10 - Chaper 10 Capital Budgeting Techniques

8/18/2019 10 - Chaper 10 Capital Budgeting Techniques

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Chapter 10

• Capital Budgeting Tecni!ues


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Learning Goals

L"1 #nderstand te $e% elements o& te capital'udgeting process.

L"2 Calculate, interpret, and e(aluate te pa%'ac$period.

L") Calculate, interpret, and e(aluate te netpresent (alue *+P and economic (alue added*E


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Learning Goals (cont.)

L"/ Calculate, interpret, and e(aluate te internalrate o& return *.

L"5 #se net present (alue pro&iles to compare +Pand tecni!ues.

L" 3iscuss +P and in terms o& con&lictingran$ings and te teoretical and practicalstrengts o& eac approac.


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Overview of Capital Budgeting

• Capital budgeting is te process o& e(aluating andselecting long-term in(estments tat are consistent4it te &irms goal o& ma6imi7ing o4ner 4ealt.

• capital expenditure is an outla% o& &unds '% te&irm tat is e6pected to produce 'ene&its o(er aperiod o& time greater than 1 %ear.

• n operating expenditure is an outla% o& &unds '%te &irm resulting in 'ene&its recei(ed within 1 %ear.


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Overview of Capital Budgeting!teps in the "rocess

Te capital budgeting process consists o& &i(e steps81. Proposal generation. Proposals &or ne4 in(estment pro9ectsare made at all le(els 4itin a 'usiness organi7ation and arere(ie4ed '% &inance personnel.

2. Review and analysis. :inancial managers per&orm &ormalre(ie4 and anal%sis to assess te merits o& in(estment

proposals3. Decision making. :irms t%picall% delegate capital e6penditure

decision ma$ing on te 'asis o& dollar limits.

4. Implementation. :ollo4ing appro(al, e6penditures are madeand pro9ects implemented. E6penditures &or a large pro9ect

o&ten occur in pases.5. Follow!p. esults are monitored and actual costs and'ene&its are compared 4it tose tat 4ere e6pected. ctionma% 'e re!uired i& actual outcomes di&&er &rom pro9ected ones.


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Overview of Capital BudgetingBasic #er$inolog%

ndependent (ersus ;utuall% E6clusi(e Pro9ects< &ndependent pro'ects are pro9ects 4ose cas

&lo4s are unrelated to *or independent o& oneanoter= te acceptance o& one does noteliminate te oters &rom &urter consideration.

< utuall% exclusive pro'ects are pro9ects tatcompete 4it one anoter, so tat teacceptance o& one eliminates &rom &urterconsideration all oter pro9ects tat ser(e asimilar &unction.


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Overview of Capital BudgetingBasic #er$inolog% (cont.)

#nlimited :unds (ersus Capital ationing< nli$ited funds is te &inancial situation in 4ic a &irm

is a'le to accept all independent pro9ects tat pro(ide anaccepta'le return.

< Capital rationing is te &inancial situation in 4ic a &irm

as onl% a &i6ed num'er o& dollars a(aila'le &or capitale6penditures, and numerous pro9ects compete &or tesedollars.


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Overview of Capital BudgetingBasic #er$inolog% (cont.)

ccept-e9ect (ersus an$ing pproaces< n accept*re'ect approach is te e(aluation o& capital

e6penditure proposals to determine 4eter te% meet te&irms minimum acceptance criterion.

< ran+ing approach is te ran$ing o& capital e6penditure

pro9ects on te 'asis o& some predetermined measure,suc as te rate o& return.


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Capital Budgeting #echni,ues

Bennett Compan% is a medium si7ed metal &a'ricatortat is currentl% contemplating t4o pro9ects8 Pro9ect re!uires an initial in(estment o& A/2,000, pro9ect B aninitial in(estment o& A/5,000. Te rele(ant operatingcas &lo4s &or te t4o pro9ects are presented in Ta'le

10.1 and depicted on te time lines in :igure 10.1.


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#able 10.1 Capital -xpenditure ata forBennett Co$pan%


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/igure 10.1 Bennett Co$pan%s "ro'ects and B


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"a%bac+ "eriod

Te pa%bac+ $ethod is te amount o& time re!uired&or a &irm to reco(er its initial in(estment in a pro9ect,as calculated &rom cas in&lo4s.

Te lengt o& te ma6imum accepta'le pa%'ac$period is determined '% management.

