The Capital Budgeting Process

Dr. Himanshu Joshi

The Capital Budgeting Process

Capital Budgeting is very important for corporations. Capital projects, which make up the long term asset portion of the balance sheet, can be so large that sound capital budgeting decisions ultimately decide the future of many corporations. Capital decisions can not be reversed at a low cost, so mistakes are very costly.

The Capital Budgeting Process

A company is distinguished from other companies more by its capital projects than by its capital structure or working capital.

The Capital Budgeting Process

Step 1. Generation of Ideas Step 2. Analyzing Individual Proposals: this step involves gathering the information to forecast cash flows for each project and then evaluating the projects profitability. Step 3. Planning the Capital Budget: the company must organize the profitable proposals into a coordinated whole that fits within the companys overall strategies, and it also must consider the projects timing. Some projects that looks good when considered in isolation may be undesirable strategically.

How one Company avoided a $100 million Mistake..

A U.S chemical producer was about to modify an existing plant to produce a specialty product, polyzone, which was in short supply on world markets. Europe being the biggest market for chemicals was also biggest potential customer for the Polyzone.. At prevailing raw material and finished product prices the expansion would have been strongly profitable. Next table shows a simplified version of managements analysis. Note that the NPV of $64 million at the companys 8 per cent real cost of capital not bad for $ 100 million company

polyzone

polyzone
Then doubt begin to creep in. notice the outlay for transportation costs. Some of the projects raw material were commodity chemicals, largely imported from Europe, and much of the polyzone production would be exported back to Europe. Moreover, the U.S company had no long run technological edge over potential European competitors. It had a head start perhaps, but was that really enough to generate a positive NPV?

The Capital Budgeting Process

Step 4: Monitoring and Post Auditing: In postaudit, actual results are compared to planned or predicted results, and any differences must be explained.

Project Classification
Mandatory Investment: for statutory requirements like pollution control equipments, fire fitting equipments etc. Replacement Projects: for replacement of old equipments so that quality and efficiency should be maintained. Expansion Projects Diversification Projects Research and Development Projects

Basic Principles of Capital Budgeting

Capital Budgeting usually uses the following assumptions: 1. Decisions are based on cash flows. They are not based on accounting profits. Intangible costs and benefits are often ignored because, if they are real, they should result in cash flows at some other time. 2. Timing of cash flows is crucial. Analysts make an extraordinary effort to detail precisely when cash flows occur. 3. Cash flows are based on opportunity costs. What are the incremental cash flows that occur with an investment compared to what have been without the investments?

Basic Principles of Capital Budgeting

4. Cash flows are analyzed on an after tax basis. Taxes must be fully reflected in all capital budgeting decisions. 5. Financing costs are ignored in calculating cash flows. After-tax cash flows and the investment outlays are discounted at the required rate of return to find the NPV. Financing costs are reflected in the required rate of return.

Some Important Capital Budgeting Concepts

A Sunk Cost is one that has already been incurred. You cannot change a sunk cost. Todays decision, on the other hand should be based on the current and future cash flows and should not be affected by prior, or sunk costs.

Some Important Capital Budgeting Concepts

An Opportunity Cost is what a resource is worth in its next best use. For example, if company uses some idle property, what should it record as the investment outlay: The purchase price several year ago, or The current market value, Or Nothing. Ans: Market Value If you replace an old machine with new one, then what is the opportunity cost? Ans: Cash flows the old machine will generate.

Some Important Capital Budgeting Concepts

An Incremental Cash Flow is the cash flow that is realized because of a decision: the cash flow with a decision minus the cash flows without that decision.

Some Important Capital Budgeting Concepts

An Externality is the effect of an investment on other things besides the investment itself. Frequently, an investment affects the cash flows of other parts of the company, and these externalities can be positive or negative. Cannibalization is one externality. Cannibalization occurs when an investment takes customers and sales away from another part of the company.

