CAPITAL BUDGETING Capital budgeting is used to describe how managers plan significant investments in projects that have longterm implications such as the purchase of new equipment or the introduction of new product. d. Lease or buy decision e. Equipment replacement decision 2 CATEGORIES OF CAPITAL BUDGETING DECISION 1. Screening decision Managers must carefully select a project which generate the highest future return. Any decision that involves a cash outlay now to obtain a future return is a capital budgeting decision. FOUR METHODS FOR MAKING CAPITAL BUDGETING DECISIONS Relate to whether a proposed project is acceptable – whether it passes a preset hurdle. 2. Preference decision Relate to selecting from among the several acceptable alternatives 1. Payback method TYPES OF CASH FLOWS IN CAPITAL BUDGETING 2. Net-present value method a. Cash Outflows 3. Internal rate of return method Initial investment of equipment, other assets, and installation costs Salvage value realized from the sale of old equipment can be recognized as a reduction in the initial investment or as a cash inflow. b. Expansion decisions Working capital required c. Equipment selection decision Periodic outlays for repairs and maintenance and additional operating costs 4. Simple rate of return method TYPICAL BUDGETING DECISIONS a. Cost reduction decision Projects that promise earlier returns are preferable than those that promise later returns. Since the money received today is worth more than the money received in the future, cash flows that are received at different times must be valued differently. b. Cash Inflows Increase in revenue or reduction in cost (savings in operating costs/incremental revenue less cash receipts) Salvage value of new asset at the end of the asset’s life Release of working capital at the end of the asset’s life BASIC TERMS TO REMEMBER REGARDING THE TIME VALUE OF MONEY 1. Annuity A series of identical cash flow Depreciation tax shield 2. Compound interest TIME VALUE OF MONEY The time value of money recognizes that a dollar today is worth more than a dollar a year from now if for no other reason than you could put the dollar in a bank today and have more than a dollar a year from now. The process of paying interest on interest in an investment 3. Discount rate Payback method does not recognize time value of money The rate of return that is used to find the present value of a future cash flow 4. Discounting Net present value and internal rate of return does not only focus on cash flows, but they also recognize time value of those cash flows. They use discounting cash flows. The process of finding the present value of a future cash flow 5. Present value The value now of an amount that will be received in some future period INTERNAL RATE OF RETURN The internal rate of return is the rate of return of an investment project over its useful life The internal rate of return is computed by finding the discount rate that equates the present value of its cash outflows with the present value of its cash inflows The internal rate of return is the discount rate that results in a net present value of zero NET PRESENT VALUE METHOD The difference between the present value of cash flows, called the net present value, determines whether or not a project is an acceptable investment. Managers assume that all cash flows other than initial investment occurs at the end of the period. COST OF CAPITAL AS A SCREENING TOOL Managers assume that all cash flows generated by an investment project are immediately reinvested at the rate of return equal to the rate used to discount the future cash flows, also known as discount rate. The company’s cost of capital is usually regarded as its minimum required rate of return. a. The net present value method The cost of capital is used as the discount rate when computing the NPV of the project Any project with negative NPV is rejected b. The internal rate of return Cost of capital is the average rate of return that the company must pay to its long-term creditors and its shareholders for the use of their funds. The cost of capital is used as the hurdle rate that a project must clear for acceptance It is compared to the IRR of a project Any project whose IRR is less than the cost of capital is rejected PAYBACK PERIOD RANKING OF COMPETING PROJECTS The payback period is the length of time it takes for a project to recover its initial cost from the net cash inflows that it generates The NPV of one project cannot be directly compared to the NPV of another project unless the initial investments are equal Sometimes referred to as time it takes for an investment to pay for itself There is a need to use the profitability index The higher the profitability index, the more desirable the project The basic premise of the payback period is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. a. Using NPV to rank competing projects b. Using IRR to rank competing projects The higher the IRR, the more desirable the project CAPITAL BUDGETING TECHNIQUES THAT IGNORE THE TIME VALUE OF MONEY CRITICISMS OF THE PAYBACK PERIOD METHOD Not a true measure of profitability of the investment. It only tells how many years are required to recover the original investment A shorter payback period does not always mean one investment is more desirable than the other It ignores all cash flows that occur after the payback period It does not consider the time value of money – a cash inflow to be received several years in the future is weighed the same as a cash inflow received right now 1. Payback period 2. Simple rate of return / Accounting rate of return / unadjusted rate of return SIMPLE RATE OF RETURN DETERMINING RELEVANT CASH FLOWS Evaluate cash flows on an incremental basis, net of applicable taxes Disregard sunk costs Include opportunity costs Include working capital requirements in outflow, and release of working capital in inflows Consider the terminal value or salvage value at the end of the projects life