< & te pa%'ac$ period is less than te ma6imum accepta'lepa%'ac$ period, accept te pro9ect.

< & te pa%'ac$ period is greater than te ma6imumaccepta'le pa%'ac$ period, re"ect te pro9ect.


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"a%bac+ "eriod (cont.)

e can calculate te pa%'ac$ period &or Bennett Compan%spro9ects and B using te data in Ta'le 10.1.

< :or pro9ect , 4ic is an annuit%, te pa%'ac$ period is ).0 %ears*A/2,000 initial in(estment A1/,000 annual cas in&lo4.

< Because pro9ect B generates a mi6ed stream o& cas in&lo4s, tecalculation o& its pa%'ac$ period is not as clear-cut.

• n %ear 1, te &irm 4ill reco(er A2?,000 o& its A/5,000 initialin(estment.

• B% te end o& %ear 2, A/0,000 *A2?,000 &rom %ear 1 D A12,000 &rom%ear 2 4ill a(e 'een reco(ered.

• t te end o& %ear ), A50,000 4ill a(e 'een reco(ered.

• nl% 50F o& te %ear-) cas in&lo4 o& A10,000 is needed to completete pa%'ac$ o& te initial A/5,000.

< Te pa%'ac$ period &or pro9ect B is tere&ore 2.5 %ears *2 %ears D50F o& %ear ).


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"a%bac+ "eriod "ros and Cons of"a%bac+ nal%sis

• Te pa%'ac$ metod is 4idel% used '% large &irms toe(aluate small pro9ects and '% small &irms to e(aluatemost pro9ects.

• ts popularit% results &rom its computational simplicit%and intuiti(e appeal.

• B% measuring o4 !uic$l% te &irm reco(ers its initialin(estment, te pa%'ac$ period also gi(es implicitconsideration to te timing o& cas &lo4s and tere&oreto te time (alue o& mone%.

• Because it can 'e (ie4ed as a measure o& ris$ e6posure,man% &irms use te pa%'ac$ period as a decisioncriterion or as a supplement to oter decisiontecni!ues.


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"a%bac+ "eriod "ros and Cons of"a%bac+ nal%sis (cont.)

• Te ma9or 4ea$ness o& te pa%'ac$ period is tatte appropriate pa%'ac$ period is merel% asu'9ecti(el% determined num'er.

< t cannot 'e speci&ied in ligt o& te 4ealt ma6imi7ationgoal 'ecause it is not 'ased on discounting cas &lo4s to

determine 4eter te% add to te &irms (alue.

• second 4ea$ness is tat tis approac &ails tota$e &ull% into account te time &actor in te (alueo& mone%.

• tird 4ea$ness o& pa%'ac$ is its &ailure torecogni7e cas &lo4s tat occur a&ter te pa%'ac$period.


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/ocus on "ractice

Limits on Pa%'ac$ nal%sis< ile eas% to compute and eas% to understand, tepa%'ac$ period simplicit% 'rings 4it it some dra4'ac$s.

< ate(er te 4ea$nesses o& te pa%'ac$ period metod o&e(aluating capital pro9ects, te simplicit% o& te metoddoes allo4 it to 'e used in con9unction 4it oter, more

sopisticated measures.In yo!r view# i$ the pay%ack period method is !sed in

con"!nction with the &P' method# sho!ld it %e !sed %e$oreor a$ter the &P' eval!ation(


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"ersonal /inance -xa$ple

Geema ;edi is considering in(esting A20,000 to o'tain a 5Finterest in a rental propert%. Geema is in te 25F ta6 'rac$et. To'e accepta'le, Geema re!uires te in(estment to pa% itsel& 'ac$in terms o& a&ter-ta6 cas &lo4s in less tan > %ears.

< Her real estate agent conser(ati(el% estimates tat Geemasould recei(e 'et4een A/,000 and A,000 per %ear in

cas &rom er 5F interest in te propert%.< Geemas calculation o& te pa%'ac$ period on tis deal

'egins 4it calculation o& te range o& annual a&ter-ta6cas &lo48

< &ter-ta6 cas &lo4 I *1 < ta6 rate × Pre-ta6 cas &lo4 I *1 < 0.25 × A/,000 I A),000

I *1 < 0.25 × A,000 I A/,500


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"ersonal /inance -xa$ple (cont.)

Geema ;edi is considering in(esting A20,000 too'tain a 5F interest in a rental propert%. Geema is inte 25F ta6 'rac$et.

