Capital Budgeting

By Prabath S Morawakage
Lecturer
Department of Finance
University of Kelaniya
9/22/2013 Corporate Finance- Capital Budgeting
Learning Outcomes
Describe the capital budgeting process, including the typical steps of the
process, and distinguish among the various categories of capital projects
Describe the basic principles of capital budgeting, including cash flow
estimation
Explain how the evaluation and selection of capital projects is affected
by mutually exclusive projects, project sequencing, and capital rationing
Calculate and interpret the results using each of the following methods to
evaluate a single capital project: net present value (NPV), internal rate
of return (IRR), payback period, discounted payback period, and
profitability index (PI)
9/22/2013
Corporate Finance- Capital Budgeting
2
Learning outcomes
Explain the NPV profile, compare the NPV and IRR methods when
evaluating independent and mutually exclusive projects, and
describe the problems associated with each of the evaluation
methods
Describe and account for the relative popularity of the various
capital budgeting methods and explain the relation between NPV
and company value and stock price
Describe the expected relations among an investments NPV,
company value, and share price
9/22/2013 Corporate Finance- Capital Budgeting
3
Introduction
Capital budgeting is the process of planning expenditures on
assets (fixed assets) whose cash flows are expected to extend
beyond one year. Managers analyze projects and decide which
ones to include in the capital budget.
The "capital" refers to long-term assets.
The "budget" is a plan which details projected cash inflows and
outflows during future period.
9/22/2013 Corporate Finance- Capital Budgeting
4
The typical steps in the capital budgeting
process
Generating good investment ideas to consider.
Analyzing individual proposals - forecast cash flows, evaluate profitability, etc.
Planning the capital budget - how does the project fit within the company's overall
strategies? What's the timeline and priority?
Monitoring and post-auditing - decision makers can:
Improve forecasts, based on which you can make good capital budgeting decisions.
Improve operations, thus making capital decisions well implemented.
9/22/2013 Corporate Finance- Capital Budgeting
5
Project classifications
Replacement projects
Replacement decisions to maintain the business
Replacement decisions to reduce costs
Expansion projects
Regulatory, safety and environmental projects
New Product and services
Others
9/22/2013 Corporate Finance- Capital Budgeting
6
Assumptions of capital budgeting
Capital budgeting decisions must be made on cash flows, not
accounting income
Cash flow timing is critical because money is worth more the
sooner you get it
The opportunity cost should be charged against a project
Expected future cash flows must be measured on an after-tax
basis
Ignore how the project is financed
9/22/2013 Corporate Finance- Capital Budgeting
7
Capital Budgeting Concepts
sunk cost is a cash outlay that has already been incurred and which
cannot be recovered regardless of whether the project is accepted or
rejected
Incremental cash flow is the net cash flow attributable to an
investment project. It represents the change in the firm's total cash flow
that occurs as a direct result of accepting the project
Opportunity cost is the return on the best alternative use of an asset or
the highest return that will not be earned if funds are invested in a
particular project.
Externalities are the effects of a project on cash flows in other parts of
the firm
9/22/2013 Corporate Finance- Capital Budgeting
8
Concepts cont..
Conventional versus non-conventional cash flows`
9/22/2013 Corporate Finance- Capital Budgeting
9
Concepts cont..
Independent versus mutually exclusive projects
Project sequencing
Unlimited funds versus capital rationing
9/22/2013 Corporate Finance- Capital Budgeting
10
Investment decision criteria
When a firm is embarking upon a project, it needs tools to assist in
making the decision of whether to invest in the project or not
NPV
IRR
Payback Period
Discounted payback
ARR
PI
9/22/2013 Corporate Finance- Capital Budgeting
11
NPV
This method discounts all cash flows (including both inflows and
outflows) at the project's cost of capital and then sums those cash
flows
CF
t
= Expected cash flow at period t
K = Project's cost of capital
n = Life of the project
9/22/2013 Corporate Finance- Capital Budgeting
12
NPV cont..
Decision Rules
The higher the NPV, the better
Reject if NPV is less than or equal to 0
NPV measures the dollar benefit of the project to
shareholders
9/22/2013 Corporate Finance- Capital Budgeting
13
IRR
It is the discount rate that forces a project's NPV to equal to zero
IRR = L+(H-L) +NPV
+NPV--NPV
9/22/2013 Corporate Finance- Capital Budgeting
14
IRR cont..
Decision Rules
The higher the IRR, the better.
Define the hurdle rate, which typically is the cost of
capital.
