Sesi1 Cap Budgeting Technique

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Copyright 2012 Pearson Education

Chapter 10

Capital

Budgeting

Techniques


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2012 Pearson Education 10-2

Learning Goals

LG1 Understand the key elements of the capital budgeting

process.

LG2 Calculate, interpret, and evaluate the payback period.

LG3 Calculate, interpret, and evaluate the net present value

!"#$ and economic value added %#&$


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Learning Goals (cont.)

LG' Calculate, interpret, and evaluate the internal rate of

return ())$.

LG* Use net present value profiles to compare !"# and()) techni+ues.

LG -iscuss !"# and ()) in terms of conflicting

rankings and the theoretical and practical strengths ofeach approach.


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Overview of Capital Budgeting

Capital budgetingis the process of evaluating and

selecting long/term investments that are consistent 0ith

the firms goal of maimiing o0ner 0ealth.

& capital expenditureis an outlay of funds by the firmthat is epected to produce benefits over a period of time

greater than1 year.

&n operating expenditureis an outlay of funds by thefirm resulting in benefits received within1 year.


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Overview of Capital Budgeting:

Steps in the rocess

4he capital budgeting processconsists of five steps5

Proposal generation."roposals for ne0 investment pro6ects are made at alllevels 0ithin a business organiation and are revie0ed by financepersonnel.

Review and analysis.7inancial managers perform formal revie0 andanalysis to assess the merits of investment proposals

Decision making.7irms typically delegate capital ependiture decisionmaking on the basis of dollar limits.

Implementation.7ollo0ing approval, ependitures are made and pro6ects

implemented. %penditures for a large pro6ect often occur in phases.

Follow-up.)esults are monitored and actual costs and benefits arecompared 0ith those that 0ere epected. &ction may be re+uired if actualoutcomes differ from pro6ected ones.


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2012 Pearson Education 10-!


Basic !er"inolog#

(ndependent versus 8utually %clusive "ro6ects

Independent projectsare pro6ects 0hose cash flo0s are

unrelated to or independent of$ one another9 the acceptance of

one does not eliminatethe others from further consideration. Mutually exclusive projectsare pro6ects that compete 0ith one

another, so that the acceptance of one eliminatesfrom further

consideration all other pro6ects that serve a similar function.


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Basic !er"inolog# (cont.)

Unlimited 7unds versus Capital )ationing

Unlimited fundsis the financial situation in 0hich a firm is

able to accept all independent pro6ects that provide an

acceptable return. Capital rationingis the financial situation in 0hich a firm has

only a fied number of dollars available for capital

ependitures, and numerous pro6ects compete for these dollars.


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Basic !er"inolog# (cont.)

&ccept/)e6ect versus )anking &pproaches

&n acceptreject approachis the evaluation of capital

ependiture proposals to determine 0hether they meet the firms

minimum acceptance criterion. & ranking approachis the ranking of capital ependiture

pro6ects on the basis of some predetermined measure, such as

the rate of return.


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Capital Budgeting !echni$ues

:ennett Company is a medium sied metal fabricator that is

currently contemplating t0o pro6ects5 "ro6ect & re+uires an

initial investment of ;'2,


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!a%le 10.1 Capital &'penditure

ata for Bennett Co"pan#


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2012 Pearson Education 10-

igure 10.1 Bennett Co"pan#*s

ro+ects , and B


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a#%ac- eriod

4he payback methodis the amount of time re+uired for afirm to recover its initial investment in a pro6ect, ascalculated from cash inflo0s.

-ecision criteria5 4he length of the maimum acceptable payback period is

determined by management.

(f the payback period is less thanthe maimum acceptable

payback period, acceptthe pro6ect. (f the payback period isgreater thanthe maimum acceptable

payback period, rejectthe pro6ect.


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a#%ac- eriod (cont.)

=e can calculate the payback period for :ennett Companys pro6ects &and : using the data in 4able 1


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a#%ac- eriod: ros and Cons

of a#%ac- ,nal#sis

4he payback method is 0idely used by large firms to evaluate small

pro6ects and by small firms to evaluate most pro6ects.

(ts popularity results from its computational simplicity and intuitive

appeal.

:y measuring ho0 +uickly the firm recovers its initial investment,

the payback period also gives implicit consideration to the timing

of cash flo0s and therefore to the time value of money.

