2015, Study Session # 11, Reading # 35

CAPITAL BUDGETING
DR
IRR
DCF
AAR
PI

=
=
=
=
=

CB = Capital Budgeting
NPV = Net Present Value
CF = After Tax Cash flows at
Time t
r
= Required Rate of Return

Discount Rate
Internal Rate of Return
Discounted Cash Flows
Average Accounting Rate of Return
Profitability Index

1. INTRODUCTION
CB is a process of decision making on capital projects (project with a life of a
year or more).

2. THE CAPITAL BUDGETING PROCESS

Steps in capital budgeting process

Step I Generating Ideas

Ideas can come from anywhere

(from top or bottom of organization
or outside the company)

Step II Analyzing Individual

Proposals

Step III Planning the Capital

Budget

To forecast CF of each project &

evaluate profitability.

Consider profitable proposals within

companys overall strategies.

Step IV Monitoring & Post

Auditing

Post audit actual result is

compared with predicted results,
any difference must be explained.

Classification of CB Projects

Replacement Projects

Expansion Projects

New Products &

Services

Regulatory, Safety &

Environmental
Projects

Other Projects

If replacement is
to just maintain
business, no
careful analysis is
required.

If replacement is to
enhance efficiency,
very detailed
analysis.

size of business.

More uncertainties
than replacement
decisions.

Decisions
considered more
carefully.

More uncertain
than expansion
projects.

More complex &
involve more
people in decision
making.

Required by a govt.
agency, insurance
company or some
other external
party.

May generate no
revenue.

Some projects
escape capital
budgeting analysis.

These are either
pet projects or so
risky that these are
difficult to analyze.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 11, Reading # 35

3. BASIC PRINCIPLES OF CAPITAL BUDGETING

Capital budgeting assumptions:

Decisions are based on CF rather than accounting concepts. Intangible costs & benefits are
ignored.

Timing of CF is crucial.

CF are based on opportunity cost (consider incremental CF only).

CF should be analyzed on after-tax basis.

Financing costs are ignored in CF (reflected in required rate of return).

Capital budgeting CFs are different from net income due to noncash charges & interest expense.

Some Important CB Concepts

Sunk cost cost already been incurred.

Opportunity cost resources worth in its next-best use.
Incremental CF CF with decision CF without decision.
Externality effect of an investment on other things beside investment itself & can be positive or negative.

Cannibalization when an investment takes customers & sales from another part of the company.
Conventional CF initial outflow followed by a series of inflows.
Nonconventional CF CF can flip from positive to negative again even after initial outflows.
Independent v/s mutually exclusive projects projects are independent if CFs are independent of each other.
Mutually exclusive projects compete directly with each other.
Project Sequencing investing in a project creates option to invest in future projects.
Unlimited funds v/s capital rationing if company can raise the funds for all profitable projects (unlimited funds).
If company has a fixed amount of funds (capital rationing).

4. INVESTMENT DECISION CRITERIA

4.1 Net Present Value

NPV = PV of future after tax CF investment outlay.

NPV = 


()

outlay.

Decision rule for NPV = invest if NPV > 0 (wealth increasing).

4.2 Internal Rate of Return

DR that makes PV of future after-tax CF equal to that of investment outlay (one investment outlay).

IRR = 


(

= outlay.

Decision rule for IRR = invest if IRR > r.

4.3 Payback Period

No. of years required to recover the original investment in a project (based on CF).
It ignores time value of money, risk of project & CF after payback period is reached.
Measure of payback & liquidity & not profitability.
Simple and very easy to explain.
No decision rule like NPV or IRR.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 11, Reading # 35

4.4 Discounted Payback Period

No. of years it takes for cumulative DCF from a project to equal the original investment.
If project has negative NPV, usually no discounted payback period.
It considers time value of money & risk within discounted payback period.
Ignores CF after discounted payback period I reached.
Not a good measure of profitability & possibility of negative CF after discounted payback period.

4.5 Average Accounting Rate of Return

 


  

Advantage easy to understand & calculate.

Disadvantages based on accounting numbers, not CF, does not account for time value of
money & no sound cutoff that distinguishes b/w profitable & unprofitable investments.

 =

4.6 Profitability Index

 =

   
 

= 1 +


 

PI is ratio of PV of future CF & initial investment while NPV is difference b/w these two.

Investment decision rule = invest if PI 1.0

Also called benefit-cost ratio in govt & not-for- profit organizations.
4.7 NPV Profile

Shows a projects NPV graphed as a function of various discount rates.

When profile goes through horizontal axis DR is IRR.

NPV declines at a decreasing rate as DR increases.
4.8 Ranking Conflicts b/w NPV & IRR

Single & independent conventional projects no conflict b/w decision rule for NPV & IRR.
Mutually exclusive projects criteria sometimes disagree (choose project based on NPV).
NPV assumes more realistic reinvestment rate assumption.
NPV shows amount of gain as currency amount while IRR gives a rate of return.

4.9 The Multiple IRR Problem & the No IRR Problem

Problem with IRR criterionmultiple IRR problem (nonconventional projects).

Possibility of no IRR (no DR exists that result in zero NPV).

Having two sign changes does not mean that you will have multiple IRR; it just
means that you might.
4.10 Popularity & Usage of the Capital Budgeting Methods

Several other methods in 4 stead of NPV & IRR are heavily used (e.g. in European countries, payback period).
U.S. companies are larger and companies prefer NPV & IRR over payback period.
Private companies use payback period more frequently.
Companies managed by an MBA preference for DCF techniques.
NPV criterion most directly related to stock prices.
Value of company = value of existing investment + PV of future investments.
Impact of investment on stock price depends on whether profitability is more or less than expected.
CB process demonstrates two things about quality of management.

Degree to which management purses goal of shareholders wealth maximization.

Effectiveness in pursuing that goal.

Copyright FinQuiz.com. All rights reserved.