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Class Notes _ Capital Budgeting

CHAPTER I. INTRODUCTION
What companies become in a distant future, be they small or large, is entirely determined by the investments they make
today!

“The generation and evaluation of creative investment proposals are an important task… In well-managed
companies, the process starts at a strategic level, with senior management specifying the business in which the
company will compete and determining the means of competition. Then operating managers translate these
strategic goals into concrete action plans involving specific investment proposals. A key aspect of this process is the
financial evaluation of investment proposals, or what is frequently called capital budgeting. The achievement of an
objective requires the outlay of money today in expectation of increased future benefits. It is necessary to decide
(a) whether the anticipated future benefits are large enough, given the risks involved, to justify the current
expenditure and (b) whether the proposed investment is the most cost-effective way to achieve the objective.”
Robert Higgins

Investment proposals can include disparate topics such as

_ analyzing equipment acquisitions/replacement,


_ choosing among competing production technologies,
_ deciding whether to launch a new product,
_ valuing companies [or divisions] for purchase/sale,
_ valuing the creation of a subsidiary,
_ assessing marketing campaigns,
_ assessing Research & Development programs,
_ etc.

The decisions made regarding the acquisition, maintenance, and abandonment of these assets are very important to most
companies for the following reasons:

1. These assets normally represent relatively large commitments of resources.


2. The funds traditionally remain invested for long periods of time.
3. The need for working capital is generally tied closely to the use of physical assets.
Reminder: Working Capital = Current Assets - Current Liabilities.
4. The future development of the company hinges on the selection of capital investment projects, the decision to
replace existing capital assets, and the decision to abandon previously accepted undertakings that turn out to be
less attractive than originally thought.

Thus, the capital budgeting effort is an integral part of the strategic management process. Also, the capital budget
constitutes a significant part of a company’s business plan.

A. ASSUMPTIONS UNDERLYING THE CAPITAL BUDGETING PROCESS

Assumption 1
The primary function of management is to increase the value of the firm as reflected by the price of the common
stock.

Assumption 2
Owners have a preference for current, as opposed to future, income. Investors must be compensated for
postponing the recovery of their investments (and their returns on investment). Since the benefits of capital
acquisitions are received over a future period, the time element lies at the core of capital budgeting.

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Class Notes _ Capital Budgeting
Assumption 3
Shareholders are risk averse. As such, they demand increasingly greater returns as their perceived risk of the firm
increases.

Assumption 4
In selecting projects for acquisition or abandonment, it is necessary to evaluate the incremental cash flows
attributable directly to the project rather than historical or sunk costs.

Assumption 5
Cash-flow analysis may differ from accounting-income reporting. Indeed, the analysis of long-term asset
management is made on a cash-flow basis, as opposed to the determination of project accounting income. Note
that, by the end of the project’s life, of course, the cash and accounting basis will reconcile, but in any given fiscal
year the return calculated on a cash or accounting basis may diverge quite significantly.

Assumption 6
Since capital acquisition represents long-term commitments, forecasting is essential to the process.

Assumption 7
Every capital project has to be financed and there are no free sources of capital. Most firms strive to maintain a
capital structure (a combination of debt capital and equity capital) that will minimize their financing costs.

Assumption 8
Capital budgeting always involves allocating scarce resources among competing investment opportunities.

Assumption 9
The capital budgeting process is expensive.

B. THE CAPITAL BUDGETING PROCESS

Capital budgeting is a managerial process and one that is at the heart of a company’s future. It is an ongoing process,
starting with the determination of the owner(s) objectives and, based on those objectives, establishing the basic financial
goals of the firm. Of course, non-financial goals and environmental, safety, and other regulations must be taken into
account. The role of the company within the community and its relationship to its employees, customers, and the society as
a whole must also be considered.

Capital budgeting is a part of long-range planning and therefore must be integrated into the company’s business plan.
Development of the business plan requires close examination of the company’s position within the marketplace in terms of
size and penetration of existing and future product lines. This leads to the examination of the physical plant in order to
assess the capability of meeting market objectives and securing the necessary inputs to production. All of this takes place
within the ever-changing economic, political, and tax environment.

The need to collect complete and accurate information throughout the company with respect to needed capital
investments typically requires the development of a capital budgeting manual _ manual that details what information is
required, who will supply it, and when it will be supplied. Moreover, ground rules must be established for assessing the
relative values of competing projects and for deciding which may be delayed or postponed.
The process of data collection and evaluation immediately suggests that projects fall into various classes with respect to
risk. Thus, management must develop rules for classifying projects with respect to their perceived risks in relationship to
the company as a whole. The evaluative and ranking criteria will have to be modified to handle projects that are more or
less risky.

