# CHAPTER 12 THE CAPITAL BUDGETING DECISION Capital Expenditures Decision §CE usually require initial cash outflows in hope of future benefits or cash.

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CHAPTER 12 THE CAPITAL BUDGETING DECISION

Capital Expenditures Decision §CE usually require initial cash outflows in hope of future benefits or cash inflows §Examples: new plant construction, acquisition of business, purchase of new machine, etc. §Projects often last for more than a year §The longer the time horizon, the greater the uncertainty

Areas of Uncertainty in CE Decision §Expected cash flows §Product life §Interest rates §Economic conditions §Technological change

Capital Budgeting §To see if the CE is economically acceptable - if it creates or adds value to the firm §To examine the CE from an investment perspective §The basic concept is to determine if it makes sense to commit to an initial cash outflows in order to receive future cash inflows

Example - Project A

Project A cont’

Project Evaluation §Discount Rate = Cost of Capital §Positive NPV indicates that the yield or rate of return on the project exceeds the cost of capital (thus add value to the firm) §Project is financially acceptable when the PV of the total cash inflows greater than the PV of the total cash outflows ( +ve NPV)

Example - Project B

Project B cont’

§Both projects A and B require an initial capital outflow of \$10000 §Both of them will generate a total return of \$12000 in the next three years §However, project A has a positive NPV while project B has a negative NPV §Why?

Cash Flows of Project A & B §Project A §Yr 0-\$10,000 §Yr 1\$5,000 §Yr 2\$5,000 §Yr 3\$2,000 §Project B §Yr 0-\$10,000 §Yr 1\$2,000 §Yr 2\$5,000 §Yr 3\$5,000

Reasons §For Project A, the cash inflows mainly occur at the first two years §For Project B, the cash inflows mainly come in at the last two years §Due to the time value of money, money received earlier has higher value than that received later §Hence, Project B is not acceptable - (negative NPV)

Flexibility of NPV - Using various discount rates across time §The longer the time horizon, the higher the risk §Sometimes, we may have to use a higher discount rate for income in the latest year §Instead of 10%, we may use 12% to discount the latest cash inflow at the end of third year §NPV method provides such a flexibility

Flexibility of NPV – allow reversal of cash flows §NPV method can be applied to any type of cash flows even cash flows with reversal §Cash flows with reversal means that there are more than one cash outflows §Example: a 2-year project with cash flows: §Yr 0 – Initial cash outflow – (-\$1000) §Yr 1 – Cash inflow – (+\$5000) §Yr 2 – Another cash outflow – (-\$3000)

Profitability Index §It is a variation of the NPV method §Profitability index (PI) = PV of cash inflows/PV of cash outflows §If PI > 1, PV of cash inflows is greater than PV of cash outflows. That is NPV > 0 §Hence project with PI > 1 is financially viable

Another method - IRR §IRR = Internal Rate of Return §The IRR is the discount rate at which the PV of cash inflows = PV of the cash outflows §I.E., IRR is the discount rate which makes the NPV = 0 §Project is financially acceptable when the IRR is greater than the cost of capital

IRR of Project A

IRR of Project B

Project Evaluation §Project A has an IRR of 11.16% which is higher than the cost of capital, 10%. Hence project A is financially acceptable. §Project B has an IRR of 8.53% which is lower than the cost of capital, 10%. Hence project B is financially not acceptable.

Why bother to use IRR? §Since both NPV and IRR generate similar results, why bother to use IRR §Yield derived from IRR may be more comprehensible than the absolute value derived from NPV §In fact, we use IRR when we cannot use the cost of capital (the risk of the project differs from the risk of the firm)

Limitations of IRR method §A single discount rate (the IRR) throughout the project life – inability to account for cash flows of different risk levels §Possibly unrealistic to assume reinvestment of the generated cash inflow at the IRR §Inapplicable when more than one reversal of cash flows exists – will generate multiple IRRs in that case

Graphical Illustration of NPV and IRR See Examples Below

Cash Flows of Investment A&B §Investment A §Yr 0-10000 §Yr 1 5000 §Yr 2 5000 §Yr 3 2000 §Investment B §Yr 0-10000 §Yr 1 1500 §Yr 2 2000 §Yr 3 2500 §Yr 4 5000 §Yr 5 5000

6000 NPV 2000 4000 Discount Rate 0 510 IRR= 11.16% IRR= 14.33% 15 NPV Profile – NPVs at different Discounting rate INV. A INV. B

Cash Flows of Investment B & C §Investment B §Yr 0-10000 §Yr 1 1500 §Yr 2 2000 §Yr 3 2500 §Yr 4 5000 §Yr 5 5000 §Investment C §Yr 0 -10000 §Yr 19000 §Yr 23000 §Yr 31200

6000 NPV 2000 4000 Discount Rate 0 510 IRR= 22.49% IRR= 14.33% 15 Crossover point 20 INV.C INV.B NPV Profile with crossover

Where are we? §How to raise capital? §We have learned the three ways of raising long- term capital for a firm. What are they? §How to use the capital to generate more money? §Underlying principle – to generate an investment return that is greater than cost of capital §The lowest required rate of return = cost of capital

Project Valuation §Similar to the valuation of financial instruments, we must assess the fair market value for any capital expenditure project. §The highest price we pay is the present value of expected cash flows (derived from the project) discounted at the rate equivalent to the cost of capital §Basic concept – lowest rate of return = highest price to be paid

Cash Flows Determination §Net of tax i.e. after tax net cash flow §Gross of all financing costs (they have been reflected in the discount rate) §Shortfalls: - Future projection may base on extrapolation - Bias built into the cash flows estimation - Over/under estimate of the inflation - Neglect other qualitative factors such as better corporate image, fairer treatment of employee, etc

Capital Rationing §Management, for some reasons, may impose a dollar constraint in certain kind of investment §Projects become mutually exclusive §Project is selected based on the amount of benefit generated by the project §That is, projects with the greatest NPV or the highest IRR

Table 12-7 Capital rationing Net Total Present ProjectInvestmentInvestmentValue CapitalA \$2,000,000 400,000 rationing B 2,000,000 380,000 solution C 1,000,000 \$5M 150,000 Best D 1,000,000100,000 solution E 800,000 \$6.8M40,000 F800,000(30,000. )

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