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Capital Budgeting
IM-605 Financial Management - II
Key Points for MBA (MS) 5 Years VI Sem. Session: Jan. 2012 Apr. 2012

Outline
Meaning of Capital Budgeting Significance of Capital Budgeting Analysis Traditional Capital Budgeting Techniques
Payback and Post Payback Period Approach Discounted Payback and Post 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

Capital Rationing

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.

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.

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What is capital budgeting?

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

Steps in Capital Budgeting

Estimate cash flows (inflows & outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows.

What is the difference between independent and 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.

Techniques of Capital Budgeting Analysis

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

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?

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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 0
-40 K

Payback Period (PBP)

1
10 K

2
12 K

3
15 K

4
10 K

5
7K

PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.

Payback Solution (#1)

0 1 2
12 K 22 K

Payback Solution (#2)

5
(d) K 7 54 K

3
15 K 37 K

(a)

0
-40 K -40 K

1
10 K -30 K

2
12 K -18 K

3
15 K -3 K

4
10 K 7K

5
7K 14 K

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

10 K (c) 47 K

PBP

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

PBP
Cumulative Cash Flows

= 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: Strengths:
Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows

Weaknesses: Weaknesses:
Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective

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Net Present Value Approach

Based on the amount of cash flows The 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.
NPV = CF1 CF2 + (1+k)1 (1+k)2
+...+

CFn (1+k)n

- ICO

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

Two Reasons NPV Profiles Cross

1. Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects. 2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPVS > NPVL.

Reinvestment Rate Assumptions

NPV assumes reinvest at r (opportunity cost of capital). IRR assumes reinvest at IRR. Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?
Yes, MIRR is the discount rate which 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. [ See last slides for details)

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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

IRR Strengths and Weaknesses

Strengths: Strengths:
Accounts for TVM Considers all cash flows Less subjectivity

Weaknesses: Weaknesses:
Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs

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

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

If cash flows alternate in signproblem of multiple IRR

If IRR and NPV conflict, use NPV approach

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:

PI Acceptance Criterion
PI = $38,572 / $40,000 = .9643 (Method #1, 13-34)

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 ]

CF1 CF2 PI = + (1+k)1 (1+k)2

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

ICO

<< OR >>
Method #2:

PI = 1 + [ NPV / ICO ]

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PI Strengths and Weaknesses

Strengths: Strengths:
Same as NPV Allows comparison of different scale projects

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.

Weaknesses: Weaknesses:
Same as NPV Provides only relative profitability Potential Ranking Problems

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 amount of initial investment

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
A 1.10 2.30 2.10 1.67 1.04 2.40 1.43 1.24

Choosing by IRRs for BW

PI Project
C 2.10 2.40 1.04 2.30

ICO

IRR

NPV
$

ICO

IRR

NPV

PI

$ 500 18% B 5,000 25 C 5,000 37 D 7,500 20 E 12,500 26 F 15,000 28 G 17,500 19 H 25,000 15

50 6,500 5,500 5,000 500 21,000 7,500 6,000

$ 5,000 37% F 15,000 28 E 12,500 26 B 5,000 25

$ 5,500 21,000 500 6,500

Projects C, F, and E have the three largest IRRs. The resulting increase in shareholder wealth is $27,000 with a $32,500 outlay.

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Choosing by NPVs for BW

Project
F 2.40 1.43 2.30

Choosing by PIs for BW

PI Project
F B

ICO

IRR

NPV

ICO

IRR

NPV

PI

$15,000 28% G 17,500 19 B 5,000 25

$21,000 7,500 6,500

Projects F and G have the two largest NPVs.

The resulting increase in shareholder wealth is $28,500 with a $32,500 outlay.

$15,000 28% $21,000 2.40 5,000 25 6,500 2.30 C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 G 17,500 19 7,500 1.43 Projects F, B, C, and D have the four largest PIs. The resulting increase in shareholder wealth is $38,000 with a $32,500 outlay.

Summary of Comparison
Method Projects Accepted PI F, B, C, and D NPV F and G IRR C, F, and E Value Added $38,000 $28,500 $27,000

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.

PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period.

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. Nuclear power plant, strip mine. Inflow (+) or Outflow (-) in Year
0 + 1 + + + + 2 + + + + 3 + + + 4 + + + + 5 + + N N NN N N NN NN

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Pavilion Project: NPV and IRR?

0 -800
r = 10%

Logic of Multiple IRRs

1. At very low discount rates, the PV of CF2 is large & negative, so NPV < 0. 2. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0. 3. In between, the discount rate hits CF2 harder than CF1, so NPV > 0. 4. Result: 2 IRRs.

1 5,000

2 -5,000

Enter CFs in CFLO, enter I = 10. NPV = -386.78 IRR = ERROR. Why?

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:

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.
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An increasing marginal cost of capital. Capital rationing

Capital Rationing
If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital. Capital rationing occurs when a company chooses not to fund all positive NPV projects. The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
(More...)

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Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.
(More...)

Reason: Companies dont have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
(More...)

Reason: Companies believe that the projects managers forecast unreasonably high cash flow estimates, so companies filter out the worst projects by limiting the total amount of projects that can be accepted. Solution: Implement a post-audit process and tie the managers compensation to the subsequent performance of the project.