CAPITAL BUDGETING

Lecture 5
Saturday March 3, 2012

Capital budget is an out line of planned investment in fixed assets and CAPITAL BUDGETING is the process of analyzing projects and deciding which ones to include in the various capital budgets. PROJECT CLASSIFICATIONS Analysing projects can be expensive. For certain types of projects, a relatively detailed analysis may be required, for others simple procedures may be used. Firms therefore categorize projects and analyse the categories differently.
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1. Replacement: Maintenance of business consists of expenditures to replace worn-out or damaged equipment used in the production of profitable products. Maintenance decisions are made without going through an elaborate decision process. 2. Replacement: Cost reduction. This category includes expenditures to replace serviceable but obsolete equipment. The purpose is to lower the cost of labour, materials and other inputs such as electricity. These decisions are discretionary and a fairly detailed analysis is generally required.
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3. Expansion of existing products or markets: These include expenditures to increase output of existing products, or to expand retail outlets or distribution facilities in markets now being served. Decisions here are more complex on the basis that they require an explicit forecast of growth in demand. More detailed analysis are required to avoid mistakes

4. Expansion into new products or markets - These involve investment to produce a new product or to expand into a new geographic area not currently being served. - These are projects which involve strategic decisions that could change the fundamental nature of the business - They require expenditure of large sums of money with delayed paybacks - A detailed analysis is required - Financial decisions are made at the very top by the Board of Directors as part of the strategic plan.
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5. Safety and ,or environmental projects - These involve expenditures to comply with government safety standards, labour agreements, or insurance policy terms. -These expenditures are called mandatory investments and often non-revenue producing projects - Handling of these projects depend on their size - Smaller ones may handled like category one described above .

6. Other These may include office buildings, parking lots, executive aircrafts etc. the handling of such projects varies among companies.

Steps
1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.
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EVALUATING STEPS INVOLED IN CAPITAL BUDGETING ANALYSIS. First determine the cost of the project -Management estimates the expected cash flows from the project, including the salvage value of the asset at the end of the expected project life. -- The riskiness of the projected cash flows must be estimated. This requires information about the probability distribution (riskiness) of the cash flows
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Steps continued
- Given the projects riskiness, management determines the cost of capital at which the cash flows are discounted. - The expected cash inflows are discounted to obtain an estimate of the assets value. - Lastly, the present value of the expected cash inflows is compared with the initial or required outlay. If the PV of cash flows exceeds the cost, the project is accepted. Otherwise it is rejected. Alternatively, if the projects IRR exceeds the cost of capital, the project is accepted
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Normal Cash Flow Project:

Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project 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.

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Inflow (+) or Outflow (-) in Year

0 1 + 2 + 3 + 4 + 5 + N N NN

+ -

+
+ +

+
+ +

+
+ -

+
+ +

+ N N

NN

NN

CAPITAL BUDGETING DECISION RULES Five main methods are used in ranking projects and to decide whether or not the project should be accepted for inclusion in the capital budget. They include - Payback - Discounted payback - Net Present Value (NPV) -Internal Rate of Returns (IRR) -Profitability Index - Modified Internal Rate of Return (MIRR)

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We will use table 1 for projects S & L to illustrate each of the methods. We assume both projects are equally risky The cash flows CFt; are expected values They have been adjusted to reflect taxes, depreciation and salvage values Many projects require investments in both fixed assets and working capital. So the investment outlays shown as CF0 include the necessary changes in net operating working capital. We assume that all cash flows occur at the end of the designated year.
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TABLE 1: EXPECTED AFTER-TAX NET CASH FLOWS, CFt

YEAR

PROJECT (S) (1000)

500 400 300 100

PROJECT (L) (1000)

100 300 400 600
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0
1 2 3 4

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.
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PAYBACK PERIOD Defined as the expected number years required to recover the original investment (calculate the payback period for projects S & L).
Paybacks = year before full recovery + unrecovered cost at start of year/Cash flow during year = 2 + 100/300 = 2.33 years Calculate payback for project L

NB . The shorter the payback period the better If the firm required payback period of 3 years S is accepted and L rejected If both projects are mutually exclusive, S would be ranked over L since S has lower payback period
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Strengths of Payback: 1. Provides an indication of a projects risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the time value of money 2. Ignores CFs occurring after the payback period. 3. Biased against long-term projects, such as research and development, and new projects
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Discounted Payback - Variant of the regular payback period -Similar to the regular payback period except that the expected cash flows are discounted by the projects cost of capital. -The discounted payback period is therefore defined as the number of years required to recover the investment from discounted net cash flows. - Discounted payback for projects S = 2.95 years -Discounted payback for project L = 3.88 years. -(to be done in class)

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Advantages and disadvantages of the discounted payback period

Advantages 1. Includes time value of money 2. Easy to understand 3. Does not accept negative estimated NPV investments 4. Biased towards liquidity 5. It shows the breakeven year after covering debt and equity (capital) costs Disadvantages 1. May reject positive NPV investments 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date 4. Biased against long-term projects such as research and development, and new projects
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NPV: Sum of the PVs of inflows and outflows.

CFt NPV . t 1 t 0 k
Cost often is CF0 and is negative.
NPV
t 1 n

1 k

CFt

CF0 .
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Whats Project Ss NPV?

Project S:
0 -1000
454.55

10%

1 500

4 100

400 300

330.58
225.39

68.30

78.82 = NPVS
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Whats Project Ls NPV?

