Capital Budgeting
Chapter 11
Capital Budgeting
An Introduction
• The word ‘capital’ means long-term.
• Long-term investments represent sizable outlay of funds.
• It is for this reason firms need effective procedures to analyze and
select projects into which they can make long-term investments.
• Capital budgeting is the name given to the process of evaluating and
selecting long-term investments.
• Firms typically make a variety of long-term investments, but the most
common for the manufacturing firm is in fixed assets, which include
property (land), plant, and equipment. These assets, often referred to
as earning assets, generally provide the basis for the firm’s earning
power and value.
Capital Budgeting
An Introduction
• Capital budgeting is the process in which a business determines if
projects having long-term significance (for example building a new
plant or buying expensive machinery) are worth pursuing.
• In capital budgeting, we forecast a set of cash flows, find the present
value of those flows, and make the investment only if the PV of the
inflows exceeds the investment’s cost.
• Capital budgeting decisions include such decisions where investment
of money and expected benefit arising from it are spread over a
period of more than 1 year.
•
Process used by companies for making decisions on long-term projects.
Capital Budgeting
An Introduction
• In an ideal situation a business would like to pursue all
projects that seem to enhance shareholder value, however
this is not possible.
• Capital budgeting techniques are used to determine which
projects will yield the most return over a given period of
time.
• Based on the results most profitable projects meshing well
with overall company objectives are selected.
Capital Budgeting
An Introduction
• For a financial analyst, capital budgeting is of extreme
importance.
• It helps a financial analyst to decide which projects to
undertake and which projects not to undertake which in
turn decides which direction a company is moving in.
• For instance a company selecting more projects in oil and
gas sector and shying away from investing in previously
favored sector for instance food and agriculture means in
the future the focus of the company will be on oil and gas
sector of the economy).
Capital Budgeting Decisions
Importance
• Capital budgeting decisions are important for a number of reasons:
1. These decisions involve commitment of a large amount of funds.
2. Capital budgeting decisions are irreversible.
3. In case of a wrong forecast concerning cash inflows or outflows a
firm may have to face serious negative consequences.
4. They carry long-term implications.
5. Capital budgeting decision involves two important decisions at
once: a financial decision and an investment decision.
6. Capital budgeting decisions have national significance as they
determine employment, creation of new job opportunities and
economic growth.
Capital Budgeting
Process
• The capital budgeting process consists of
following steps:
1.
2.
3.
4.
5.
Identification and evaluation of opportunities.
Cash flow estimation
Project selection
Implementation
Follow-up
Capital Budgeting Projects
Categories
•
•
1.
Analyzing capital expenditure proposals is not costless—benefits can be gained, but analysis does have a
cost. For certain types of projects, an extremely detailed analysis may be warranted, while for other
projects, simpler procedures are adequate.
Accordingly, firms generally categorize projects and then analyze them in each category somewhat
differently:
Replacement Projects
– As a firm’s growth slows and it reaches maturity, most capital expenditures will be made to replace
or renew obsolete or worn-out assets
•
•
2.
3.
4.
Maintaining the business
Cost reduction
Expansion projects
– The most common motive for a capital expenditure is to expand the level of operations—usually
through acquisition of fixed assets. A growing firm often needs to acquire new fixed assets rapidly, as
in the purchase of property and plant facilities.
– Requires complex decision making
New products and services
– These investments relate to new products or geographic areas, and they involve strategic decisions
that could change the fundamental nature of the business. Invariably, a detailed analysis is required,
and the final decision is generally made at the top level of management.
– More complex decision making than both replacement decisions and expansion decisions
– High uncertainty
Mergers
– In a merger, one firm buys another one.
– The concepts of capital budgeting underlie merger analysis.
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Capital Budgeting Projects
Important Terminologies
• Independent vs. Mutually Exclusive Projects
– Independent Projects
• For example the decision to replace a company's computer
system would be considered independent of a decision to
build a new factory.
– Mutually Exclusive Projects
• Projects that compete directly with each other (i.e. you own
some manufacturing equipment that must be replaced. Two
different suppliers present a purchase and installation plan
for your consideration).
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Capital Budgeting Projects
Important Terminologies
• Unlimited Funds versus Capital Rationing
– Unlimited Funds
• The availability of funds for capital expenditures affects the
firm’s decisions. If a firm has unlimited funds for investment,
making capital budgeting decisions is quite simple: All
independent projects that will provide an acceptable return can be
accepted.