:ecause it can be vie0ed as a measure of risk eposure, many firmsuse the payback period as a decision criterion or as a supplement to

other decision techni+ues.


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a#%ac- eriod: ros and Cons

of a#%ac- ,nal#sis (cont.)

4he ma6or 0eakness of the payback period is that the appropriate

payback period is merely a sub6ectively determined number.

(t cannot be specified in light of the 0ealth maimiation goal because it is

not based on discounting cash flo0s to determine 0hether they add to the

firms value.

& second 0eakness is that this approach fails to take fully into

account the time factor in the value of money.

& third 0eakness of payback is its failure to recognie cash flo0s

that occur after the payback period.


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ocus on ractice

Limits on "ayback &nalysis

=hile easy to compute and easy to understand, the paybackperiod simplicity brings 0ith it some dra0backs.

=hatever the 0eaknesses of the payback period method ofevaluating capital pro6ects, the simplicity of the method doesallo0 it to be used in con6unction 0ith other, more sophisticatedmeasures.

(n your vie0, if the payback period method is used incon6unction 0ith the !"# method, should it be used before orafter the !"# evaluation


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ersonal inance &'a"ple

Deema 8ehdi is considering investing ;2


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(cont.)

Deema 8ehdi is considering investing ;2


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!a%le 10. /elevant Cash lows and a#%ac-

eriods for ear"an &nterprises* ro+ects


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!a%le 10. Calculation of the a#%ac- eriod for

/ashid Co"pan#*s !wo ,lternative 2nvest"ent

ro+ects


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3et resent 4alue (34)

Net present value (N!"is a sophisticated capital

budgeting techni+ue9 found by subtracting a pro6ects initial

investment from the present value of its cash inflo0s

discounted at a rate e+ual to the firms cost of capital.!"# F "resent value of cash inflo0s (nitial investment


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3et resent 4alue (34) (cont.)

-ecision criteria5

(f the !"# isgreater than;


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igure 10. Calculation of 34s for Bennett

Co"pan#*s Capital &'penditure ,lternatives


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"ro6ect & "ro6ect :


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3et resent 4alue (34):

34 and the rofita%ilit# 2nde'

7or a pro6ect that has an initial cash outflo0 follo0ed bycash inflo0s, the profitability inde "($ is simply e+ual tothe present value of cash inflo0s divided by the initial cashoutflo05

=hen companies evaluate investment opportunities usingthe "(, the decision rule they follo0 is to invest in the

pro6ect 0hen the inde is greater than 1.


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3et resent 4alue (34): 34 and

the rofita%ilit# 2nde' (cont.)

=e can refer back to 7igure 1 ;'*,


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3et resent 4alue (34): 34

and &cono"ic 4alue ,dded

%conomic #alue &dded or %#&$, a registered trademark ofthe consulting firm, Dtern Dte0art J Co., is another closecousin of the !"# method.

4he %#& method begins the same 0ay that !"# doesKbycalculating a pro6ects net cash flo0s.

Eo0ever, the %#& approach subtracts from those cash flo0sa charge that is designed to capture the return that the firmsinvestors demand on the pro6ect.

%#& determines 0hether a pro6ect earns a pure economicprofita profit above and beyond the normal competitiverate of return in a line of business.


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3et resent 4alue (34): 34

and &cono"ic 4alue ,dded

Duppose a certain pro6ect costs ;1,


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2nternal /ate of /eturn (2//)

4he Internal #ate of #eturn (I##"is a sophisticated

capital budgeting techni+ue9 the discount rate that e+uates

the !"# of an investment opportunity 0ith ;< because the

present value of cash inflo0s e+uals the initial investment$9it is the rate of return that the firm 0ill earn if it invests in

the pro6ect and receives the given cash inflo0s.


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2nternal /ate of /eturn (2//)

-ecision criteria5

(f the ()) isgreater thanthe cost of capital, acceptthe pro6ect.

(f the ()) is less thanthe cost of capital, rejectthe pro6ect.

4hese criteria guarantee that the firm 0ill earn at least its

re+uired return. Duch an outcome should increase the market

value of the firm and, therefore, the 0ealth of its o0ners.


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igure 10.a Calculation of 2//s for Bennett



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igure 10. Calculation of 2//s for Bennett



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2nternal /ate of /eturn (2//):

Calculating the 2// (cont.)

