Capital Budgeting
Capital Budgeting
● The process of planning investments in
assets whose cash flows are expected to
extend beyond one year
Importance of
Capital Budgeting
● Impact of capital Budget decisions continue over
many years
● Since asset expansion is fundamentally related
to expected future sales, a decision to buy a fixed
asset that to last as many years involves implicit
sales forecast for that period
● Capital budgeting decision defines strategic
direction
● Erroneous forecast of asset requirement has a
serious consequences in terms of over
investment or inadequate investment
● Timing of purchase of asset is important. An
asset should be available when needed
● Substantial expenditures for which funds must
Capital Budgeting
Classification
● Replacements (for worn out or
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obsolete equipment)
Expansion (Existing Products/Markets
or New Products/Markets)
Safety and Environment – to comply
with standards
Research and DevelopmentPharmaceuticals business
Corporate Mergers
Others (Office building)
Project Classifications
● Independent projects
● projects whose cash flows are not
affected by the acceptance or rejection
of other projects
Project Classifications
● Mutually exclusive projects
● a set of projects where the acceptance
of one project means the others
cannot be accepted
Capital Budgeting
Evaluation Techniques
Six Methods
● Payback Period
● Discounted Payback
● Net Present Value (NPV)
● Internal Rate of Return (IRR)
● Modified Internal Rate of Return (MIRR)
● Profitability Index (PI)
Payback
● Payback period is the length of time before
the original cost of an investment is
recovered from the expected cash flows
● Shorter payback period is better and will
be ranked before the one that has longer
period
Discounted Payback
● Here expected cash flows are discounted
by project’s cost of capital and then
Payback period is calculated
● Shorter payback period is better and will
be ranked before the one that has longer
period
Shortcomings of Payback
period
● Regular payback period does not take in to account
the cost of capital. This method takes that aspect into
account and therefore shows the breakeven point
after recovering debt and equity costs.
● Regular and discounted payback calculation at times
can show conflicting ranking
● Both these methods ignore cash flows after the
payback period
● These methods do provide the information as to how
long funds will be tied up in a project. Thus shorter
the payback the greater the project’s liquidity
● Since cash flows expected in the distant future are
generally riskier, than near term cash flows, the
payback is often used as one indicator of project’s
riskiness.
Net Present Value
● NPV is a method of evaluating capital
investment proposals by finding the present
value of future net cash flows, discounted at
the rate of return required by the firm
● One of two discounted cash flow (DCF)
techniques using time value of money that
we will cover
Net Present Value (NPV)
● NPV method relies on the discounted cash
flow(DCF) methodology. Following methodology is
used
● Find the present value of each period’s net cash
flow, discounted at the project’s cost of capital
● Sum these discounted cash flows and this sum is
called project’s NPV
● If NPV is positive then project is accepted, if negative
it is rejected. If projects are mutually exclusive then
the project with higher positive NPV is selected.
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n
CFt
● NPV = ∑
------------●
t = 0 (1+k)t
● CFt = It is expected net cash flow at period t
● k = It is the project’s cost of capital
Net Present Value
Net Present Value (NPV)
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Cash flows could occur on monthly, quarterly, half
yearly basis, in which case t would represent quarters or
months rather than years. In such a case cost of capital
must also be adjusted to reflect the periodic rate
accordingly.
Rationale for NPV is that NPV of zero signifies that
project’s cash flows are exactly sufficient to repay the
invested capital and to provide the required rate of
return on that capital.( note invested capital is assumed
to be paid through dividend streams in case of common
stock on the assumption that it has no maturity date).
In case of positive NPV assumption is that any positive
balance will go to common stock holder because return
to bond holders is fixed
In case of zero NPV, the assumption is that common
stock holder gets the same rate of return (without
growth) year after year, thus its stock price would
remain unchanged
Internal Rate of Return
● IRR is the discount rate that forces the
PV of a project’s expected cash flows to
equal its initial cost
● Similar to the YTM on a bond
Internal Rate of Return (IRR)
● Concept is the same as applied to YTM (yield
to maturity) on bonds.
● The IRR is defined as the discount rate which
equates the present value of a project’s
expected cash inflows to the present value of
project’s expected costs or equivalently
forces the NPV to be zero.
●
n
CFt
● NPV = ∑
-------------= 0
●
t = 0 (1+IRR)t
Internal Rate of Return (IRR)
● IRR can be calculated with the help of financial
calculators and computers.
● If both projects have the same cost of capital or hurdle
rate then IRR rule indicates that if projects are
independent, both should be accepted because both
are expected to earn more than cost of the capital
needed to finance them.
