Capital Budgeting

Capital budgeting• How do we know whether your idea create value or not.

• We understood how market works?• How is pricing done?• How to make risk adjustments?

• Now the perspective changes to that of the corporation.

• How to take projects?

6-1

How will one know whether we are creating value or not?• Context:

• Start with a idea / project (small or big??)• A collection of ideas / projects is a firm / company• Value creation only through good ideas/projects• How do you determine what is good idea or project

• - history of classical finance• - how the world adopted them

6-2

Capital budgeting• Difference between revenue expenditure and capital

expenditure• Capital• Efficient allocation• Capital Budgeting

6-3

4

Introduction• The important points are: Capital budgeting is the most significant financial activity

of the firm.Capital budgeting determines the core activities of the firm

over a long term future.Capital budgeting decisions must be made carefully and

rationally.

Capital budgeting• Long term ‘Investment decision’ of a firm is known as

capital budgeting.• Capital budgeting decision is the decision to invest current

funds efficiently in the long term assets in anticipation of future cash flow/benefits over a series of years

• Capital budgeting involves planning and justifying how ‘capital rupees’ are spent on long term projects

6-5

6

Capital Budgeting Within The FirmThe Position of Capital Budgeting

Capital Budgeting

L o n g T e rm A sse ts S h o rt T e rm A sse ts

Investm ent D ecison

D e b t/E qu ity M ix

Financing D ecis ion

D iv id en d P a yo u t R a tio

D ividend Decision

Financial Goal of the F irm :W ealth M axim isation

Capital budgetingWhat projects should the firm take?• Marketing and advertising • R&D • Choices among different production processes • Expanding into new products, industries, or markets • Investments in new technology • Acquisitions

8

Examples of ‘Long Term Assets’

Project Types and Risk• Replacement projects• Expansion projects• New venture

Projects can be evaluated in another context also• Prerequisites• Stand alone or independent projects• Mutually exclusive• Two ways of doing (or) Monetary constraint

6-9

EVALUATION CRITERIA

6-10

Properties of a good evaluation criteria• Should make sense ( benefit should exceed costs)• Unit of measurement a criteria uses is extremely important.• What is the benchmark?( is it obvious??)• Easy to communicate, why? (research vs applied field)• Easy to compare different ideas• Easy to calculate

6-11

Net Present Value• Simple example:

• Year CF Years to discount PV • Year 0 : -1000• Year 1 : 1320• Similar investments earn 10%?

• Difference between PV and NPV

6-12

Project’s Cash Flows (CFt)

Marketinterest rates

Project’s business risk

Marketrisk aversion

Project’sdebt/equity capacityProject’s risk-adjusted

cost of capital (r)

The Big Picture:The Net Present Value of a

Project

NPV = + + ··· + − Initial cost

CF1

CF2

CFN(1 + r )1 (1 + r)N(1 + r)2

ReviewValuation The value of any asset or project equals the net present

value of its expected cashflows

r = opportunity cost of capital Rate of return required on investments in the financial market with similar risk

A project creates value (NPV > 0) only if it has a higher return than other investments with the same risk

NPV• Where do the ‘cash flows’ come from?

• Where does ‘r’ come from? (opportunity cost of capital?)

• What does the final number mean?

6-15

• It tells us what is the value that is added because of the project in rupee units.

• What will happen if you don’t have money to implement your great project? What comes to our help?

6-16

NPV - what is it actually?

• Value is incremental. To what?

• Existing vs your idea

6-17

Investment decision

Cash

shareholderFirmInvestmentOpportunity(real asset)

InvestmentOpportunities

(financial assets)

investAlternative:Pay dividend

To shareholders

ShareholdersInvest for themselves

Why Use Net Present Value?• Accepting positive NPV projects benefits shareholders.NPV uses cash flowsNPV uses all the cash flows of the projectNPV discounts the cash flows properly

6-19

The Net Present Value (NPV) Rule• Net Present Value (NPV) =

Total PV of future CF’s + Initial Investment

• Estimating NPV:• 1. Estimate future cash flows: how much? and when?• 2. Estimate discount rate• 3. Estimate initial costs

6-20

NPV• Minimum Acceptance Criteria: Accept if NPV > 0• For a single project, take if it and only if its NPV is positive• For many independent projects, take all those with

positive NPV• For mutually exclusive projects, take the one with positive

and highest NPV

6-21

Good Attributes of the NPV Rule• 1. Uses cash flows• 2. Uses ALL cash flows of the project• 3. Discounts ALL cash flows properly

• Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.