< 3i(iding te A20,000 initial in(estment '% eac o& teestimated a&ter-ta6 cas &lo4s, 4e get te pa%'ac$ period8

< Pa%'ac$ period I nitial in(estment &ter-ta6 cas &lo4I A20,000 A),000 I .> %earsI A20,000 A/,500 I /.// %ears

< Because Geemas proposed rental propert% in(estment 4illpa% itsel& 'ac$ 'et4een /.// and .> %ears, 4ic is a

range 'elo4 er ma6imum pa%'ac$ o& > %ears, tein(estment is accepta'le.


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#able 10.2 3elevant Cash /lows and"a%bac+ "eriods for e4ar$an-nterprises "ro'ects

3eJarman Enterprises, a small medical appliancemanu&acturer, is considering t4o mutuall% e6clusi(epro9ects named "old and Gil(er.


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#able 10.5 Calculation of the "a%bac+"eriod for 3ashid Co$pan%s #wolternative &nvest$ent "ro'ects

asid Compan%, a so&t4are de(eloper, as t4oin(estment opportunities.


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6et "resent 7alue (6"7)

6et present value (6"7) is a sopisticated capital

'udgeting tecni!ue= &ound '% su'tracting a pro9ectsinitial in(estment &rom te present (alue o& its casin&lo4s discounted at a rate e!ual to te &irms cost o&capital.

+P I Present (alue o& cas in&lo4s < nitial in(estment


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6et "resent 7alue (6"7) (cont.)

• 3ecision criteria8< & te +P is greater tan A0, accept te pro9ect.< & te +P is less tan A0, re9ect te pro9ect.

• & te +P is greater tan A0, te &irm 4ill earn areturn greater tan its cost o& capital. Guc actionsould increase te mar$et (alue o& te &irm, andtere&ore te 4ealt o& its o4ners '% an amounte!ual to te +P.


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Bennett Co$pan% (cont.)

& te compan% as a 10F cost o& capital, 4at is te+P o& eac pro9ectK

#able 10.1 Capital -xpenditure ata for Bennett Co$pan%


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/igure 10.2 Calculation of 6"7s forBennett Co$pan%s Capital -xpenditurelternatives


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6et "resent 7alue (6"7)6"7 and the "rofitabilit% &ndex

:or a pro9ect tat as an initial cas out&lo4 &ollo4ed'% cas in&lo4s, te pro&ita'ilit% inde6 *P is simpl%e!ual to te present (alue o& cas in&lo4s di(ided '%te initial cas out&lo48

en companies e(aluate in(estment opportunitiesusing te P, te decision rule te% &ollo4 is to in(estin te pro9ect 4en te inde6 is greater tan 1.0.


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6et "resent 7alue (6"7) 6"7 and the"rofitabilit% &ndex (cont.)

e can re&er 'ac$ to :igure 10.2, 4ic so4s tepresent (alue o& cas in&lo4s &or pro9ects and B, tocalculate te P &or eac o& Bennetts in(estmentoptions8

P ) I A5),0>1 A/2,000 I 1.2

P* I A55,@2/ A/5,000 I 1.2/


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6et "resent 7alue (6"7) 6"7 and-cono$ic 7alue dded

• Economic alue dded *or E, a registeredtrademar$ o& te consulting &irm, Gtern Gte4art Co., is anoter close cousin o& te +P metod.

• Te E metod 'egins te same 4a% tat +PdoesM'% calculating a pro9ects net cas &lo4s.

• Ho4e(er, te E approac su'tracts &rom tosecas &lo4s a carge tat is designed to capture tereturn tat te &irms in(estors demand on tepro9ect.

• E determines 4eter a pro9ect earns a pureecono$ic profit


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6et "resent 7alue (6"7) 6"7 and-cono$ic 7alue dded

Guppose a certain pro9ect costs A1,000,000 up &ront,'ut a&ter tat it 4ill generate net cas in&lo4s eac%ear *in perpetuit% o& A120,000. & te &irms cost o&capital is 10F, ten te pro9ects +P and E are8

+P I


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&nternal 3ate of 3eturn (&33)

Te &nternal 3ate of 3eturn (&33) is te discountrate tat e!uates te +P o& an in(estmentopportunit% 4it A0 *'ecause te present (alue o&cas in&lo4s e!uals te initial in(estment= it is terate o& return tat te &irm 4ill earn i& it in(ests in te

pro9ect and recei(es te gi(en cas in&lo4s.


