Capital Budgeting

Capital Budgeting Process

Capital Project
 Decisions/projects which entail capital expenditure such as buying a new machine,
expanding business in a new geography, replace existing office premises, etc. HSBC, a British bank, wants to shift its global operations
Categories to a low-cost labour country such as India. It appoints
KPMG to conduct a viability study and receives the
 Replacement projects following proposals:
 Expansion projects
i. To invest in a Back-Office Unit in Hyderabad, whre it
 New products or services has to manage the operations directly and incur one
 Regulatory, safety and environmental projects
time fixed expenditure of USD 100 million. Annual
expenses for salaries and administration would be
 Other: Pet projects / highly risky projects about USD 10 million.
Steps
ii. To appoint TCS BPO Services with annual contract of
 Generating Ideas USD 20 million, to manage the operations as per
agreed service delivery. The contract will be renewed
 Analyzing Individual Proposals
annually if TCS performs as desired.
 Planning the Capital Budget
This kind of decisions require capital budgeting!
 Monitoring and Post auditing
 Principles of Capital Budgeting

Inclusions:
 After-tax incremental cash flows and timing is crucial (to discount Cash Flows)
 Opportunity Costs (to ascertain cost of forgoing other proposals)
 Externalities – Cannibalization (how the intended proposal will impact existing
business set-up)

Exclusions:
 Financing costs – excluded from cash flows as it is part of the discount rate
 Sunk Cost – Costs that have been incurred and cannot be recovered (such as cost
for determining feasibility of a project)
 Accounting net income
 Probable Issues with Project Interactions

Independent • Projects are independent – accept as many projects

Projects as resources permit
Various methodologies to
evaluate capital projects:
Mutually Exclusive • Projects compete with each other for resources –
Projects accept one and reject the other  Net present value
method

Unlimited Funds • Company can raise funds for all profitable projects  Internal rate of return
 Payback period/
Capital Rationing • Company has fixed amount of funds to invest – must discounted payback
allocate funds to optimize shareholder value period
 Profitability Index
• Projects sequenced through time – e.g. invest in
Project
project today, if results positive, invest in subsequent
Sequencing project; otherwise do not invest in second project
 Net Present Value (NPV)

+ve NPV
Rate of return > cost of PV at r=10%
t=0 1 2 3 4
capital -60
= accept project
27.28 CF= -60 30 30 30 40
-ve NPV 24.80
Rate of return < cost of 22.54
capital
27.32
= reject project
NPV = 41.92
 Net Present Value (NPV)
In a gold harvest scheme, Tanishq is accepting a deposit of Rs 1000
today and will pay Rs 325 for next 4 years. Assuming a discount rate
of 10%, does this proposal have a positive NPV?

Solution:
 Plot the cash flows of Rs 325 for 4 years Step Screen Remark
1 ON Start
 Discount each cash flow with 10% and aggregate the discounted
2 2ND -> CLR WORK Erase earlier data
cash flows 3 CF -> -1000 -> First cash flow (negative)
 Compare the aggregated discounted cash flows with the initial ENTER
4 Go to next cash flow
outflow of Rs 1000 to compute the NPV
5 325 -> ENTER -> Second cash flow
 NPV is positive: Rs 30.21 6 4-> ENTER -> Cash flow of how many years
7 Press NPV
8 Enter Rate = 10% As discount rate
9 Compute Rs 30.21
 Internal Rate of Return (IRR)
Discount rate that makes PV of future after-tax cash flows equal to investment outlay
(ergo, its a return on the amount invested)

𝑛
𝐶𝐹𝑡
෍ − 𝑂𝑢𝑡𝑙𝑎𝑦 = 0
1 + 𝐼𝑅𝑅 𝑡
𝑡=0
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛
i.e. 𝐶𝐹0 = 1 + 2 + ………+ 𝑛
1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 1+𝐼𝑅𝑅

