Project Feasibility

&Finance

www.greybricks.com
Principles of capital budgeting
1. Evaluation of decisions is based on cash flows, not accounting income

2. Cash flows are analyzed on an after-tax basis because shareholders get benefit from profit
after tax only
Cash flows After Tax is NOT EQUAL to Net Income. (PAT from Income Statement)

3. Evaluation is based on Incremental Cash Flows

– Difference between the cash flows with project & cash flows without the project under
consideration. This cash flows should be taken for analysis & not the total cash flows

4. Timing of cash flows affects decisions because of time value of money

– Earlier cash flows are more valuable than future cash flows

5. A project must earn equal to or more than its opportunity Cost to be accepted (like a
benchmark)
– Opportunity Costs is the profit that would have earned through the next best project
– E.g. :Investment in Stocks Vs. Interest income in an FD
Principles of capital budgeting
6. Sunk Costs do not play any role in Capital Budgeting
– It is the cost which cannot be recovered (whether the project is selected or not)
– E.g.: money paid to market research firm for determining demand for a new product, Purchase price of
the old machinery which is now contemplated to be replaced.

7. Externalities MUST be considered while evaluating a project

– It is the effect of the investment on other aspects besides the investment itself:
– It can be a negative impact or a Positive Impact
– Cannibalization: One product of a company eating over the share of another product of the same
company e.g. Maruti Suzuki’s Alto model’s sale being impacted due to the launch of A-Star model

8. Financing costs (like interest rate) are not considered as a part of the cash flows because they
are already considered in project's hurdle rate (required rate of return)

9. Pattern of Cash Flows

a) Conventional Cash flow – One initial outflow followed by a series of inflows
b) Nonconventional Cash Flows – Cash flows can flip from positive to negative after the initial outflow
Principles of capital budgeting
10. Role of Depreciation
– Depreciation is a non-cash expense hence does not play any active role in determining CF
– However, since it’s a tax deductible expense, it leads to tax saving
– Reduced tax outflow is deemed to a cash inflow
– Two approaches to calculate CFAT
1. CFAT = PBDT *(1 - T) + Dep x T
2. CFAT = PAT + Dep

11. Gain or Loss on Capital Asset

– Whenever a capital asset is sold, gain / loss is calculated
– Gain (or Loss) = Scrap or Sale value - Book Value (on the date of Sale)
– This capital gain (or loss) is taxable thus results into additional taxes (or tax savings)
– Net Cash Flow in case of:
1. Gain = Sale Value – additional taxes
2. Loss = Sale value + Tax Savings (deemed inflow)
Principles of capital budgeting
12. Working Capital Adjustment
– In case a new capital asset is purchased, there is a change warranted in the operational or
working capital requirement also.
– E.g. A bigger machinery will
• Need more stock of Raw material – Additional Raw Material
• Will have more WIP at any point in time - Additional WIP
• Will produce more finished output - Additional finished goods
• Overall, more investments will have to be made in the Working capital
– Adjustments required are:
1. Treat the ADDITIONAL working capital as cash out flow at To (as part of the initial cash
flow)
2. Treat the same amount as cash inflow at the end of the project (as part of the terminal
value)
Cash Flows
– FCFF = Net Income + Interest * (1-Tax Rate) + Depreciation – Increase
in Working Capital – Capital Expenditures
• FCFF is available to all shareholders of the firm including Debt, Equity and Preferred.

– FCFE = Net Income – Increase in Working Capital – Capital

Expenditures + New Debt Borrowed – Debt Repayment
• FCFE is available to only equity shareholders.

– FCFF is discounted using WACC

– FCFE is discounted using Cost of Equity

Project Beta
– Lot of companies while estimating the cost of capital for a project, use
the WACC applicable to the Company.