– Capital Rationing
• Typically, though, firms operate under capital rationing instead.
This means that they have only a fixed number of dollars
available for capital expenditures and that numerous projects will
compete for these dollars.
Capital Budgeting Projects
Important Terminologies
• Conventional versus Nonconventional Cash Flow Patterns
• Conventional (Normal) Cash Flow Patterns
• A conventional cash flow pattern consists of an initial outflow followed
only by a series of inflows. For example see the figure.
Capital Budgeting Projects
Important Terminologies
• Non-Conventional (Non-Normal) Cash Flow Patterns
• A nonconventional cash flow pattern is one in which an initial outflow is
followed by a series of inflows and outflows.
Capital Budgeting Projects
Criteria used for accepting or rejecting projects
• Companies use the following criteria for deciding to accept or reject
projects:
1. Payback Period
I.
II.
2.
Regular Payback
Discounted Payback
Net Present Value (NPV)
•
3.
Net Present Value Profile
Internal Rate of Return (IRR)
•
Multiple Internal Rate of Return
4. Modified Internal Rate of Return (MIRR)
• The NPV is the best method, primarily because it addresses directly the
central goal of financial management—maximizing shareholder wealth.
• However, all of the methods provide useful information, and all are used in
practice at least to some extent.
1. Payback Period
I.
Simple Payback Period
•
Definition
•
•
Amount of time it takes for project’s cumulative cash flows to recover the cost (initial
investment) of the project.
The sooner the cost is recovered the better it is.
•
Formula
Full recovery
year
•
•
Decision Rule
– The length of the maximum acceptable payback period is determined by
management.
– If the payback period is less than the maximum acceptable payback period, accept
the project.
– If the payback period is greater than the maximum acceptable payback period,
reject the project.
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1. Payback Period (contd.)
•
Example 1
Suppose the firm requires cost to be recovered within 3 years.
•
Important Questions =>
•
•
•
Which project we would accept?
What if the two projects are mutually exclusive?
What if the two projects are independent?
Cut-off payback period:
It is the pre-determined
(desired) length of time
for an investment to be
recovered.
15
1. Payback Period (contd.)

Concept
What if cash flows are received evenly during the year?
•
Formula:
Original investment
cash inflows per period
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1. Payback Period (contd.)
I. Simple Payback Period
Advantages
1.
2.
3.
4.
Easy to calculate.
Easy to comprehend.
Easy to analyze.
Very good indicator of liquidity of a project.
Disadvantages
1.
2.
3.
All dollars received in different years are given the same weight (i.e., the
time value of money is ignored).
Does not consider cash inflows after the original investment is recovered.
which implies it is biased against long-term projects that take longer time
periods to become lucrative .
Sets off unrealistic expectations.
17
1. Payback Period (contd.)
I.
Simple Payback Period
Disadvantages
1.
All dollars received in different years are given the same weight (i.e., the time value of
money is ignored).
18
1. Payback Period (contd.)
I.
Simple Payback Period
Disadvantages
2.
Does not consider cash inflows after the original investment is recovered which implies it is
biased against long-term projects that take longer time periods to become lucrative .
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1. Payback Period (contd.)
•
Example 1
Suppose the firm requires cost to be recovered within 3 years.
•
Important Questions =>
•
•
•
Which project we would accept?
What if the two projects are mutually exclusive?
What if the two projects are independent?
Cut-off payback period:
It is the pre-determined
(desired) length of time
for an investment to be
recovered.
20
Class Practice
Questions from Book
1. Payback Period (contd.)
II. Discounted Payback Period
• Definition: Number of years it takes for project’s cumulative
discounted cash flows to recover its costs.
or
Length of time required to recover original investment from the present
value of expected future cash flows.
•
Formula:
Years before full recovery + unrecovered cost at the start of the year
cash flow during full recovery year
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1. Payback Period (contd.)
II. Discounted Payback Period
Advantages
1. A more realistic measure than simple pay back period.
2. Takes into account the principle of time value of money (PV
of cash inflows taken into consideration).
Disadvantages
1. Ignores cash flows beyond cut-off point.
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1. Payback Period (contd.)