4o find the ()) using the preprogrammed function in a financialcalculator, the keystrokes for each pro6ect are the same as those forthe !"# calculation, ecept that the last t0o !"# keystrokespunching ( and then !"#$ are replaced by a single ()) keystroke.

Comparing the ())s of pro6ects & and : given in 7igure 1


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(t is interesting to note in the preceding eample that the()) suggests that pro6ect :, 0hich has an ()) of 21.HB,is preferable to pro6ect &, 0hich has an ()) of 1I.IB.

4his conflicts 0ith the !"# rankings obtained in anearlier eample.

Duch conflicts are not unusual.

4here is no guarantee that !"# and ()) 0ill rank

pro6ects in the same order. Eo0ever, both methods shouldreach the same conclusion about the acceptability ornonacceptability of pro6ects.


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4ony -iLoreno is evaluating an investment opportunity. Eefeels that this investment must earn a minimum compoundannual after/ta return of IB in order to be acceptable.4onys initial investment 0ould be ;H,*


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Co"paring 34 and 2// !echni$ues: 3et

resent 4alue rofiles

Net present value profilesare graphs that depict a pro6ects

!"#s for various discount rates.

4o prepare !"# profiles for :ennett Companys pro6ects &

and :, the first step is to develop a number of discount rate/!"# coordinates and then graph them as sho0n in the

follo0ing table and figure.


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!a%le 10.5 iscount /ate634

Coordinates for ro+ects , and B

i 10 5


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igure 10.5

34 rofiles


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Co"paring 34 and 2//

!echni$ues: Conflicting /an-ings

Conflicting rankingsare conflicts in the ranking given apro6ect by !"# and ()), resulting from differences in themagnitude and timing of cash flo0s.

Ane underlying cause of conflicting rankings is theimplicit assumption concerning the reinvestment ofintermediate cash inflo$sKcash inflo0s received priorto the termination of the pro6ect.

!"# assumes intermediate cash flo0s are reinvested atthe cost of capital, 0hile ()) assumes that they arereinvested at the ()).


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Co"paring 34 and 2// !echni$ues:

Conflicting /an-ings (cont.)

& pro6ect re+uiring a ;1H


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!a%le 10.7 /einvest"ent /ate

Co"parisons for a ro+ect


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Conflicting /an-ings (cont.)

(f the future value in each case in 4able 1


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!a%le 10.8 ro+ect Cash lows

,fter /einvest"ent


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!i"ing of the Cash low

&nother reason 0hy the ()) and !"# methods may providedifferent rankings for investment options has to do 0ithdifferences in the timing of cash flo0s.

=hen much of a pro6ects cash flo0s arrive early in its life, thepro6ects !"# 0ill not be particularly sensitive to the discountrate.

An the other hand, the !"# of pro6ects 0ith cash flo0s thatarrive later 0ill fluctuate more as the discount rate changes.

4he differences in the timing of cash flo0s bet0een the t0opro6ects does not affect the ranking provided by the ())method.

! %l 10 9 / -i + t , d


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!a%le 10.9 /an-ing ro+ects , and

B sing 2// and 34 ;ethods

C i 34 d 2// ! h i


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;agnitude of the 2nitial 2nvest"ent

4he scale problem occurs 0hen t0o pro6ects are verydifferent in terms of ho0 much money is re+uired to invest

in each pro6ect.

(n these cases, the ()) and !"# methods may rank pro6ectsdifferently.

4he ()) approach and the "( method$ may favor small pro6ects

0ith high returns like the ;2 loan that turns into ;3$.

4he !"# approach favors the investment that makes theinvestor the most money like the ;1,


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;atter of act

=hich 8ethods -o Companies &ctually Use

& recent survey asked Chief 7inancial Afficers C7As$ 0hat

methods they used to evaluate capital investment pro6ects.

4he most popular approaches by far 0ere ()) and !"#, used byHB and H*B respectively$ of the C7As responding to the

survey.

4hese techni+ues en6oy 0ider use in larger firms, 0ith the

payback approach being more common in smaller firms.


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ocus on &thics

!onfinancial Considerations in "ro6ect Delection 7or most companies ethical considerations are primarily concerned 0ith the reduction

of potential risks associated 0ith a pro6ect.

