Capital Budgeting we Should

pursue building of this plant?

Introduction Introduction
Capital expenditures involve investments of significant financial resources in Capital expenditures involve investments of significant financial resources in projects to develop or introduce new products or services. projects to develop or introduce new products or services.

Characteristics of capital purchases: Characteristics of capital purchases: Largecapital outlays are required Large capital outlays are required Long-termimpact on earnings Long-term impact on earnings Lackof liquidity (they cannot be readily disposed of) Lack of liquidity (they cannot be readily disposed of)

Introduction Introduction
A basic A basic requirement for a requirement for a systematic systematic approach to approach to capital budgeting capital budgeting is a well-defined is a well-defined set of long-range set of long-range goals. goals.
An organization An organization should have a wellshould have a welldefined business defined business strategy.. strategy Procedures Procedures should should be developed for the be developed for the review, evaluation, review, evaluation, approval, and postapproval, and postaudit of capital audit of capital expenditure expenditure proposals.. 3 proposals

Time value of money Time value of money

Money has time value if it can be invested at some positive return
Today
Year 1 Year 2 Year 3 Year 4

Year 5

1.0000

1.1000

$1.2100

1.3310

1.4641

1.6105

Value of 1.00 today

Value 5 years from today Assume a 10% interest rate

Amounts of money received at different periods of time must be converted to their value on a common date to be compared, added or subtracted

Time value of money Time value of money

Future value
It is the amount a current sum of money earning a stated rate of interest will accumulate to at the end of the future period FV = PV (1 + r)n where r: compound rate

Present value
It is the current worth of a specified amount of money to be received at some future date at some interest rate. PV = FV / (1 + r)n where r: discount rate

It is very useful to draw a time line in calculations that involve the time value of money

Time value of money Time value of money

Annuities
An annuity is a stream of equal cash flows that occur at equal intervals over a given period of time 2 types of annuity
Ordinary annuity: Cash flows occur at the end of each year
Formula: PVOA = (a / r) x [1 1/(1 + r)n] Refer to annuity table PVOA = Ordinary Annuity Factor (n, r) x Annuity

Annuity due: Cash flows occur at the beginning of each period

Formula: PVOAD = (a / r) x [1 1/(1 + r)n-1] + a Refer to annuity table. PVOAD = Ordinary Annuity Factor (n -1, r) x Annuity + Annuity

Time value of money Time value of money

Practice questions on time value of money
Determine the answers to each of the following situations:
a. b. c. d. e. The future value in 2 years of 1,000 deposited today in a savings account with interest compounded annually at 8%. The present value of 9,000 to be received in five years, discounted at 12%. The present value of an annuity of 2,000 per year for five years discounted at 16%. A proposed investment of 32,010 is to be retuned in eight equal annual payments. Determine the amount of each payment if the interest rate is 10%. A proposed investment will provide cash flows of 20,000; 8,000; and 6,000 at the end of Years 1, 2 and 3 respectively. Using a discount rate of 20%, determine the present value of these cash flows.
7

 Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to an organizations future.
Capital budgeting is a process that involves the Capital budgeting is a process that involves the identification of potentially desirable projects for capital identification of potentially desirable projects for capital expenditures, the subsequent evaluation of capital expenditures, the subsequent evaluation of capital expenditure proposals, and the selection of proposals that expenditure proposals, and the selection of proposals that meet certain criteria. meet certain criteria.

What is capital budgeting?

Steps to capital budgeting

1. 2. 3. 4. 5.

Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC.

Relevancy in Capital Relevancy in Capital Budgeting Budgeting

Relevance analysis is very Relevance analysis is very important in capital important in capital budgeting because only budgeting because only relevant information relevant information should be included. should be included. To make a choice To make a choice between 2 alternatives, between 2 alternatives, incremental relevance incremental relevance analysis often simplifies analysis often simplifies the capital budgeting. the capital budgeting.

RELEVANT CASHFLOWS IN CAPITAL BUDGETING

Initial Investment cost Annual operating cash flows. Terminal cash flow

What is the difference between independent and mutually exclusive projects?

Independent projects if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other.

What is the difference between normal and non-normal cash flow streams?
Normal cash flow stream Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal cash flow stream Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

Capital Budgeting Models Capital Budgeting Models

There are two main types of Capital Budgeting Models:
Capital budgeting models that consider the time value of money
Net Present Value (NPV) Internal Rate of Return (IRR) Discounted Payback Period

Capital budgeting models that do not consider the time value of money
Payback Period Accounting Rate of Return (ARR)

What is the Payback period?

