Capital Budgeting

Syed Mohammed Shamsul Arifeen

Tuesday, June 18, 2013

Financial Theory & Practices, MBA Spring 2013, IBA, DU

Capital Budgeting
The process of evaluating and selecting long-term investments that are consistent with the rms goal of maximizing owners wealth.

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Motives for Capital Expenditure

Capital Expenditure

Vs

Operating Expenditure

An outlay of funds resulting in benets received within 1 year

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Motives for Capital Expenditure

Capital Expenditure

Vs

Operating Expenditure

An outlay of funds that is expected to produce benets over a period of time greater than 1 year

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Motives for Capital Expenditure

Expansion

Renewal Replacement

Others

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Steps in the Process

Proposal generation Review and analysis Decision making Implementation Follow-up

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Basic Terminology
Independent Projects
Projects whose cash ows are unrelated or independent of one another; the acceptance of one does not eliminate the others from further consideration.

Mutually Exclusive Projects

Projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

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Basic Terminology

Unlimited Fund
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Capital Rationing

Basic Terminology
Unlimited Funds
The nancial situation in which a rm is able to accept all independent projects that provide an acceptable return.

Capital Rationing
The nancial situation in which a rm has only a xed amount available for capital expenditures, and numerous projects compete for this resource.

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Basic Terminology

Accept-Reject Approach

Ranking Approach

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Basic Terminology
Accept-Reject Approach
The evaluation of capital expenditure proposals to determine whether they meet the rms minimum acceptance criterion.

Ranking Approach
The ranking of capital expenditure projects on the basis of some predetermined measure, such as the rate of return.

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Basic Terminology
Conventional Cash Flow Pattern 0 1 2 3 4 5

An initial outlay followed only by a series of inows

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Basic Terminology
Nonconventional Cash Flow Pattern 0 1 2 3 4 5

An initial outlay followed by a series of inows and outows

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Basic Terminology
Sunk Costs
Cash outlays that have already been made and therefore have no effect on the cash ows relevant to a current decision.

Opportunity Costs
Cash ows that could be realized from the best alternative use of an owned asset.

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Capital Budgeting Techniques

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Accounting Rate of Return (ARR) Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Modied Internal Rate of Return (MIRR) Protability Index (PI)

Accounting Rate of Return (ARR)

Focuses on a projects net income rather than its cash ows
= Average annual income Average investment

Average annual income = Average cash flow ! Average annual depreciation Average investment = (Cost + Salvage value) 2

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Accounting Rate of Return (ARR)

The Decision Criteria

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If the ARR is greater than the minimum acceptable rate of return, ACCEPT the project. If the payback period is less than the minimum acceptable rate of return, REJECT the project. If the projects are mutually exclusive, accept the project with the highest ARR.

Accounting Rate of Return (ARR)

Revenue Expenses Before-tax cash ow Depreciation EBT Taxes (TC = 25%) Net income
433,333 200,000 233,333 100,000 133,333 33,333 100,000 450,000 150,000 300,000 100,000 200,000 50,000 150,000 266,667 100,000 166,667 100,000 66,667 16,667 50,000 200,000 100,000 100,000 100,000 0 0 0 133,333 100,000 33,333 100,000 -66,667 -16,667 -50,000

Average annual income = (100,000+150,000+50,000+0!50,000)/5 = 50,000 Average investment = (500,000+0)/2 = 250,000 ARR = 50,000/250,000 = 20%
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Accounting Rate of Return (ARR)

Disadvantages

Considers accounting prot and not cash ows Does not consider time value of money Does not consider risk Minimum acceptable ARR is determined subjectively

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Payback Period
The expected number of years required to recover the initial investment
Year 0 1 2 3 4 Cash Flow -1,000 500 400 300 100

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Payback Period
Year before = complete recovery + Unrecovered investment Cash flow during the year in which complete recovery occurs
Cumulative Cash Flow -1,000 -500 -100 200 300

Year 0 1 2 3 4

Cash Flow -1,000 500 400 300 100

= 2 + (100/300) = 2" years

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Payback Period
The Decision Criteria

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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. If the projects are mutually exclusive, accept the project with the lowest payback period.

Payback Period
Advantages

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Easy to compute and intuitive Considers cash ows rather than accounting prots Measure of projects riskiness Measure of liquidity

Payback Period
Disadvantages

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Ignores time value of money Ignores all cash ows after the payback period The maximum acceptable payback period is set subjectively Does not indicate whether or not an investment increases the companys value

Discounted Payback Period

The expected number of years required to recover the investment from discounted net cash ows
Year 0 1 2 3 4 Cash Flow -1,000 500 400 300 100 Discounted Cash Flow (@10%) -1,000 455 331 225 68

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Discounted Payback Period

Year 0 1 2 3 4 CF -1,000 500 400 300 100 DCF (@10%) -1,000 455 331 225 68 CDCF -1,000 -545 -214 11 79

= 2 + (214/225) = 2.95 years

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Discounted Payback Period

Advantages

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Considers cash ows rather than accounting prots Considers time value of money Is a measure of projects riskiness Is a measure of liquidity

Discounted Payback Period

Disadvantages

Ignores all cash ows after the payback period The maximum acceptable discounted payback period is set subjectively Does not indicate whether or not an investment increases the companys value

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Net Present Value (NPV)

The difference between the present value of the cash inows and the present value of the cash outows of a project discounted at a rate equal to the rms cost of capital.
= PV of Cash Inflows ! PV of Cash Outflows

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Net Present Value (NPV)

The Decision Criteria

If the NPV is positive, ACCEPT the project. If the NPV is negative, REJECT the project. If the projects are mutually exclusive, accept the project with the highest NPV.