Some Important Capital Budgeting Concepts

Conventional Cash Flows vs. Non Conventional Cash Flows: A Conventional Cash flow pattern is one with an initial outflow followed by a series of inflows. In a non-conventional cash flow pattern, the initial outflow is not followed by inflows only, but the cash flows can flip from positive to negative again. (or even changes several times).

Some Important Capital Budgeting Concepts

Individual Projects vs. Mutually Exclusive Projects- Independent projects are projects whose cash flows are independent of each other. Mutually exclusive projects compete directly with each other. For example: if Project A and B are mutually exclusive, you can choose A or B, but you can not choose both. Sometimes there are several mutually exclusive projects and you can choose any one from the group.

Some Important Capital Budgeting Concepts

Project Sequencing: Many projects are sequenced through time, so that investing in a project creates the option to invest in future projects.

Project Sequencing
My Father and I started a Cosmetic factory in
the late 1940s. At the time, no company could supply us with the plastic caps of adequate quality for cream jars, so we had to start a Plastic business. Plastic caps were not sufficient to run the plastic molding plant, so we added Combs, Toothbrushes, and Soap boxes.

Project Sequencing
This Plastic business led us to manufacture Electric fan blades and Telephone cases, which in turn led us to manufacture Electrical and Electronics products and Telecommunication equipments. The Plastic business also took us into Oil refining which needed a tanker Shipping company.

Project Sequencing
The Oil-refining company alone was paying an insurance premium amounting to more than half of total revenue of the then largest insurance company in Korea. Thus an Insurance company was started. This natural step by step evolution through related business resulted in the Lucky-Gold

Star

(LG) group as we see it today.

Unlimited Funds Vs. Capital Rationing

An unlimited environment assumes that company can raise the funds it wants for all profitable projects simply by paying the required rate of return. Capital rationing exists when the company has fixed amount of funds to invest. If the company has more profitable projects than it has funds for, it must allocate the funds to achieve the maximum shareholder value subject to the funding constraints.

Investment Criteria / Evaluation Techniques :

It is classified into two broad categories traditional methods and time adjusted methods (or discounted cash flow methods).

Investment Criteria

Traditional Method or Non-Discounting Criteria

Time Adjusted Methods or Discounting Criteria

Payback Period

Average rate of return

Net Present Value Benefit Cost Ratio Internal Rate of Return

Modified IRR Net Terminal Value Profitability Index

A. Traditional Method / NonDiscounting Criteria :

Payback Period It is the length of time required to recover the initial cash outlay on the project. PB = Investment / Constant annual cash flow (if cash flow is constant) Accept-Reject Criterion: If actual pay back period is less than the predetermined by the management, project will be accepted, otherwise rejected.

Payback period..
For irregular cash flow, cumulative cash flow will be calculated and then pay back period will be calculated. suppose a project require investment of Rs50000. and the stream of cash flow is as follows Rs 15000,12000,15000,10000,5000 for next 5 years,

Calculation..
Year 1 2 3 4 5 Cash Flow 15000 12000 15000 10000 5000 Cumulative C. F. 15000 27000 42000 52000 57000

Thus pay back period will be between 3rd and 4th year. The fractional part (after 3rd year) can be calculated as 8000/10000 = 0.8, therefore pay back period will be 3.8 years.

Drawback of the Payback Period Method

Drawback of the Payback Method

Comment on why payback period is providing misleading information: Project A Project B versus Project C Project D versus Project E Project D versus Project F

Drawback of the Payback Method

Project A: Project A does indeed pay itself back in one year. However, this result is misleading because the investment is unprofitable, with a negative NPV. Project B versus C: Project B and C have the same payback period, the payback period does not detect the fact that Project Cs cash flows within the payback period occur earlier and result in a higher NPV. Project D and E: project D and E illustrate a common situation. The project with shorter payback period is the less profitable project. Project E has a longer payback and higher NPV. Project D and F: payback ignores cash flows after the payback period is reached. In this case, project F has much larger Cash flow in year 3, but payback period method does not recognize its value.

Discounted Payback Period

A major shortcoming of the conventional payback method is that it does not consider time value of money.
To overcome this limitation, discounted payback period is used.