• Disadvantage: static

6-22

CHECK!!

• Should make sense ( benefit should exceed costs)• Unit of measurement a criteria uses is extremely

important.• What is the benchmark?• Easy to communicate, why? (research vs applied field)• Easy to compare different ideas• Easy to calculate

6-23

The Payback Period Rule• How long does it take the project to “pay back” its initial

investment?• Payback Period = number of years to recover initial costs• Minimum Acceptance Criteria:

• set by management• Ranking Criteria:

• set by management

6-24

The Payback Period Rule (continued)• Disadvantages:

• Ignores the time value of money• Ignores cash flows after the payback period• Biased against long-term projects• Requires an arbitrary acceptance criteria• A project accepted based on the payback criteria may not have a

positive NPV• Advantages:

• Easy to understand• Biased toward liquidity• Deals with risk

6-25

The Discounted Payback Period Rule• How long does it take the project to “pay back” its initial

investment taking the time value of money into account?• By the time you have discounted the cash flows, you

might as well calculate the NPV.

6-26

The Average Accounting Return Rule

• Another attractive but fatally flawed approach.• Ranking Criteria and Minimum Acceptance Criteria set by management

• Disadvantages:• Ignores the time value of money• Uses an arbitrary benchmark cutoff rate• Based on book values, not cash flows and market values

• Advantages:• The accounting information is usually available• Easy to calculate

6-27

Investent o f V alueBoo k A verageInco meN et A verageA A R

IRR• Year Cashflow (Rs)• 0 - 100• 1 110

• IRR intuition• What is the NPV if I use the IRR to calculate it?• IF one uses IRR to calculate NPV , it should be always be zero. What is it saying?

• What is the only thing that is needed to calculate IRR?• Is the idea good idea? – very important

6-28

The Internal Rate of Return (IRR) Rule• IRR: the discount rate that sets NPV to zero • Minimum Acceptance Criteria:

• Accept if the IRR exceeds the required return.• Ranking Criteria:

• Select alternative with the highest IRR• Reinvestment assumption:

• All future cash flows assumed reinvested at the IRR.

6-29

The Internal Rate of Return (IRR) Rule• Disadvantages:

• Does not distinguish between investing and borrowing.• IRR may not exist or there may be multiple IRR • Problems with mutually exclusive investments

• Advantages:• Easy to understand and communicate

6-30

The Internal Rate of Return: Example

Consider the following project:

6-31

0 1 2 3

$50 $100 $150

-$200

The internal rate of return for this project is ???19.4

32 )1(150

)1(100

)1(502000

IRRIRRIRRNPV

The NPV Payoff Profile for This Example6-32

Discount Rate NPV0% $100.004% $71.048% $47.3212% $27.7916% $11.6520% ($1.74)24% ($12.88)28% ($22.17)32% ($29.93)36% ($36.43)40% ($41.86)

If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.

IRR = 19.44%

($60.00)($40.00)($20.00)

$0.00$20.00$40.00$60.00$80.00

$100.00$120.00

-1% 9% 19% 29% 39%

Discount rate

NPV

Problems with the IRR Approach• Multiple IRRs.• Are We Borrowing or Lending?• The Scale Problem• The Timing Problem

6-33

Multiple IRRsThere are two IRRs for this project:

6-34

0 1 2 3

$200 $800

-$200

- $800

($150.00)

($100.00)

($50.00)

$0.00

$50.00

$100.00

-50% 0% 50% 100% 150% 200%

Discount rate

NPV 100% = IRR2

0% = IRR1

Which one should we use?

The Scale Problem• Would you rather make 100% or 50% on your

investments?• What if the 100% return is on a $1 investment while the

50% return is on a $1,000 investment?

6-35

The Timing Problem6-36

0 1 2 3

$10,000 $1,000$1,000

-$10,000

Project A

0 1 2 3

$1,000 $1,000 $12,000

-$10,000

Project B

What is the bias? What will you choose?• IRR of A is 16.04 %• IRR of B is 12.94%

• Now which will you choose?