•
Example 2
Suppose the firm requires cost to be recovered within 3 years.
•
Important Questions =>
•
•
•
Which project we would accept?
What if the two projects are mutually exclusive?
What if the two projects are independent?
We calculate the discounted paybacks
for S and L assuming that both have a
10% cost of capital. Each inflow is
divided by (1 + i)n = (1.10)n where n is
the year in which the cash flow occurs
and i is the project’s cost of capital;
and those PVs are used to find the
payback.
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Class Practice
Questions from Book
2. Net Present Value
a.
•
•
•
•
Net Present Value (NPV)
Definition: NPV is the present value of cash inflows minus the
present value of cash outflows.
Characteristics
A very important capital budgeting tool.
Helps firm assess the level of importance various capital budgeting
projects have.
–
–
•
Why doing such a thing is important?
Capital budgeting projects normally requires expenditures in millions
and billions of dollars, before embarking on any such project they
want to be reasonably sure that the cash inflows generated from the
project will pay off project’s costs within a reasonable amount of
time.
Firms generally can carry out multiple projects, capital budgeting
tools like NPV help firms choose the best among them.
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2. Net Present Value (contd.)
•
i.
•
•
ii.
Formula:
NPV = Present value of cash inflows - Present value of cash outflows
Cash outflows: As on today (PV)
Cash inflows: Discounted back (To find PV)
.
•
Decision Criteria (3 scenarios):
– NPV = Positive (Cash inflows than outflow) => Accept the project.
– NPV = Zero (Cash inflows than outflow) => Indifferent
– NPV = Negative (Cash inflows than outflow) => Reject the project.
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2. Net Present Value (contd.)
•
•
•
•
•
•
In case of:
Independent projects: NPV > 0 (Accept both projects or all within budget)
Mutually exclusive projects: Accept the project with highest positive NPV
Example:
Global Enterprises is considering two projects. Each project requires
an initial outlay of $100,000 and provides the following cash flows.
The firm requires a ROR of 10% on both projects.
Project A:
Cash Outflow = 100,000
Cash Inflows: 1st year = 30,000
•
2nd year = 40,000
3rd year = 50,000
4th year = 60,000
2nd year = 30,000
3rd year = 30,000
4th year = 20,000
Project B:
Cash Outflow = 100,000
Cash Inflows: 1st year = 40,000
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Class Practice
Questions from Book
2. Net Present Value (contd.)
•
Remember: For doing NPV analysis always make a timeline.
Advantages
1.
2.
3.
4.
Adjusts for the TVM.
Provides a straight forward method for controlling risk of competing
projects, higher risk cash flows can be discounted at higher costs whereas
lower risk cash flows are discounted at lower costs.
Tells whether the investment will increase firm’s value.
Considers all the cash flows.
Disadvantages
1.
2.
3.
May not be considered as simple or intuitive as some other methods.
Requires an estimate of cost of capital in order to calculate NPV.
Expressed in dollar terms, not as a percentage.
31
Net present value profile
The net present value profile is the graphical illustration of the
NPV of a project at different required rates of return.
The NPV profile intersects the
vertical axis at the sum of the
cash flows (i.e., 0% required rate
of return).
Net
Present
Value ($)
The NPV profile crosses the
horizontal axis at the project’s
Required Rate of Return (%)
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3. IRR
• IRR stands for ‘Internal Rate of Return’.
• Concept:
– IRR quite simply tells you what is the return on a project.
– IRR is the discount rate at which NPV of a project is equal to
‘zero’.
– When we say NPV of a project is equal to ‘zero’ we mean PV of
cash inflows = PV of cash outflows.
• Definition:
• IRR is the discount rate at which PV of cost is equal to PV
of future cash inflows.
• It is the rate of return that the firm will earn if it invests in
the project and receives the given cash inflows.
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3. IRR
– We stated, “IRR is the discount rate at which NPV of a project is equal
to zero”.
– Using the NPV formula
– In IRR we calculate the discount rate, the ‘r’ at which NPV = 0
34
3. IRR
• Decision Criteria
• For Independent Projects
IF IRR > cost of capital => accept the project
IF IRR < cost of capital => reject the project
• For Mutually Exclusive Projects
Accept the project with highest IRR provided IRR for
the project is greater than cost of capital.