The number of years required to recover a projects cost, or How long does it take to get our money back? Calculated by adding projects cash inflows to its cost until the cumulative cash flow for the project turns positive.

PAYBACK PERIOD
PAY BACKPERIOD= CAPITAL OUTLAY CASHFLOWS PER PERIOD

SITUATION 1: EVEN (SAME) CASHLOWS

SITUATION 2: UNEVEN CASHFLOWS

PAY BACK PERIOD= A + B/C Where: A is the number of full years immediately before covering the capital outlay B is the balance remaining to cover the capital outlay C is the total amount that is received in the year when the capital outlay is fully covered

Calculating Payback
Project L CFt Cumulative PaybackL Project S CFt Cumulative PaybackS
0 -100 -100 1 10 -90 2

2.4

3 80 50

60 100 -30 0

= 2 =
0 -100 -100

+
1

30 / 80 1.6
100 0 2 50 20

= 2.375 years
3 20 40

70 -30

= 1 =

30 / 50

= 1.6 years

Strengths &weaknesses of Payback

Strengths
Provides an indication of a projects risk and liquidity. Easy to calculate and understand.

Weaknesses
Ignores the time value of money. Ignores CFs occurring after the payback period.

Discounted payback period

Uses discounted cash flows rather than raw CFs.
0 CFt PV of CFt Cumulative -100 -100 -100 2 +
10%

1 10 9.09 -90.91

2 60 49.59 -41.32

2.7 3

80 60.11 18.79 = 2.7 years

Disc PaybackL= =

41.32 / 60.11

Net Present Value Net Present Value

Net present value is the Net present value is the present value of the projects present value of the projects net cash inflows from net cash inflows from operations... operations...

and disinvestment and disinvestment less the amount of the less the amount of the initial investment. initial investment.

Net Pr esent Value (NPV)

Sum of the PVs of all cash inflows and outflows of a project:

CFt NPV = t t =0 ( 1 + k )
PRESENT VALUE INTEREST FACTOR AT r%=1/(1+r)^n

What is Project Ls NPV?

Year 0 1 2 3 CFt -100 10 60 80 PVIF@10% PV of CFt 1 0.909 0.8264 0.7513 NPVL = 100 9.09 49.59 60.11 18.79

NPVS = 19.98

Rationale for the NPV method

NPV

= PV of inflows Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. In this example, would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent.

Internal Rate of Return Internal Rate of Return (IRR) (IRR)

1. Also called the time-adjusted rate of return. 2. It is the minimum rate that could be paid for the money invested in a project without losing money. 3. It is also described as the discount rate that results in a projects net present value equaling zero.

Inter nal Rate of Retur n (IRR)

IRR is the discount rate that forces PV of inflows to be equal to cost, and the NPV = 0:

CFt 0= ( 1 + IRR ) t t =0
n

Internal rate of return (IRR)

Interpolation
Finding the discount rate that results in a zero npv. IRR = r1 + npv1 (r2-r1) (npv1-npv2) where: r1 discount rate that results in a positive NPV r2 discount rate that results in a negative NPV npv1 positive NPV npv2 negative NPV.

Rationale for the IRR method

If IRR > WACC, the projects rate of return is greater than its costs. There is some return left over to boost stockholders returns.

Calculate IRR using the previous example

Calculate IRR using the previous example

IRR Acceptance Criteria

If IRR > k, accept project. If IRR < k, reject project. If projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept S, because IRRs > IRRL.

Internal Rate of Return Method

When using the internal rate of return method to rank competing investment projects, the preference rule is:

The higher the internal rate of return, the more desirable the project.

Internal Rate of Return (IRR) Internal Rate of Return (IRR)

Spreadsheet Approach
1. Input

1 2 3 4 5 6 7 8

A B Year of cash flow Cash flow 0 $-94,554 1 30,000 2 30,000 3 30,000 4 30,000 5 42,000 IRR =IRR(B2:B7,0.08)

Internal Rate of Return (IRR) Internal Rate of Return (IRR)

Spreadsheet Approach

2. Output

A 1 Year of cash flow

2 3 4 5 6 7 8 0 1 2 3 4 5 IRR

B Cash flow
$-94,554 30,000 30,000 30,000 30,000 42,000 0.20

Differences Between Net Present Value Differences Between Net Present Value and the Internal Rate of Return Models and the Internal Rate of Return Models

The net present value model gives explicit The net present value model gives explicit

consideration to investment size. The internal consideration to investment size. The internal rate of return does not. rate of return does not. The net present value model assumes all net The net present value model assumes all net cash inflows are reinvested at the discount cash inflows are reinvested at the discount rate. rate. The internal rate of return model The internal rate of return model assumes all net cash inflows are reinvested at assumes all net cash inflows are reinvested at the projects internal rate of return. the projects internal rate of return.