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&nternal 3ate of 3eturn (&33)

3ecision criteria8

< & te is greater than te cost o& capital, accept tepro9ect.

< & te is less than te cost o& capital, re"ect tepro9ect.

Tese criteria guarantee tat te &irm 4ill earn atleast its re!uired return. Guc an outcome souldincrease te mar$et (alue o& te &irm and, tere&ore,

te 4ealt o& its o4ners.

/i 10 5 C l l ti f &33 f


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/igure 10.5 Calculation of &33s forBennett Co$pan%s Capital -xpenditurelternatives

& t l 3 t f 3 t (&33)


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&nternal 3ate of 3eturn (&33)Calculating the &33 (cont.)

• To &ind te using te preprogrammed &unction in a

&inancial calculator, te $e%stro$es &or eac pro9ect arete same as tose &or te +P calculation, e6cept tatte last t4o +P $e%stro$es *puncing and ten+P are replaced '% a single $e%stro$e.

• Comparing te s o& pro9ects and B gi(en in:igure 10.) to Bennett Compan%s 10F cost o& capital,4e can see tat 'ot pro9ects are accepta'le 'ecause< I 1@.@F N 10.0F cost o& capital

< B I 21.>F N 10.0F cost o& capital

• Comparing te t4o pro9ects s, 4e 4ould pre&erpro9ect B o(er pro9ect 'ecause B I 21.>F N I 1@.@F.

& t l 3 t f 3 t (&33)


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& t l 3 t f 3 t (&33)


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• t is interesting to note in te preceding e6ampletat te suggests tat pro9ect B, 4ic as an o& 21.>F, is pre&era'le to pro9ect , 4ic asan o& 1@.@F.

• Tis con&licts 4it te +P ran$ings o'tained in an

earlier e6ample.• Guc con&licts are not unusual.

• Tere is no guarantee tat +P and 4ill ran$pro9ects in te same order. Ho4e(er, 'ot metodssould reac te same conclusion a'out teaccepta'ilit% or nonaccepta'ilit% o& pro9ects.


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"ersonal /inance -xa$ple

Ton% 3iLoren7o is e(aluating an

in(estment opportunit%. He &eels tat tisin(estment must earn a minimumcompound annual a&ter-ta6 return o& @Fin order to 'e accepta'le. Ton%s initialin(estment 4ould 'e A>,500, and ee6pects to recei(e annual a&ter-ta6 cas&lo4s o& A500 per %ear in eac o& te &irst/ %ears, &ollo4ed '% A>00 per %ear at teend o& %ears 5 troug ?. He plans to sellte in(estment at te end o& %ear ? andnet A@,000, a&ter ta6es.

< Ton% &inds te in(estments o&@.5/F.

< "i(en tat te e6pected o&@.5/F e6ceeds Ton%s re!uiredminimum o& @F, tein(estment is accepta'le.

Co$pa ing 6"7 and &33 #echni, es 6et


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Co$paring 6"7 and &33 #echni,ues 6et"resent 7alue "rofiles

6et present value profiles are graps tat depict apro9ects +Ps &or (arious discount rates.

To prepare +P pro&iles &or Bennett Compan%spro9ects and B, te &irst step is to de(elop a num'ero& discount rate-+P coordinates and ten graptem as so4n in te &ollo4ing ta'le and &igure.

#able 10 8 iscount 3ate 6"7


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#able 10.8 iscount 3ate*6"7Coordinates for "ro'ects and B


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/igure 10.8 6"7 "rofiles

Co$paring 6"7 and &33 #echni,ues


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Co$paring 6"7 and &33 #echni,uesConflicting 3an+ings

• Conflicting ran+ings are con&licts in te ran$inggi(en a pro9ect '% +P and , resulting &romdi&&erences in te magnitude and timing o& cas&lo4s.

• ne underl%ing cause o& con&licting ran$ings is te

implicit assumption concerning te rein(estment o&inter$ediate cash inflowsMcas in&lo4s recei(edprior to te termination o& te pro9ect.

• +P assumes intermediate cas &lo4s arerein(ested at te cost o& capital, 4ile assumes

tat te% are rein(ested at te .


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#able 10 9 3einvest$ent 3ate


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Co$paring 6"7 and &33 #echni,uesConflicting 3an+ings (cont.)

