CHAPTER 9: CAPITAL – BUDGETING

DECISION CRITERIA

What is Capital Budgeting?Capital budgeting – is the process of planning for purchases of long – term assets.

Capital Budgeting Decision Criteria The Payback Period

Net Present Value Profitability Index Internal Rate of Return

Payback Period The number of years needed to recover the

initial cash outlay.

How long will it take for the project to generate enough cash to pay for itself?

RULE:If payback is ≤ maximum acceptable payback period, ACCEPTIf payback is > maximum acceptable payback period, REJECT

=

Initial Investment

Payback Period

Average Annual Cash Inflow

It is calculated as:

Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will generate $10,000 per year of net cash flow. Alaskan is also considering the purchase of a conveyor system for $36,000, which will reduce saw mill transport costs by $12,000 per year. If Alaskan only has sufficient funds to invest in one of these projects, and if it were only using the payback method as the basis for its investment decision, it would buy the conveyor system, since it has a shorter payback period.

EXAMPLE 1:

=

Initial Investment

Payback Period

Average Annual Cash Inflow

(for band saw) A

= $50,000/$10,000 = 5.0 years, payback period for this capital investment.

(for conveyor system) B

= $36,000/$12,000= 3.0 years, , payback period for this capital investment.

Year Cash Flow

0 -1000

1 500

2 400

3 200

4 200

5 100

The calculation of the Payback Period is best illustrated with an example. Consider Capital Budgeting project A which yields the following cash flows over its five year life.

EXAMPLE 2:

Year Cash Flow Net Cash Flow0 -1000 -1000

1 500 -500

2 400 -100

3 200 100

4 200 300

5 100 400

To begin the calculation of the Payback Period for project A let's add an additional column to the above table which represents the Net Cash Flow (NCF) for the project in each year.

Notice that after two years the Net Cash Flow is negative (-1000 + 500 + 400 = -100) while after three years the Net Cash Flow is positive (-1000 + 500 + 400 + 200 = 100). Thus the Payback Period, or breakeven point, occurs sometime during the third year. If we assume that the cash flows occur regularly over the course of the year, the Payback Period can be computed using the following equation:

Payback Period = 2 + (100)/(200) = 2.5 yearsrs

ADVANTAGESUses Free Cash FlowsIs Easy To Calculate And UnderstandMay Be Use As Rough Screening Device

DISADVANTAGESIgnores The Time Value Of MoneyIgnores Free Cash Flows Occurring After The Payback PeriodSelection Of The Maximum Acceptable Payback Period Is Arbitrary

Discounted Payback PeriodIt determines how long it takes an investment to recover its costs.It’s similar to a simple payback, but a discounted payback period accounts for money’s time value.It’s more precise estimate of when investors will recover their total investment.

Table 10-2 shows the difference between traditional payback and discounted payback methods.

With undiscounted free cash flows, the payback period is only 2 years while with discounted free cash flows (at 17%), the discounted payback period is 3.07 years.

Discounted Payback Period Example

Uses Free Cash FlowsIs Easy To Calculate And UnderstandConsiders time value of money

DISADVANTAGESIgnores free cash flows occurring after the discounted payback period Selection Of The Maximum Acceptable Payback Period Is Arbitrary

ADVANTAGES

NET PRESENT VALUE

DECISION RULE: If NPV is positive, ACCEPT If NPV is negative, REJECT

where

• CFt = the cash flow at time t and

• r = the cost of capital.

The example below illustrates the calculation of Net Present Value. Consider Capital Budgeting projects A and B which yield the following cash flows over their five year lives. The cost of capital for the project is 10%.

Year Cash Flow Net Cash Flow0 -1000 -1000

1 500 100

2 400 200

3 200 200

4 200 400

5 100 700

Uses Free Cash FlowsRecognizes the time value of moneyIs consistent with the firm’s goal of shareholder wealth maximization

DISADVANTAGESRequires detailed long-term forecasts of a project’s free cash flows Sensitivity to the choice of the discount rate

ADVANTAGES

PROFITABILITY INDEXProfitability Index, divides the projected capital inflow by the projected capital outflow to determine the profitability of a project.

