Capital Budgeting

What is Capital Budgeting?

The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

The Capital Budgeting Process

Generate investment proposals consistent with the firms strategic objectives. Estimate after-tax incremental operating cash flows for the investment projects. Evaluate project incremental cash flows.

The Capital Budgeting Process

Select projects based on a value-maximizing acceptance criterion. Reevaluate implemented investment projects continually and perform postaudits for completed projects.

Classification of Investment Project Proposals

1. New products or expansion of existing products 2. Replacement of existing equipment or buildings 3. Research and development 4. Exploration 5. Other (e.g., safety or pollution related)

Capital Budgeting Techniques

Project Evaluation and Selection Potential Difficulties Capital Rationing Project Monitoring Post-Completion Audit

Project Evaluation: Alternative Methods

Payback Period (PBP) Discounted Payback Period Accounting Rate of Return(ARR) Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR)

Proposed Project Data

Amit is evaluating a new project for her firm, Amit Ltd. He has determined that the after-tax cash flows for the project will be Rs.10,000; Rs.12,000; Rs.15,000; Rs.10,000; and Rs.7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be Rs.40,000.

Independent Project
For this project, assume that it is independent of any other potential projects that Amit Ltd may undertake.
Independent A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.

Payback Period (PBP)

0
40 K

1
10 K

2
12 K

3
15 K

4
10 K

5
7K

PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.

Payback Solution (#1)

0 1 2
12 K 22 K

3
15 K 37 K

(a) 4 10 K (c) 47 K

5
7 K (d) 54 K

40 K (-b) 10 K 10 K Cumulative Inflows

PBP

=a+(bc)/d = 3 + (40 37) / 10 = 3 + (3) / 10 = 3.3 Years

Payback Solution (#2)

0
40 K 40 K

1
10 K 30 K

2
12 K 18 K

3
15 K 3 K

4
10 K 7K

5
7K 14 K

Cumulative Cash Flows

PBP = 3 + ( 3K ) / 10K = 3.3 Years

Note: Take absolute value of last negative cumulative cash flow value.

PBP Acceptance Criterion

The management of Amit Ltd has set a maximum PBP of 3.5 years for projects of this type. Should this project be accepted? Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.]

PBP Strengths and Weaknesses

Strengths:
Easy to use and
understand Can be used as a measure of liquidity Easier to forecast ST than LT flows

Weaknesses:
Does not account
for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective

Accounting Rate of Return

Accounting Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return. Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows.

Accounting income Accounting rate of return book assets

Net Present Value (NPV)

NPV is the present value of an investment projects net cash flows minus the projects initial cash outflow.
CF1 CF2 + NPV = 1 (1+k)2 (1+k) CFn +...+ (1+k)n
- ICO

NPV Solution
Amit Ltd has determined that the appropriate discount rate (k) for this project is 13%.
NPV = Rs.10,000 Rs.12,000 Rs.15,000 + + + 1 2 3 (1.13) (1.13) (1.13)

Rs.10,000 Rs.7,000 - Rs.40,000 4 + (1.13)5 (1.13)

NPV Solution
NPV = Rs.10,000(PVIF13%,1) + Rs.12,000(PVIF13%,2) + Rs.15,000(PVIF13%,3) + Rs.10,000(PVIF13%,4) + Rs. 7,000(PVIF13%,5) Rs.40,000 Rs.10,000(0.885) + Rs.12,000(0.783) + Rs.15,000(0.693) + Rs.10,000(0.613) + Rs. 7,000(0.543) Rs.40,000 Rs.8,850 + Rs.9,396 + Rs.10,395 + Rs.6,130 + Rs.3,801 Rs.40,000 - Rs.1,428

NPV =

NPV = =

NPV Acceptance Criterion

The management of Amit Ltd has determined that the required rate is 13% for projects of this type. Should this project be accepted?
No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ]

NPV Strengths and Weaknesses

Strengths:
Cash flows assumed to be reinvested at the hurdle rate. Considers all cash flows.

Weaknesses:
May not include managerial options embedded in the project.

Profitability Index (PI)

PI is the ratio of the present value of a projects future net cash flows to the projects initial cash outflow.
Method #1:

PI =

CF1 CF2 + 1 (1+k)2 (1+k)

CFn +...+ (1+k)n

ICO

<< OR >>
Method #2:

PI = 1 + [ NPV / ICO ]

PI Acceptance Criterion
PI = Rs.38,572 / Rs.40,000 = .9643 (Method #1, previous slide)

Should this project be accepted? No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI < 1.00 ]

PI Strengths and Weaknesses

Strengths:
Same as NPV Allows comparison of different scale projects

Weaknesses:
Same as NPV Provides only relative profitability Potential Ranking Problems

Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the projects initial cash outflow. CF1 CF2 CFn

+ ICO = (1 + IRR)1 (1 + IRR)2

+...+

(1 + IRR)n

IRR Solution
Rs.40,000 = Rs.10,000 + Rs.12,000 + (1+IRR)1 (1+IRR)2 Rs.15,000 Rs.10,000 Rs.7,000 + + 3 4 (1+IRR) (1+IRR) (1+IRR)5
Find the interest rate (IRR) that causes the discounted cash flows to equal Rs.40,000.

IRR Solution (Try 10%)

Rs.40,000 = Rs.10,000(PVIF10%,1) + Rs.12,000(PVIF10%,2) + Rs.15,000(PVIF10%,3) + Rs.10,000(PVIF10%,4) + Rs. 7,000(PVIF10%,5) Rs.40,000 = Rs.10,000(0.909) + Rs.12,000(0.826) + Rs.15,000(0.751) + Rs.10,000(0.683) + Rs. 7,000(0.621) Rs.40,000 = Rs.9,090 + Rs.9,912 + Rs.11,265 + Rs.6,830 + Rs.4,347 = Rs.41,444 [Rate is too low!!]