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Class Notes _ Capital Budgeting
C. CATEGORIES OF PROJECTS

Most firms have several investment projects running at the same time. The type of relationship that may exist between
these projects can impact the firm’s cash flows, and, thus, its growth and profitability. Three types of relationship can exist:

1. INDEPENDENT PROJECTS
Two projects are said to be independent if the cash flows generated by one of them does not affect the acceptance
(or rejection) of the other project.

2. MUTUALLY EXCLUSIVE PROJECTS


Two projects are said to be mutually exclusive if the acceptance of one of them is inducing the rejection of the
other. For example, erecting a building vs acquiring a building.

3. CONTINGENT PROJECTS
Two projects are said to be contingent if the acceptance of one of them can only happen if the other one has
already been accepted. For example, the construction of a building can only be done if the piece of land where it
will be erected is bought.

D. INVESTMENT PROJECTS CHARACTERISTICS

All investment projects have two components namely, cash flows and horizon.

D1. CASH FLOWS

PRINCIPLE: Keep in mind that the focus is on cash flows, not profits. More importantly, the focus is on incremental
cash flows, not just cash flows.

The whole point of capital budgeting is to judge whether the firm will be better off or worse off if it undertakes a
given project. Thus, it is imperative to focus on the changes in cash flows affected by the project. For example, a
proposal to invest in an automated machine should trigger questions like:

Will the machine expand capacity (and thus permit the company to exploit demand beyond its current
limits)?
Will the machine reduce costs (at the current level of demand) and thus permit the company to operate
more efficiently than before it had the machine?
Will the machine create other benefits (e.g., higher quality, more operational flexibility)?

The key economic question asked of project proposals should be, “How will things change (i.e., be better or worse)
if the project is undertaken?”

When defining cash flows, the following rules also apply:


 Never account for past or sunk costs,
 If a project is using some of the firm’s already existing resources, they have to be accounted for,
 any increase/decrease in working capital resulting directly from the project should be accounted
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for ,
 If a project is using some working capital, it is assumed that the amounts used during the
project’s life are recovered at the end of the useful life of the project,

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Working Capital [WC] = Current Assets–Current Liabilities, which, more often than not, translates into WC = Cash + Account Receivables
+ Inventories–Account Payables.

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Class Notes _ Capital Budgeting
 If a project entails outflows during its life-time, they should be accounted for,
 Finally, but not least, the fiscal environment of the firm has to be dealt with.
o All cash flows have to be expressed on an after-tax basis using the firm’s marginal tax
rate,
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o Depreciation expenses have to abide by the CRA rules .

D2. INVESTMENT HORIZON

The investment horizon is equivalent to the economic life of the investment project. This period of time (horizon) is
largely dependent upon the number of years during which a project can generate “satisfactory” cash flows. For
example, if a project requires the purchase of some equipment then, the horizon is linked to the “normal” physical
life for this type of equipment.

E. OVERVIEW OF THE DIFFERENT METHODS COMMONLY USED TO ASSESS THE ECONOMIC VIABILITY OF PROJECTS

Once the company’s management has established its goals and priorities for capital expenditures, it must address the
question of evaluating proposed expenditures in some systematic manner. Since in most organizations, the amount of
funds available for capital expenditures is limited, management is faced with the dual problem of establishing some basic
criteria for the acceptance, rejection, or postponement of proposed investments, and then ranking the projects that meet
the criteria for acceptance in order of their value to the firm.

As you have seen in BFN200, several methods are used to evaluate capital investments: the payback period [PP], the net
present value [NPV], the internal rate of return [IRR], the modified internal rate of return [MIRR], the profitability index [PI],
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and the equivalent annual annuity [EAA] . The latter five are called discounted cash-flow methods because they consider
the time value of money by discounting expected after tax cash flows to their present value.

Payback [PP]
This method involves determining the number of years necessary to recover the cost of a project and comparing
the recovery period with the maximum payback period acceptable to the management of the firm.

Net Present Value [NPV]


This method requires discounting all expected after-tax cash flows to present value and taking the difference
between the sum of the discounted after tax cash inflows and outflows. This difference is called the NPV [Net
Present Value].

Internal Rate of Return [IRR]


This method involves determining the discount rate that will exactly equate the present value of the after tax cash
inflows with the present value of the cash outflows so that the NPV will be zero. That discount rate is called the IRR
[Internal Rate of Return].

Modified Internal Rate of Return [MIRR]


This method involves determining the average return by taking the present value of the cash outflows and the
future value of the after tax cash inflows.

Profitability Index [PI]


This method involves dividing the present value of the after tax cash inflows by the present value of the cash
outflows. The quotient provides an index for measuring return per dollar of investment.

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CRA stands for Canada Revenue Agency.
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In case you were wondering or having doubts, the MIRR as well as the EAA were not methods presented in BFN200.

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