• What is the problem here?

6-37

6-38

• The preferred project in this case depends on the discount rate, not the IRR.

• What is the NPV at 10%

• NPV of A is rs 10668

• NPV of B is rs 10751

The Timing Problem6-39

($4,000.00)

($3,000.00)

($2,000.00)

($1,000.00)

$0.00

$1,000.00

$2,000.00

$3,000.00

$4,000.00

$5,000.00

0% 10% 20% 30% 40%

Discount rate

NPV

Project AProject B

10.55% = crossover rate

16.04% = IRRA12.94% = IRRB

Calculating the Crossover Rate6-40

Compute the IRR for either project “A-B” or “B-A”

Year Project A Project B Project A-B Project B-A 0 ($10,000) ($10,000) $0 $01 $10,000 $1,000 $9,000 ($9,000)2 $1,000 $1,000 $0 $03 $1,000 $12,000 ($11,000) $11,000

($3,000.00)($2,000.00)($1,000.00)

$0.00$1,000.00$2,000.00$3,000.00

0% 5% 10% 15% 20%

Discount rate

NPV A-B

B-A

10.55% = IRR

CHECK!!

• Should make sense ( benefit should exceed costs)• Unit of measurement a criteria uses is extremely

important.• What is the benchmark?• Easy to communicate, why? (research vs applied field)• Easy to compare different ideas• Easy to calculate

6-41

The Profitability Index (PI) Rule

• Minimum Acceptance Criteria: • Accept if PI > 1

• Ranking Criteria: • Select alternative with highest PI

• Disadvantages:• Problems of scale and hence• Problems with mutually exclusive investments

• Advantages:• May be useful when available investment funds are limited• Easy to understand and communicate• Correct decision when evaluating independent projects

6-42

Investent Initia lF lo w sC ash F uture o f P V To ta lP I

Why now amount of rupees instead of rate of return?

• Because now we are dealing with the investment of a corporation not an individual investor

• What is the difference??

6-43

Mutually Exclusive vs.Independent Project• Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system.

• RANK all alternatives and select the best one.

• Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.

• Must exceed a MINIMUM acceptance criteria.

6-44

6.8 The Practice of Capital Budgeting

• Varies by industry:• Earlier many firms used payback, others used accounting rate of

return.• Now many firms use IRR or NPV as the primary or secondary tool and

Payback continues to be a important tool albeit secondary .• The most frequently used technique for large corporations is

IRR or NPV.

6-45

Problems• The expected cash flow of a project are as follows

•The cost of capital is 12%. Calculate a) payback period b)discounted payback period c) NPV d) IRR e) PI

6-46

Year Cash flow

0 -100000

1 20,000

2 30,000

3 40,000

4 50,000

5 30,000

Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%.

Year Project A Project B0 -$200 -$1501 $200 $502 $800 $1003 -$800 $150

6-47

Example of Investment Rules

Project A Project BCF0 -$200.00 -$150.00

PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80IRR = 0%, 100% 36.19%PI = 1.2096 1.6053

6-48

Example of Investment Rules

Payback Period:Project A Project B

Time CF Cum. CF CF Cum. CF0 -200 -200 -150 -1501 200 0 50 -1002 800 800 100 03 -800 0 150 150

Payback period for project B = 2 years.Payback period for project A = 1 or 3 years?

6-49

Relationship Between NPV and IRRDiscount rate NPV for A NPV for B

-10% -87.52 234.770% 0.00 150.00

20% 59.26 47.9240% 59.48 -8.6060% 42.19 -43.0780% 20.85 -65.64

100% 0.00 -81.25120% -18.93 -92.52

6-50

NPV Profiles6-51

Project AProject B

($200)

($100)

$0

$100

$200

$300

$400

-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%

Discount rates

NPV

IRR 1(A) IRR (B)

Cross-over Rate

IRR 2(A)

Summary and Conclusions• This chapter evaluates the most popular alternatives to

NPV:• Payback period• Internal rate of return• Profitability index

• When it is all said and done, they are not the NPV rule; for those of us in finance, it makes them decidedly second-rate.

6-52