Capital Budgeting

Capital Budgeting

Syed Mohammed Shamsul Arifeen Financial Theory & Practices, MBA Spring 2013, IBA, DUTuesday, June 18, 2013

Capital Budgeting

The process of evaluating and selecting long-term

investments that are consistent with the firm’s goal of

maximizing owners’ wealth.

Tuesday, June 18, 2013

Motives for Capital Expenditure

Capital Expenditure Vs Operating

Expenditure

An outlay of funds resulting in benefits received within 1 year



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

Capital Expenditure Vs Operating

Expenditure



Expansion

Replacement

Renewal Others


Steps in the Process

Proposal generation

Review and analysis

Decision making

Implementation

Follow-up


Basic Terminology

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

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

Independent Projects

Mutually Exclusive Projects


Basic Terminology

Capital RationingUnlimited Fund


Basic Terminology

The financial situation in which a firm is able to accept all independent projects that provide an acceptable return.

The financial situation in which a firm has only a fixed amount available for capital expenditures, and numerous projects compete for this resource.

Unlimited Funds

Capital Rationing


Basic Terminology

Accept-RejectApproach

RankingApproach


Basic Terminology

The evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion.

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

Accept-Reject Approach

Ranking Approach


Basic Terminology

0

1 2 3 4 5

An initial outlay followed only by a series of inflows

ConventionalCash Flow Pattern


Basic Terminology

0

1 2

3

4 5

NonconventionalCash Flow Pattern

An initial outlay followed by a series of inflows and outflows


Basic Terminology

Cash outlays that have already been made and therefore have no effect on the cash flows relevant to a current decision.

Cash flows that could be realized from the best alternative use of an owned asset.

Sunk Costs

Opportunity Costs


Capital Budgeting Techniques

• Accounting Rate of Return (ARR)

• Payback Period

• Discounted Payback Period

• Net Present Value (NPV)

• Internal Rate of Return (IRR)

• Modified Internal Rate of Return (MIRR)

• Profitability Index (PI)


Accounting Rate of Return (ARR)

Focuses on a project’s net income rather than its cash flows

Average annual incomeAverage investment

=

Average annual income = Average cash flow − Average annual depreciation

Average investment = (Cost + Salvage value) ÷ 2



• 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.

The Decision Criteria



RevenueExpenses

433,333200,000

450,000150,000

266,667100,000

200,000100,000

133,333100,000

Before-tax cash flowDepreciation

233,333100,000

300,000100,000

166,667100,000

100,000100,000

33,333100,000

EBTTaxes (TC = 25%)

133,33333,333

200,00050,000

66,66716,667

00

-66,667-16,667

Net income 100,000 150,000 50,000 0 -50,000

Average annual income = (100,000+150,000+50,000+0−50,000)/5 = 50,000Average investment = (500,000+0)/2 = 250,000ARR = 50,000/250,000 = 20%



• Considers accounting profit and not cash flows

• Does not consider time value of money

• Does not consider risk

• Minimum acceptable ARR is determined subjectively

Disadvantages


Payback Period

Year Cash Flow

0 -1,000

1 500

2 400

3 300

4 100

The expected number of years required to recover the initial investment


Payback Period

Year Cash Flow Cumulative Cash Flow

0 -1,000 -1,000

1 500 -500

2 400 -100

3 300 200

4 100 300

Year before complete recovery

Unrecovered investment

Cash flow during the yearin which complete recovery occurs

+=

= 2 + (100/300) = 2⅓ years


Payback Period

• 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

• Easy to compute and intuitive

• Considers cash flows rather than accounting profits

• Measure of project’s riskiness

• Measure of liquidity

Advantages


Payback Period

• Ignores time value of money

• Ignores all cash flows after the payback period

• The maximum acceptable payback period is set subjectively

• Does not indicate whether or not an investment increases the company’s value

Disadvantages


Discounted Payback Period

Year Cash Flow Discounted Cash Flow (@10%)

0 -1,000 -1,000

1 500 455

2 400 331

3 300 225

4 100 68

The expected number of years required to recover the investment from discounted net cash flows



= 2 + (214/225) = 2.95 years

Year CF DCF (@10%) CDCF

0 -1,000 -1,000 -1,000

1 500 455 -545

2 400 331 -214

3 300 225 11

4 100 68 79



• Considers cash flows rather than accounting profits

• Considers time value of money

• Is a measure of project’s riskiness

• Is a measure of liquidity

Advantages



• Ignores all cash flows after the payback period

• The maximum acceptable discounted payback period is set subjectively

• Does not indicate whether or not an investment increases the company’s value

Disadvantages


Net Present Value (NPV)

The difference between the present value of the cash inflows and the present value of the cash outflows of a project discounted at a rate equal to the firm’s cost of capital.

= PV of Cash Inflows − PV of Cash Outflows



• 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.



Net Present Value (NPV)Calculation

=78.82

0 1 2 3 4

-1,000 500 400 300 100


NPV Profile

A graph which relates a project’s NPV to the

discount rate used to calculate the NPV


NPV Profile

-150.00

0

150.00

300.00

0 0.05 0.10 0.15 0.20

Cost of capital (%)

Net Present Value (Tk)

IRR = 14.5%

Net Present Value Profile


• Tells whether or not an investment increases firm value

• Considers all cash flows of the project


• Considers risk of future cash flows

Advantages



• Requires an estimate of the firm’s cost of capital

• Expressed in terms of dollars, not as a percentage

Disadvantages



Internal Rate of Return(IRR)

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


Internal Rate of Return (IRR)

• 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


Calculation

0 1 2 3 4

-1,000 500 400 300 100



Calculation


= 0.1243

=12.43%


Improper Decision

Year 0 1 IRR

CFL -100,000 120,000 20%

CFB 83,333 -100000 20%

-20000

-15000

-10000

-5000

0

5000

10000

15000

20000

0 12.5 25.0 37.5 50.0-20000

-15000

-10000

-5000

0

5000

10000

15000

20000

0 12.5 25.0 37.5 50.0

k (%)

NPV (Tk)

Investment or Financing?


