Capital Budgeting - Measuring Investment

Returns

6th June 2014

Enhancing Shareholder Value

The corporate strategy is tuned to maximize the return to the shareholders

Operating & Investment Decisions

Financing & Funding Decisions

Cash Flow Cost of CapitalValue to

Shareholders

Shareholder Value Analysis

Key decisions impacting Shareholder Value • Investment Strategy

– Invest only when the asset is expected to earn more than the minimum acceptable return ( hurdle rate )

• Capital Investments , Acquisitions & Working Capital

• Financing Strategy – Capital Structure to optimize the cost of capital

• Borrowing Strategy & credit rating

• Pay-out Strategy – Combination of incremental dividend and plough back for

capital appreciation

Shareholder Value – First Principles

Invest only when the asset is expected to earn more than the minimum acceptable return ( hurdle rate )

– Return on projects to be measured based on cash flows generated and the timing of these cash flows

– Choose a financing mix which minimizes the hurdle rate

If there is not enough investment opportunities then Pay-out to shareholders

Measuring Returns Right Convert Accounting Earnings to Cash Flows • Add back Non cash expenses ( like depreciation, provisions, loss on disposal of assets etc )• Subtract out non cash incomes (like accrued income )•Subtract out cash flows , which are not expensed ( such as capital expenditure )•Consider changes in working capital to make accrual revenues and expenses in to cash revenues and expenses Use “Incremental Cash Flows” ,duly “ Time weighted” returns ( cash flow generated in near time to be valued higher )

The Basics of RiskSpecific Risks : Variability in the return due to factors unique to a Project/ Company , having impact on sales and earnings • Operational Risks associated with the projects• Environmental & other political-socio risks • Regulatory regime capping the returns

Systematic Risk : Variability in the return due to factors that influence return on all traded security • Macro economic conditions • Swings in Interest Rates & Exchange Rates

The Basics of Risk

Systematic Risk is measured by Beta

Beta establishes relationship between the excess returns of an individual asset to that of the market portfolio , where the beta of the market portfolio is 1

Beta is the covariance of the asset with the market divided by the variance of market portfolio

Covariance measures the tendency of any pair of random variables to move together

Assets having betas in excess of 1 are riskier than the market portfolio and vice versa

Cost of CapitalWe source capital needs from both equity and debt Cost of equity ( Ke) = Risk free return + Risk premium* beta => R f + beta ( Rm- Rf)

Where R f = Risk free rate R m = Expected Return on market portfolio

Cost of Debt => Post tax cost of debt = Interest Rate * ( 1- tax rate )

Wtd Avg Cost of Capital =( Proportion of debt* Post tax Interest Rate ) + (Proportion of Sh. Capital* Ke)

WACC ( .70 gearing) = [0.70*10%* (1-.3399)] + (0.30*20 % ) = 10.62 %

Measuring Returns ( ROC)

After Tax ROC =EBIT( 1-Tax Rate ) / ( BV of Debt + BV of Equity).( calculate this from available data of the most recent periods)

Return Spread = After Tax ROC- Cost of Capital

EVA = Return Spread (BV of Debt + BV of Equity)

Capital Allocation Rules • Cost of Capital represents the hurdle rate

of the firm to which project specific risk premium is added to arrive at project specific hurdle rate

• Expected Return on Capital > Cost of Capital ( Project is viable )

• Pay back Period is a measure of how quickly the cash flows generated can cover the initial investment

DCF – as a measure of return

Cash flows across the time horizon cannot be added , hence to be brought to the Present Value

Discounted Cash Flow measure ( NPV )• Cash flow over the life of the project including

the initial investment is discounted at Hurdle rate

If NPV > 0 accept the project • For competing projects , select the project

with highest NPV

DCF – as a measure of return

The internal rate of return method finds the interest yield of the potential investment.

This is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows. Increase the discount rate till NPV reaches “0”

If IRR > Cost of Capital ( Accept the Project)

DCF – as a measure of return

Profitability Index : It is the ratio of the present value of cash flows to present value of initial investments

PI = NPV of Cash Flows / PV of Outlays If PI > 1 , accept the project

Project A Project B

Present Value of Net Cash Flows

58,112 110,574

Initial Investment 40,000 90,000

Profitability Index 1.4528 1.2286

Accept Project A

Evaluating projects with unequal lives

Projects S and L are mutually exclusive, and will be repeated. If k = 10%, which is better?

Expected Net CFsYear Project S Project L

0 (Rs100000) (Rs100,000) 1 59,000 33,500 2 59,000 33,500 3 - 33,500 4 - 33,500

Evaluating projects with unequal lives

Calculate the NPV of both the Projects S & L

NPV_ Project S= Rs. 2,179

NPV of Project L = Rs.5,628

Is Project L always better - NO?

Need to perform replacement chain analysis , as it unfair to compare to projects with unequal lives

-100,000 59,000 59,000 59,000 59,000 -100,000

-41,000

0 1 2 310%

4

Revised NPV Project S 10,810 Project L 5,628

Equity Analysis

Here the returns , cash flows and hurdle rates are defined entirely from the point of view of equity investors

•Accounting Return ( ROE) = PAT/ BV of Equity

•Under DCF method , ROE = Residual Cash Flows – Debt Repayment ( Use hurdle rate for cost of equity)

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Why Capital Rationing ?

• Internal capital markets– Costly (time-consuming )– Regulatory Framework – “Strategic direction” of firm

• Access to external capital markets is imperfect.– Expensive (float costs, etc.)– Informational asymmetry issues.