Use your financial calculator to see that for previous example

 IRR = 37.9%

To actually see how this is done, we use the process of trial and error….
 Internal Rate of Return (IRR)
IRR calculated using process of Trial and Error Step Screen Remark
Discount Rate (%) NPV 1 ON Start

10 41.92 2 2ND -> CLR WORK Erase earlier data

3 CF -> -x -> ENTER First cash flow (negative)
20 22.48
4 Go to next cash flow
30 8.48
5 x1 -> ENTER -> Second cash flow
40 -1.920 6 y-> ENTER -> Cash flow of how many years
37 0.904 7 Enter more CFs in similar manner

37.93 0.00 8 IRR -> CPT Compute the IRR

 In previous example, NPV was $41.92 with discount rate at 10%

 To find IRR we need to bring NPV = 0, thus we increase discount rate
 Table above shows that IRR lies between 30% to 40%  through trial and error we find actual IRR is
37.93%
 Our financial calculator just makes it easier!
Selection criterion – IRR should be higher than cost of capital!
 Payback Period
No. of years required to recover original investment in a project We have often heard
Year 0 1 2 3 our relatives saying
when will your
CF -20,000 8,000 9,000 6,000 education payback?
Cumulative CF -20,000 -12,000 -3,000 3,000
Payback period (yrs.) = 2 + [3000/6000] = 2.50 yrs. So assuming a CFA
degree costs
Amount Amount approximately Rs 3
Drawback: pending paid lacs and a CFA
 A measure of payback, not of profitability – doesn’t give you the return on capital charter-holder earns
at-least Rs 4 lacs per
 Ignores time value of money
annum more than a
 Does not consider cash flows which arises after the pay-back period non-CFA, so the
However: payback for the CFA
degree is 9 months!
 Easy to use.
 Good to Ball park for maximum time
 May be used as an indicator of project liquidity
Selection criterion: Payback Period <= Desired number of years
 Discounted Payback Period
No. of yrs. it takes for cumulative discounted cash flows from a project to equal original
investment
E.g. when discounting at r = 5%

Year 0 1 2 3
CF -20,000 8,000 9,000 6,000
Cumulative CF -20,000 -12,000 -3,000 3,000
Discounted CF -20,000 7,620 8,164 5,184
Cum. Disc. CF -20,000 -12,380 -4,216 968

Discounted payback period = 2 + [4216/5184] = 2.81yrs.

Drawback: Still ignores profitability and cash flows after payback period
Selection criterion: Payback Period <= Desired number of years
 Profitability Index (PI)
𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑁𝑃𝑉
𝑃𝐼 = =1+
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

PI is the ratio of PV of future cash flows to initial investment while NPV is difference
between PV of future cash flows and initial investment.

When NPV = +ve PI > 1  Invest in project

When NPV = -ve  PI < 1  Do not invest in project

E.g. ABC Corp. investment had an outlay of $60Mio, PV of $73Mio, and NPV of
$3Mio:
PI = (73/60) = 1.22
Thus, invest in project.
 Cross over rate/NPV Profile
NPV Profile Aman has to decide between replacing an existing equipment or leasing it.
Below are the cash flows of the two projects. Compute the cross-over rate for
both the projects?
 It’s a graph which shows a project’s NPV for different
discount rates
Today After 1 yr After 2 yrs
 Let us chart out two projects with various NPVs on a graph Replacement -400 100 450
Discount Rate NPV1 NPV2 Lease -200 150 150
Solution
0% 500 750
5% 350 450
 Cross-over rate is the discount rate at which NPVs of both projects are same
(or the NPV of the differences between the projects’ cash flows should be
10% 250 250 Zero)
15% 100 80
Today After 1 yr After 2 yrs
1 Difference -200(Year 1) = 50,
50Cash Flow (Year
300 2) = 300,
 Cash Outflow = -200, Cash Flow
2 Cross-over rate Compute IRR
NPV

 IRR/ Cross-over rate = 35.61%

Selection criteria: At cross over rate, one will be indifferent to whichever
Project he/she selects, so other factors would need to be considered.

