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Capital Budgeting

Should we
build this
plant?

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.

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
Capital budgeting involves
commitment of large amount of
funds.

The capital budgeting process


Step 1

Generating Ideas

Generate ideas from inside or outside of the company

Step 2

Analyzing Individual Proposals

Collect information and analyze the profitability of alternative projects

Step 3

Planning the Capital Budget

Analyze the fit of the proposed projects with the companys strategy

Step 4

Monitoring and Post Auditing

Compare expected and realized results and explain any deviations

Independent vs. mutually


exclusive projects

When evaluating more than one project at a time, it is important to


identify whether the projects are independent or mutually exclusive
This makes a difference when selecting the tools to evaluate the
projects.

Independent projects are projects in which the acceptance of one


project does not preclude the acceptance of the other(s).

Mutually exclusive projects are projects in which the acceptance


of one project precludes the acceptance of one or more alternative
projects.

Investment decision criteria


Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
Discounted Payback Period
Profitability Index (PI)

Which Technique should we


follow?
The ideal evaluation method should:
Include all the cash flows that occur during the
life of the project
Considers time value of money
Incorporate the required rate of return on the
project

Payback Period

The payback period is the length of time it takes to recover the initial cash
outlay of a project from future incremental cash flows.

The payback occurs in the last year, Year 4:


Cash Flow
Period
0
1
2
3
4
5

(millions)

$1,000
200
300
400
100
600

Accumulated
Cash flows
$1,000
$800
$500
$100
0
+600

Payback Period
When the numbers do not work out exactly, it is customary to work with
fractional years. For example:

Initial investment
Net cash flow year 1
Net cash flow year 2
Net cash flow year 3

:
:
:
:

R60 000
R20 000
R90 000
R100 000

The cash flows over the first 2 years are R110 000, so the project obviously
pays back sometime in the second year.

After year 1, the project has paid back R20 000, leaving R40 000 to be
recovered.
To figure out the fractional year, note that this R40 000, is R40 000/R90
000 = 4/9 of the second years cash flow.
Assuming that the R90 000 cash flow is paid uniformly throughout the
year, the payback would thus be 1 4/9 years. (1.44 years)

PBP Acceptance Criterion


The management has set a maximum
PBP of 2 years for projects of this type.
Should this project be accepted?
Yes! The firm will receive back the initial
cash outlay in less than 2 years.
[1.44 Years < 2 Year Max.]

PBP Strengths and


Weaknesses
Strengths:

Easy to use and


understand
Can be used as a
measure of
liquidity
Easier to forecast
ST than LT flows

Weaknesses:

Does not account


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

Other Methods
1. Net Present Value
2. Profitability Index
3. Internal Rate of Return
Each of these decisions making criteria:
Examines all net cash flows
Considers time value of money
Considers required rate of return

Net Present Value (NPV)


NPV is the present value of an
investment projects net cash flows
minus the projects initial cash
outflow.
CF1
NPV =
(1+k)1

CF2
+
(1+k)2

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

Net Present Value (NPV)


P R O J E C T
Time
A
0
(10,000.)
1
500
2
500
3
4,600
4
10,000

k=10%
0

(10,000)

500

500

4,600

10,000

Net Present Value (NPV)


P R O J E C T
Time
A
0
(10,000.)
1
500
2
500
3
4,600
4
10,000

k=10%
0

(10,000)
455

500
$500
(1.10)

500

4,600

10,000

Net Present Value (NPV)


P R O J E C T
Time
A
0
(10,000.)
1
500
2
500
3
4,600
4
10,000

k=10%
0

(10,000)

500

455
413

500
$500
(1.10) 2

4,600

10,000

Net Present Value (NPV)


P R O J E C T
Time
A
0
(10,000.)
1
500
2
500
3
4,600
4
10,000

k=10%
0

(10,000)

500

455
413
3,456

500

4,600
$4,600
(1.10) 3

10,000

Net Present Value (NPV)


P R O J E C T
Time
A
0
(10,000.)
1
500
2
500
3
4,600
4
10,000

k=10%
0

(10,000)

500

455
413
3,456
6,830

500

4,600

10,000

$10,000
(1.10) 4

Net Present Value (NPV)


P R O J E C T
Time
A
0
(10,000.)
1
500
2
500
3
4,600
4
10,000

k=10%
0

(10,000)

500

455
413
3,456
6,830
$11,154

500

4,600

10,000

Net Present Value (NPV)


P R O J E C T
Time
A
0
(10,000.)
1
500
2
500
3
4,600
4
10,000

k=10%
0

(10,000)

500

455
413
3,456
6,830
$11,154

500

4,600

PV Benefits > PV Costs


$11,154 > $ 10,000

10,000

Net Present Value (NPV)


P R O J E C T
Time
A
0
(10,000.)
1
500
2
500
3
4,600
4
10,000

k=10%
0

(10,000)

500

500

4,600

455
PV Benefits > PV Costs
413
$11,154 > $ 10,000
3,456
6,830
$11,154
$1,154 = NPV

10,000

NPV > $0
$1,154 > $0

NPV Acceptance Criterion


The management has determined that
the required rate is 13% for projects of
this type.
Should this project be accepted?
Yes! The NPV is Positive. This means that
the project is increasing shareholder
wealth. [Accept as NPV >0 ]

NET PRESENT VALUE


Decision Rule:

If NPV is Positive. Accept


If NPV is negative. Reject

If projects are independent then accept all projects


with NPV 0.
If projects are mutually exclusive, accept projects
with higher NPV.