No IRR

Year 0 1 2

CF 1.0 -2.0 1.5

0

0.10

0.20

0.30

0.40

0.50

0.60

0% 24% 48% 72% 96% 120% k (%)

NPV (Tk)


Multiple IRR

Year 0 1 2

CF -1.5 10 -10

-1.50

-1.25

-1.00

-0.75

-0.50

-0.25

0

0.25

0.50

0.75

1.00

1.25

1.50

0% 100% 200% 300% 400% 500%

k (%)

NPV

(T

k)IRR2

IRR1






Advantages




• 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 non-conventional cash flow pattern

Disadvantages



• For independent projects: there is no conflict

• For mutually exclusive projects

Conflict between NPV & IRR

- Scale difference

- Timing difference


Scale DifferenceYear 0 1 2 3 4 5

Project L -20 6 6 6 6 6

Project S -6 2 2 2 2 2

Project ∆ -14 4 4 4 4 4

NPVL = Tk 2.74 NPVS = Tk 1.58 NPV∆ = Tk 1.16

IRRL = 15.2% IRRS = 19.9% IRR∆ = 13.2%

k = 10%


Timing DifferenceYear 0 1 2 3 4 5

Project L -10 0 2 3 5 9

Project S -10 4 4 3 3 2

Project ∆ 0 -4 -2 0 2 7

NPVL = Tk 2.91 NPVS = Tk 2.49 NPV∆ = Tk 0.42

IRRL = 17.3% IRRS = 20.5% IRR∆ = 12.5%

k = 10%


Cause of Conflict

The use of NPV method implicitly assumes that the opportunity cost rate at which cash flows can be reinvested is the cost of capital.

The IRR method assumes that the firm has the opportunity to reinvest at the IRR.

Reinvestment Rate Assumption


Cause of Conflict

The correct reinvestment rate assumption is the

cost of capital, which is implicit in the NPV method.

Reinvestment Rate Assumption


NPV Profiles

-200

-100

0

100

200

300

400

500

0% 5.00% 10.00% 15.00% 20.00%-200

-100

0

100

200

300

400

500

0% 5.00% 10.00% 15.00% 20.00%

Cost of capital (%)

Net Present Value (Tk)

IRRS = 14.5%

IRRL = 11.8%

Fisher’s Rate of Intersectionor

Crossover Rate = 7.2%


Modified IRR (MIRR)

The discount rate which forces the present value of the cash outflows to equate the present value of the project’s terminal value.


Modified IRR (MIRR)


Modified IRR (MIRR)

• 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.



Modified IRR (MIRR)

0 1 2 3 4

-10,000 7,000 -5,000 8,000 5,000

= 1.1309 − 1 = 0.1309 = 13.09%






Advantages

Modified IRR (MIRR)




• May not give the value-maximizing decision when there is capital rationing

Disadvantages

Modified IRR (MIRR)


Profitability Index (PI)



• 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.




PV of cash inflows = 1,078.82

PV of cash outflows = 1,000

PI = 1,078.82÷1,000 = 1.08

Year Cash Flow

0 -1,000

1 500

2 400

3 300

4 100






• Useful in ranking and selecting projects when capital is rationed

Advantages





Disadvantages



Beximco Limited is considering an investment proposal to install new equipment costing Tk. 60,000. The facility has life expectancy of five years and has no salvage value. Assume that the company uses straight line depreciation. The tax rate is 35 percent. The cash flows before depreciation and tax (CFBDT) from the investments are as follows:

Year CFBDT

1 Tk. 12,000

2 12,000

3 15,000

4 20,000

5 25,000

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


CFBDT(-) DepreciationEBT(-) Tax @ 35%EAT/NI(+) DeprecationCFAT

Year 1

Tk. 12,00012,000

000

12,00012,000

Year 2

Tk. 12,00012,000

000

12,00012,000

Year 3

Tk. 15,00012,000

3,0001,0501,950

12,00013,950

Year 4

Tk. 20,00012,0008,0002,8005,200

12,00017,200

Year 5

Tk. 25,00012,00013,0004,5508,450

12,00020,450

CCF -48,000 -36,000 -22,050 -4,850 15,600


NPV at 5% discount rate


Phoenix Company is considering two mutually exclusive investments, Project P and Project Q. The expected cash flows of these projects are as follows:

Year Project P Project Q

0 Tk -1,000 Tk -1,600

1 -1,200 200

2 -600 400

3 -250 600

4 2,000 800

5 4,000 100

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 project’s MIRR if the cost of capital is 12 percent?(iv)Construct the NPV profiles for projects P and Q.


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 firm’s marginal tax rate is 34 percent.

What is the initial cash inflow at time period 0?

What would be the relevant incremental cash inflows over the machine’s

useful life?


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 outflow?

What are the interim incremental net cash flows for each year?

What is the terminal year cash flow?


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 outflow?

What are the interim incremental net cash flows for each year?

What is the terminal year cash flow?


Capital Budgeting

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