Lecture+5+ +Capital+Budgeting

7/30/2019 Lecture+5+ +Capital+Budgeting

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Capital budget is an out line of planned investment

in fixed assets and

CAPITAL BUDGETING is the process of analyzing

projects and deciding which ones to include in the

various capital budgets.

PROJECT CLASSIFICATIONSAnalysing projects can be expensive.

For certain types of projects, a relatively detailed

analysis may be required, for others simple

procedures may be used.Firms therefore categorize projects and analyse

the categories differently.

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1. Replacement: Maintenance of business

consists of expenditures to replace worn-out or

damaged equipment used in the production ofprofitable products.

Maintenance decisions are made without going

through an elaborate decision process.

2. Replacement: Cost reduction.

This category includes expenditures to replace

serviceable but obsolete equipment. The purpose is to

lower the cost of labour, materials and other inputssuch as electricity. These decisions are discretionary

and a fairly detailed analysis is generally required.

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3. Expansion of existing products or markets:

These include expenditures to increase output of

existing products, or to expand retail outlets ordistribution facilities in markets now being

served.

Decisions here are more complex on the basisthat they require an explicit forecast of growth in

demand.

More detailed analysis are required to avoidmistakes

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4. Expansion into new products or markets

- These involve investment to produce a new product

or to expand into a new geographic area not currentlybeing served.

- These are projects which involve strategic decisions

that could change the fundamental nature of the

business

- They require expenditure of large sums of money with

delayed paybacks

- A detailed analysis is required- Financial decisions are made at the very top by the

Board of Directors as part of the strategic plan.

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5. Safety and ,or environmental projects

- These involve expenditures to comply withgovernment safety standards, labour agreements, or

insurance policy terms.

-These expenditures are called mandatory

investments and often non-revenue producingprojects

- Handling of these projects depend on their size

- Smaller ones may handled like category one

described above.

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6. Other

These may include office buildings, parking

lots, executive aircrafts etc. the handling ofsuch projects varies among companies.

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Steps

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.3. Determine k = WACC for project.

4. Find NPV and/or IRR.

5. Accept if NPV > 0 and/or IRR >WACC.

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EVALUATING STEPS INVOLED IN CAPITAL

BUDGETING ANALYSIS.

First determine the cost of the project-Management estimates the expected cash

flows from the project, including the salvage

value of the asset at the end of the expectedproject life.

-- The riskiness of the projected cash flows

must be estimated. This requires information

about the probability distribution (riskiness)

of the cash flows

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Steps continued

- Given the projects riskiness, management determinesthe cost of capital at which the cash flows are

discounted.

- The expected cash inflows are discounted to obtain

an estimate of the assets value.

- Lastly, the present value of the expected cash inflows

is compared with the initial or required outlay. If the PV

of cash flows exceeds the cost, the project is accepted.Otherwise it is rejected. Alternatively, if the projects IRR

exceeds the cost of capital, the project is accepted

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Normal Cash Flow Project:Cost (negative CF) followed by a series of positive

cash inflows.One change of signs.

Nonnormal Cash Flow Project

Two or more changes of signs.

Most common: Cost (negative CF), then string of

positive CFs, then cost to close project.

Nuclear power plant, strip mine.

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Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN

- + + + + + N

- + + + + - NN

- - - + + + N

+ + + - - - N

- + + - + - NN


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CAPITAL BUDGETING DECISION RULES

Five main methods are used in rankingprojects and to decide whether or not the

project should be accepted for inclusion in

the capital budget.

They include

- Payback

- Discounted payback

- Net Present Value (NPV)-Internal Rate of Returns (IRR)

-Profitability Index

- Modified Internal Rate of Return (MIRR) 13


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We will use table 1 for projects S & L to illustrate each

of the methods.

We assume both projects are equally riskyThe cash flows CFt; are expected values

They have been adjusted to reflect taxes, depreciation

and salvage values

Many projects require investments in both fixed

assets and working capital. So the investment outlays

shown as CF0 include the necessary changes in net

operating working capital.We assume that all cash flows occur at the end of the

designated year.