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Net Present Value (NPV)

Calculation
0 -1,000 1 500 2 400 3 300 4 100

=78.82

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NPV Prole
A graph which relates a projects NPV to the discount rate used to calculate the NPV

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NPV Prole
Net Present Value (Tk)
300.00

Net Present Value Prole IRR = 14.5%

150.00

Cost of capital (%)

-150.00

0.05

0.10

0.15

0.20

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Net Present Value (NPV)

Advantages

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Tells whether or not an investment increases rm value Considers all cash ows of the project Considers time value of money Considers risk of future cash ows

Net Present Value (NPV)

Disadvantages

Requires an estimate of the rms cost of capital Expressed in terms of dollars, not as a percentage

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Internal Rate of Return (IRR)

The discount rate which equates the NPV of an investment opportunity with zero.

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Internal Rate of Return (IRR)

The Decision Criteria

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If the IRR is greater than the cost of capital, ACCEPT the project. If the IRR is less than the cost of capital, REJECT the project. If the projects are mutually exclusive, accept the project with the highest IRR.

Internal Rate of Return (IRR)

Calculation Trial & Error Method

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Internal Rate of Return (IRR)

Calculation
0 -1,000 1 500 2 400 3 300 4 100

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Internal Rate of Return (IRR)

Calculation

= 0.1243 =12.43%

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Improper Decision
Investment or Financing?
NPV (Tk)
20000 15000

Year CFL CFB

IRR 20% 20%

10000 5000

-100,000 120,000 83,333 -100000

0 -5000 -10000 -15000 -20000 0 12.5 25.0 37.5 50.0

k (%)

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No IRR
NPV (Tk)
0.60 0.50

Year CF

0 1.0

1 -2.0

2 1.5

0.40 0.30 0.20 0.10 0

0%

24%

48%

72%

96%

120%

k (%)

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Multiple IRR
1.50 1.25 1.00 0.75 0.50

IRR2

NPV (Tk)

Year CF

0 -1.5

1 10

2 -10

0.25 0 -0.25 -0.50 -0.75 -1.00 -1.25 -1.50 0% 100% 200% 300% 400% 500%

k (%) IRR1

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Internal Rate of Return (IRR)

Advantages

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Tells whether or not an investment increases rm value Considers all cash ows of the project Considers time value of money Considers risk of future cash ows

Internal Rate of Return (IRR)

Disadvantages

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Requires an estimate of the rms cost of capital May not give the value-maximizing decision when used to compare mutually exclusive projects May not give the value-maximizing decision when there is capital rationing Cannot be used with projects with nonconventional cash ow pattern

Conict between NPV & IRR

For independent projects: there is no conict For mutually exclusive projects
Scale difference Timing difference

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Scale Difference
Year Project L Project S Project ! 0 -20 -6 -14 1 6 2 4 2 6 2 4 3 6 2 4 4 6 2 4 5 6 2 4

k = 10%
NPVL = Tk 2.74 IRRL = 15.2% NPVS = Tk 1.58 IRRS = 19.9% NPV! = Tk 1.16 IRR! = 13.2%

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Timing Difference
Year Project L Project S Project ! 0 -10 -10 0 1 0 4 -4 2 2 4 -2 3 3 3 0 4 5 3 2 5 9 2 7

k = 10%
NPVL = Tk 2.91 IRRL = 17.3% NPVS = Tk 2.49 IRRS = 20.5% NPV! = Tk 0.42 IRR! = 12.5%

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Cause of Conict
Reinvestment Rate Assumption
The use of NPV method implicitly assumes that the opportunity cost rate at which cash ows can be reinvested is the cost of capital. The IRR method assumes that the rm has the opportunity to reinvest at the IRR.

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Cause of Conict
Reinvestment Rate Assumption

The correct reinvestment rate assumption is the cost of capital, which is implicit in the NPV method.

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NPV Proles
Net Present Value (Tk)
500 400 300 200

Fishers Rate of Intersection or Crossover Rate = 7.2% IRRS = 14.5%

100 0 -100 -200

Cost of capital (%) IRRL = 11.8%

0% 5.00% 10.00% 15.00% 20.00%

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Modied IRR (MIRR)

The discount rate which forces the present value of the cash outows to equate the present value of the projects terminal value.