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3. IRR
Advantages
1. Considers all cash flows of the project.
2. Considers time value of money.
Disadvantages
1. Requires an estimate of cost of capital in order to make a
decision.
2. Cannot be used in situations where sign of the cash flows of
the project change more than once during project’s life.
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Class Practice
Questions from Book
37
The Multiple IRR problem
• If cash flows change sign more than once during the
life of the project, there may be more than one rate
that can force the present value of the cash flows to
be equal to zero.
– This scenario is called the “multiple IRR problem.”
– In other words, there is no unique IRR if the cash flows are
nonconventional.
39
Class Practice
Questions from Book
4. MIRR
•
•
•
MIRR stands for ‘Modified Internal Rate of Return’.
Definition: MIRR is the discount rate at which the
present value of a project’s cost is equal to the PV of
its terminal value where the terminal value is found
by summing up the future value of the cash inflows,
compounded at company’s cost of capital.
Formula:
PV costs = Terminal Value
(1+MIRR)n
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4. MIRR
• Decision Criteria
• For Independent Projects
IF MIRR > cost of capital => accept the project
IF MIRR < cost of capital => reject the project
• For Mutually Exclusive Projects
Accept the project with highest MIRR provided
MIRR for the project is greater than cost of
capital.
44
4. MIRR
Advantages
1.
2.
3.
4.
Considers all cash flows of the project.
Considers time value of money.
Eliminates the multiple IRR problem, there can only be one MIRR.
A better capital budgeting tool than IRR as it assumes cash
inflows are reinvested at the cost of capital.
Disadvantages
1.
2.
Requires an estimate of cost of capital in order to make a decision.
Cannot be used in situations where sign of the cash flows of the
project change more than once during project’s life.
45
Class Practice
Questions from Book
46
Reinvestment Rate Assumption
• In slide no. 26 the last difference points towards an
important assumption built into the three capital
budgeting tools.
– NPV: The NPV technique assumes that cash inflows are
reinvested at the cost of capital (i.e. the same rate by which
they were discounted).
– IRR: The IRR technique assumes that cash inflows are
reinvested at IRR.
– MIRR: The MIRR technique assumes that cash inflows are
reinvested at the cost of capital.
47
Pg. 346
Pg. 346
Which Reinvestment Rate Assumption
is better?
• Obaidullah Jan at accountingexplained.com states that,
50
Key differences between NPV, IRR and MIRR
IRR
NPV
•
Calculation
•
–
– We determine the PV
of future cash inflows
and then subtract the
initial cash outflow
from them to obtain
NPV.
•
•
•
Cost of capital is used
as the actual discount
rate.
Projects with positive
NPV’s are accepted.
NPV assumes cash
flows are reinvested
at cost of capital.
Calculation
–
•
•
•
MIRR
•
We calculate the rate at
which NPV is zero ‘or’
simply stated we calculate
the rate of return on a
project.
IRR is the rate at which
PV of cost is equal to PV
of future cash inflows.
IRR is compared with
cost of capital to
determine if it is feasible
to accept the project.
Projects with IRR > cost
of capital are accepted.
IRR assumes cash flows
are reinvested at IRR.
Calculation
–
–
•
•
•
We calculate the terminal value
(TV) by summing up the future
value of the cash inflows,
compounded at company’s cost
of capital then find the PV of
the TV.
MIRR is the rate at which PV
of cost is equal to PV of the TV.
MIRR is compared with cost of
capital to determine if it is
feasible to accept the project.
Projects with MIRR > cost of
capital are accepted.
MIRR assumes cash flows are
reinvested at cost of capital.
51
Conclusion
• MIRR is a superior method to the regular IRR as an
indicator of a project’s true rate of return.
but,
• NPV is better than IRR and MIRR when choosing
among competing projects.
52
Conclusion
• Independent Projects
– For independent projects, NPV, IRR and MIRR all give the
same result if NPV says accept, IRR and MIRR also say
accept and vice versa.
• Mutually Exclusive Projects
– For mutually exclusive projects, NPV is the best method
to use because it focuses on maximizing shareholder value.
• Obaidullah Jan at accountingexplained.com states that,
53
Conclusion
• Mutually Exclusive Projects
54
Class Practice
Questions from Book
55
Class Practice
Questions from Book
56
Class Practice
Questions from Book
57