Discount rate
 Ranking conflict: NPV vs. IRR
Difference in Timing of Cash flows Year 0 1 2 3 NPV IRR
60 Project A -100 60 60 50 41.75 33.21%
crossover rate
40 Project B -100 0 0 200 50.26 25.99%
20
NPV

Project A Discount rate used for both projects =

0 Project B 10%
10 20 30 40
-20

-40
Discount Rate

 Project A has cash flows coming in earlier; thus IRR is higher because IRR method
assumes that all interim cash flows are being reinvested at 33.21%
 NPV method however assumes that all cash flows are being reinvested at 10% and gives
a better idea of relative profitability of projects A and B
 2 mutually exclusive projects, one has higher NPV, the other has a higher IRR; which
one do you choose and why?
 Choose Project B because of higher NPV and profitability
 Ranking conflict: NPV vs. IRR
Difference in Project scale Year 0 1 2 3 NPV IRR
150 Project A -100 60 60 60 63.40 36.31%
crossover rate
100
Project B -400 180 180 180 90.18 16.65%
50
NPV

0 Project A
Discount rate used for both projects =
5 10 20 30 40 Project B
-50 5%
-100

-150
Discount Rate

 If we look only at IRR, then Project A is more attractive as it seems to give a much
higher return
 However, at a discount rate of 5%, Project B is more profitable with a higher NPV
 Only when the discount rate crosses 10% does Project A become more profitable as
shown in the graph
 Always look at the NPV when trying to decide between mutually exclusive projects!
 NPV vs. IRR
NPV IRR
Absolute measure: increase in shareholder Relative measure: IRR is compared to
value measured in dollars required rate of return or “hurdle rate”
Ranking of projects remains consistent Multiple IRRs or no IRRs may result when
regardless of cash flow pattern cash flows are unconventional
Better measure when projects are mutually Problematic when projects are mutually
exclusive; for independent projects both NPV exclusive e.g. 50% IRR on a $10M project is
and IRR will give the same result much better than a 50% IRR on a $100K
project whereas total value added will always
reflect in NPV
More realistic – reinvestment at discount rate Less realistic – reinvestment at IRR
 Multiple IRR and no IRR
IRR Problems
100

0 Year 0 1 2
50 100 150 200 250 300
-100 Project A -1000 5000 -6000
NPV

Project A
-200 Project B Project B 100 -300 250
-300

-400
Discount Rate

 It is possible for a project to have a nonconventional cash flow pattern like the projects
here
 In Project A we have 2 IRR’s where NPV becomes zero while Project B has no IRR at all
 Thus overall, NPV is always the most preferred method to determine the profitability of
a project
 Popularity and usage
Based on research:
Payback period method used more often in European countries and larger companies
tend to prefer NPV and IRR over Payback period method
Discounting cash flow methods more widely used in companies run by MBA’s, public
corporations and primarily in the US

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑜. = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑠𝑚𝑒𝑛𝑡𝑠 + 𝑁𝑃𝑉 (𝑓𝑢𝑡𝑢𝑟𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠)

Stock price depends on expectations of investment profitability

E.g. If analyst knows of positive NPV projects a company is pursuing but NPV is less
than expectations, then stock price may fall; and vice versa.
 NPV and Stock Prices
E.g. ABC Co. is investing $100 M in manufacturing facilities; PV of future after-tax
cash flows is estimated to be $160 M. Currently ABC Co. has 20 M share outstanding
with current market price at $10 per share. If the investment is new information
and independent of other expectations about the company what will be the effect
of the project value on the stock price?

 NPV (Project) = 160 – 100 = $60 M

 MV (company) = $10 x 20 M shares = $200 million
 Value of Co. will should increase to = $200 million + $60 million = $260 M
 New price per share should be = $260 million / 20 M shares = $13

Also note that news of such a project may be considered as a signal about other
profitable capital projects underway or in future
In such a scenario, the stock price may rise to levels higher than $13 per share