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 ● ● ● ● ● 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. ● 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) ● ● ● ● 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 ● ● ● ● ● ● ● ● ● ● ● 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.
