Capital Budgeting Decisions

NATURE OF INVEST DECISIONS

Invest decisions also known as Capital Budgeting decisions
It may be defined as firms decision to invest its current funds most efficiently in the longterm assets in anticipation of an expected flow of benefits over a series of years.

 FEATURES
Exchange of current funds for future benefits Funds are invested in long-term assets The future benefits will occur to the firm over a series of years

In invest analysis it is CF which is imp not the accounting profit. IMPORTANCE OF INVEST DECISIONS
They influence the firms growth in long term They affect the risk of the firm They involve commitment of large amt of funds They are irreversible They are among the most difficult decisions to make

TYPES OF INVEST DECISIONS

One way of classifying
Expansion & diversification Replacement & modernisation

Another way of classifying

Mutually exclusive investments Independent investments Contingent investments

INVEST EVALUATION CRITERIA

Steps
Estimation of CFs Estimation of required rate of return Application of decision rule for making the choice

CAPITAL BUDGETING METHODS IN PRACTICE

In a survey of 14 cos it found out that all except one use payback method. With payback 2/3rd use IRR and 2/5th NPV. IRR was second most popular method. DCF methods were secondary because of difficulty in understanding and using the techniques, lack of qualified professionals and unwillingness of top mgmt to use DCF

NET PRESENT VALUE METHOD

It is a DCF technique Accept-Reject Rule
Accept the project if NPV > 0 Reject the project if NPV < 0 May accept the project if NPV = 0 If projects are mutually exclusive then one with higher NPV shd be selected.

 Advantages
Time value Measure of true profitability ( considers all CFs) Value additivity [ NPV(A+B) = NPV (A) = NPV (B) ] Shholder value (consistent with SWM)

Limitations
CF estimation (uncertainty) Discount rate Mutually exclusive projects with unequal lives or under funds constraint Ranking of projects not independent of dis rate

INTERNAL RATE OF RETURN METHOD

IRR is the rate that equates invest outlay with the present value of cash inflow received after one period. IRR is the discount rate which makes the NPV zero. Accept-Reject Rule (IRR=r & Opportunity cost of capital = k)
Accept the project when r > k Reject the project when r < k May accept the project when r = k

 Advantages
Time value Profitability measure (all CFs considered) Acceptance rule (same as NPV) Shholders value (consistent with SWM Obj)

Demerits
Multiple rates Mutually exclusive projects Value additivity (IRR cannot be added)

PROFITABILITY INDEX METHOD

PI also known as BCR, is the ratio of the present value of cash inflows to the initial cash outflow. Accept-Reject Rule
Accept project when PI > 1 Reject project when PI < 1 May accept the project when PI = 1

 Advantages
Time value Value maximisation (consistent with SWM obj) Relative profitability (ratio i.e. relative measure)

Demerits
Cash flow estimation Discount rate

PAYBACK METHOD
It is the no of years req to recover the original cash outlay invested in a project. Accept-Reject Rule
Project would be accepted if the projects payback is less than the standard payback decided by the mgmt. It gives highest ranking to the project which has the shortest payback.

 Merits
Simplicity Cost effective Risk shield (risk can be tackled by having a shorter std payback period) Liquidity (emphasis is on recovery)

Limitations
Cash flow after payback ignored Cash flow patterns (magnitude & timings of CFs ignored) Administrative difficulty (deciding std payback) Inconsistent with shholders value maximisation

 Payback reciprocal and the rate of return

Payback reciprocal is a good approximation of the rate of return when
The life of the project is large or at least twice the payback period The project generates equal annual cash inflows

DISCOUNTED PAYBACK PERIOD METHOD

It is the no of periods taken in recovering the invest outlay on the present value basis. But it still fails to consider the cash flows occurring after the payback period.

ACCOUNTING RATE OF RETURN METHOD

It is also known as return on Investment. It is the ratio of the average after tax profit divided by the average investment. Accept-Reject Rule
Accept those projects whose ARR is greater than min rate decided by the mgmt and vice versa. Highest ARR project would be ranked no1.

 Merits
Simplicity Accounting data Entire stream of profits

Demerits
CFs ignored Time value ignored Arbitrary cut-off

NPV V/S IRR

EQUIVALENCE OF NPV & IRR
In case of Conventional Independent Projects, NPV and IRR will result in same accept or reject decision if the firm is not constrained for funds.

NON CONVENTIONAL INVEST: PROBLEM OF MULTIPLE IRRs

The no of rates of return depends on the no of times the sign of the CF stream changes. No of adaptations of the IRR criterion are there to take care of multiple IRR problem but not very satisfactory. Hence best alternative is NPV method.

 MUTUALLY EXCLUSIVE PROJECTS: NPV AND IRR WILL GIVE CONFLICTING RANKINGS BECAUSE
CF pattern of project may differ Initial invest of projects may differ Projects may have diff expected lives

 CF pattern of projects may differ:

Fishers intersection rate Compare NPV of mutually exclusive projects and choose one with larger NPV Incremental Approach
Series of incremental CFs may result in ve and +ve CFs and it would result in problem multiple rate of return and we would revert back to NPV method

Initial Investment of Projects

NPV method shd be used

 Projects life span

NPV rule can be used to choose since it is always consistent with SWM.

REINVEST ASSUMPTION AND MODIFIED IRR

NPV & IRR are assumed to rest on an underlying implicit assumption about reinvest of the CFs generated during the lifetime of the project. The source of conflict lies in their diff implicit reinvest rates. The MIRR is the compound average annual rate that is calculated with a reinvest rate diff than the projects IRR.

 All do not accept the implicit reinvest assumption vis--vis the IRR. They do not consider it valid.
The IRR is a time-adjusted percentage of the principal amt outst and it is independent of how CFs are received and utilised.

The reason for the ranking conflict bet the IRR and NPV rules lies in the diff timing of the projects CFs rather than in the wrongly conceived reinvestment assumption.

VARYING OPPORTUNITY COST OF CAPITAL

If the opportunity cost of capital varies over time, the use of the IRR rule creates problems, as there is not a unique benchmark opportunity cost of capital to compare with IRR.
To get a comparable opportunity cost one will have to compute weighted average of these opportunity costs. This is tedious

There is no problem in using NPV method each CF can be discounted by the relevant opportunity cost of capital.

NPV V/s PI
NPV method shd be preferred except under capital rationing because the net present value represents the net increase in the firms wealth.