Capital Budget

Definition:
The amount of money set aside for the purchase of fixed assets (e.g.,
equipment, buildings, etc.). Also, a request for authorization to purchase new fixed
assets.

The capital budget is a statement of the planned capital expenditures. It is more than a
simple listing, however, and is not a "budget" in the usual sense. Given the nature of
capital expenditures, the capital budget is best thought of as an expression of the goals
and strategy of the firm. Creation of the capital budget is a central task that affects, and is
affected by, all others areas of decision making. The "capital budgeting process" can be
envisioned as shown in Figure 1. Present and anticipated business conditions are the
opportunities and constraints from which the goals of the firm are developed. The goals
drive the strategic decisions of capital budget and financing, but feasibility and
consistency with the interdependent financing and capital budget decisions must be
considered in setting the goals. Operating decisions may be thought of as the tactical
choices driven by strategy, but again feasibility and consistency of operating decisions
must be considered in setting strategy. The process is in actuality part simultaneous, part
iterative. Given the interdependency of goals, strategy, and tactics in a changing
environment, the capital budget is properly considered as an active planning document,
rather than a fixed conclusion.

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From a narrow economic viewpoint creating the capital budget is relatively simple: a
project should be accepted if the return is greater than the cost. Projects are listed in order
of decreasing return, and investment should continue until the marginal return (roughly,
the return to the next dollar spent) is greater than marginal cost (roughly, the required rate
of return on the next dollar spent). This simple, elegant statement of the problem masks a
number of complications. Projects of different risk will likely have different required
returns, will be of different sizes and have different lives, and may be mutually exclusive
or interdependent.

Mutually Exclusive Proposals

Consideration of two or more assets that perform the same function. If one is chosen for
purchase, the others are automatically rejected.

REQUIRED RATE OF RETURN

The marginal cost of the project is expressed as a required rate of return

(sometimes called the "hurdle rate"). Estimation of the required rate is
integral to evaluating projects and setting the capital budget. The controlling
concept is that of opportunity cost. Opportunity cost reflects the idea that the
relevant cost of using a resource is the rate of return on forgone alternative
opportunities of similar risk. For projects that are extensions of or similar to
the normal operations of the firm, and so have a similar risk profile, a readily
available comparable use of funds is reinvesting in the firm itself. For these
projects, the opportunity cost/required rate of return/hurdle rate can be
approximated by the firm's weighted average cost of capital (WACC). The
WACC is the rate of return that just meets investor expectations, leaving the
value of the shares of the firm unchanged. WACC is computed by first
estimating the rate of return required to meet the obligations for each source
of capital. These required rates are then weighted according to the target
capital structure of the firm to obtain the overall rate of return required to
meet the combined obligationsthe WACC. This is the return that could be
obtained by reinvesting the funds within the firm (downsizing).

Where the project is outside the normal operations of the firm or has a
different risk profile, the WACC is not be a good estimate of the required
rate of return on the project. The required rate of return may be estimated by
using the WACC for firms similar in nature to the project, or by applying
capital asset pricing model at the estimated systematic risk of the project.
These comparison-based estimates are satisfactory for projects of
standardized technology that does not require that the firm develop new
expertise. Where the project is nonstandard or innovative, or requires
developing new expertise, such comparison may underestimate the risk. In
such cases the required return on the new project must be arrived at by ad
hoc adjustment. Decision tree, Monte Carlo, or other risk analysis tools are
helpful.

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The Major Capital Budgeting Techniques

A variety of measures have evolved over time to analyze capital budgeting requests. The
better methods use time value of money concepts. Older methods, like the payback
period, have the deficiency of not using time value techniques and will eventually fall by
the wayside and be replaced in companies by the newer, superior methods of evaluation.

Very Important

A capital budgeting analysis conducts a test to see if the benefits (i.e., cash inflows) are
large enough to repay the company for three things: (1) the cost of the asset, (2) the cost
of financing the asset (e.g., interest, etc.), and (3) a rate of return (called a risk premium)
that compensates the company for potential errors made when estimating cash flows that
will occur in the distant future.

Let's take a look at the most popular techniques for analyzing a capital budgeting
proposal.

1. Payback Period (PBP)

Alright, let's get this out of the way up front: the Payback Period isn't a
very good method. After all, it doesn't use the time value of money principle, making it
the weakest of the methods that we will discuss here. However, it is still used by a large
number of companies, so we'll include it in our list of popular methods.

The payback period method is decreasing in use every year and doesn't deserve extensive
coverage here.

Formula:
The formula to calculate payback period of a project depends on whether the cash flow
per period from the project is even or uneven. In case they are even, the formula to
calculate payback period is:

Payback Period = Initial Investment / Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for
each period and then use the following formula for payback period:

Payback Period = a + b - c / d

Both of the above situations are applied in the following example.

Example:
Julie 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 project
A project whose acceptance (or rejection) does not prevent the
acceptance of other projects under consideration.

Solution
cash flow in millions

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

PBP Acceptance Criterion

Yes! The firm will receive back the initial cash outlay in less than 3.5 years.
[3.3 Years < 3.5 Year Max.]

Advantages of PBP are:

0 Payback period is very simple to calculate.

1 It can be a measure of risk inherent in a project. Since cash flows that occur
 later in a project's life are considered more uncertain, payback period provides an
indication of how certain the project cash inflows are.

