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Capital Budgeting Analysis

CA. Sonali Jagath Prasad

Outline
Meaning of Capital Budgeting
Significance of Capital Budgeting Analysis
Traditional Capital Budgeting Techniques
Payback Period Approach
Discounted Payback Period Approach
Discounted Cash Flow Techniques

Net Present Value


Internal Rate of Return
Profitability Index
Net Present Value versus Internal Rate of Return

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.

Capital Budgeting
Is to a company what buying
stocks or bonds is to individuals:
An investment decision where each
want a return > cost

CFs are key for each

Cap. Budgeting & CFs


COMPANY

CFs
generated by a project &
returned to company .
costs

INDIVIDUAL
CFs
generated by stocks or
bonds & returned to
individual > costs

Significance of Capital
Budgeting

Considered to be the most


important decision that a
corporate treasurer has to make.
So much is the significance of
capital budgeting that many
business schools offer a separate
course on capital budgeting

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

Due to the above factors, capital budgeting


decisions become critical and must be evaluated
very carefully.
Any firm that does not follow the capital
budgeting process will not be maximizing
shareholder wealth and
management will not be acting in the best
interests of shareholders.
RJR Nabiscos smokeless cigarette project example
Similarly, Euro-Disney, Concorde Plane, Saturn of
GM all faced problems due to bad capital
budgeting, while Intel became global leader due
to sound capital budgeting decisions in 1990s.

Techniques of Capital Budgeting


Analysis

Payback Period Approach


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

What is capital budgeting?


Analysis of potential projects.
Long-term decisions; involve large
expenditures.
Very important to firms future.

10

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
11

Capital Budgeting Project


Categories
1. Replacement to continue profitable
2.
3.
4.
5.
6.
7.
8.

operations
Replacement to reduce costs
Expansion of existing products or markets
Expansion into new products/markets
Contraction decisions
Safety and/or environmental projects
Mergers
Other
12

Independent versus 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.

13

Normal vs. Nonnormal Cash


Flows
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.
For example, nuclear power plant or strip mine.
14

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

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
Simplicity is the main benefit, but suffers from
drawbacks
Technique is not consistent with wealth
maximizationWhy?

Proposed Project Data


Julie Miller is evaluating a new
project for her firm, Basket
Wonders (BW). She has
determined that the after-tax cash
flows for the project will be
$10,000; $12,000; $15,000;
$10,000; and $7,000, respectively,
for each of the Years 1 through 5.
The initial cash outlay will be

Independent Project
For this project, assume that it is
independent of any other potential projects
that Basket Wonders 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

15 K

10 K

PBP is the period of time


required for the cumulative
expected cash flows from an
investment project to equal
the initial cash outflow.

7K

Payback Solution (#1)


0

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

2
12 K
22 K

3
15 K
37 K

(a)

10 K
(c) 47 K

5
(d)
7K
54 K

PBP = a + ( b c ) / d
= 3 + (40 37) / 10 =
3 + (3) / 10 = 3.3
Years

Payback Solution (#2)


0

40 K
40 K

10 K
30 K

12 K
18 K

Cumulative
Cash Flows

3
15 K
3 K

4
10 K
7K

5
7K
14 K

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


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

PBP Acceptance Criterion


The management of Basket
Wonders 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:

Weaknesses:

Easy to use and Does not account


for TVM
understand
Can be used as a Does not consider
cash flows
measure of
beyond
the PBP
liquidity
Easier to forecast
ST than LT flows Cutoff period is
subjective

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 Payback: Uses


Discounted CFs
0
1
2
10%

CFt

-100

PVCFt

-100

Cumulative-100

10

60

80

9.09

49.59

60.11

-90.91

-41.32

18.79

Discounted
= 2 + $41.32/$60.11 = 2.7 yrs
payback

Recover investment + capital costs in 2.7 y


25

Net Present Value Approach


Based on the dollar amount of cash flows
The dollar amount of value added by a
project
NPV equals the present value of cash
inflows minus initial investment
Technique is consistent with the principle
of wealth maximizationWhy?
Accept a project if NPV 0

Net Present Value (NPV)


NPV is the present value of an
investment projects net cash
flows minus the projects initial
cash outflow.
CF1
NPV =
(1+k)1

CF2
+
(1+k)2

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

- ICO

Rationale for the NPV Method


NPV = PV inflows Cost
This is net gain in wealth, so accept
project if NPV > 0.
Choose between mutually exclusive
projects on basis of higher positive NPV.
Adds most value.
Risk Adjustment: higher risk, higher cost
of cap, lower NPV
28

NPV Solution
Basket Wonders has determined that
the appropriate discount rate (k) for
this project is 13%.
NPV = $10,000 +$12,000 $15,000
+
+
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 +
(1.13)
(1.13)5

- $40,000

NPV Solution

NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2)


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

NPV Acceptance Criterion


The management of Basket Wonders
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 ]

Using NPV method, which franchise(s)


should be accepted?
If Franchises S and L are
mutually exclusive, accept S
because NPVs > NPVL.
If S & L are independent,
accept both; NPV > 0.
NPV is dependent on cost of
capital.
32

NPV Strengths
and Weaknesses
Strengths:

Weaknesses:

May not include


Cash flows
assumed to be
managerial
reinvested at the options
hurdle rate.
embedded
in
the project. See
Accounts for TVM.
Chapter
14.
Considers all
cash flows.

