KHALID AZIZ

Capital Budgeting

2

JOIN KHALID AZIZ

• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

• FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.

• COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.

• CONTACT:

• 0322-3385752

• 0312-2302870

• 0300-2540827

• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

3

The capital budgeting process involves three basic steps:

• Generating long-term investment proposals;

• Reviewing, analyzing, and selecting from the proposals that have been granted, and

• Implementing and monitoring the proposals that have been selected.

Managers should separate investment and financing decisions.

The Capital Budgeting Decision Process

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Payback period: most commonly used

Accounting rate of return (ARR): focuses on project’s impact on accounting profits

Net present value (NPV): best technique theoretically; difficult to calculate realistically

Internal rate of return (IRR): widely used with strong intuitive appeal

Profitability index (PI): related to NPV

Capital Budgeting Decision Techniques

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Account for the time value of money;

Account for risk;

Focus on cash flow;

Rank competing projects appropriately, and

Lead to investment decisions that maximize shareholders’ wealth.

A Capital Budgeting Process Should:

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Example: Global Wireless

• Global Wireless is a worldwide provider of wireless telephony devices.

• Global Wireless is contemplating a major expansion of its wireless network in two different regions:– Western Europe expansion– A smaller investment in Southeast U.S. to

establish a toehold

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Global Wireless

Initial Outlay

-$250

Year 1 inflow

$35

Year 2 inflow

$80

Year 3 inflow

$130

Year 4 inflow

$160

Year 5 inflow

$175Initial Outlay

-$50

Year 1 inflow

$18

Year 2 inflow

$22

Year 3 inflow

$25

Year 4 inflow

$30

Year 5 inflow

$32

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Can be computed from available accounting data

ARR uses accounting numbers, not cash flows; no time value of money.

vestmentAverage in

r taxesofits afteAverage prARR

Average profits after taxes

Average annual operating cash inflows

Average annual depreciation

= –

• Need only profits after taxes and depreciation.

• Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.

Accounting Rate Of Return (ARR)

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The payback period is the amount of time required for the firm to recover its initial investment.

• If the project’s payback period is less than the maximum acceptable payback period, accept the project.

• If the project’s payback period is greater than the maximum acceptable payback period, reject the project.

Management determines maximum acceptable payback period.

Payback Period

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• Management’s cutoff is 2.75 years.

• Western Europe project: initial outflow of -$250M– But cash inflows over first 3 years is only $245 million.– Global Wireless will reject the project (3>2.75).

• Southeast U.S. project: initial outflow of -$50M– Cash inflows over first 2 years cumulate to $40 million.– Project recovers initial outflow after 2.40 years.

• Total inflow in year 3 is $25 million. So, the project generates $10 million in year 3 in 0.40 years ($10 million $25 million).

– Global Wireless will accept the project (2.4<2.75).

Payback Analysis For Global Wireless

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Advantages of payback method:

• Computational simplicity• Easy to understand

• Focus on cash flow

Disadvantages of payback method:

• Does not account properly for time value of money

• Does not account properly for risk• Cutoff period is arbitrary

• Does not lead to value-maximizing decisions

Pros and Cons of the Payback Method

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• Discounted payback accounts for time value.• Apply discount rate to cash flows during payback period.• Still ignores cash flows after payback period.

• Global Wireless uses an 18% discount rate.

Discounted Payback

Reject (46.3<50)Reject (166.2 < 250)

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NPV: The sum of the present values of a project’s cash inflows and outflows.

Discounting cash flows accounts for the time value of money.

Choosing the appropriate discount rate accounts for risk.

NN

r

CF

r

CF

r

CF

r

CFCFNPV

)(...

)()()(

1111 33

221

0

Accept projects if NPV > 0.

Net Present Value (NPV)

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NN

r

CF

r

CF

r

CF

r

CFCFNPV

)(...

)()()(

1111 33

221

0

A key input in NPV analysis is the discount rate.

r represents the minimum return that the project must earn to satisfy investors.

r varies with the risk of the firm and /or the risk of the project.

