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Chapter 2 Capital Budgeting Principles and Techniques Capital budgeting and investment Analysis by Alan Shapiro

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Net Present Value (NPV) NPV is the present value of the project’s cash flows minus the cost of the project The value placed on an investment project must satisfy three criteria: – Focus on cash – Account for TVM – Account for Risk

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NPV Decision Rule Invest in positive NPV projects Reject negative NPV projects Use the appropriate discount rate If two projects are mutually exclusive, accept the one with higher NPV Cost of capital is the minimum acceptable rate of return on projects with similar risk.

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NPV cont. NPV=-Initial cash investment+ PV of future CFs Initial investment includes any working capital requirements Net CF is after tax profit plus depreciation and other non-cash charges such as deferred taxes less any additions to working capital during the period It is cash, and only cash that matters to shareholders

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Example 1 Plant and equipment of $6 million 5 year contract Sale of $10 per pound 800,000 pounds of dye in the 1 st year 1,600,000 pounds per year in each of the next 4 years Plant is expected to be sold at its book value in end of year 5 for $1 million

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Example 1 cont. Variable cost = $6.5 per pound Fixed cost = $1,700,000 per year Deprecation = $1,000,000 per year Tax rate = 40% Working capital requirement =$1,200,000 and will be freed at end of year 5 Required return = 10%

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Example 1 cont. Calculate the following: – Initial investment for this project – Net Cash Flow for years 1-5. – NPV – Decide whether you would accept or reject this project and Why?

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Example 2 (Contingent projects) Purchase and transport mining equipment which costs $90 million Cost of extracting ore = $50 per ton Expected to sell ore for $150 a ton Produce 200,00 tons a year 20 Years Construct a rail line at cost of $30 million Cost of transport = $10 per ton Required rate of return= 15% What are the NPVs for the mine and the railway? Which project(s) should they take?

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Strengths of NPV It evaluates investments in the same way that shareholders do It is a theoretically correct technique It obeys the value additivity principle The NPV of a set of independent projects is just the sum of the NPVs of the individual projects It implies that the value of a firm equals the sum of the values of its component parts

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Weakness of NPV Many corporate executives and non technical people have a tough time understanding the concept Applying the NPV has the problem of computing the proper discount rate.

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Payback Period Payback period is the length of time necessary to recoup the initial investment from net cash flows Discounted payback period is the length of time it takes to the present value of CFs to equal the cost of the initial investment Find the payback period (PB) for example 1.

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Payback period decision rule Projects with a payback less than a specified cutoff period are accepted whereas those with a payback beyond this figure are rejected The riskier the project is, the shorter the required payback will be

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Payback period Strengths and Weaknesses Strength: It is simple to understand and easy to apply Weaknesses: – It ignores time value of money – It ignores cash flows beyond the payback period: it is biased against longer projects

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Accounting rate of return Also known as average rate of return or average return on book value It is the ratio of average after tax profit to average book investment (the initial investment less accumulated depreciation). Decision Rule – Investments yielding a return greater than this standard are accepted, whereas those falling below it would be rejected.

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Strengths and Weaknesses of Accounting rate of return Strength: It is simple to apply Weakness: – It ignores the time value of money – It is based on accounting income rather than cash flow. Cash flow and reported income often differ

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Internal Rate of Return (IRR) IRR is the discount rate that sets the present value of the project cash flow to the initial investment outlay It is the discount rate that equates the project NPV to zero Calculate the IRR of Example 1

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IRR Decision Rule If the IRR exceeds the cost of capital, the firm should undertake the project; otherwise, the project should be rejected

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IRR Strengths and Weaknesses Strengths: – Managers seem to visualize and understand more easily the concept of a rate of return rather than they do the concept of a sum discounted dollars – It permits an investment analysis without requiring advance specification of the discount rate Weaknesses: – When cash flows change more than once (Multiple IRR) – When mutually exclusive projects are involved

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Multiple IRRs IRR of 0%, 100%, and 200% Year0123 Cash flow-$200+$1,200-$2,200+$1,200

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Mutually exclusive projects In case of mutually exclusive projects choices, NPV and IRR can favor conflicting projects When forced to choose between two mutually exclusive investments, the NPV will always provide the correct answer. When projects are substantially different in – Timing of cash flows Most of CFs coming in early years vs. later years – Scale differences Differences in the amount of the initial investment

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Differences between rankings of NPV and IRR YearXY 0-$100,000-$1,000,000 1$140,000$1,250,000 NPV (k=15%)$21,739$86,957 IRR40%25% YearAB 0-1,000, ,000100, ,000400, ,000500, ,000800,000 NPV (k=17%)$81,154$116,781 IRR22.99%21.46%

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Profitability Index (PI) It is also called the benefit-cost ratio It equals the present value of future cash flows divided by the initial cash investment Calculate Profitability Index (PI) for Example 1 The project returns a present value of $X for every $1 of the initial investment

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PI Decision Rule As long as the profitability index exceeds 1, the project should be accepted Strength: – NPV and PI give the same accept/reject signal Weakness: – NPV and PI sometimes disagree in the rank ordering of acceptable projects – When there are mutually exclusive projects and when there is capital rationing

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Surveys of Capital budgeting used in practice Graham and Harvey (2002) – US companies – 75% of CFOs always or almost always use NPV – 75.7 always or almost always use IRR – Most popular secondary or supplemental method of evaluation is the payback period due to its simplicity along with top management’s lack of familiarity with more sophisticated techniques – Only about 20% of companies used accounting rate of return What about Kuwait? Other international surveys?

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Capital Rationing Some firms constrain the size of their capital budgets. Whenever such a constraint exist, we have the situation known as capital rationing Capital rationing may be self-imposed or externally imposed – Limit CapEx to internally generated cash flows – Limit # of attractive projects to undertake – Current lenders may restrict the amount of future borrowing

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Heuristic approach Calculate the PI for each project Rank all projects in term of their PIs, from highest to lowest Starting with the project having the highest PI, go down the list and select all projects having PI>1 until the capital budget is exhausted

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Capital Rationing: NPV vs. PI The NPV method does not necessarily select the best combination of projects under capital rationing The PI approach will select the optimal combination of projects provided that: – The budget constraint is for 1 period only – The entire budget can be consumed by accepting projects in descending order of PI.

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Example on Capital Rationing Capital budget of $5 million ProjectInitial investment NPVPIRanking NPV Ranking PI A500,000100, DF B500,00070, CA C2,000,000300, EE D3,000,000480, FD E1,000,000170, AC F500,000125, BB

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Mutually exclusive projects with Different Lives Equivalent annual cost of an asset is an annuity that has the same life as the asset whose present value equals the cost of the asset Rule: – Compute the equivalent annual cost of each asset. Select the asset with the lowest equivalent annual cost For a revenue generating project, this rule becomes select the project with the highest equivalent annual net cash flow

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Example: Different Lives YearDoleDaihatsu 0$12,000$7,500 1$3,000$4,000 2$3,000$4,000 3$3,000$4,000 4$3,000$4,000 5$3,000- Present value of cost at 8%$23,978.10$20, Dole TruckDaihatsu truck Initial cost$12,000$7,500 Salvage Value00 Life5 years4 years Operating cost$3,000/year$4,000/year

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