Eo0ever, 4he Mu0ait 7und 0as established as the first institution in the 8iddle %astthat took an active role in international development efforts. 4he fund finances

development pro6ects and their feasibility studies in developing countries. Ane of the ma6or ob6ectives of the Mu0ait 7und is to build a solid bridge of friendship

and solidarity bet0een the state of Mu0ait and the developing nations.

4he success of the Mu0ait 7und in achieving this ob6ective helped the state of Mu0aitto get the necessary votes in the United !ations and the U.!. Decurity Council for the0ar against (ra+ to liberate Mu0ait in 1II1.

4he Mu0ait 7und offers many forms of assistance, including direct loans or theprovision of guarantees, and grants/in/aid to finance technical, economic, and financialstudies.

"hat are the potential #eneits to the state o $uwait o the ethical #ehavior o the$uwait Fund%


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/eview of Learning Goals

LG1 Understand the key elements of the capital budgeting process.

Capital budgeting techni+ues are the tools used to assess pro6ect

acceptability and ranking. &pplied to each pro6ects relevant cash flo0s,

they indicate 0hich capital ependitures are consistent 0ith the firms

goal of maimiing o0ners 0ealth.



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(cont.)

LG2 Calculate, interpret, and evaluate the payback period.

4he payback period is the amount of time re+uired for the firm to

recover its initial investment, as calculated from cash inflo0s. Dhorter

payback periods are preferred. 4he payback period is relatively easy to

calculate, has simple intuitive appeal, considers cash flo0s, andmeasures risk eposure. (ts 0eaknesses include lack of linkage to the

0ealth maimiation goal, failure to consider time value eplicitly, and

the fact that it ignores cash flo0s that occur after the payback period.



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(cont.)

LG3 Calculate, interpret, and evaluate the net present value !"#$and economic value added %#&$.

!"# measures the amount of value created by a given pro6ect9 onlypositive !"# pro6ects are acceptable. 4he rate at 0hich cash flo0s arediscounted in calculating !"# is called the discount rate, re+uired

return, cost of capital, or opportunity cost. :y 0hatever name, this raterepresents the minimum return that must be earned on a pro6ect to leavethe firms market value unchanged.

4he %#& method begins the same 0ay that !"# doesKby calculating apro6ects net cash flo0s. Eo0ever, the %#& approach subtracts from

those cash flo0s a charge that is designed to capture the return that thefirms investors demand on the pro6ect. 4hat is, the %#& calculationasks 0hether a pro6ect generates positive cash flo0s above and beyond0hat investors demand. (f so, then the pro6ect is 0orth undertaking.



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(cont.)

LG' Calculate, interpret, and evaluate the internal rate of return())$.

Like !"#, ()) is a sophisticated capital budgeting techni+ue. ()) is

the compound annual rate of return that the firm 0ill earn by investing

in a pro6ect and receiving the given cash inflo0s. :y accepting onlythose pro6ects 0ith ())s in ecess of the firms cost of capital, the firm

should enhance its market value and the 0ealth of its o0ners.



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(cont.)

LG* Use net present value profiles to compare !"# and ())techni+ues.

& net present value profile is a graph that depicts pro6ects !"#s for

various discount rates. 4he !"# profile is prepared by developing a

number of Ndiscount ratenet present valueO coordinates includingdiscount rates of < percent, the cost of capital, and the ()) for each

pro6ect$ and then plotting them on the same set of discount rate!"#

aes.



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(cont.)

LG -iscuss !"# and ()) in terms of conflicting rankings and thetheoretical and practical strengths of each approach.

Conflicting rankings of pro6ects fre+uently emerge from !"# and ())as a result of differences in the reinvestment rate assumption, as 0ell asthe magnitude and timing of cash flo0s. !"# assumes reinvestment of

intermediate cash inflo0s at the more conservative cost of capital9 ())assumes reinvestment at the pro6ects ()). An a purely theoretical basis,!"# is preferred over ()) because !"# assumes the moreconservative reinvestment rate and does not ehibit the mathematicalproblem of multiple ())s that often occurs 0hen ())s are calculatedfor nonconventional cash flo0s. (n practice, the ()) is more commonlyused because it is consistent 0ith the general preference of businessprofessionals for rates of return, and corporate financial analysts canidentify and resolve problems 0ith the ()) before decision makers useit.

Chapter /esources on


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;#inanceLa%

Chapter Cases

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Sesi1 Cap Budgeting Technique