Capital Budgeting

Course : Financial Management

Class : Magister Manajemen WM 71

Session : 4 & 5

Topics Covered

Introduction Steps in the Capital Budgeting Process Categories of Capital Budgeting Projects Basic Principles of Capital Budgeting Payback Period (PBP) Net Present Value (NPV) Discounted PBP Internal Rate of Return (IRR) Profitability Index (PI) Modified Internal Rate of Return (MIRR) Capital Rationing Equivalent Annual Annuity

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Capital Budgeting: Introduction

The capital budgeting process is the process of identifying and evaluating capital project, that is, projects where the cash flow to the firm will be received over a period longer than a year.

Any corporate decisions with an impact on future earnings can be examined using this framework:

Decisions about whether to buy a new machine, expand business in another geographic area, move the corporate headquarters to other place, or replace a delivery truck, to name a few, can be examined using a capital budgeting analysis.

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The Importance of Capital Budgeting

For a number of good reasons, capital budgeting may be the most important responsibility that a financial manager has.

First, since a capital budgeting decision often involves the purchase of costly long-term assets with lives of many years, the decisions made may determine the future success of the firm.

Second, the principles underlying the capital budgeting process also apply to other corporate decisions, such as working capital management and making strategic mergers and acquisitions.

Finally, making good capital budgeting decisions is consistent with managements primary goal of maximizing shareholder value.

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Steps in the Capital Budgeting Process

The capital budgeting process has four administrative steps:

Step 1: Idea generation.

Step 2: Analyzing project proposals.

Step 3: Create the firm-wide capital budget.

Step 4: Monitoring decisions and conducting a post-audit.

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Categories of Capital Budgeting Projects

Capital budgeting projects may be divided into the following categories:

Replacement projects to maintain the business

Replacement projects for cost reduction

Expansion projects

New product or market development

Mandatory projects

Other projects

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Basic Principles of Capital Budgeting

Decisions are based on cash flows, not accounting income.

Cash flows are based on opportunity costs.

The timing of cash flows is important.

Cash flows are analyzed on an after-tax basis.

Financing costs are reflected in the projects required rate of return.

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Methods to Evaluate Capital Project

Payback Period (PBP)

Net Present Value (NPV)

Discounted PBP

Internal Rate of Return (IRR)

Profitability Index (PI)

Modified Internal Rate of Return (MIRR)

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Payback Period (PBP)

Payback period is the number of years before cumulative cash flow equals initial outlay

Only accept projects that pay back within desired time frame

Ignores later year cash flows and present value of future cash flows

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Payback Period (PBP) Example

Calculate the PBP for these projects!

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Payback Period (PBP) Example ...(continued)

Answer:

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Issues with PBP

Does not look beyond payback period.

Example:

Although project C is clearly superior, pick Project A Shorter PBP

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Issues with PBP ...(continued)

PBP does not account for Time Value of Money.

Example:

Accept Project D, but you earn nothing!

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Net Present Value (NPV)

The NPV is the sum of the present values of all the expected incremental cash flows if a project is undertaken.

The discount rate use is the firms cost of capital, adjusted for the risk level of the project.

For a normal project, with an initial cash outflow followed by a series of expected after-tax cash inflows, the NPV is the present value of the expected inflows minus the initial cost of the project.

Decision rule: accept projects with a positive NPV

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Net Present Value (NPV) Example

Example

Calculate the NPV for these projects with 10% discount rate!

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Net Present Value (NPV) Example ...(continued)

Answer

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Net Present Value (NPV) Example ...(continued)

Answer ...(continued)

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Discounted PBP

Discounted payback period is the number of years before cumulative discounted cash flow equals initial outlay.

It is the number of years it takes to a project to recover its initial investment in present value terms and, therefore, must be greater than the payback period without discounting.

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Discounted PBP Example

Example

Using 10% discount rate, calculate the discounted PBP for these projects!

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Discounted PBP Example ...(continued)

Answer

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Internal Rate of Return

For a normal project, the internal rate of return (IRR) is the discount rate that makes the present value of the expected incremental after-tax cash inflows just equal to the initial cost of the project.

More generally, the IRR is the discount rate that makes the present values of a projects estimated cash inflows equal to the present value of the projects estimated cash outflows. That is, IRR is the discount rate that makes the following relationship hold:

PV (inflows) = PV (outflows)

Decision rule: If IRR > the required rate of return, accept the project.

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Internal Rate of Return Example

Example

Calculate the IRR for these projects!

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Internal Rate of Return Example ...(continued)

Answer

Using financial calculator

IRR for Project A:

CF 2nd CLR WRK

400 +/- Enter

300 Enter

200 Enter

100 Enter

IRR CPT = 28.86%

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Internal Rate of Return Example ...(continued)

Answer ...(continued)

Using financial calculator

IRR for Project B:

CF 2nd CLR WRK

400 +/- Enter

100 Enter

200 Enter

300 Enter

IRR CPT = 19.44%

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Profitability Index

The profitability index (PI) is the present value of a projects future cash flows divided by the initial cash outlay

PI = PV / CF0 = 1 + (NPV/CF0)

Decision rule: If PI > 1, accept the project.