Reject if IRR is less than or equal to the hurdle rate
IRR does provide "safety margin" information
9/22/2013 Corporate Finance- Capital Budgeting
15
Payback Period
It is the expected number of years required to recover the original
investment. Payback occurs when the cumulative net cash flow
equals 0
Decision rules
The shorter the payback period, the better.
A firm should establish a benchmark payback period.
Reject if payback is greater than benchmark.
9/22/2013 Corporate Finance- Capital Budgeting
16
Discounted Payback Period
Similar to the regular payback method except that it discounts
cash flows at the project's cost of capital
9/22/2013 Corporate Finance- Capital Budgeting
17
ARR
9/22/2013 Corporate Finance- Capital Budgeting
18
Profitability Index (PI)
determined by dividing the present value of each proposal by its
initial investment
PI indicates the value you are receiving in exchange for one unit of
currency invested
9/22/2013 Corporate Finance- Capital Budgeting
19
PI cont
Decision Rules
An index value greater than 1.0 is acceptable and the higher the number,
the more financially attractive the proposal
A ratio of 1.0 is logically the lowest acceptable measure on the index. Any
value lower than 1.0 would indicate that the project's PV is less than the
initial investment
9/22/2013 Corporate Finance- Capital Budgeting
20
NPV Profiles
a graph showing the relationship between a project's NPV and the
firm's cost of capital
9/22/2013 Corporate Finance- Capital Budgeting
21
Observations
The IRR is the discount rate that sets the NPV to 0.
The NPV profile declines as the discount rate increases.
Project A has a higher NPV at low discount rates, while Project B
has a higher NPV at high discount rates. The NPV profiles of
Project A and B join at the crossover rate, at which the projects'
NPVs are equal.
The slope of Project A's NPV profile is steeper. This indicates that
Project A's NPV is more sensitive to changes in the discount rates.
9/22/2013 Corporate Finance- Capital Budgeting
22
Ranking Conflicts b/n NPV & IRR
For independent projects, the NPV and IRR methods make the
same accept or reject decisions
Accept if IRR > hurdle rate
Accept if NPV > 0
For mutually exclusive projects, ranking conflicts can arise
Due to differing cash flow patterns
Differing project scales
9/22/2013 Corporate Finance- Capital Budgeting
23
Assuming that Project A and B are mutually exclusive, consider
their NPV profiles
If the cost of capital > crossover rate, then NPVB > NPVA, and IRRB > IRRA.
Thus, both methods lead to the selection of Project B.
If the cost of capital < crossover rate, then NPVB < NPVA, and IRRB > IRRA.
Thus, a conflict arises because now the NPV method will select Project A
while the IRR method will choose B.
Therefore, for mutually exclusive projects, the NPV and IRR methods lead
to same decisions if the cost of capital > the crossover rate, and different
decisions if the cost of capital < the crossover rate.
9/22/2013 Corporate Finance- Capital Budgeting
24
Which Supersedes
NPV method assumes that cash flows will be reinvested at the
firm's cost of capital
IRR method assumes reinvestment at the project's IRR
9/22/2013 Corporate Finance- Capital Budgeting
25
Multiple IRR
Multiple IRRs is the situation where a project has two or more
IRRs. This problem is caused by non-conventional cash flows of a
project
9/22/2013 Corporate Finance- Capital Budgeting
26
MIRR
MIRR is the discount rate that causes the PV of a projects
terminal value (TV) to equal the PV of costs.
TV is found by compounding inflows at WACC.
Thus, MIRR correctly assumes reinvestment at opportunity cost =
WACC. MIRR also avoids the problem of multiple IRRs.
Managers like rate of return comparisons, and MIRR is better for
this than IRR.
9/22/2013 Corporate Finance- Capital Budgeting
27
Find PV and TV (r = 10%)
9/22/2013 Corporate Finance- Capital Budgeting
28
10.0 80.0 60.0
0 1 2 3
10%
66.0
12.1
158.1
-100.0
10%
10%
TV inflows
-100.0
PV outflows
Find Discount Rate that Equates PV and TV
9/22/2013 Corporate Finance- Capital Budgeting
29
MIRR = 16.5%
158.1
0 1 2 3
-100.0
TV inflows
PV outflows
MIRR
L
= 16.5%
$100 =
$158.1
(1+MIRR
L
)
3
Capital Budgeting and Wealth Maimization
Capital budgeting is also relevant to external analysts to estimate
the value of stock prices. Theoretically, if a company invests in
positive NPV projects, the wealth of its shareholders should
increase.
The integrity of a firm's capital budgeting processes can also be
used to show how the management pursues its goal of shareholder
wealth maximization.
9/22/2013 Corporate Finance- Capital Budgeting
30