DECISION RULE: If PI is greater or equal to 1, ACCEPT If PI is less than 1, REJECT

PI = PV of FCF/Initial outlay

A firm with a 10% required rate of return is considering investing in a new machine with an expected life of six years. The initial cash outlay is $50,000.

EXAMPLE:

FCF PVF @ 10% PV

Initial Outlay –$50,000 1.000 –$50,000

Year 1 15,000 0.909 13,636

Year 2 8,000 0.826 6,612

Year 3 10,000 0.751 7,513

Year 4 12,000 0.683 8,196

Year 5 14,000 0.621 8,693

Year 6 16,000 0.564 9,032

PI = ($13,636 + $6,612+$7,513 + $8,196 + $8,693+ $9,032) / $50,000= $53,682/$50,000

= 1.0736

Project’s PI is greater than 1. Therefore, accept.

Uses Free Cash FlowsRecognizes the time value of moneyIs consistent with the firm’s goal of shareholder wealth maximization

DISADVANTAGESRequires detailed long-term forecasts of a project’s free cash flows

ADVANTAGES

INTERNAL RATE OF RETURN The return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

DECISION RULE: If IRR is greater or equal to the

required rate of return, ACCEPT If IRR is less than the required rate

of return, REJECT

IRR is the discount rate that equates the present value of a project’s future net cash flows with the project’s initial cash outlay.

Uses Free Cash FlowsRecognizes the time value of moneyIs in general consistent with the firm’s goal of shareholder wealth maximization.

DISADVANTAGESRequires detailed long-term forecasts of a project’s free cash flows Possibility of multiple IRRsAssumes cash flows over the life of the project are reinvested at the IRR

ADVANTAGES

Initial Outlay: $3,817 Cash flows: Yr.1=$1,000, Yr. 2=$2,000,

Yr. 3=$3,000 Discount rate NPV15% $4,35620% $3,95822% $3,817

IRR is 22% because the NPV equals the initial cash outlay at that rate.

EXAMPLE:

FCF PVF @ 15% PV

Initial Outlay –$3,817

Year 1 $1,000 .870 $ 870

Year 2 2,000 .756 1,512

Year 3 3,000 .658 1,974

Present value of inflows

$4,356

Initial outlay -$3,817

FCF PVF @ 20% PV

Initial Outlay –$3,817

Year 1 $1,000 .833 $ 833

Year 2 2,000 .694 1,388

Year 3 3,000 .579 1,737

Present value of inflows

$3,958

Initial outlay -$3,817

FCF PVF @ 22% PV

Initial Outlay –$3,817

Year 1 $1,000 .820 $ 820

Year 2 2,000 .672 1,344

Year 3 3,000 .551 1,653

Present value of inflows

$3,817

Initial outlay -$3,817

Modified internal rate of returnThe discount rate that equates the present value of the project’s cash outflows with the present value of the project’s terminal value.

ADVANTAGES• Use free cash flows• Recognizes the time value of money• In general, is consistent with the goal of maximization of

shareholder wealth

DISADVANTAGES• Requires detailed long- term forecasts of a project’s free cash

flows

Modified IRR allows the decision maker to directly specify the appropriate reinvestment rate.

DECISION RULE: If MIRR is ≥ to the required rate of return, ACCEPT If MIRR is < to the required rate of return, REJECT

FCF

Initial Outlay –$6,000

Year 1 $2,000

Year 2 3,000

Year 3 4,000

Project having a 3 year life and a required rate of return of 10% with the following cash flows:

EXAMPLE:

Step 3: Determine the discount rate that equates to the PV of the terminal value and the PV of the project’s cash outflows. MIRR = 17.446%. It is greater than required rate of return so Accept.

Step 1: Determine the PV of the project’s cash outflows. $6,000 is already at present.

Step 2: Determine the terminal value of the project’s free cash flows. To do this use the project’s required rate of return to calculate the FV of the project’s three cash flows of the project’s cash outflows. They turn out to be $2,420 + $3,300 + $4,000 = $9,720 for the terminal value.

Calculation:6000 =

6000 =

6000 =

MIRR = 17.446%

Ethics play a role in capital budgeting Any actions that violate ethical

standards can have a negative impact on the image of the firm and consequently, future cash flows.

Ethics in Capital Budgeting

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