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Profitability Index Example

Example

Using 10% discount rate, calculate PI for these projects!

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Profitability Index Example ...(continued)

Answer

Using the discounted cash flows from previous calculation:

PIA = (273 + 165 + 75) / 400 = 1.28

PIB = (91 + 165 + 225) / 400 = 1.20

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Issues with IRR

Lending or Borrowing? Different NPV but the same IRR

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Issues with IRR ...(continued)

Multiple IRRs: Project can have multiple IRRs

Multiple IRRs: Project can have 0 IRR and positive NPV

Implies all funds reinvested at IRR

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Terminal Rate of Return or Modified Internal rate of Return

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Terminal Rate of Return or Modified Internal rate of Return ...(continued)

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Capital Rationing

If a firm has unlimited access to capital, the firm can undertake all projects with expected returns that exceed the cost of capital.

Many firms have constraints on the amount of capital they can raise and must use capital rationing.

If a firms profitable project opportunities exceed the amount of funds available, the firm must ration, or prioritize, its capital expenditure with the goal of achieving the maximum increase in value for shareholders given its available capital.

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Capital Rationing Example

Select the best projects if a company has $300,000 available funds.

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Capital Rationing Example ...(continued)

Answer

Select projects with the highest weighted average profitabilit index (WAPI)

WAPI (BD) = [1.13 x (125/300)] + [1.08 x (150/300)] + [0 x (25/300)]

= 1.01

WAPI (A) = 0.77

WAPI (BC) = 1.12

Choose projects B and C

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Equivalent Annual Annuity (EAA) Approach

The EAA approach is a simple approach to evaluating mutually exclusive projects with different lives.

The EAA approach finds the sequence of annual payments that is equal to the projects NPV.

The resulting calculation is an annual payment that allows for an apples to apples comparison of projects with different lives.

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Equivalent Annual Annuity (EAA) Approach Example

Suppose a firm is forced to choose between two machines, A and B. The two machines are designed differently but have identical capacity and do exactly the same job. Machine A costs $15,000 and will last three years. It costs $4,000 per year to run. Machine B is an economy model, costing only $10,000, but it will last only two years and costs $6,000 per year to run. Which machine to choose? The present value of each machines cost is as follows:

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Equivalent Annual Annuity (EAA) Approach Example ...(continued)

PVAMachineA = ANN x PVIFA6%,3yrs

$28.37 = ANN x 2.673 ANN = $10.61

PVAMachineB = ANN x PVIFA6%,2yrs

$21.00 = ANN x 1.8334 ANN = $11.45

So, we choose Machine A because it has lower equivalent annual cost.

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Conflicted Project Rankings Example

Consider two projects with an initial investment of $1,000 and a required rate of return of 10%. Project X will generate cash inflows of $500 at the end of each of the next five years. Project Y will generate a single cash flow of $4,000 at the end of the fifth year. Project X has higher IRR, but Project Y has higher NPV. Which project should you choose?

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Conflicted Project Rankings Example ...(continued)

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Conflicted Project Rankings Example ...(continued)

Answer:

Project Y is expected to increase the value of the firm by $1,484. So Project y is the better project. Because NPV measures the expected increase in wealth from undertaking a project, NPV is the only acceptable criterion when ranking projects.

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Working Capital Calculation Example (Problem Sets 6.5 p.150)

The following table tracks the main components of working capital over the life of a four-year project.

Calculate net working capital and the cash inflows and outflows due to investment in working capital.

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Working Capital Calculation Example (Problem Sets 6.5 p.150) ...[continued]

Answer:

Working capital = inventory + accounts receivable accounts payable.

Cash flows = change in working capital

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Equivalent Annual Cash Flows Example (Problem Sets 6.8 p.151)

Machine A and B are mutually exclusive and are expected to produce the following real cash flows:

The real opportunity cost of capital is 10%.

a. Calculate the NPV of each machine.

b. Calculate the equivalent annual cash flow from each machine

c. Which machine should you buy?

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Equivalent Annual Cash Flows Example (Problem Sets 6.8 p.151) ...[continued]

Answer:

a. NPVA = $100,000; NPVB = $180,000.

b. Given the NPV for each project, we need to find the annuity factors. Project A has a two-year annuity factor of 1.736. Project B has a three-year annuity factor of 2.487. Therefore:

Equivalent annual cash flow of A = 100,000/1.736 = $57,604

Equivalent annual cash flow of B = 180,000/2.487 = $72,376

c. We should buy Machine B because it has higher equivalent annual cash flow

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End of Session! Thank you

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