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

2. 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

3. 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.

4. 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

5. Example 1 Plant and equipment of $6 million 5 year contract
Sale of $10 per pound
800,000 pounds of dye in the 1st 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

6. 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%

7. 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?

8. 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?

9. 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

10. 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.

11. 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.

12. 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

13. 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

14. 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.

15. 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

16. 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

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

18. IRR Strengths and Weaknesses
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

19. Multiple IRRs IRR of 0%, 100%, and 200% Year 1 2 3 Cash flow -$2001 2 3
Cash flow
-$200
+$1,200
-$2,200

20. 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

21. Differences between rankings of NPV and IRR
Year X Y
-$100,000
-$1,000,000 1
$140,000
$1,250,000
NPV (k=15%)
$21,739
$86,957
IRR
40%
25%
Year A B
-1,000,000 1
800,000
100,000 2
300,000
400,000 3
200,000
500,000 4
NPV (k=17%)
$81,154
$116,781
IRR
22.99%
21.46%

22. 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

23. 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

24. 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?

25. 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

26. 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

27. 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.

28. Example on Capital Rationing Capital budget of $5 million
Project
Initial investment
NPV PI
Ranking NPV
Ranking PI A
500,000
100,000
1.20
1. D F B
70,000
1.14
2. C C
2,000,000
300,000
1.15
3. E E D
3,000,000
480,000
1.16
4. F
1,000,000
170,000
1.17
5. A
125,000
1.25
6. B

29. 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

30. Example: Different Lives
Year
Dole
Daihatsu
$12,000
$7,500 1
$3,000
$4,000 2 3 4 5 -
Present value of cost at 8%
$23,978.10
$20,740.40
Dole Truck
Daihatsu truck
Initial cost
$12,000
$7,500
Salvage Value
Life
5 years
4 years
Operating cost
$3,000/year
$4,000/year