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  • 1.The Basics of Capital Budgeting

2. What is capital budgeting?

  • Analysis of potential additions to fixed assets.
  • Long-term decisions; involve large expenditures.
  • Very important to firms future.

3. Examples:

  • Expansion
  • Replacement
  • Buy or lease
  • Choice of equipment
  • Capital expenditure

4. Problems:

  • Demand for capital-how much money needed for expenditure
  • Supply of capital internal and external
  • Capital rationing selection of the projects

5. Types of capital

  • Debt
  • Preference share
  • Equity capital
  • Retained earnings
  • WACC: weighted average cost of capital

6. methods

  • Pay back method
  • Accounting rate of return
  • Internal rate of return
  • Net present value

7. Steps to capital budgeting

  • 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.

8. 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.

9. What is the difference between normal and nonnormal 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.

10. 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.

11. Calculating payback Payback L =2+/=2.375 years CF t -1001060100 Cumulative-100-90050 0 1 2 3 = 2.4 30 80 80 -30 Project L Payback S =1+/=1.6 years CF t -1007010020 Cumulative-10002040 0 1 2 3 = 1.6 30 50 50 -30 Project S 12. Strengths and 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.

13. Discounted payback period

  • Uses discounted cash flows rather than raw CFs.

Disc Payback L=2+/=2.7 years CF t -100106080 Cumulative-100-90.9118.79 0 1 2 3 = 2.7 60.11 -41.32 PV of CF t -1009.0949.59 41.32 60.11 10% 14. Accounting rate of return

  • = estimated net profits/ capital employed . 100
  • Average investment =( initial investment + scrap value) / 2
  • Limitation : does not look at time value of money

15. Net Present Value (NPV)

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

16. What is Project Ls NPV?

  • Year CF t PV of CF t
  • 0 -100-$100
  • 1 10 9.09
  • 2 60 49.59
  • 3 80 60.11
  • NPV L=$18.79
  • NPV S= $19.98

17. 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 (NPV s> NPV L ), and would accept both if independent.

18. Internal Rate of Return (IRR)

  • IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:
  • Normally NPV METHOD and IRR method gives the same result

19. How is a projects IRR similar to a bonds YTM?

  • They are the same thing.
  • Think of a bond as a project.The YTM on the bond would be the IRR of the bond project.
  • EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20.
    • Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

20. 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.

21. 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 IRR s> IRR L .

22. NPV Profiles

  • A graphical representation of project NPVs at various different costs of capital.
  • kNPV L NPV S
  • 0 $50 $40
  • 53329
  • 101920
  • 15 712
  • 20(4) 5

23. 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.

24. Comparisons : proposals Initialinv Annual cash flow Life in years 1 60,000 12000 15 2 88,000 22,500 22 3 2150 1,500 3 4 20,500 4500 10 5 4,25,000 2,25000 20 25. Pay back method Pay back period= Initial investment/annual cash flow 1 60,000/12,000 5 2 88,00/22500 3.9 3 21,50/1500 1.4 4 2,5000/4500 4.6 5 4,25000/2,25000 1.9 26. Accounting rateproposal Initial investment Annual cash flow Life in years Annual depreciation Net profits Rate of return 1 60,000 12000 15 4000 8000 26.67 2 88,000 22,500 22 4000 18,500 42 3 2150 1500 3 717 783 72.84 4 20,500 4500 10 2050 2450 23.9 5 4,25000 2,25000 20 21,250 203750 95.88 27. NPV proposal Initial inv Annual cash low life Pv(10%) Pv npvi 1 60,000 12,000 15 7.7688 93225.6 1.55 2 88,000 22,500 22 8.8919 200,067.75 2.27 3 2150 1500 3 2.5918 3887.7 1.81 4 20,500 4500 10 6.3213 28445.8 1.39 5 425,000 2,25000 20 8.6466 1945485 4.56 28. DCF

  • Discounted cash flows or internal rate of return may sometimes give different results

29.

  • All methods do not give the same interpretation

methods payback accounting DCF NPV Proposal rank ranks ranks ranks 1 5 4 4 4 2 3 3 3 2 3 1 2 2 3 4 4 5 5 5 5 2 1 1 1