Other Capital budgeting Techniques: Profitability Index:

The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project. = PV Initial Investment

Capital budgeting Techniques:

Profitability Index cont: Decision Criterion In this method, a project with a PI greater than 1 is accepted, but a project is rejected when its PI is less than 1.

Capital budgeting Techniques:

Average Rate of Return
Non discounting method: ARR = Average annual profits Average Investment Where average investment = (Initial outlay+scrap value)/2 & Average annual profits = sum of annual profits/ no. of years.

NPV Profiles
A graphical representation of project NPVs at various different costs of capital. k 0 5 10 15 20 NPVL 50 33 19 7 (4) NPVS 40 29 20 12 5

Drawing NPV profiles

NPV 60 ($)

. 40 .
50 30 20 10 0

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

. .
15

5 -10

20

. .

.
23.6

IRRS = 23.6% Discount Rate (%)

Comparing the NPV and IRR methods

If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive
If k > crossover point, the two methods lead to the same decision and there is no conflict. If k < crossover point, the two methods lead to different accept/reject decisions.

Reasons Why NPV profiles cross

Size (scale) differences the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high k favors small projects. Timing differences the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.

Capital Budgeting Techniques:

A good method of investment appraisal must: Take time value of money into account. Use cashflows instead of profits Use all cashflows. Take into account cost of capital of the firm.

TASK 1
Suppose you are asked whether or not a new consumer product should be launched. Based on projected sales and costs, we expect that the cash flows over the five year life of the project would be E2 000 in the first two years, E4 000 in the next two, and E5 000 in the last year. It will cost E10 000 to begin production. We use a 10% discount rate to evaluate new products. Should we take on the new project?

TASK 2
Period

The projected cashflows from a proposed investment are:

Cash flows

1 2 3

100 200 500

This project costs E500. -What is the payback period for this investment? -What is the discounted payback period for this investment, if the discount rate is 10%?

TASK 3
A project has a total upfront cost of E435.44 The cash flow E100 in the first year, E200 in the second year and E300 in the third year. What is the IRR? If we require 18% return, should we take this investment?

The accounting rate The accounting rate of return is the of return is the average annual average annual increase in net increase in net income that results income that results from acceptance of a from acceptance of a capital expenditure capital expenditure proposal divided by proposal divided by the initial investment the initial investment or the average or the average investment in the investment in the project. project.

Accounting Rate of Accounting Rate of Return Return

Mobile Yogurt Shoppe purchased a vehicle and equipment costing $90,554. It has a disposal value of $8,000 at the end of 5 years.
Mobile Y ogurt Sh oppe

Accounting Rate of Return Accounting Rate of Return

Annual net cash inflow from operations Less average annual depreciation: [90,554 - 8,000]/5) Average annual increase in net income 30,000 16,511 13,489

Accounting Rate of Return Accounting Rate of Return

Accounting rate of return on initial = investment Average annual increase in net income Initial investment = 0.1427

Accounting rate 13,489 of return on initial = 94,554 investment

Accounting Rate of Return Accounting Rate of Return

Average annual Accounting rate increase in net income of return on = average Average investment investment Accounting rate 13,489 of return on = 0.2532 = 53,277 average investment ([94,554 + 12,000])/2
94,544 = initial investment,12,000 = disinvestment

Evaluating Capital Budgeting Evaluating Capital Budgeting Models Models

Predicted net cash Project A Project B inflow from operations: Year 1 50,000 10,000 Year 2 50,000 10,000 Year 3 10,000 50,000 Year 4 10,000 50,000 Total 120,000 120,000 Total depreciation -100,000 -100,000 Total net income 20,000 20,000 Project life 4 years 4 years Average annual increase in income$ 5,000$ 5,000
ARR of Project A: 5,000/100,000 = 0.05 ARR of Project B: 5,000/100,000 = 0.05