2 For companies facing liquidity problems, it provides a good ranking of

projects that would return money early.

Disadvantages of PBP are:

3 Payback period does not take into account the time value of money which is
a serious drawback since it can lead to wrong decisions. A variation of payback
method that attempts to remove this drawback is called discounted payback
period method.
4 It does not take into account, the cash flows that occur after the payback period.

2.Net Present Value(NPV)

NPV is the present value of an investment projects net cash flows minus
the projects initial cash outflow.

Using a minimum rate of return known as the hurdle rate, the net present value of an
investment is the present value of the cash inflows minus the present value of the cash
outflows. A more common way of expressing this is to say that the net present value
(NPV) is the present value of the benefits (PVB) minus the present value of the costs
(PVC)

Formula:

NPV = PVB - PVC or

NPC=ICO - NPC

If the NPV is: Benefits vs. Costs Should we expect to Accept the
earn at least investment?
our minimum rate
of return?
Positive Benefits > Costs Yes, more than Accept
Zero Benefits =Costs Exactly equal to indiffernt
Negative Benefits < Costs No. Less than Reject

Remember that we said above that the purpose of the capital budgeting analysis is to see
if the project's benefits are large enough to repay the company for
 (1) the asset's cost,
(2) the cost of financing the project, and
(3) a rate of return that adequately compensates the company for the risk found in the
cash flow estimates.

Therefore, if the NPV is:

5 positive, the benefits are more than large enough to repay the company for (1)
the asset's cost, (2) the cost of financing the project, and (3) a rate of return that
adequately compensates the company for the risk found in the cash flow
estimates.

6 zero, the benefits are barely enough to cover all three but you are at breakeven -
no profit and no loss, and therefore you would be indifferent about accepting the
project.

7 negative, the benefits are not large enough to cover all three, and therefore the
project should be rejected.

Example:
Basket Wonders has determined that the appropriate discount rate (k) for this
project is 13% .

Solution:

Year Cash Flow PVIF13% NPC

1 $10,000 .885 $8,850
2 $12,000 .783 $9,396
3 $15,000 .693 $10,395
4 $10,000 .613 $6,130
5 $ 7,000 .543 $3,801

$38572

NPV=ICO - NPC
= 40000 - 38572
= $1428
NPV Acceptance Criterion
8 No! The NPV is negative. This means that the project is
reducing shareholder wealth. [Reject as NPV < 0 ]

NPV Strengths:

9 Cash flows assumed to be reinvested at the hurdle rate.

10 Accounts for TVM.

11 Considers all cash flows.

3. Internal Rate of Return (IRR)

Definition
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.

The Internal Rate of Return (IRR) is the rate of return that an investor can expect to earn
on the investment. Technically, it is the discount rate that causes the present value of the
benefits to equal the present value of the costs. According to surveys of businesses, the
IRR method is actually the most commonly used method for evaluating capital budgeting
proposals. This is probably because the IRR is a very easy number to understand because
it can be compared easily to the expected return on other types of investments (savings
accounts, bonds, etc.). If the internal rate of return is greater than the project's minimum
rate of return, we would tend to accept the project.

Example:

Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000.

Solution:

IRR Solution (Try 10%)

12 $40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +$15,000(PVIF10%,3)
+ $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5)
13 $40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) +
$10,000(.683) + $ 7,000(.621)
14 $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347
=$41,444[Rate is too low!!]

IRR Solution (Try 15%)

15 $40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3)
+ $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5)
16 $40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) +
$10,000(.572) + $ 7,000(.497)
 17 $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 =$36,841[Rate
is too high!!]

IRR Solution (Interpolate)

18 .10$41,444
19 .05IRR$40,000 $4,603
20 .15$36,841

21 X$1,444.05$4,603

IRR Solution (Interpolate)

22 .10$41,444
23 .05IRR$40,000 $4,603
24 .15$36,841

25 X$1,444.05$4,603

IRR Solution (Interpolate)

26 .10$41,444
27 .05IRR$40,000 $4,603
28 .15$36,841

29 ($1,444)(0.05) $4,603
IRR Acceptance Criterion
30 No! The firm will receive 11.57% for each dollar invested in this
project at a cost of 13%. [ IRR < Hurdle Rate ]

Advantages of IRR are:

31 The NPV method is a direct measure of the dollar contribution to the

stockholders.
32 The IRR method shows the return on the original money invested.

Disadvantages of IRR are:

33 The NPV method does not measure the project size.

34 The IRR method can, at times, give you conflicting answers when compared
to NPV for mutually exclusive projects.

4. Profitability Index (PI):

Definition:
PI is the ratio of the present value of a projects future net cash flows to the
projects initial cash outflow.
Profitability index (PI), also known as profit investment ratio (PIR) and value investment
ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool
for ranking projects because it allows you to quantify the amount of value created per
unit of investment.

The ratio is calculated as follows:

PI = NPC / ICO

PI Acceptance Criterion
35 No! The PI is less than 1.00. This means that the project is not
profitable. [ Reject as PI < 1.00 ]

Advantages of PI are:

36 Same as NPC

37 Allows comparison of different scale projects