Profitability index

Profitability Index
Profitability Index for Project B

PI =

500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4

10,000

Time
0
1
2
3
4

P R O J E C T
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000

Profitability Index for Project


B Index for Project B
Profitability
P R O J E C T
PI =
PI =

500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4

10,000
11,154
= 1.1154
10,000

Time
0
1
2
3
4

A
(10,000.)
3,500
3,500
3,500
3,500

B
(10,000.)
500
500
4,600
10,000

Profitability Index
PI =
PI =

500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4

10,000
11,154
= 1.1154
10,000

Profitability Index for Project A

PI =

3,500 x PVIFA 4, .10


10,000

Time
0
1
2
3
4

P R O J E C T
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000

Capital Budgeting Methods

Profitability Index for Project B

PI =
PI =

500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4

10,000
11,154
= 1.1154
10,000

Profitability Index for Project A


1
3,500(.10

PI =
PI =

1
4
.10(1+.10) )

10,000
11,095
= 1.1095
10,000

Time
0
1
2
3
4

P R O J E C T
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000

Profitability Index Decision


Rules

Independent Projects
Accept

Project if PI 1

Mutually Exclusive Projects


Accept

Highest PI 1 Project

Internal Rate of Return

Measures the rate of return that will make the PV of future CF equal to the
initial outlay.

Definition:
The IRR is that discount rate at which

NPV = 0

IRR is like the YTM. It is the same cocept but


the term YTM is used only for bonds.

Internal Rate of Return


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.

IRR Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3
(1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.

IRR Solution (Try 10%)


$40,000 =
+
+
$40,000 =

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

IRR Solution (Try 15%)


$40,000 =
+
+
$40,000 =

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

IRR Solution (Interpolate)

.05

X
.05

.10 $41,444
IRR $40,000
.15 $36,841
$1,444
$4,603

$1,444

$4,603

IRR Solution (Interpolate)


.05

X
.05

.10 $41,444
IRR $40,000
.15 $36,841
$1,444
$4,603

$1,444

$4,603

IRR Solution (Interpolate)


.05

.10 $41,444
IRR $40,000
.15 $36,841

($1,444)(0.05)
X=
$4,603

$1,444

$4,603

X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

IRR Acceptance Criterion


The management of Basket Wonders
has determined that the hurdle rate is
13% for projects of this type.
Should this project be accepted?

No! The firm will receive 11.57%


for each dollar invested in this
project at a cost of 13%. [ IRR <
Hurdle Rate ]

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
B
C
D
E
F
G
H

ICO
$

500
5,000
5,000
7,500
12,500
15,000
17,500
25,000

IRR
18%
25
37
20
26
28
19
15

NPV

PI

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

1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24

Choosing by IRRs for BW


Project
C
F
E
B

ICO

IRR

NPV

$ 5,000
37%
$ 5,500
15,000
28
21,000
12,500
26
500
5,000
25
6,500
Projects C, F, and E have the
three largest IRRs.

PI
2.10
2.40
1.04
2.30

The resulting increase in shareholder wealth is $27,000


with a $32,500 outlay.

Available Projects for BW


Project
A
B
C
D
E
F
G
H

ICO
$

500
5,000
5,000
7,500
12,500
15,000
17,500
25,000

IRR
18%
25
37
20
26
28
19
15

NPV

PI

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

1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24

Choosing by NPVs for BW


Project
F
G
B

ICO

IRR

NPV

$15,000
17,500
5,000

28%
19
25

$21,000
7,500
6,500

PI
2.40
1.43
2.30

Projects F and G have the


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

Available Projects for BW


Project
A
B
C
D
E
F
G
H

ICO
$

500
5,000
5,000
7,500
12,500
15,000
17,500
25,000

IRR
18%
25
37
20
26
28
19
15

NPV

PI

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

1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24

Choosing by PIs for BW


Project

ICO

IRR

NPV

PI

F
$15,000
28%
$21,000 2.40
B
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
PI generates the greatest increase in shareholders
wealth when a limited capital budget exists for a single
period

Summary of Key Formulas/Definitions and


Decision Criteria for Capital Budgeting
Techniques

Practice Question

A Project has the following after tax-cash inflows for


years 1 through 4:
Year 1
34,444
Year 2
39,877
Year 3
25,000
Year 4
52,800

Given the initial cash outflow is $104,000, discount


rate is 12%, Hurdle rate is 13% and the maximum
Pay back period is 3.5 years.
Calculate the Pay Back Period, NPV,PI AND IRR

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