● If they are mutually exclusive, the one with higher IRR
will be accepted.
● IRR on project is its expected rate of return and if it is
higher than cost of capital it will mean that surplus
accrues to common stock holders. That means it
increases share holder’s wealth
Profitability Index
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It is also called benefit/cost ratio.
n
CIFt
∑
----------PV benefits
t = 0 (1+k)t
PI = -------------- =
PV cost
n
COFt
∑
-------------t = 0 (1+k)t
CIFt = expected cash inflows or benefits
COFt = expected cash outflows or costs
PI = shows relative profitability or the present value of
benefits per present value rupee of cost
Profitability Index
● A project is acceptable if its PI is greater than
1.
● The higher the PI the higher the ranking of
the project
● Mathematically NPV, IRR and PI method will
always lead to the same accept/reject
decision for independent projects.
● In mutually exclusive projects NPV, IRR and
PI can give conflicting rankings
Modified Internal Rate of
Return (MIRR)
●
We can modify IRR and make it a better indicator of relative
profitability, hence for better use in capital budgeting.
PV cost
=
PV terminal value
n
n
∑
t=0
COFt
-----------(1+k)t
PV cost =
=
∑
t=0
CIFt (1+k) n - t
------------------(1+MIRR)n
TV
-------------------------(1+MIRR)n
COFt = This refers to cash outflows, or the cost of the project
CIFt = This refers to cash inflows
Modified Internal Rate of
Return (MIRR)
● Left term is PV of investment outlays when
discounted at the cost of capital.
● The numerator of the right term is the total
future value of the inflows, assuming the
inflows are reinvested at the cost of capital.
The future values of inflows is also called
terminal value or TV .
● The discount rate that forces PV of TV to
equal PV of the costs is defined as MIRR
Comparisons
● Mathematically, NPV, IRR and PI
methods will always lead to same
accept reject decisions for independent
projects
● However NPV, IRR and PI can give
conflicting ranking for mutually
exclusive projects
Independent Projects
● NPV and IRR will both lead to the same
decision
● if a project’s NPV is positive, its IRR will
exceed k, while if NPV is negative, k will
exceed the IRR
Mutually Exclusive Projects
● If NPV profiles cross, NPV and IRR
decisions may conflict depending on
discount rate selected
● project size differences
● timing differences
● reinvestment rate may not match IRR
● NPV method is preferred
Comparison of the NPV and
IRR Methods
● NPV profile is a graph (curve) showing
the relationship between a project’s
NPV and various discount rates
(required rates of return)
● IRR is at the point where the NPV
profile crosses the X axis
NPVs and the Required Rate
of Return
● Crossover rate
● the discount rate at which the NPV
profiles of two projects cross and, thus, at
which the project’s NPVs are equal
MIRR VS IRR
● MIRR has significant advantage over the
regular IRR
● MIRR assumes that cash flows from all
projects are reinvested at the cost of capital
while regular IRR assumes that the cash flows
from each project are reinvested at project’s
own IRR. (This means that it is not earning
anything extra)
● Since reinvestment at cost of capital is a
better assumption the MIRR is a better
indicator of project’s profitability
● MIRR also solves the multiple IRR problem
MIRR COMPARISONS
● If the two projects are of equal size (outflow) and have
the same life, then NPV and MIRR will always lead to the
same project selection decision. Conflicts similar to
comparing NPV and IRR do not occur in MIRR & NPV
comparison.
● If the two projects are of equal size (outflow) but different
lives, MIRR will always lead to the same decision as in
NPV, if the MIRR are both calculated on the basis of the
longer project’s life. (In this case cash inflows are
assumed at zero for the balance years of shorter life
project)
● If projects differ in scale (size) then conflicts can occur- if
we are comparing a large project with a small mutually
exclusive one, then we might find NPV of large project is
greater than small project and MIRR of small project is
greater than large project
MIRR COMPARISONS
● In conclusion we can say MIRR is a better indictor than
of project’s true rate of return or expected long term rate
of return, but NPV method is still better for choosing
among competing projects because it always provides a
good indicator of how much each project contributes to
the value of the firm.
● Occasionally a project will require cash outlay sometime
during its life. When this occurs the question arises
whether this outlay should be netted off from inflow and
the net amount is used for calculating future value in
MIRR calculations or gross values should be used such
that present value of cash outflow is added to cost and
gross amount of inflow should be used to work out
future value. Preferred way is to use gross value
method. However, net versus gross treatment will never
change the accept reject decision, it might reduce the
MIRR rate.