Capital Budgeting
Decide how to invest resources to
maximize their contribution to the
organization’s objectives.
Capital Budgeting Process
• Capital budget
(investment) proposals
are examined on basis
of their cash outlays
and resulting flow of
future benefits over
period of time greater
than one year.
Capital Budgeting Process
1. Clearly define short-term and
long-term objectives
2. Identify alternative investment
opportunities and the capital
required for each one.
3. Assess organizations ability to
generate investment capital for
capital budgeting period
Capital Budgeting Process
4. Measure cash
(benefit) flows
from alternative
capital investment
opportunities
5. Evaluate proposals using
selected criteria
Increase log inventory to
reduce risk of mill downtime
during Spring breakup?
Capital Budgeting Process
6. Select alternatives to fund and implement
5. Review performance for feed-back to decision
makers
Buy new skidder
to reduce
maintenance cost
on old one and
increase
productivity?
Financial Criteria to Rank
Alternatives
• Net Present Value
• Internal Rate of Return
• Benefit /Cost Ratio
• Payback Period
Other Criteria
• Capacity to carry out proposed projects
– Management
– Labor
• Sources of capital
– Borrow from commercial lenders or private
parties (leverage assets)
– Sell (issue) stock – corporation; or
membership interests - limited liability
companies (LLC)
Notation
• ARR – alternative rate of return
• MAR – minimum acceptable rate of
return (hurdle rate)
• B - annual nonmarket value, dollars
• B/C - benefit/cost ratio
• EAA - equivalent annual annuity
• IRR - internal rate of return
• N - project life, years
• NPV = net present value
Notation
•
•
•
•
t - index of years
Ct – cost in year t
Rt - revenue in year t
PV - present value at a specified
point in time
• r - real interest rate
• f – rate of inflation
• i – nominal interest rate
Net Present Value
n
NPV = ∑
t=0
n
=∑
t=0
Rt
Ct
(1+r)t
(1+r)t
R t - Ct
(1+r)t
Example of NPV
0
Project D
Cash Flows
-400
5
-100
Year
8
15
+200
30
+6,600
Project D NPV
C0 = - $400/(1.06)0 =
C5 = - $100/(1.06)5 =
R15 = $200/(1.06)15 =
R30 = $6,600/(1.06)30 =
NPV =
- $ 400.00
- $ 74.73
$ 83.45
$1,149.13
757.85
Net Present Value Guideline
• Project must at least cover the
opportunity cost as measured by the
minimum acceptable rate of return
(MAR) used to calculate present values
• Project is acceptable if NPV is zero or
greater
• Projects with negative NPV are
unacceptable, don’t cover opportunity
cost
Internal Rate of Return (IRR)
• The r that makes NPV = 0
• Meaning – r that makes PV of costs and
PV of revenues equal
• Find by
– iterating over r until NPV = 0
– Use “Goal Seek” function in Excel
IRR Guideline
• Project is acceptable if its IRR is equal
to or greater than the minimum
acceptable rate of return (MAR)
• Relationship to NPV criteria – if MAR is
the discount rate (r) used to calculate
NPV, then IRR and NPV will accept
same projects.
Benefit/Cost Ratio
• PV (benefits)/PV (costs), or
• PV (revenues)/PV (expenses)
n
∑ Rt / (1+r)t
=
t=0
n
∑ Ct/(1+r)t
y=0
Benefit/Cost Ratio Guideline
• Accept project if B/C ≥ 1.0
• If B/C ≥ 1.0 then
– NPV ≥ 0, and
– IRR ≥ MAR
Relationship of NPV, IRR and B/C
Year 0 – ($400), Year 5 – ($100), Year 15 - $200, Year 30 - $6,600
8000
IRR
Present Values $'s
7000
6000
B/C > 1
B/C < 1
NPV > 0
NPV < 0
5000
4000
PV of revenues
3000
2000
PV of costs
1000
0
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17
Interest Rate
Payback Period
• Time required for net revenue to equal
invested capital
• Example,
– Invest $10,000
– Net revenue is $5,000 per year
– Payback is 2 years, ($10,000/$5,000)
• Best used in conjunction with other
criteria
Ranking Projects
• NPV, IRR, and B/C may not rank
alternative projects in the same order
• Additional ranking criteria
– Mutually exclusive projects – only one can
be chosen
– Independent
• Opposite of mutually exclusive,
• Can all be adopted
Ranking Projects
• Additional ranking criteria, cont.
– Divisible – can invest in part of a project
– Indivisible – all or nothing
Timing of cash flows effects rankings
• Timing of revenue and expenditures is critcal
– Worst case is front-loaded costs and back-loaded
revenues
• Rankings by NPV and IRR are different
depending on MAR
Example of NPV
Year
0
5
Project D
Project N
Cash Flows Cash Flows
-400
-400
-100
8
-100
+1,200
15
+200
30
+6,600
+2,500
Project D NPV
C0 = - $400/(1.06)0 =
C5 = - $100/(1.06)5 =
R15 = $200/(1.06)15 =
R30 = $6,600/(1.06)30 =
NPV =
- $ 400.00
- $ 74.73
$ 83.45
$1,149.13
757.85
Project N NPV
C0 = - $400/(1.06)0 =
C5 = - $100/(1.06)5 =
R8 = $1,200/(1.06)8 =
R30 = $6,600/(1.06)30 =
NPV =
- $ 400.00
- $ 4.73
$ 752.89
$ 435.28
$ 713.44
Example of NPV
Year
Project D
Project N
Cash Flows Cash Flows
0
-400
-400
5
-100
-100
8
15
30
+1,200
+200
+6,600
+2,500
$2,756 gives D & N
same NPV’s
NPV
$758
$713
NPV
NPV project D
NPV same at 6.3%
NPV project N
IRR=14.5%
2
4
6
IRR =
9.7%
10
14
Interest Rate