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YEAR PROJECT

(S)

PROJECT

(L)

0 (1000) (1000)

1 500 100

2 400 3003 300 400

4 100 600

TABLE 1: EXPECTED AFTER-TAX NET CASH

FLOWS, CFt

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Independent and mutually exclusive

projects?

Projects are:

independent, if the cash flows of one are

unaffected by the acceptance of the other.

mutually exclusive, if the cash flows ofone can be adversely impacted by the

acceptance of the other.

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PAYBACK PERIOD

Defined as the expected number years required to

recover the original investment(calculate the payback period for projects S & L).Paybacks = year before full recovery + unrecovered cost at start of

year/Cash flow during year

= 2 + 100/300 = 2.33 yearsCalculate payback for project L

NB . The shorter the payback period the better

If the firm required payback period of 3 years S is

accepted and L rejected

If both projects are mutually exclusive, S would be

ranked over L since S has lower payback period

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Strengths of Payback:

1. Provides an indication of a projects risk andliquidity.

2. Easy to calculate and understand.

Weaknesses of Payback:

1. Ignores the time value of money

2. Ignores CFs occurring after the payback

period.

3. Biased against long-term projects, such as

research and development, and new projects


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Discounted Payback

- Variant of the regular payback period

-Similar to the regular payback period except that the

expected cash flows are discounted by the projects

cost of capital.

-The discounted payback period is therefore definedas the number of years required to recover the

investment from discounted net cash flows.

- Discounted payback for projects S = 2.95 years

-Discounted payback for project L = 3.88 years.-(to be done in class)

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Advantages and disadvantages of the discounted

payback period

Advantages1. Includes time value of money

2. Easy to understand

3. Does not accept negative estimated NPV investments

4. Biased towards liquidity

5. It shows the breakeven year after covering debt and equity(capital) costs

Disadvantages

1. May reject positive NPV investments

2. Requires an arbitrary cutoff point3. Ignores cash flows beyond the cutoff date

4. Biased against long-term projects such as research and

development, and new projects


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.

10t

t

n

t k

CFNPV

NPV: Sum of the PVs of inflows andoutflows.

Cost often is CF0 and is negative.

.CFk1

CFNPV

0t

tn

1t

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Whats Project Ss NPV?

500 100400

0 1 2 410%

Project S:

-1000

454.55

330.58

68.30

78.82 = NPVS22

3

300

225.39


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Whats Project Ls NPV?

100 600300

0 1 2 410%

Project S:

-1000

90.9

247.93

409.81

49.18 = NPVL23

3

400

300.53


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Rationale for the NPV Method

- NPV of zero means that the projects cash flows are

exactly sufficient to repay the investment capital and

to provide the required rate of return on that capital.

If a project has a positive NPV, then it is generating

more cash than is needed to service its debt and to

provide the required returns to shareholders, this

excess cash accrues solely to the stockholders.Projects with positive NPV improve stockholders

wealth by the NPV.

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Rationale for the NPV Method

NPV = PV inflows - Cost= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutuallyexclusive projects on basis ofhigher NPV. Adds most value.

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Using NPV method, which project(s)

should be accepted?

If Projects S and L are mutually

exclusive, accept S because NPVs >NPVL .

If S & L are independent, accept

both; NPV > 0.

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The Profitability Index (PI)

Minimum Acceptance Criteria: Accept if PI > 1

Ranking Criteria: Select alternative with highest PI

InvestentInitial

FlowsCashFutureofPVTotalPI


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The Profitability Index

Disadvantages:

Problems with mutually exclusive investments

Advantages:

May be useful when available investment funds

are limited

Easy to understand and communicate

Correct decision when evaluating independentprojects


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INTERTNAL RATE OF RETURN (IRR)

IRR is defined as the discount rate that

equates the present value of a projects

expected cash inflows to the present value of

the projects cost.

PV (inflows) = PV (investment costs)Or the rate that forces the NPV to equal zero

Calculate the IRR for projects L and S

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Internal Rate of Return: IRR

0 1 3 4

CF0 CF1 CF3 CF4Cost Inflows

IRR is the discount rate that forcesPV inflows = cost. This is the same

as forcing NPV = 0.

30

2

CF2


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.NPVk1

CFt

t

n

0t

.0IRR1CF

t

t

n

0t

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

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Whats Project Ss IRR?

