Basics of Capital Budgeting

An Overview of Capital Budgeting

Capital Budgeting Capital budgeting is the process of analyzing potential expenditures on fixed assets and deciding whether the firm should undertake those investments. Capital budgeting = Strategic asset allocation Capital budgeting decision = Strategic long-term investment decision

Capital Budgeting Process Determine the cost of the project. Estimate the expected cash flows from the project and the riskiness of those cash flows. Determine the appropriate cost of capital at which to discount the cash flows. Determine the present values of the expected cash flows and of the project.

Investment Criteria

Evaluation of Decision Criteria Does it consider all cash flows throughout the entire life of a project? Does it consider the time value of money? Does it consider the risk? Does it provide information on whether you are creating value for the firm? When it is used to select from a set of mutually exclusive projects, does it choose the project which maximizes the wealth of the shareholders?

Example The firm is considering a new project with the following estimated cash flows: Year 0:CF = -158,000 Year 1:CF = 54,200; NI = 12,100 Year 2:CF = 66,900; NI = 5,800 Year 3:CF = 89,300; NI = 27,600 Average Book Value = 64,000 The required return is 11%.

Net Present Value (NPV) The NPV of an investment is the difference between the market value of a project and its cost. Steps The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment. Decision Rule : If the NPV is positive, accept the project. If the NPV is negative, reject the project.

Net Present Value (NPV): Example NPV = -$158, ,200/(1.11) + 66,900/(1.11) ,300/(1.11) 3 = $10, NPV is positive. Do you accept the project? Yes!

Net Present Value (NPV) NPV has no serious flaws. NPV selects the project which adds the most to shareholder wealth. NPV is the preferred decision criterion. When there is a conflict between NPV and another decision rule, you should always use NPV.

Payback Period The payback period is the length of time until the sum of an investment’s cash flows equals to its cost. Steps Estimate the cash flows. Subtract the future cash flows from the initial cost until the initial investment has been recovered. Decision Rule: If the payback period is less than some prespecified cutoff, accept the project.

Payback Period: Example Assume you will accept the project if it pays back within two years. Year 1: $158,000 – 54,200 = $103,800 Year 2: $103,800 – 66,900 = $36,900 Year 3: $36,900/89,300=0.41 The project pays back in year 2.41 years. The payback period is more than the prespecified cutoff. Do you accept the project? No!

Advantages and Disadvantages of Payback Period Advantages Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity Disadvantages Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long-term projects, such as research and development, and new projects

Discounted Payback Period The discounted payback period is the length of time until the sum of an investment’s discounted cash flows equals its cost. Decision Rule: If the discounted payback period is less than some prespecified cutoff, accept the project.

Discounted Payback Period: Example Assume you will accept the project if it pays back on a discounted basis in 2 years. Year 1: $158,000 – 54,200/ = $109, Year 2: $109, – 66,900/ = $54, Year 3: $54, / (89,300/ )= 0.84 The project pays back in 2.84 years. The discounted payback period is more than the prespecified cutoff. Do you accept the project? No!

Advantages and Disadvantages of Discounted Payback Period Advantages Includes time value of money Easy to understand Does not accept negative estimated NPV investments Biased towards liquidity Disadvantages May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long- term projects, such as research and development, and new products

Average Accounting Return (AAR) The AAR is a measure of accounting profit relative to book value. One form of the AAR is: Average net income / average book value Decision Rule: If the AAR exceeds a target AAR, accept the project.

Average Accounting Return (AAR): Example Assume the firm requires an average accounting return of 25% ($12, , ,600) / 3 = $15, AAR = 15, / 64,000 = 23.70% The AAR is less than the target AAR. Do you accept the project? No!

Advantages and Disadvantages of AAR Advantages Easy to calculate Needed information will usually be available Disadvantages Not a true rate of return; time value of money is ignored Uses an arbitrary benchmark cutoff rate Based on book values, not cash flows and market values

Internal Rate of Return (IRR) The IRR is the discount rate that makes the estimated NPV of an investment equal to zero. It is sometimes called the discounted cash flow (DCF) return. Decision Rule: if the IRR exceeds the required return, accept the project. It is the most important alternative to NPV. It is very popular in practice, more so than even the NPV.

Internal Rate of Return (IRR): Example Trial and error or using a financial calculator or using a spreadsheet. -158, ,200/(1+r) + 66,900/(1+r) ,300/(1+r) 3 =0 IRR = 14.45% > 11% The IRR exceeds the required return. Do you accept the project? Yes!

NPV Profile for the Project IRR = 14.45%

Summary of Decisions for the Project Do you accept the project? Net Present Value –Yes Payback Period – No Discounted Payback Period – No Average Accounting Return – No Internal Rate of Return – Yes The final decision should be based on the NPV. You should accept the project.

NPV vs. IRR NPV and IRR usually lead to identical decisions. The project’s cash flows must be conventional: the first cash flow is negative and all the rest are positive. The project must be independent: a project whose cash flows are unaffected by the decision to accept or reject some other project. Exceptions Nonconventional cash flows Mutually exclusive projects

IRR and Nonconventional Cash Flows When the cash flows change sign more than once, there is more than one IRR. This is the multiple rates of return problem. You need to look at the NPV profile.

IRR and Mutually Exclusive Projects Mutually exclusive projects A set of projects of which only one can be accepted. Decision rules NPV – choose the project with the higher NPV IRR – choose the project with the higher IRR You need to look at the NPV profile.

Mutually Exclusive Projects: Example PeriodProject AProject B 0$-1000$ IRR19.43%22.17% NPV$128.10$ The required return for both projects is 10%. Which project should you accept and why?

NPV Profiles IRR for A = 19.43% IRR for B = 22.17% Crossover Rate = 11.8%

Mutually Exclusive Projects: Example The crossover rate is the discount rate the makes the NPVs of two projects equal. When there is a conflict between NPV and another decision rule, you should always use NPV. If the required return is less than the crossover rate of 11.8%, then you should choose A. If the required return is greater than the crossover rate of 11.8%, then you should choose B.

Advantages and Disadvantages of IRR Advantages Closely related to NPV, often leading to identical decisions Easy to understand and communicate Disadvantages May result in multiple answers or not deal with nonconventional cash flows. May lead to incorrect decisions in comparisons of mutually exclusive investments

Modified Internal Rate of Return (MIRR) The MIRR is a modification to the IRR. Steps: A project’s cash flows are modified by: Discounting the negative cash flows back to the present. Compounding cash flows to the end of the project’s life. Combining the above two. Compute the IRR on the modified cash flows. It avoids the multiple rate of return problem, but it is unclear to interpret them.

Profitability Index (PI) The PI is the ratio of present value to cost. It is also called the benefit-cost ratio. It measures the present value of an investment per dollar invested. Decision rule: If the PI exceeds 1, accept the project.

Advantages and Disadvantages of PI Advantages Closely related to NPV, generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited Disadvantages May lead to incorrect decisions in comparisons of mutually exclusive investments

Capital Budgeting in Practice Firm use multiple criteria for evaluating a proposal. NPV and IRR are the most commonly used primary investment criteria. Payback period is a commonly used secondary investment criteria. Less commonly used were discounted payback period, AAR and PI.