Capital Budgeting Analysis

Meaning of Capital Budgeting

Capital

budgeting addresses the issue of strategic long-term investment decisions. Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.

Why Capital Budgeting is so Important?

Involve

massive investment of resources Are not easily reversible Have long-term implications for the firm Involve uncertainty and risk for the firm

Decisions important to the financial manager

Investment Decision

Financing Decision

Financial Manager Reinvestment Refinancing Financial Real Assets Markets Returns from Investment Returns to Security Holders

Capital Budgeting is used to make the Investment Decision

Typical Capital Budgeting Decisions

Plant expansion Equipment selection Lease or buy Equipment replacement Cost reduction

CAPITAL BUDGETING
Why? Business Application

Perhaps

most important function financial managers must perform

Results of Cap Budgeting decisions continue for many future years, so firm loses some flexibility Cap Budgeting decisions define firms strategic direction. Timing key since Cap Assets must be put in place when needed

Valuing

projects that affect firms strategic direction Methods of valuation used in business Parallels to valuing financial assets (securities)

Capital Budgeting
Describes

how managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.

Typical Capital Budgeting Decisions

Capital budgeting tends to fall into two broad categories . . .
Screening decisions. Does a proposed project meet some present standard of acceptance? Preference decisions. Selecting from among several competing courses of action.

Steps in Capital Budgeting

Estimate

cash flows (inflows & outflows). Assess risk of cash flows. Determine appropriate discount rate (r = WACC) for project. Evaluate cash flows. (Find NPV or IRR etc.) Make Accept/Reject Decision

Typical Cash Outflows

Repairs and maintenance

Working capital

Initial investment

Incremental operating costs

Typical Cash Inflows

Salvage value Release of working capital Reduction of costs

Incremental revenues

What is the difference between independent and mutually exclusive projects? Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

Techniques of Capital Budgeting Analysis

Non-DCF

TECHNIQUES:

Accounting rate of return Payback Period Approach

DCF

TECHNIQUES:

Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index

Which Technique should we follow?

A

technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization. A technique is considered consistent with wealth maximization if
It is based on cash flows Considers all the cash flows Considers time value of money Is unbiased in selecting projects

Accounting rate of return (ARR)

One

of the natural ways of deciding whether or not a venture should be undertaken is based on the profit the project would generate. ARR is defined as average profit as % of average investment over the life of the project.

ARR: Strengths and Weaknesses

Strengths:

Easy to calculate and understand. Accounting information is easily available and easy to interpret.
Weaknesses:

Ignores the TVM. Ignores CFs occurring after payback period.

Payback Period Approach

The

amount of time needed to recover the initial investment The number of years it takes including a fraction of the year to recover initial investment is called payback period To compute payback period, keep adding the cash flows till the sum equals initial investment

Payback: Strengths and Weaknesses

Strengths:

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

Ignores the TVM. Ignores CFs occurring after payback period. No specification of acceptable payback.

Discounted Payback Period

Similar

to payback period approach with one difference that it considers time value of money The amount of time needed to recover initial investment given the present value of cash inflows Keep adding the discounted cash flows till the sum equals initial investment All other drawbacks of the payback period remains in this approach Not consistent with wealth maximization

Discounted Cash Flow (DCF) Techniques

The main DCF techniques for capital budgeting include: Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI) Each requires estimates of expected cash flows (and their timing) for the project.

Including cash outflows (costs) and inflows (revenues or savings) normally tax effects are also considered.

Each requires an estimate of the projects risk so that an appropriate discount rate (opportunity cost of capital) can be determined.

The discussion of risk will be deferred until later. For now, we will assume we know the relevant opportunity cost of capital or discount rate.

Sometimes

the above data is difficult to obtain this is the main weakness of all DCF techniques.

Time Value of Money

Business

investments extend over long periods of time, so we must recognize the time value of money. Investments that promise returns earlier in time are preferable to those that promise returns later in time.

The Net Present Value Method

To determine net present value we ...

Calculate the present value of cash inflows, Calculate the present value of cash outflows, Subtract the present value of the outflows from the present value of the inflows.

The Net Present Value Method

General decision rule . . .

The Net Present Value Method Lets look at

how we use present value to make business decisions.

NPV: Strengths and Weaknesses

Strengths Resulting number is easy to interpret: shows how wealth will change if the project is accepted. Acceptance criteria is consistent with shareholder wealth maximization. Relatively straightforward to calculate Weaknesses Requires knowledge of finance to use. An improper NPV analysis may lead to the wrong choices of projects when the firm has capital rationing.

The Internal Rate of Return Method

The

internal rate of return is the interest yield promised by an investment project over its useful life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero. Accept a project if IRR Cost of Capital

IRR: Strengths and Weaknesses

Strengths

IRR number is easy to interpret: shows the return the project generates. Acceptance criteria is generally consistent with shareholder wealth maximization.
Weaknesses

Requires knowledge of finance to use. Difficult to calculate need financial calculator.

NPV versus IRR

Usually,

NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project IRR can be in conflict with NPV if
Investing or Financing Decisions Projects are mutually exclusive
Projects differ in scale of investment Cash flow patterns of projects is different

If cash flows alternate in signproblem of multiple IRR

If

IRR and NPV conflict, use NPV approach

Profitability Index (PI)

A

part of discounted cash flow family PI = PV of Cash Inflows/initial investment Accept a project if PI 1.0, which means positive NPV Usually, PI consistent with NPV PI may be in conflict with NPV if
Projects are mutually exclusive
When
Scale of projects differ Pattern of cash flows of projects is different

in conflict with NPV, use NPV

PI: Strengths and Weaknesses

Strengths PI number is easy to interpret: shows how many rupees (in PV terms) you get back per rupee invested. Acceptance criteria is generally consistent with shareholder wealth maximization. Relatively straightforward to calculate. Useful when there is capital rationing. Weaknesses Requires knowledge of finance to use. Method needs to be adjusted when there are mutually exclusive projects.

Which technique is superior?

Although

our decision should be based on NPV, but each technique contributes in its own way. Payback period is a rough measure of riskiness. The longer the payback period, more risky a project is IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the projects estimated cash flows PI is a measure of cost-benefit analysis. How much NPV for every rupee of initial investment