500 100400

0 1 2 4IRR = ?

-1000

PV4

PV2PV1

0 = NPV

IRRS = 14.5%.

300

3

PV3

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Whats Project Ls IRR?

100 600300

0 1 2 4IRR = ?

-1000

PV4

PV2PV1

0 = NPV

IRRL = 11.8%.

400

3

PV3

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90 1,09090

0 1 2 10IRR = ?

Q. How is a projects IRRrelated to a bonds YTM?

A. They are the same thing.A bonds YTM is the IRR

if you invest in the bond.

-1,134.2

IRR = 7.08%

...

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Rationale for the IRR Method


The IRR is special because

It is the projects expected rate of return

If the IRR exceeds the cost of the funds used to

finance the project, a surplus remains after

paying for the capital, and this surplus accrues

to the firms stockholdersUndertaking a project whose IRR exceeds its

cost of capital increases stockholders wealth.

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If IRR > WACC, then the projects

rate of return is greater than itscost-- some return is left over toboost stockholders returns.

Example: WACC = 10%, IRR = 15%.Profitable.

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IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.

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Decisions on Projects S and L per IRR

If S and L are independent, accept both.

IRRs > k = 10%.

If S and L are mutually exclusive, accept Sbecause IRRS > IRRL .

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Construct NPV Profiles

Enter CFs in CFLO and find NPVL and

NPVS at different discount rates:

k0

5

1015

20

NPVL

400

206.18

49.18(80.14)

NPVS

300

180.42

78.82(8.33)

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-100

0

100

200

300

400

60

5 7.2

NPV ($)

Discount Rate (%)

IRRL = 11.8%

IRRS = 14.5%

Crossover

Point = 7.2%

k

0

5

10

15

20

NPVL

400

206.5

49.18

(80.14)

(4)

NPVS

300

180.42

78.82

(8.33)

5

S

L

.

.

...

.

.

. .

..

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NPV and IRR always lead to the same accept/rejectdecision for independent projects:

k > IRR

and NPV < 0.Reject.

NPV ($)

k (%)IRR

IRR > k

and NPV > 0Accept.

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Mutually Exclusive Projects

k 7.2 k

NPV

%

IRRS

IRRL

L

S

k < 7.2: NPVL> NPVS , IRRS > IRRL

CONFLICT

k > 7.2: NPVS> NPVL , IRRS > IRRL

NO CONFLICT

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To Find the Crossover Rate

1. Find cash flow differences between the projects.See data at beginning of the case.

2. Enter these differences in CFLO register, then

press IRR. Crossover rate = 7.2%,3. Can subtract S from L or vice versa, but better to

have first CF negative.

4. If profiles dont cross, one project dominates the

other.

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Two Reasons NPV Profiles Cross

1. Size (scale) differences. Smallerproject frees up funds at t = 0 for

investment. The higher the opportunitycost, the more valuable these funds, sohigh k favors small projects.

2. Timing differences. Project with fasterpayback provides more CF in earlyyears for reinvestment. If k is high,early CF especially good, NPVS > NPVL.

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Reinvestment Rate Assumptions

NPV assumes reinvest at k (opportunitycost of capital).

IRR assumes reinvest at IRR. Reinvest at opportunity cost, k, is more

realistic, so NPV method is best. NPVshould be used to choose betweenmutually exclusive projects.

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Managers like rates--prefer IRR toNPV comparisons. Can we give

them a better IRR?

Yes, MIRR is the discount rate which

causes the PV of a projects terminalvalue (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.

Thus, MIRR assumes cash inflows arereinvested at WACC.


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MIRR = 16.5%

10.0 80.060.0

0 1 2 310%

66.012.1

158.1

MIRR for Project L (k = 10%)

-100.0

10%

10%

TV inflows-100.0

PV outflowsMIRRL = 16.5%

$100 = $158.1(1+MIRRL)

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Why use MIRR versus IRR?

MIRR correctly assumes reinvestmentat opportunity cost = WACC. MIRRalso avoids the problem of multipleIRRs.

Managers like rate of return

comparisons, and MIRR is better forthis than IRR.

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Lecture+5+ +Capital+Budgeting