Capital Budgeting AnalysisCA. Sonali Jagath Prasad

OutlineMeaning of Capital BudgetingSignificance of Capital Budgeting AnalysisTraditional Capital Budgeting TechniquesPayback Period ApproachDiscounted Payback Period ApproachDiscounted Cash Flow TechniquesNet Present ValueInternal Rate of ReturnProfitability IndexNet Present Value versus Internal Rate of Return

Meaning of Capital BudgetingCapital 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 BudgetingIs to a company what buying stocks or bonds is to individuals:An investment decision where each want a return > costCFs are key for each*

Cap. Budgeting & CFsCOMPANYCFs generated by a project & returned to company . costs INDIVIDUALCFs generated by stocks or bonds & returned to individual > costs*

Significance of Capital BudgetingConsidered 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 resourcesAre not easily reversibleHave long-term implications for the firmInvolve 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 exampleSimilarly, 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 AnalysisPayback Period ApproachDiscounted Payback Period ApproachNet Present Value ApproachInternal Rate of Return and MIRRProfitability Index

*What is capital budgeting?Analysis of potential projects.Long-term decisions; involve large expenditures.Very important to firms future.

*Steps in Capital BudgetingEstimate 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

*Capital Budgeting Project CategoriesReplacement to continue profitable operationsReplacement to reduce costsExpansion of existing products or marketsExpansion into new products/marketsContraction decisionsSafety and/or environmental projectsMergersOther

*Independent versus Mutually Exclusive ProjectsProjects 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.

*Normal vs. Nonnormal Cash FlowsNormal 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.

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 flowsConsiders all the cash flowsConsiders time value of moneyIs unbiased in selecting projects

Payback Period ApproachThe amount of time needed to recover the initial investmentThe number of years it takes including a fraction of the year to recover initial investment is called payback periodTo compute payback period, keep adding the cash flows till the sum equals initial investmentSimplicity is the main benefit, but suffers from drawbacksTechnique is not consistent with wealth maximizationWhy?

Proposed Project DataJulie 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 $40,000.

Independent ProjectIndependent A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.

Payback Period (PBP)PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.0 1 2 3 4 5 40 K 10 K 12 K 15 K 10 K 7 K

(c)10 K 22 K 37 K 47 K 54 KPayback Solution (#1)PBP = a + ( b c ) / d= 3 + (40 37) / 10= 3 + (3) / 10= 3.3 Years0 1 2 3 4 5 40 K 10 K 12 K 15 K 10 K 7 KCumulativeInflows(a)(-b)(d)

Payback Solution (#2)PBP = 3 + ( 3K ) / 10K= 3.3 YearsNote: Take absolute value of last negative cumulative cash flow value.CumulativeCash Flows 40 K 10 K 12 K 15 K 10 K 7 K0 1 2 3 4 540 K 30 K 18 K 3 K 7 K 14 K

PBP Acceptance CriterionYes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.]The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type.Should this project be accepted?

PBP Strengths and WeaknessesStrengths: Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flowsWeaknesses: Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective

Discounted Payback PeriodSimilar to payback period approach with one difference that it considers time value of moneyThe amount of time needed to recover initial investment given the present value of cash inflowsKeep adding the discounted cash flows till the sum equals initial investmentAll other drawbacks of the payback period remains in this approachNot consistent with wealth maximization

*Discounted Payback: Uses Discounted CFs

Net Present Value ApproachBased on the dollar amount of cash flowsThe dollar amount of value added by a projectNPV equals the present value of cash inflows minus initial investmentTechnique 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 CF2 CFn (1+k)1 (1+k)2 (1+k)n+ . . . ++- ICONPV =

*Rationale for the NPV MethodNPV = 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

Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%.$10,000 $7,000 NPV Solution$10,000 $12,000 $15,000 (1.13)1 (1.13)2 (1.13)3 +++- $40,000(1.13)4 (1.13)5NPV =+

NPV SolutionNPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $ 7,000(PVIF13%,5) $40,000NPV = $10,000(0.885) + $12,000(0.783) + $15,000(0.693) + $10,000(0.613) + $ 7,000(0.543) $40,000NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 $40,000 =- $1,428

NPV Acceptance Criterion No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ]The management of Basket Wonders has determined that the required rate is 13% for projects of this type.Should this project be accepted?