Here the project is evaluated on the basis of time value of money of each cash-flow.

Average Rate of Return / Accounting Rate of Return (ARR)

It based on the concept of ROI or rate of return. Defined as the annualized net income earned on the average funds invested in a project. ARR = Profit After Tax Book value of the investment
.

Accept-Reject Rule
The actual ARR will be compared with predetermined or a minimum required rate of return or a cut-off rate. A project would be accepted if actual ARR is higher than the minimum desired ARR.

ARR
Consider the following investment opportunity: a machine is available for purchase at a cost of Rs.80,000. we expect it to have a scrap value of Rs.10,000 at the end of five year period. We have estimated that it will generate additional profits over its life Amount (Rs.) time as follows: Year
1 2 3 4 5 20,000 40,000 30,000 15,000 5,000

B. Time Adjusted Methods / Discounting Criterion : NPV

It is defined as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows.

NPV..
n

Ct Initial Investment t t 1 (1 r)

NPV..
If cash outflow is also expected to occur at some time other than at initial investment and salvage value and working capital is also to be adjusted, then NPV will be calculated as

Ct CO t Sn Wn NPV t n t (1 r) t 1 (1 r) t 0 (1 r)
n n
where Ct = cash inflow at different time periods COt = cash outflow at different time periods r = discount rate t = time periods Sn = salvage value Wn = working capital adjustment Accept-Reject Rule : NPV > zero, accept; NPV < zero, reject; NPV = zero, indifferent. However it is rare that NPV is equal to zero.

NPV..SpreadsheetModelling.xlsx
Calculate the NPV of a Project having cash outlay of Rs. 1,00,000 at present, and homogenous cash inflow of Rs. 28,000 per year for five years after one from the commencement of the project. Appropriate discounting rate for the project is 10%.

Basic NPV

Proper NPV Format in Spreadsheet

Properties of NPV Rule : NPVs are additive the NPVs of different projects can be added to arrive at a cumulative NPV for a business Intermediate cash flows are reinvested at cost of capital i.e., the cash flows that occur between the initiation and termination of the project are reinvested at a rate of return equal to the cost of capital.

NPV Profile: NPV Profile shows a projects NPV graphed as a function of various Discount Rates. Typically NPV is graphed vertically on Y-Axis and Discount Rates are graphed horizontally on X-Axis.

NPV
30000 20000 10000 0 0 -10000 -20000 -30000 0.05 0.1 0.15 0.2 0.25 NPV

NPV Profile..
There are two interesting points on this NPV profile: 1. Where the profile goes through the vertical axis (the NPV when the discount rate is zero), 2. Where the profile goes through the horizontal axis (where the discount rate is the IRR). The NPV profile in the above example is very well behaved. The NPV declines at a decreasing rate as the discount rate increases. The profile is convex from the origin.

Internal Rate of Return (IRR) :

It is defined as the IRR of a project is the discount rate which makes its NPV equal to zero.

Thus IRR is the discount rate which will equates the present value of cash inflows with the present value of cash outflows.
Therefore for a project, the IRR will be

Ct Sn Wn CO 0 t n (1 r) t 1 (1 r)
n
where COo = initial cash outflow or investment Ct = cash inflow at different time periods Sn & Wn = salvage value and working capital at the end of n years r = rate of discount / IRR (to be calculated) n = life of the project

If the project requires investment at different time periods, then

CO t Ct Sn Wn t t n (1 r) t 0 (1 r) t 1 (1 r)
n n
Accept-Reject Rule : If IRR > cost of capital, accept. If IRR < cost of capital, reject. If IRR = cost of capital, indifferent.

NPV and IRR : The IRR approach solves for a rate unique to each project, while the NPV approach solves for trade-off cash inflows and outflows using a general required rate of return. IRR gives percentage return while NPV gives absolute return.

NPV shows expected increase in the wealth of the share holders while IRR does not.
NPV of different projects are additive while the IRRs can not be added.

