Capital Budgeting

Decide how to invest money so that its value is maximized

Capital Budgeting Process

• Capital budget (investment) proposals are examined on basis of their cash outlays and resulting flow of future benefits over period of time greater than one year.

Capital Budgeting Process

1. Identify alternative investment opportunities and the capital required for each one.

2. Assess organizations ability to generate investment capital for capital budgeting period

Capital Budgeting Process

3. Measure cash (benefit) flows from alternative capital investment opportunities

4. Evaluate proposals using selected criteria

Increase log inventory to reduce risk of mill downtime

during Spring breakup?

Capital Budgeting Process

5. Select alternatives to fund and implement

6. Review performance for feed-backto decision makers

Buy new skidder to reduce maintenance cost on old one and increase productivity?

Criteria to Rank Alternatives

• Net Present Value

• Internal Rate of Return

• Benefit /Cost Ratio

• Payback Period

Notation• ARR – alternative rate of return• B - annual nonmarket value, dollars• B/C - benefit/cost ratio• EAA - equivalent annual annuity• IRR - internal rate of return• MAR – minimum acceptable rate of

return• N - project life, years• NPV = net present value

Notation

• Cy – cost in year y

• PV - present value

• r - real interest rate

• Ry - revenue in year y

• y - index of years

Net Present Value

NPV = ∑

= ∑

Ry Cy

(1+r)y (1+r)yy=0

n

Ry - Cy

(1+r)yy=0

n

Example of NPV

Year Project D

Cash Flows

Project N

Cash Flows

0 -400 -400

5 -100 -100

8 +1,200

15 +200

30 +6,600 +2,500

Project D NPV

C0 = - $400/(1.06)0 = - $ 400.00

C5 = - $100/(1.06)5 = - $ 74.73

R15 = $200/(1.06)15 = $ 83.45

R30 = $6,600/(1.06)30 = $1,149.13

NPV = 757.85

0

1000

2000

3000

4000

5000

6000

7000

8000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Interest Rate

Pre

se

nt

Va

lue

s $

's

PV of costs

PV of revenues

IRR

Comparison of PVC and PVR for example

Net Present Value Guideline

• Project must at least cover the opportunity cost as measured by the minimum acceptable rate of return (MAR) used to calculate present values

• Project is acceptable if NPV is zero or greater

• Projects with negative NPV are unacceptable

Internal Rate of Return (IRR)

• The r that makes NPV = 0

• Find by iterating over r until NPV = 0

• Meaning – r that makes PV of costs and PV of revenues equal

IRR Guideline

• Project is acceptable if its IRR is equal to or greater than the minimum acceptable rate of return (MAR)

• Relationship to NPV criteria – if MAR is the discount rate (r) used to calculate NPV, then IRR and NPV will accept same projects.

Benefit/Cost Ratio

• PV (benefits)/PV (costs), or

• PV (revenues)/PV (expenses)

∑ Ry/(1+r)y

=

∑ Cy/(1+r)y

nn

n

y=0

y=0

Benefit/Cost Ratio Guideline

• Accept project if B/C ≥ 1.0

• If B/C ≥ 1.0 then – NPV ≥ 0, and– IRR ≥ MAR

0

1000

2000

3000

4000

5000

6000

7000

8000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Interest Rate

Pre

se

nt

Va

lue

s $

's

PV of costs

PV of revenues

Relationship of NPV, IRR and B/C

B/C < 1

NPV < 0

B/C > 1

NPV = 0

IRR

Payback Period

• Time required for net revenue to equal invested capital

• Example,– Invest $10,000– Net revenue is $5,000 per year– Payback is 2 years, ($10,000/$5,000)

• Best used in conjunction with other criteria

Ranking Projects

• NPV, IRR, and B/C may not rank alternative projects in the same order

• Additional ranking criteria– Mutually exclusive projects – only one can

be chosen– Independent

• Opposite of mutually exclusive,• Can all be adopted

Ranking Projects

• Additional ranking criteria, cont.– Divisible – can invest in part of a project– Indivisible – all or nothing

Example of NPV

Year Project D

Cash Flows

Project N

Cash Flows

0 -400 -400

5 -100 -100

8 +1,200

15 +200

30 +6,600 +2,500

Timing of cash flows affects rankings

• Alternatives D and N have same total cost and revenue

• Rankings by NPV and IRR are different depending on MAR

NPV project D

NPV project N

NPV same at 6.3%

2 4 6 1410IRR = 9.7%

IRR=14.5%

NPV

Interest Rate