Project S:
0 -1000 90.9
247.93
300.53

10%

1 100

4 600

300 400

409.81 49.18 = NPVL

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Rationale for the NPV Method

- NPV of zero means that the projects cash flows are exactly sufficient to repay the investment capital and to provide the required rate of return on that capital. If a project has a positive NPV, then it is generating more cash than is needed to service its debt and to provide the required returns to shareholders, this excess cash accrues solely to the stockholders. Projects with positive NPV improve stockholders wealth by the NPV.
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Rationale for the NPV Method

NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
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Using NPV method, which project(s) should be accepted?

If Projects S and L are mutually exclusive, accept S because NPVs > NPVL . If S & L are independent, accept both; NPV > 0.

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The Profitability Index (PI)

Total PV of Future Cash Flows PI Initial Investent

Minimum Acceptance Criteria:

Accept if PI > 1

Ranking Criteria:
Select alternative with highest PI

The Profitability Index

Disadvantages:
Problems with mutually exclusive investments

Advantages:
May be useful when available investment funds are limited Easy to understand and communicate Correct decision when evaluating independent projects

INTERTNAL RATE OF RETURN (IRR) IRR is defined as the discount rate that equates the present value of a projects expected cash inflows to the present value of the projects cost. PV (inflows) = PV (investment costs) Or the rate that forces the NPV to equal zero

Calculate the IRR for projects L and S

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Internal Rate of Return: IRR

0 CF0 Cost 1 CF1 2
CF2

3 Inflows CF3

4 CF4

IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.
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NPV: Enter k, solve for NPV.

CFt 1 k t NPV. t 0
n

IRR: Enter NPV = 0, solve for IRR.

CFt 1 IRR t 0. t 0
n
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Whats Project Ss IRR?

0 -1000 PV1 PV2
PV3
IRR = ?

1 500

2 400

3 300

4 100

PV4 0 = NPV

IRRS = 14.5%.
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Whats Project Ls IRR?

0 -1000 PV1 PV2
PV3
IRR = ?

1 100

2 300

3 400

4 600

PV4 0 = NPV

IRRL = 11.8%.
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A.

They are the same thing. A bonds YTM is the IRR if you invest in the bond. How is a projects IRR related to a bonds YTM?
1 2 10

Q.

IRR = ?

...
90 90 1,090

-1,134.2

IRR = 7.08%
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Rationale for the IRR Method

Rationale for the IRR Method The IRR is special because It is the projects expected rate of return If the IRR exceeds the cost of the funds used to finance the project, a surplus remains after paying for the capital, and this surplus accrues to the firms stockholders Undertaking a project whose IRR exceeds its cost of capital increases stockholders wealth.
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Rationale for the IRR Method

If IRR > WACC, then the projects rate of return is greater than its cost-- some return is left over to boost stockholders returns. Example: WACC = 10%, IRR = 15%. Profitable.
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IRR Acceptance Criteria

If IRR > k, accept project. If IRR < k, reject project.

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Decisions on Projects S and L per IRR

If S and L are independent, accept both. IRRs > k = 10%. If S and L are mutually exclusive, accept S because IRRS > IRRL .

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Construct NPV Profiles

Enter CFs in CFLO and find NPVL and NPVS at different discount rates:

k 0 5 10 15 20

NPVL 400 206.18 49.18 (80.14)

NPVS 300 180.42 78.82 (8.33)

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NPV ($)
60

. 300 .
400 200 100

. .

Crossover Point = 7.2%

.
L
7.2

k 0 5 10 15 20

NPVL 400 206.5 49.18 (80.14) (4)

NPVS 300 180.42 78.82 (8.33) 5

. .

0
5 -100

. .

IRRS = 14.5%

Discount Rate (%)

IRRL = 11.8%
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NPV and IRR always lead to the same accept/reject decision for independent projects:
NPV ($)

IRR > k and NPV > 0 Accept.

k > IRR and NPV < 0. Reject.

IRR
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k (%)

Mutually Exclusive Projects

NPV
L

k < 7.2: NPVL> NPVS , IRRS > IRRL CONFLICT k > 7.2: NPVS> NPVL , IRRS > IRRL NO CONFLICT

IRRS

7.2 k

%
IRRL
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To Find the Crossover Rate

Find cash flow differences between the projects. See data at beginning of the case. 2. Enter these differences in CFLO register, then press IRR. Crossover rate = 7.2%, 3. Can subtract S from L or vice versa, but better to have first CF negative. 4. If profiles dont cross, one project dominates the other.
1.

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Two Reasons NPV Profiles Cross

1. Size (scale) differences. 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.
2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
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Reinvestment Rate Assumptions

NPV assumes reinvest at k (opportunity cost of capital). IRR assumes reinvest at IRR. Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

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Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?
Yes, MIRR is the discount rate which causes the PV of a projects terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC.

Thus, MIRR assumes cash inflows are reinvested at WACC.

MIRR for Project L (k = 10%)

0 -100.0 1 10.0
10% MIRR = 16.5%

10%

2 60.0
10%

3 80.0

66.0 12.1 158.1

TV inflows

-100.0 PV outflows

$158.1 $100 = (1+MIRRL)3 MIRRL = 16.5%

Why use MIRR versus IRR?

MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs.
Managers like rate of return comparisons, and MIRR is better for this than IRR.