Capital Budgeting

Fixed assets used in production

Capital Budgeting - Capital budgeting (also known as investment appraisal) is the

process by which a company determines whether projects (such as investing in R&D,
opening a new branch, replacing a machine) are worth pursuing. A project is worth pursuing
if it increases the value of the company. A project typically adds value to the company
if it earns a rate of return that exceeds the cost of capital.
 Importance of Capital Budgeting

Impact is long term (i.e. locked in by the CB decision)

An error in the forecast can have serious consequences
Timing is important (Dont miss any opportunity!)
Acquisition of fixed assets typically involves substantial expenditure
 Project Classifications
1. Replacement: needed to continue current operations
2. Replacement: cost reduction
3. Expansion of existing products or markets
4. Expansion into new products or markets
5. Safety and/or environmental projects
6. Independent projects: Projects whose cash flows are
not affected by decisions made about other projects
7. Mutually exclusive projects: A set of projects in which
the acceptance of one project means the others cannot
be accepted
 THE CAPITAL BUDGETING PROCESS

Step 1 Generating Ideas

Generate ideas from inside or outside of the company

Step 2 Analyzing Individual Proposals

Collect information and analyze the profitability of alternative projects

Step 3 Planning the Capital Budget

Analyze the fit of the proposed projects with the companys strategy

Step 4 Monitoring and Post Auditing

Compare expected and realized results and explain any deviations
 INVESTMENT DECISION CRITERIA

Net Present Value (NPV)

Internal Rate of Return (IRR)

Payback Period

Discounted Payback Period

Profitability Index (PI)

 NET PRESENT VALUE
The net present value is the present value of all incremental cash flows, discounted to the present, less the
initial outlay:
n CFt
NPV = t=1 Outlay
t
(1+r)
The larger the NPV, the more value the project adds; and added value means a higher stock price
where
CFt = After-tax cash flow at time t
r = Required rate of return for the investment
Outlay = Investment cash flow at time zero
If NPV > 0:
Invest: Capital project adds value
If NPV < 0:
Do not invest: Capital project destroys value
Independent projects: If NPV > 0, accept it
Mutually exclusive: Accept the project with highest positive NPV
 NPV

Time Line
0 1 2 3 4
| | | | |
| | | | |

$1,000 $200 $300 $400 $500

Solving for the NPV:

$200 $300 $400 $500

NPV = $1,000 + + + +
1 + 0.05 1 1 + 0.05 2 1 + 0.05 3 1 + 0.05 4

NPV = $1,000 + $190.48 + $272.11 + $345.54 + $411.35

NPV = $219.47 million
PROBLEM: CAPITAL BUDGETING

Cash Flow
Period (millions)
0 $1,000
1 200
2 300
3 400
4 500
Project M:
NPV (Project M) = $(10,000 x PVIFA14%, 4 years) - $ 28,500
= $ (10,000 x 2.914) - $ 28,500 = $640 PRESENT VALUE OF AN
ORDINARY ANNUITY

Project N:
 INTERNAL RATE OF RETURN

IRR: The discount rate that forces a projects NPV to zero. PV of inflows = Cost
WHY?: IRR is as estimate of projects rate of return, if IRR > Cost of capital; Stock price

Independent projects:
If IRR > r (required rate of return):
Invest: Capital project adds value
If IRR < r:
Do not invest: Capital project destroys value
Mutually exclusive projects:
Accept the project with higher IRR, provided that IRR > WACC
INTERNAL RATE OF RETURN

Project M:
Lets assume higher discount rate rb = 16%
@ 16%, NPV (Project M) = $(10,000 x PVIFA16%, 4 years) - $ 28,500
= $ (10,000 x 2.798) - $ 28,500 = - $520
NPVa (640)
IRR = 13% + x (16% - 13%)
NPVa 640 NPV b (520)
= 14.7%
 INTERNAL RATE OF RETURN

NPV (Project N)
Project N:
1 2 3
Lets assume higher discount rate rb =
PVIF PV 16%
Year Cash Flow
(16%, 4 years) (1x2)
1 11,000 0.862 9,482
2 10,000 0.743 7,430 IRR = 13% + NPVa NPVa (1,155.18)
1,155.18 NPV b (97)
x
(16% - 13%)
3 9,000 0.641 5,769
4 8,000 0.552 4,416
= 16.23%
27,097
Intial Investment (27,000)
NPV 97
 WHY NPV IS BETTER?

NPV tells us how much value each project will add

L M
NPV 5500 30
IRR 18% 25%

Multiple IRRs

NPV assumes reinvestment at WACC, while IRR assumes reinvestment at IRR (unrealistic!)
 PAYBACK PERIOD (NON DISCOUNTED)
The length of time required for an investments net revenues to cover its cost.
The shorter the payback, the better the project

Mixed stream

Annuity
 PAYBACK PERIOD (DISCOUNTED)

Cash PVIF at Cumulative cash

Period PV of CF
Flow 5% inflows
0 ($1,000)
1 500 0.909 454.5 455
2 400 0.826 330.4 785
3 300 0.751 225.3 1010
4 100 0.683 68.3 1079

PBP = [3-1] + [(1,000 785) / 225]

= 2.95
 PROFITABILITY INDEX

The profitability index (PI) is the ratio of the present value of future cash flows to the initial outlay:

Present value of future cash flows

PI =
Initial investment
If PI > 1.0:
Invest
Capital project adds value

If PI < 0:
Do not invest
Capital project destroys value
 EXAMPLE: PI

In the Hoofdstad Project, with a required rate of return of 5%,

Cash PVIF at
Period PV of CF
Flow 5%
0 ($1,000)
1 200 0.952 190.4
2 300 0.907 272.1
3 400 0.864 345.6
4 500 0.823 411.5
1219.6

the present value of the future cash flows is $1,219.6. Therefore, the PI is:

$1,219.47
PI = = 1.219
$1,000.00