Evaluating Capital Budgeting Models Evaluating Capital Budgeting Models

Net present value analysis of Project A:
Predicted Cash Inflows (Outflows) Initial investment Operation (100,000) 50,000 10,000 Net present value of all cash flows Year(s) of Cash Flows 0 1-2 3-4 12% Present Value Factor Present Value of Cash Flows (100,000) 86,800 14,340 1,140

1.000 1.736 3.170-1.736

Evaluating Capital Budgeting Models Evaluating Capital Budgeting Models

Net present value analysis of Project B:
Predicted Cash Inflows (Outflows) Initial investment Operation (100,000) 10,000 50,000 Net present value of all cash flows Year(s) of Cash Flows 0 1-2 3-4 12% Present Value Factor 1.000 1.736 3.170-1.736 Present Value of Cash Flows (100,000) 17,360 71,700 (10,940)

Evaluating Capital Evaluating Capital Budgeting Proposals Budgeting Proposals

Capital budgeting models do not make investment decisions. They only help managers separate capital expenditure proposal that meet certain criteria from those that do not Multiple Investment Criteria
Management may use a single capital budgeting model or they may use multiple models, including those that have not been discussed

Evaluating Capital Evaluating Capital Budgeting Proposals Budgeting Proposals

For example, to be accepted, a proposal must meet the following criteria:
Proposal must be in line with the organizations longrange goals and business strategy Maximum payback period of 3 years Have a net positive NPV when discounted at 14 percent Have an initial investment of less than 500,000

If many of the criteria suggest the project should be taken, the chance is greater that the 53 project is desirable

Ranking Capital Budgeting Ranking Capital Budgeting Proposals Proposals

Proposal A Predicted cash flows (in 000): Initial investment Operation: Year 1 Year 2 Year 3 Year 4 Disinvestment (26,900) 10,000 10,000 10,000 10,000 0 Proposal B (55,960) 20,000 20,000 20,000 20,000 0 Proposal C (30,560) 20,000 20,000 0 0 0

Ranking Capital Budgeting Ranking Capital Budgeting Proposals Proposals

Proposal A

Predicted cash flows (in 000): Initial investment Operation: Year 1 Year 2 Year 3 Year 4 Disinvestment Net present value (in 000) at 12% Internal rate of return

(26,900) 10,000 10,000 10,000 10,000 0 3,470 18%

Ranking Capital Budgeting Proposals Ranking Capital Budgeting Proposals

Proposal B

Predicted cash flows (in 000): Initial investment Operation: Year 1 Year 2 Year 3 Year 4 Disinvestment Net present value (in 000) at 12% Internal rate of return

(55,960) 20,000 20,000 20,000 20,000 0 4,780 16%

Ranking Capital Budgeting Proposals Ranking Capital Budgeting Proposals

Proposal C

Predicted cash flows (in 000): Initial investment Operation: Year 1 Year 2 Year 3 Year 4 Disinvestment Net present value (in 000) at 12% Internal rate of return

(30,560) 20,000 20,000 0 0 0 $3,240 20%

Ranking Capital Budgeting Proposals Ranking Capital Budgeting Proposals

Prop. A Prop. B Prop. C

Ranking by investment criterion: Net present value 2 Internal rate of return 2

1 3

3 1

Present Value Index Present Value Index

A frequent criticism of NPV, when it is used to rank proposals, is that it fails to adjust for the size of the proposed investment To overcome this difficulty, managers may rank projects on the basis of each projects present value index, which is computed as the present value of the projects subsequent cash flows divided by the initial investment.

Present Value Index Present Value Index

Present value of subsequent Present value cash flows = index Initial investment Present value = index 30,370,000 26,900,000 Proposal A

Present value = 1.129 index

Present Value Index Present Value Index

Present value of subsequent Present value cash flows = index Initial investment Present value = index 60,675,000 55,960,000 Proposal B

Present value = 1.080 index

Present Value Index Present Value Index

Present value of subsequent Present value cash flows = index Initial investment Present value = index 33,800,000 30,560,000 Proposal C

Present value = 1.110 index

Ranking Capital Budgeting Proposals Ranking Capital Budgeting Proposals

Prop. A Prop. B Prop. C

Ranking by investment criterion: Net present value 2 Internal rate of return 2 Present value index 1

1 3 3

3 1 2