Long Term Investment Decisions -Capital Budgeting

By :

Anmol Saini

OutlineWhat is Capital Budgeting?

Classification of investment

Stages in Capital Budgeting Process

Decision-making Criteria in Capital Budgeting

Methods of Evaluating Investment Proposals

Payback PeriodNet Present Value (NPV)Profitability IndexInternal Rate of Return (IRR)

Summary and Conclusions

What is Capital Budgeting? Capital Budgeting is the process of evaluating and selecting long-term

investment projects that achieve the goal of owner wealth maximization.

Features of investment decision:

1. exchange of current funds for future benefits

2. funds are invested in long term assets

3. future benefits will occur to firm over a series of year

The purposes of Capital Budgeting Projects include: to expand, replace, or renew fixed assets over a long period.

requires intensive planning

As It involve commitment of financial resources to a project on a long-term basis, it is important that a firm makes the right decision.

A wrong decision can lead to huge financial distress and even bankruptcy for a firm.

The longer the time horizon associated with a capital expenditure, the greater the uncertainty ( outflow and inflow, product life, economic conditions, cost of capital, technological change)

Type I: a: expansion and diversification

- adding capacity to expand existing operations

- expand by adding a new business or new product

b: replacement and modernization

- to improve operational efficiency and reducing the cost

Type II: a: mutually exclusive( serve same purpose, compete with each other)

b: independent(different purposes, do not compete)

c: contingent (dependent projects)

Classification of Investment Decisions

Stages in Investment Process

1. Generating alternative investment proposals

2. Estimating the incremental cash flows associated with projects

3. Estimation of required rate of return (opportunity cost of capital)

4. Evaluating and selecting project

Decision-making Criteria in Capital Budgeting

The Ideal Evaluation Method: considers the time value of money, focuses on resultant cash flows, uses a firm’s cost of capital as the discount rate to evaluate a project. Consider all cash flows to determine profitability Should help ranking the projects according to their true profitability Should recognize the fact that bigger cash flows are preferable to smaller

ones and early cash flows are preferable to later ones Should help in choosing among mutually exclusive projects

Converting Accounting Flow to Cash Flow

Earnings before depreciation and taxes . . . . . . 20,000Depreciation . . . . . . . . . . . . . . -5,000Earnings before taxes . . . . . . . . . . . 15,000Taxes (50%) . . . . . . . . . . . . . . - 7,500Earnings after taxes . . . . . . . . . . . . 7,500Depreciation . . . . . . . . . . . . . . + 5,000Cash flow . . . . . . . . . . . . . . . 12,500

Methods of Evaluating Investment Proposals

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

Accounting rate of return (ARR)

Payback Period (PP)

Net Present ValueNet Present Value (NPV):

the present value of the cash inflows minus the present value of the cash outflows

the future cash flows are discounted back over the life of the investment

the basic discount rate is usually the firm’s cost of capital Accept/Reject Decision:

if NPV > 0, accept the project

if NPV < 0, reject the project

Internal Rate of Return Is the Rate of Return that equates the initial cash outflow (cost) with

the future cash inflows (benefits)

is the discount rate where the cash outflows equal the cash inflows (or NPV = 0), that is, IRR is simply the discount rate at which the NPV of the project equals zero.

Accept/Reject Decision:

if IRR > cost of capital, accept the project

if IRR < cost of capital, reject the project

Profitability Index (PI)

Profitability Index (PI):

is computed by dividing the present value of inflows by the present value of outflows.

Accept/Reject Decision:

if PI > 1, accept the project

if PI < 1, reject the project

Payback Period

computes the amount of time required to recover the initial investment

Advantages:

Easy to understand and use

Emphasizes the shorter time-horizon

Disadvantages:

ignores inflows after the cutoff period

fails to consider the time value of money

fails to consider any required rate of return

Project Data

Net Cash Inflows (of a 10,000 investment)

Year Investment A Investment B

1 3000 1,500

2 5,000 2,000

3 2,000 2,500

4 2000 5,000

5 3000 5,000

cost of capital = 10%

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Capital budgeting results

Investment A Investment B SelectionPayback period . . . . 3 years 3.8 years Quickest payback:

Investment A

Net present value . . . 1588 1,413 Highest net present value:

Investment A

Internal rate of return 16.54% 14.33% Highest yield: Investment A

Profitability Index . . 1.16 1.141 Highest relativeprofitability:

Investment A

NPV – most reliable measure

Payback period is the least reliable measure of project acceptability. NPV, PI and IRR are more reliable measure.

In case of conflict among NPV, PI and IRR, NPV should prevail. NPV has proven to be the only reliable measure of a project’s acceptability.

Consider all cash flow

True measure of profigtability

Recognizes time values of money

Consistent with SWM principle

NPV is the only measure which always gives the correct decision when evaluating projects.

Only NPV measures the amount by which a project would increase the value of the firm.

Summary and Conclusions

A capital budgeting decision involves planning cash flows for a long-term investment

Several methods are used to analyse investment proposals: payback, net present value, internal rate of return, and profitability index

The net present value method, in particular, considers the amount and timing of cash flows

The analysis is based upon estimates of incremental cash flows after tax that will result from the investment