Example: IRR..CB.xlsx
A company has to select one of the following two projects: (Rs.) using the IRR method suggest which project is better?
Project A Cost Cash in Flows Year 1 Year 2 6000 2000 1000 1000 11,000 Project B 10,000

Year 3
Year 4

1000
5000

2000
10000

Calculation..IRRsx.xlsx
Key Factor F = I/C I = Original Investment C = Average Cash inflows per year Key factor should then be located into table for value of Re 1 received annually for n years.

Profitability Index Method..

Present va lue of cash inflows PI Present va lue of cash outflows

PI

t 1 t 1 n

CI t (1 r) t CO t (1 r) t

Profitability Index..
where CI = cash inflow CO = cash outflow r = discount rate n = project life

Accept-Reject Rule : PI >1, accept; PI < 1, reject; PI = 0, indifferent.

Example of PI..
The XYZ INC. had an outlay of $50 million, a present value of future cash flow of $63.136 million, and an NPV of $13.136 million. PI = PV of Future cash inflows/PV of CO = 63.136/50 = 1.26 Or the PI can also be calculated as PI = 1+ (NPV/Initial Investment) = 1+ 13.136/50 = 1.26. Since PI > 1, it is acceptable.

Profitability Index
The PI indicates the value you are receiving in exchange for one unit of a currency invested. Although the PI is used less frequently than NPV and IRR, it is some times used as guide in capital rationing. It is also known as benefit-cost ratio.

IRR/NPV Ranking Conflict Due to Differing Project Scale

Project A has much smaller outlay than Project B, although they have similar future cash flow patterns. The Cash Flows and NPVs and IRR are shown for the both the projects, are shown in the table below: @ 10% discount Rate
Year 0 1 50 170 2 50 170 3 50 170 4 50 170 NPV 58.49 IRR (%) 34.90

Project A -100 Project B -400

138.88 25.21

If they were not mutually exclusive, you would invest in both projects because they are both profitable. However, you can choose either Project A (which has higher IRR or Project B which has NPV).

Ranking Conflict Due to Differing Project Scale

When choice is between two mutually exclusive projects and the NPV and IRR rank the two projects differently, the NPV criterion is strongly preferred. There are good reasons for this preference. The NPV shows the amount of gain, or wealth increase, as currency account. IRR give does give you a rate of return, but IRR could be for small investment or for only a short period of time.

Ranking Conflict between NPV and IRR

For a single, conventional project, the NPV and IRR will agree on whether to invest or not to invest. For independent, conventional projects, no conflicts exists between the decision rules of NPV and IRR. However, in cash of two mutually exclusive projects, the two criteria will some times disagree.

Differing Cash Flow Patterns and NPV/IRR..

Project A and B have similar outlays but different patterns of future cash flows.
Year Project B 0 -200 1 80 0 2 80 0 3 80 0 4 80 400 NPV 53.39 73.21 IRR 21.86 18.92 Project A -200

Which project should be selected A or B?

Differing Cash Flow Patterns and NPV/IRR..

Whenever the NPV and IRR rank two mutually exclusive projects differently, as they do in the above example, you should choose the project based on the NPV. Project B, with higher NPV is the better project because of reinvestment assumption. Mathematically whenever we discount a cash flow at a particular discount rate, we are implicitly assuming that you can reinvest a cash flow at the same discount rate.

Differing Cash Flow Patterns and NPV/IRR..

In the NPV calculation, you use a discount rate of 10 percent for both projects. In the IRR calculation you use discount rate of 21.86% for project A and 18.92 for project B. Can you reinvest the cash inflows from the projects at 10%, 21.86% or 18.92%? When you assume required rate is 10%, you are assuming an opportunity cost of 10%- that you can either find other projects that pay 10% or higher return or payback your sources of capital that cost you 10%.

Differing Cash Flow Patterns and NPV/IRR..

The fact that you earned 21.86% and 18.92% for project A and B respectively, does not mean that you can reinvest future cash flows at those rates. (in fact if you can reinvest future cash flows at 21.86% and 18.92%, these should have been used as your required rate of return instead of 10%). Because the NPV criteria uses the most realistic discount rate- the opportunity cost of funds- the NPV criterion should be used for evaluating mutually exclusive projects.