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Modied IRR (MIRR)

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Modied IRR (MIRR)

The Decision Criteria

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If the MIRR is greater than the cost of capital, ACCEPT the project. If the MIRR is less than the cost of capital, REJECT the project. If the projects are mutually exclusive, accept the project with the highest MIRR.

Modied IRR (MIRR)

0 -10,000 1 7,000 2 -5,000 3 8,000 4 5,000

= 1.1309 ! 1 = 0.1309 = 13.09%

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Modied IRR (MIRR)

Advantages

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Tells whether or not an investment increases rm value Considers all cash ows of the project Considers time value of money Considers risk of future cash ows

Modied IRR (MIRR)

Disadvantages

Requires an estimate of the rms cost of capital May not give the value-maximizing decision when used to compare mutually exclusive projects May not give the value-maximizing decision when there is capital rationing

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Protability Index (PI)

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Protability Index (PI)

The Decision Criteria

If the PI > 1.0, ACCEPT the project. If the PI < 1.0, REJECT the project. If the projects are mutually exclusive, accept the project with the highest PI.

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Protability Index (PI)

Year 0 1 2 3 4 Cash Flow -1,000 500 400 300 100

PV of cash inflows = 1,078.82 PV of cash outflows = 1,000 PI = 1,078.821,000 = 1.08

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Protability Index (PI)

Advantages

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Tells whether or not an investment increases rm value Considers all cash ows of the project Considers time value of money Considers risk of future cash ows Useful in ranking and selecting projects when capital is rationed

Protability Index (PI)

Disadvantages

Requires an estimate of the rms cost of capital May not give the value-maximizing decision when used to compare mutually exclusive projects

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Beximco Limited is considering an investment proposal to install new equipment costing Tk. 60,000. The facility has life expectancy of ve years and has no salvage value. Assume that the company uses straight line depreciation. The tax rate is 35 percent. The cash ows before depreciation and tax (CFBDT) from the investments are as follows:
Year 1 2 3 4 5 CFBDT Tk. 12,000 12,000 15,000 20,000 25,000

Requirements: (i)Payback period (ii)ARR (iii)IRR (iv)NPV @ 12% discount rate

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Year 1

Year 2

Year 3

Year 4

Year 5

CFBDT Tk. 12,000 Tk. 12,000 Tk. 15,000 Tk. 20,000 Tk. 25,000 (-) Depreciation 12,000 12,000 12,000 12,000 12,000 EBT 0 0 3,000 8,000 13,000 (-) Tax @ 35% 0 0 1,050 2,800 4,550 EAT/NI 0 0 1,950 5,200 8,450 (+) Deprecation 12,000 12,000 12,000 12,000 12,000 CFAT 12,000 12,000 13,950 17,200 20,450 CCF

-48,000

-36,000

-22,050

-4,850

15,600

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NPV at 5% discount rate

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Phoenix Company is considering two mutually exclusive investments, Project P and Project Q. The expected cash ows of these projects are as follows: Year 0 1 2 3 4 5 Project P Project Q Tk -1,000 Tk -1,600 -1,200 -600 -250 2,000 4,000 200 400 600 800 100

Requirements: (i) What is the IRR of each project? (ii) Which project would you choose if the cost of capital is 10 percent? (iii) What is each projects MIRR if the cost of capital is 12 percent? (iv) Construct the NPV proles for projects P and Q.
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Adam Smith is considering automating his pen factory with the purchase of a $475,000 machine. Shipping and installation would cost $5,000. Smith has calculated that automation would result in savings of $45,000 a year due to reduced scrap and $65,000 a year due to reduced labor costs. The machine has a useful life of 4 years for depreciation purposes. The estimated salvage of the machine at the end of four years is $120,000. The old machine is fully depreciated, but has a salvage value today of $100,000. The rms marginal tax rate is 34 percent. What is the initial cash inow at time period 0? What would be the relevant incremental cash inows over the machines useful life?

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Basket Wonders (BW) is considering the purchase of a new basket weaving machine. The machine will cost $50,000 plus $20,000 for shipping and installation and will be depreciated over 4 years. NWC will rise by $5,000. Lisa Miller forecasts that revenues will increase by $110,000 for each of the next 4 years. The machine will then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends. Operating costs will rise by $70,000 for each of the next four years. BW is in the 40 percent tax bracket. What is the initial cash outow? What are the interim incremental net cash ows for each year? What is the terminal year cash ow?

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BugBusters of Antarctica, Inc. is considering replacing a machine that has a four-year life. The purchase of this new machine has a cost of $700,000, shipping cost of $80,000, and a installation charge of $20,000. This machine will not require any additional working capital. The old machine can be salvaged for $75,000 currently. The old machine has four years useful life remaining with a depreciation expense of $200,000. The new machine will not generate additional revenues, but will decrease operating expenses by $90,000 for each of the four-year project. The equipment has four years of operable life. The company is subject to a marginal tax rate of 40%. The salvage value at the end of the fourth year for the new machine is expected to be $50,000. What is the initial cash outow? What are the interim incremental net cash ows for each year? What is the terminal year cash ow?
Tuesday, June 18, 2013