nominal amounts.
- 20. International Capital Budgeting There are two equivalent ways of calculating the NPV of a foreign project. Home CurrencyApproach • Convert all the foreign currency cash flows into rupees (use fore- casted exchange rates) • Calculate the NPV in rupees ( use the rupee discount rate) Foreign CurrencyApproach • Calculate the NPV in foreign currency (use the foreign currency discount rate) • Convert the foreign currency NPV into rupees (use the spot ex- change rate)
- 21. Investment in Capabilities Empirical evidence suggests that companies that perform well have organisational capabilities that enable them to exploit opportunities. What are these organisational capabilities? As Baldwin and Clark say: “ Organisational capabilities are combinations of human skills, organisational procedures and routines, physical assets, and the systems of information and incentives that improve performance along particular dimensions. Such capabilities are indeed organisational assets.”
- 22. Capabilities Baldwin and Clark mention five specific capabilities: External Integration Capability The ability of the firm to link its understanding of customers with engineering design to develop improved products. Internal Integration Capability Internal integration makes a company faster and more efficient in performing various functions like new product development, prototyping, facilities engineering, and capacity expansion Flexibility The ability of a firm to do a variety of things and to respond quickly to changes. Capacity to Experiment The capacity to experiment depends on the investments a firm makes in developing knowledge, disseminating knowledge, and adopting the same in practice Capacity to Cannibalise Cannibalisation involves introducing a new product that cuts into the sales of the existing products.
- 23. Characteristics of Capabilities – Building Investments Investments required to build capabilities have certain special characteristics. These are: Many of the outlays required are on things like common language and communication, human training and skill development, and support services. These are not ordinarily regarded as capital expenditure in many firms. Investments required to build a capability range widely in scale and scope. While costs of building capabilities are visible and appear on someone’s budget, the benefits are derived by the company as a whole and occur only after a time lag.
- 24. Allocating Resources to Build Capabilities The challenge for a company lies in developing a capital allocation system that accommodates investment in capabilities without sacrificing the benefits of a formal financial analysis. Towards this end, the following actions are required. • Identify the capabilities that the firm should develop and ensure that there is a firm organisational commitment to them. • Develop a capital budget for capabilities and a proper system of authorisation and accounting for expenditures relating to capabilities. • Translate the desired capabilities into appropriate goals and rewards that are clearly understood and used by people throughout the organisation. • Link compensation of managers to improvements in speed, quality, and flexibility, which are the outcomes of capabilities.
- 25. SUMMARY For a proper comparison of two mutually exclusive alternatives, that have different lives, we have to convert the present value of costs into a uniform annual equivalent (UAE) figure. The UAE is simply: PV (Cost)/PVIFA r,n In real life, an investment can typically be undertaken now or at some point of time in future. The timing that has the highest current value represents the optimal timing. The economic life of an asset is conceptually defined as the period after which the asset should be replaced to minimise the sum of operating and maintenance costs and capital costs expressed on an annual basis. Strictly speaking, WACC is the right discount rate for a project that is a carbon copy of the firm’s existing business. A project may have financing effects that differ from those of the existing investments of the firm. It may have different debt capacity or be entitled to certain subsidies or have some special financial features. In such cases the recommended method is to calculate the adjusted NPV (orAPV for short).
- 26. APV is calculated by first estimating the base-case NPV and then adjusting it to reflect the financing impact of the project. APV = Base-case NPV + Present value of the financing side effects of the project The base-case NPV is the NPV of the project under the following assumptions : (a) The project is financed entirely by equity. (b) There is no financing effect like issue cost or subsidy. The present value of financing side effects is equal to : Present value of positive financing side effects like tax subsidies – Present value of negative financing side effects like issue costs. Though conceptually sound, APV is not very popular because (i) it requires some sophistication to assess the financing side effects, and (ii) it involves a series of adjustments which may be cumbersome. That is why WACC, which is the cost of capital adjusted for financing effects, is more commonly used in practice. WACC is equal to : D E rD (1- Tc) + rE V V
- 27. There are some other formulae also for calculating the adjusted cost of capital. Two of them are: Modigliani and Miller formula : r* = r (1-TL) 1+r Miles and Ezzell formula : r* = r – L rD T 1+ rD The adjustment for inflation should be done properly in practice. There are two ways of evaluating an international capital budgeting proposal: the home currency approach and the foreign currency approach. Correctly applied both the approaches yield the same result. Empirical evidence suggest that companies that perform well have organisational capabilities that enable them to exploit opportunities.