IRR Solution (Try 15%)

Rs.40,000 = Rs.10,000(PVIF15%,1) + Rs.12,000(PVIF15%,2) + Rs.15,000(PVIF15%,3) + Rs.10,000(PVIF15%,4) + Rs. 7,000(PVIF15%,5) Rs.40,000 = Rs.10,000(0.870) + Rs.12,000(0.756) + Rs.15,000(0.658) + Rs.10,000(0.572) + Rs. 7,000(0.497) Rs.40,000 = Rs.8,700 + Rs.9,072 + Rs.9,870 + Rs.5,720 + Rs.3,479 = Rs.36,841 [Rate is too high!!]

IRR Solution (Interpolate)

0.05 X

0.10 Rs.41,444 Rs.1,444 IRR Rs.40,000 Rs.4,603 0.15 Rs.36,841

Rs.1,444 Rs.4,603

X 0.05

IRR Solution (Interpolate)

X

0.05

0.10 Rs.41,444 Rs.1,444 IRR Rs.40,000 Rs.4,603 0.15 Rs.36,841

Rs.1,444 Rs.4,603

X 0.05

IRR Solution (Interpolate)

X

0.05

0.10 Rs.41,444 Rs.1,444 IRR Rs.40,000 Rs.4,603 0.15 Rs.36,841

(Rs.1,444)(0.05) Rs.4,603 X=

X = 0.0157

IRR = 0.10 + 0.0157 = 0.1157 or 11.57%

IRR Acceptance Criterion

The management of Amit Ltd has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted?
No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR < Hurdle Rate ]

IRR Strengths and Weaknesses

Strengths:
Accounts for TVM Considers all cash flows Less subjectivity

Weaknesses:
Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs

Evaluation Summary
Amit Ltd Independent Project

Method Project Comparison Decision PBP IRR NPV PI 3.3 11.47% -1,424 .96 3.5 13% 0 1.00 Accept Reject Reject Reject

Capital Rationing
Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.
Example: Amit must determine what investment opportunities to undertake for Amit Ltd. He is limited to a maximum expenditure of Rs.32,500 only for this capital budgeting period.

Available Projects for Amit Ltd.

Project ICO A Rs. 500 B 5,000 C 5,000 D 7,500 E 12,500 F 15,000 G 17,500 H 25,000 IRR 18% 25 37 20 26 28 19 15 NPV Rs. 50 6,500 5,500 5,000 500 21,000 7,500 6,000 PI 1.10 2.30 2.10 1.67 1.04 2.40 1.43 1.24

Choosing by IRRs for Amit Ltd

Project ICO
C F E B

IRR

NPV

PI

Rs. 5,000 37% Rs. 5,500 2.10 15,000 28 21,000 2.40 12,500 26 500 1.04 5,000 25 6,500 2.30 Projects C, F, and E have the three largest IRRs. The resulting increase in shareholder wealth is Rs.27,000 with a Rs.32,500 outlay.

Choosing by NPVs for Amit Ltd

Project ICO
F Rs.15,000 G 17,500 B 5,000

IRR
28% 19 25

NPV

PI

Rs.21,000 2.40 7,500 1.43 6,500 2.30

Projects F and G have the two largest NPVs.

The resulting increase in shareholder wealth is Rs.28,500 with a Rs.32,500 outlay.

Choosing by PIs for Amit Ltd

Project ICO IRR NPV PI
F Rs.15,000 28% Rs.21,000 2.40 B 5,000 25 6,500 2.30 C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 G 17,500 19 7,500 1.43 Projects F, B, C, and D have the four largest PIs. The resulting increase in shareholder wealth is Rs.38,000 with a Rs.32,500 outlay.

Summary of Comparison
Method Projects Accepted Value Added PI F, B, C, and D Rs.38,000 NPV F and G Rs.28,500 IRR C, F, and E Rs.27,000
PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period.

Multiple IRR Problem*

Let us assume the following cash flow pattern for a project for Years 0 to 4: Rs.100 +Rs.100 +Rs.900 Rs.1,000 How many potential IRRs could this project have? Two!! There are as many potential IRRs as there are sign changes.

Other Project Relationships

Dependent A project whose acceptance depends on the acceptance of one or more other projects.
Mutually Exclusive A project whose acceptance precludes the acceptance of one or more alternative projects.

Potential Problems Under Mutual Exclusivity

Ranking of project proposals may create contradictory results.

A. Scale of Investment B. Cash-flow Pattern C. Project Life

A. Scale Differences
Compare a small (S) and a large (L) project.
END OF YEAR 0 1 2

NET CASH FLOWS Project S Project L

-Rs.100 0 Rs.400 -Rs.100,000 0 Rs.156,250

Scale Differences
Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why?
Project IRR NPV PI

S L

100% 25%

Rs. 231 Rs.29,132

3.31 1.29

B. Cash Flow Pattern

Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project.
END OF YEAR 0 1 2 3 NET CASH FLOWS Project D Project I -Rs.1,200 1,000 500 100 -Rs.1,200 100 600 1,080

Cash Flow Pattern

Calculate the IRR, NPV@10%, and PI@10%. Which project is preferred?
Project D I 23% 17% IRR NPV PI 1.17 1.17

Rs.198 Rs.198

C. Project Life Differences

Let us compare a long life (X) project and a short life (Y) project.
END OF YEAR 0 1 2 3 NET CASH FLOWS Project X Project Y -Rs.1,000 0 0 3,375 -Rs.1,000 2,000 0 0

Project Life Differences

Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why?
Project IRR NPV PI

X Y

50% 100%

Rs.1,536 Rs. 818

2.54 1.82