Net Present Value (NPV)

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• Assuming Global Wireless uses 18% discount rate, NPVs are:

5432 )18.1(

175

)18.1(

160

)18.1(

130

)18.1(

80

)18.1(

352503.75$ EuropeWesternNPV

Western Europe project: NPV = $75.3 million

5432.. )18.1(

32

)18.1(

30

)18.1(

25

)18.1(

22

)18.1(

18507.25$ SUSoutheastNPV

Southeast U.S. project: NPV = $25.7 million

Should Global Wireless invest in one project or both?

NPV Analysis for Global Wireless

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The NPV Rule and Shareholder Wealth

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Key benefits of using NPV as decision rule:

• Focuses on cash flows, not accounting earnings• Makes appropriate adjustment for time value of

money• Can properly account for risk differences between

projects

Though best measure, NPV has some drawbacks:

• Lacks the intuitive appeal of payback, and• Doesn’t capture managerial flexibility (option

value) well.

NPV is the “gold standard” of investment decision rules.

Pros and Cons of NPV

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NN

r

CF

r

CF

r

CF

r

CFCFNPV

)(....

)()()(

11110

33

221

0

IRR: the discount rate that results in a zero NPV for a project.

The IRR decision rule for an investing project is:

• If IRR is greater than the cost of capital, accept the project.

• If IRR is less than the cost of capital, reject the project.

Internal Rate of Return (IRR)

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NPV Profile and Shareholder Wealth

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Western Europe project: IRR (rWE) = 27.8%

5432 )1(

175

)1(

160

)1(

130

)1(

80

)1(

352500

WEWEWEWEWE rrrrr

Southeast U.S. project: IRR (rSE) = 36.7%

5432 )1(

32

)1(

30

)1(

25

)1(

22

)1(

18500

SESESESESE rrrrr

Global Wireless will accept all projects with at least 18% IRR.

IRR Analysis for Global Wireless

21

JOIN KHALID AZIZ

• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

• FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.

• COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.

• CONTACT:

• 0322-3385752

• 0312-2302870

• 0300-2540827

• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

22

Advantages of IRR:

• Properly adjusts for time value of money

• Uses cash flows rather than earnings

• Accounts for all cash flows

• Project IRR is a number with intuitive appeal

Disadvantages of IRR:

• “ Mathematical problems”: multiple IRRs, no real solutions

• Scale problem

• Timing problem

Pros and Cons of IRR

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Which IRR do we use?

IRR

IRR

When project cash flows have multiple sign changes, there can be multiple IRRs.

Multiple IRRs

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Sometimes projects do not have a real IRR solution.

Modify Global Wireless’s Western Europe project to include a large negative outflow (-

$355 million) in year 6.

•There is no real number that will make NPV=0, so no real IRR.

Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!

No Real Solution

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NPV and IRR do not always agree when ranking competing projects.

$25.7 mn36.7%Southeast U.S.

$75.3 mn27.8%Western Europe

NPV (18%)IRRProject

• The Southeast U.S. project has a higher IRR, but doesn’t increase shareholders’ wealth as much as the Western Europe project.

The scale problem:

Conflicts Between NPV and IRR:The Scale Problem

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Conflicts Between NPV and IRR:The Scale Problem

Why the conflict?

• The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project.

• Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive.

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Conflicts Between NPV and IRR:The Timing Problem

• The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.

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Conflicts Between NPV and IRR:The Timing Problem

Because of the differences in the timing of the two projects’ cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign.

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Decision rule: Accept project with PI > 1.0, equal to NPV > 0

0

221

)1(...

)1()1(CF

r

CF

r

CF

r

CF

PIN

N

• Both PI > 1.0, so both acceptable if independent.

1.5$50 million$75.7 millionSoutheast U.S.

1.3$250 million$325.3 millionWestern Europe

PIInitial OutlayPV of CF (yrs1-5)Project

Calculated by dividing the PV of a project’s cash inflows by the PV of its initial cash

outflows.

Like IRR, PI suffers from the scale problem.

Profitability Index

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Methods to generate, review, analyze, select, and implement long-term investment proposals:

• Accounting rate of return

• Payback Period

• Discounted payback period

• Net Present Value (NPV)

• Internal rate of return (IRR)

• Profitability index (PI)

Capital Budgeting

31

JOIN KHALID AZIZ

• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

• FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.

• COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.

• CONTACT:

• 0322-3385752

• 0312-2302870

• 0300-2540827

• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.