– In most of the instances, the project will be more risky then the
Company an a combined entity (aggregation of several projects)

– For such cases, we need to adapt a ‘pure play’ method to arrive at the
beta of the project before using it in cost of equity estimation (CAPM).
Project Beta: Pure Play Method
– Pure play method is a 2-step process

Step 1: Un-levering

(betaasset ) = (betaequity )/(1+(1-tax rate)*(debt/equity))

where
debt , equity and tax rate represent comparable company data

Step 2: Re-levering

(betaproject ) = (betaasset )*(1+(1-tax rate)*(debt/equity))

where
debt , equity and tax rate represent project specific data
Floatation Cost
– Cost incurred by the Company while raising equity financing.
– Ex: Underwriting cost, brokerage expenses, fees of merchant bankers,
advertising expenses etc.
– There are two ways to handle floatation cost.

– Method 1:
• Let’s assume floatation cost is 6% and WACC is 12%.
• Revised WACC = WACC / (1-Floatation Cost) = 12%/(1-6%) = 12.7%

– Method 2: (Preferred)
• Consider floatation cost as a part of the project cost.
• Raise more so as to pay floatation cost from the raise.
• Ex: 8% floatation cost and you need $200.0 mn for a project
• Then raise 200/(1-8%) = 217.39 mn
• In a way, 217.39*8% is 17.39 mn of floatation cost and leaves $200mn for the proj.
Investment Criteria
– Net Present Value
– The Payback Rule
– The Discounted Payback
– The Average Accounting Return
– The Internal Rate of Return
– The Profitability Index
NPV
• The difference between the market value of a project and its cost

• How much value is created from undertaking an investment?

– The first step is to estimate the expected future cash flows.
– The second step is to estimate the required return for projects of this
risk level.
– The third step is to find the present value of the cash flows and
subtract the initial investment.

• If NPV > 0, accept the project

• If NPV < 0, reject the project
NPV
• You are reviewing a new project and have estimated the following cash
flows:
– Year 0: CF = -165,000
– Year 1: CF = 63,120;
– Year 2: CF = 70,800;
– Year 3: CF = 91,080;

• Your required return for assets of this risk level is 12%.

• NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 +

91,080/(1.12)3 = 12,627.41
Payback Period
• How long does it take to get the initial cost back in a nominal sense?

• Computation
– Estimate the cash flows
– Subtract the future cash flows from the initial cost until the initial
investment has been recovered

• Decision Rule – Accept if the payback period is less than some preset limit
Payback Period
• Assume we will accept the project if it pays back within two years.

– Year 1: 165,000 – 63,120 = 101,880 still to recover

– Year 2: 101,880 – 70,800 = 31,080 still to recover
– Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3

• If we assume that the cash flows occur evenly throughout the year, then
the project pays back in 2.34 years and leads to rejection of the project.
Payback Period
• Advantages
– Easy to understand
– Adjusts for uncertainty of later cash flows
– Biased toward liquidity

• Disadvantages
– Ignores the time value of money
– Requires an arbitrary cutoff point
– Ignores cash flows beyond the cutoff date
– Biased against long-term projects, such as research and development,
and new projects
Discounted Payback Period
• Compute the present value of each cash flow and then determine how
long it takes to pay back on a discounted basis.

• Compare to a specified required period.

• Decision Rule - Accept the project if it pays back on a discounted basis

within the specified time.
Discounted Payback Period
• Assume we will accept the project if it pays back on a discounted basis in 2
years.

• Compute the PV for each cash flow and determine the payback period
using discounted cash flows
– Year 1: 165,000 – 63,120/1.121 = 108,643
– Year 2: 108,643 – 70,800/1.122 = 52,202
– Year 3: 52,202 – 91,080/1.123 = -12,627 project pays back in year 3
Discounted Payback Period
• Advantages
– Includes time value of money
– Easy to understand
– Does not accept negative estimated NPV investments when all future
cash flows are positive
– Biased towards liquidity

• Disadvantages
– May reject positive NPV investments
– Requires an arbitrary cutoff point
– Ignores cash flows beyond the cutoff point
– Biased against long-term projects, such as R&D and new products
Internal Rate of Return
• This is the most important alternative to NPV.