*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.

NPV Strengths and Weaknesses Strengths: Cash flows assumed to be reinvested at the hurdle rate. Accounts for TVM. Considers all cash flows.Weaknesses: May not include managerial options embedded in the project. See Chapter 14.

Internal Rate of ReturnThe 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 investmentProjects promised rate of return given initial investment and cash flowsConsistent with wealth maximizationAccept 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 CFn (1 + IRR)1 (1 + IRR)2 (1 + IRR)n+ . . . ++ICO =

$15,000 $10,000 $7,000 IRR Solution$10,000 $12,000(1+IRR)1 (1+IRR)2Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000.++++$40,000 =(1+IRR)3 (1+IRR)4 (1+IRR)5

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 =$41,444[Rate is too low!!]

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!!]

0.10$41,4440.05IRR$40,000 $4,6030.15$36,841

X$1,4440.05$4,603IRR Solution (Interpolate)$1,444X=

0.10$41,4440.05IRR$40,000 $4,6030.15$36,841

X$1,4440.05$4,603IRR Solution (Interpolate)$1,444X=

0.10$41,4440.05IRR$40,000 $4,6030.15$36,841

($1,444)(0.05) $4,603IRR Solution (Interpolate)$1,444XX =X = 0.0157IRR = 0.10 + 0.0157 = 0.1157 or 11.57%

IRR Acceptance Criterion No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR < Hurdle Rate ] The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted?

*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.

*MIRR for Franchise L: First, Find PV and TV (r = 10%)

*Second, Find Discount Rate that Equates PV and TV

*To find TV with 12B: Step 1, Find PV of InflowsFirst, 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

*Step 2, Find TV of InflowsEnter PV = -118.78, N = 3, I/YR = 10, PMT = 0.

Press FV = 158.10 = FV of inflows.

*Step 3, Find PV of OutflowsFor 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.

*Step 4, Find IRR of TV of Inflows and PV of OutflowsEnter FV = 158.10, PV = -100, PMT = 0, N = 3.

Press I/YR = 16.50% = MIRR.

*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.

NPV versus IRRUsually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the projectIRR can be in conflict with NPV if Investing or Financing DecisionsProjects are mutually exclusiveProjects differ in scale of investmentCash flow patterns of projects is differentIf cash flows alternate in signproblem of multiple IRRIf IRR and NPV conflict, use NPV approach

Profitability Index (PI)A part of discounted cash flow familyPI = PV of Cash Inflows/initial investmentAccept a project if PI 1.0, which means positive NPVUsually, PI consistent with NPVPI may be in conflict with NPV if Projects are mutually exclusiveScale of projects differPattern of cash flows of projects is differentWhen 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.CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n+ . . . ++ICOPI =PI = 1 + [ NPV / ICO ]>Method #2:Method #1:

PI Acceptance Criterion No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI < 1.00 ]PI = $38,572 / $40,000= .9643 (Method #1, previous slide)

Should this project be accepted?

PI Strengths and Weaknesses Strengths: Same as NPV Allows comparison of different scale projectsWeaknesses: Same as NPV Provides only relative profitability Potential Ranking Problems

Evaluating Projects with Unequal LivesReplacement Chain AnalysisEquivalent Annual Cost MethodIf 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 isIRR is a measure of safety margin in a project. Higher IRR means more safety margin in the projects estimated cash flowsPI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment

*Choosing the Optimal Capital BudgetFinance 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

*Increasing Marginal Cost of CapitalExternally 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.

Capital RationingCapital 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 PIA $ 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 E12,500 26 500 1.04 F15,000 28 21,000 2.40 G17,500 19 7,500 1.43 H25,000 15 6,000 1.24

Choosing by IRRs for BW Project ICO IRR NPV PIC $ 5,00037% $ 5,500 2.10 F15,000 28 21,000 2.40 E12,50026 500 1.04 B 5,00025 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 PI F $15,000 28% $21,000 2.40 G17,50019 7,500 1.43 B 5,00025 6,500 2.30Projects F and G have the two largest NPVs.The resulting increase in shareholder wealth is $28,500 with a $32,500 outlay.

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