The Multiple IRR Problem and the NO IRR ProblemNPV_Payback_Multi_IRR.xlsx

A Problem that can arise with the IRR criterion is the multiple IRR problem. This is possible when we have non-conventional cash flows: Time Cash Flow 0 -1000 1 5000 2 -6000

The IRR for these cash flows satisfies this equation: -1000 + 5000/(1+IRR)1 + -6000/(1+IRR)2 = 0

No IRR Problem
Time Cash Flow 0 100 1 -300 2 250

80
70 60 50 40 30 20 10 0 Series1

10

12

Problems with IRR

For non-conventional cash flows projects, the multiple IRR problem and no IRR problem can occur. The IRR Equation is essentially an nth degree polynomial. An nth degree polynomial can have up to n solutions, although it will have no real solutions than the number of cash flow sign changes. For example: a project with two sign changes could have zero, one or two IRRs. Analyst should be aware of the unusual cash flow pattern that can generate the multiple IRR problem.

NPV and the Share Price

XYZ Inc. is investing $600 million in distribution facilities. The present value of the future after tax cash flows is estimated to be $ 850 million. XYZ has 200 million shares outstanding with a current market price of $32.00 per share. This investment is a new information, and it is independent of other expectations about the company. What should be effect of the project on the value of company and stock?

Solution NPV and Stock Price..

NPV of the Project = $850M - $600M =$250 M Market Capitalization without Project = $32x 200 Million = $6400 million. Market Capitalization with Project = $6400M+$250M =$6650M New Price Per share = $6650 M/200 M = $33.25. Change in MPS due to Project = $33.25-$32 = $1.25.

Capital Rationing..
Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of capital expenditures during a particular period. Capital rationing refers to a situation where a company can not undertake all positive NPV projects it has identified because of shortage of capital.

Factors leading to Capital Rationing..

External Factors: Imperfections in the capital market or deficiency in market information which might have for the availability of capital.

Factors leading to..

Internal Factors: Reluctance to take resort to financing by external debt in order to avoid assumption of further risk. Reluctance to broaden the equity share base for fear of loosing control. Reluctance to accept some viable projects because of its inability to manage the firm in the scale of operation resulting from inclusion of all the viable projects.

Situations of Capital Rationing

Situation I. Projects are divisible and constraint is a single period one. Situation II. Projects are indivisible and constraint is a single period one. Situation III. Projects are divisible and constraint is a multi-period one.

Situation I
Projects are divisible and constraint is a single period one

Steps: 1. Calculate the Profitability Index of each Project. 2. Rank the Projects on the basis of their P.I. 3. Choose the optimum combination of the projects.

Example:
Project A B Required initial investment NPV at appropriate cost of capital 100000 300000 20000 35000

C
D E

50000
200000 100000 Total Fund Available

16000
25000 30000 3,00,000

Situation II
Projects are indivisible and constraint is a single period one.. Step 1. Construct the table showing the feasible combinations of the project (whose aggregate of initial outlay does not exceed the fund available for investment). Choose the combination whose aggregate NPV is maximum and consider it as optimal project mix..

Situation III
Projects are divisible and constraint is multi period one. Under this situation, the problem of capital rationing can be solved with the help of linear programming.

Example:
Outlays in present value terms:
Project 1 2 Period I 500 600 Period II 300 300 NPV 5 6

3
4 Fund Available

300
800 1200

600
400 800

6
7

Determine the optimal project mix in order to maximize NPV assuming that projects are divisible.

Solution..
Let X1,X2,X3 and X4 be the number of units of projects 1,2,3,4 respectively. Then the linear programming problem will be as follows: Maximize NPV = 5X1+6X2+6X3+7X4 Subject to the constraints: 500X1+600X2+300X3+800X4 1200 300X1+300X2+600X3+400X4800 1> (X1,X2,X3,X4)0