• It is often used in practice and is intuitively appealing.

• It is based entirely on the estimated cash flows and is independent of

interest rates found elsewhere.

• Definition: IRR is the return that makes the NPV = 0

• Decision Rule: Accept the project if the IRR is greater than the required
return
Internal Rate of Return
• Knowing a return is intuitively appealing

• It is a simple way to communicate the value of a project to someone who

doesn’t know all the estimation details

• If the IRR is high enough, you may not need to estimate a required return,
which is often a difficult task
NPV v/s IRR
• NPV and IRR will generally give us the same decision

• Exceptions
– Nonconventional cash flows – cash flow signs change more than once
– Mutually exclusive projects
• Initial investments are substantially different (issue of scale)
• Timing of cash flows is substantially different
Conflicts Between NPV and IRR
• NPV directly measures the increase in value to the firm.

• Whenever there is a conflict between NPV and another decision rule, you
should always use NPV

• IRR is unreliable in the following situations

– Nonconventional cash flows
– Mutually exclusive projects
Profitability Index
• Measures the benefit per unit cost, based on the time value of money.

• A profitability index of 1.1 implies that for every $1 of investment, we

create an additional $0.10 in value.

• This measure can be very useful in situations in which we have limited

capital.
Profitability Index
• Advantages
– Closely related to NPV, generally leading to identical decisions
– Easy to understand and communicate
– May be useful when available investment funds are limited

• Disadvantages
– May lead to incorrect decisions in comparisons of mutually exclusive
investments
Mutually Exclusive Projects
• As mentioned previously, NPV and IRR can sometimes lead to conflicting
results in the analysis of mutually exclusive projects. One reason for this
potential problem is the timing of the cash flows of the mutually exclusive
projects. As a result, we need to adjust for the timing issue in order to
correct this problem.

There are two methods used to make the adjustments:

• Replacement-chain method (LCM – Least Common Multiple Method)
• Equivalent annual annuity
Replacement Chain Method (LCM)
Year 1 2 3 4 5 6 7

Cash Flow - Project A (10,000) 2,000 3,500 3,250 3,000 2,750 2,500
Cash Flow - Project B (5,000) 1,750 3,250 3,000

WACC 8.40%

NPV - Project A $ 2,699

NPV - Project B $ 1,601
IRR - Project A 17.5%
IRR - Project B 25.2%

Cash Flow - Project A (10,000) 2,000 3,500 3,250 3,000 2,750 2,500
Cash Flow - Project B (5,000) 1,750 3,250 3,000
Cash Flow - Project B Repeated (5,000) 1,750 3,250 3,000
Cash Flow - Project B (6 Years) (5,000) 1,750 3,250 (2,000) 1,750 3,250 3,000

NPV - Project A $ 2,699

NPV - Project B $ 2,858
IRR - Project A 17.5%
IRR - Project B 25.2%
Equivalent Annual Annuity
Year 1 2 3 4 5 6 7

Cash Flow - Project A (10,000) 2,000 3,500 3,250 3,000 2,750 2,500
Cash Flow - Project B (5,000) 1,750 3,250 3,000

WACC 8.40%

NPV - Project A $ 2,699

NPV - Project B $ 1,601
IRR - Project A 17.5%
IRR - Project B 25.2%

Cash Flow - Project A (10,000) 2,000 3,500 3,250 3,000 2,750 2,500
Cash Flow - Project B (5,000) 1,750 3,250 3,000
Cash Flow - Project B Repeated (5,000) 1,750 3,250 3,000
Cash Flow - Project B (6 Years) (5,000) 1,750 3,250 (2,000) 1,750 3,250 3,000

NPV - Project A $ 2,699

NPV - Project B $ 2,858
IRR - Project A 17.5%
IRR - Project B 25.2%
EAA - Project A $591.00
EAA - Project B $625.72