Internal Rate of Return


The rate at which the net present value of
cash flows of a project is zero, I.e., the
rate at which the present value of cash
inflows equals initial investment
Projects promised rate of return given
initial investment and cash flows
Consistent with wealth maximization
Accept a project if IRR Cost of Capital

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

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

+...+

CFn

(1 + IRR)n

IRR Solution
$10,000
$12,000
$40,000 =
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
+
(1+IRR)3 (1+IRR)4

$7,000
+
(1+IRR)5

Find the interest rate (IRR) that causes the


discounted cash flows to equal $40,000.

IRR Solution (Try 10%)


$40,000 =
$10,000(PVIF10%,1) +
$12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 =
$10,000(0.909) +
$12,000(0.826) +
$15,000(0.751)
+ $10,000(0.683) +
$
7,000(0.621)
$40,000 =
$9,090 + $9,912 + $11,265 +
$6,830 + $4,347

IRR Solution (Try 15%)


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

IRR Solution (Interpolate)


0.05

X
0.05

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

$4,603

IRR Solution (Interpolate)


0.05

X
0.05

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

$4,603

IRR Solution (Interpolate)


0.05

0.10 $41,444
$1,444
IRR $40,000
0.15 $36,841

($1,444)(0.05)
$4,603
X=

$4,603

X = 0.0157

IRR = 0.10 + 0.0157 = 0.1157 or 11.57%

IRR Acceptance Criterion


The management of Basket
Wonders 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 ]

Modified Internal Rate of Return


(MIRR)

MIRR is the discount rate that


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.
43

MIRR for Franchise L: First,


Find PV and TV (r = 10%)
0

10%

-100.0

10.0

60.0

80.0

10%
10%

100.0
PV outflows

66.0
12.1
158.1
TV inflows
44

Second, Find Discount Rate that


Equates PV and TV
0

MIRR = 16.5%

-100.0
PV outflows

3
158.1
TV inflows

$100
=
MIRRL =

$158.1
(1+MIRRL)3
45

To find TV with 12B: Step 1, Find


PV of Inflows
First, enter cash inflows in CFLO
register:
CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80
Second, enter I/YR = 10.
Third, find PV of inflows:
Press NPV = 118.78
46

Step 2, Find TV of Inflows


Enter PV = -118.78, N = 3, I/YR =
10, PMT = 0.
Press FV = 158.10 = FV of inflows.

47

Step 3, Find PV of Outflows


For this problem, there is only one
outflow, CF0 = -100, so the PV of
outflows is -100.
For other problems there may be
negative cash flows for several
years, and you must find the
present value for all negative cash
flows.
48

Step 4, Find IRR of TV of


Inflows and PV of Outflows
Enter FV = 158.10, PV =
-100, PMT = 0, N = 3.
Press I/YR = 16.50% = MIRR.

49

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.
50

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
Scale of projects differ
Pattern of cash flows of projects is different

When in conflict with NPV, use NPV

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:

CF1
PI =
(1+k)1

CF2
+
(1+k)2

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

<< OR >>
Method #2:

PI = 1 + [ NPV / ICO ]

ICO

PI Acceptance Criterion
PI

= $38,572 / $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:

Weaknesses:

Same as NPV Same as NPV


Provides only
Allows
relative
comparison of
different scale profitability
projects
Potential Ranking
Problems

Evaluating Projects with


Unequal Lives

Replacement Chain Analysis


Equivalent Annual Cost Method
If two machines are unequal in life,
we need to make adjustment
before computing NPV.

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 dollar of initial investment

Choosing the Optimal Capital


Budget

Finance theory says to accept all


positive NPV projects.
Two problems can occur when there
is not enough internally generated
cash to fund all positive NPV
projects:
An increasing marginal cost of capital.
Capital rationing
58

Increasing Marginal Cost of


Capital

Externally raised capital can have large


flotation costs, which increase the cost
of capital.
Investors often perceive large capital
budgets as being risky, which drives up
the cost of capital.
If external funds will be raised, then the
NPV of all projects should be estimated
using this higher marginal cost of capital.
59

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: Julie Miller must determine


what investment opportunities to
undertake for Basket Wonders (BW). She
is limited to a maximum expenditure of
$32,500 only for this capital budgeting
period.

Available Projects for BW


Project

ICO

IRR

NPV

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

Choosing by IRRs for BW


Project

ICO

IRR

NPV

PI

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

Choosing by NPVs for BW


Project

ICO

IRR

NPV

F
$15,000 28%
$21,000
G 17,500
19
7,500 1.43 B
5,000
25
6,500 2.30

Projects F and G have the


largest NPVs.

PI
2.40

two

The resulting increase in shareholder wealth


is $28,500 with a $32,500 outlay.