& te &uture (alue in eac case in Ta'le 10.5 4ere(ie4ed as te return recei(ed ) %ears &rom toda%&rom te A1>0,000 in(estment, ten te cas &lo4s4ould 'e tose gi(en in Ta'le 10. on te &ollo4ingslide.

#able 10 : "ro'ect Cash /lows fter


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#able 10.: "ro'ect Cash /lows fter3einvest$ent



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Co$paring 6"7 and &33 #echni,ues#i$ing of the Cash /low

noter reason 4% te and +P metods ma%pro(ide di&&erent ran$ings &or in(estment options asto do 4it di&&erences in te timing o& cas &lo4s.

< en muc o& a pro9ects cas &lo4s arri(e earl% in its li&e,te pro9ects +P 4ill not 'e particularl% sensiti(e to tediscount rate.

< n te oter and, te +P o& pro9ects 4it cas &lo4stat arri(e later 4ill &luctuate more as te discount ratecanges.

< Te di&&erences in te timing o& cas &lo4s 'et4een tet4o pro9ects does not a&&ect te ran$ing pro(ided '% te

metod.

#able 10 ; 3an+ing "ro'ects and B


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Co$paring 6"7 and &33 #echni,uesagnitude of the &nitial &nvest$ent

Te scale pro'lem occurs 4en t4o pro9ects are (er%di&&erent in terms o& o4 muc mone% is re!uired toin(est in eac pro9ect.

< n tese cases, te and +P metods ma% ran$pro9ects di&&erentl%.

< Te approac *and te P metod ma% &a(or smallpro9ects 4it ig returns *li$e te A2 loan tat turns intoA).

< Te +P approac &a(ors te in(estment tat ma$es tein(estor te most mone% *li$e te A1,000 in(estment tat

%ields A1,100 in one da%.



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atter of /act

ic ;etods 3o Companies ctuall% #seK

< recent sur(e% as$ed Cie& :inancial &&icers *C:s 4atmetods te% used to e(aluate capital in(estment pro9ects.

< Te most popular approaces '% &ar 4ere and +P,used '% >F and >5F *respecti(el% o& te C:s

responding to te sur(e%.< Tese tecni!ues en9o% 4ider use in larger &irms, 4it te

pa%'ac$ approac 'eing more common in smaller &irms.


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/ocus on -thics

+on&inancial Considerations in Pro9ect Gelection< :or most companies etical considerations are primaril%

concerned 4it te reduction o& potential ris$s associated4it a pro9ect.

< noter 4a% to incorporate non&inancial considerations intocapital pro9ect e(aluation is to ta$e into account te li$el%

e&&ect o& decisions on nonsareolder parties orsta$eoldersM emplo%ees, customers, te localcommunit%, and suppliers.

,hat are the potential risks to a company o$ !nethical%ehaviors %y employees( ,hat are potential risks

to the p!%lic and to stakeholders(


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3eview of Learning Goals

L"1 #nderstand te $e% elements o& te capital'udgeting process.

Capital 'udgeting tecni!ues are te tools used toassess pro9ect accepta'ilit% and ran$ing. pplied toeac pro9ects rele(ant cas &lo4s, te% indicate 4ic

capital e6penditures are consistent 4it te &irms goalo& ma6imi7ing o4ners 4ealt.


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3eview of Learning Goals (cont.)

L"2 Calculate, interpret, and e(aluate te pa%'ac$period.

Te pa%'ac$ period is te amount o& time re!uired &orte &irm to reco(er its initial in(estment, as calculated&rom cas in&lo4s. Gorter pa%'ac$ periods are

pre&erred. Te pa%'ac$ period is relati(el% eas% tocalculate, as simple intuiti(e appeal, considers cas&lo4s, and measures ris$ e6posure. ts 4ea$nessesinclude lac$ o& lin$age to te 4ealt ma6imi7ationgoal, &ailure to consider time (alue e6plicitl%, and te&act tat it ignores cas &lo4s tat occur a&ter tepa%'ac$ period.

i f i l ( )


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L") Calculate, interpret, and e(aluate te net present (alue

*+P and economic (alue added *E.+P measures te amount o& (alue created '% a gi(enpro9ect= onl% positi(e +P pro9ects are accepta'le. Te rateat 4ic cas &lo4s are discounted in calculating +P iscalled te discount rate, re!uired return, cost o& capital, oropportunit% cost. B% 4ate(er name, tis rate represents te

minimum return tat must 'e earned on a pro9ect to lea(ete &irms mar$et (alue uncanged.

Te E metod 'egins te same 4a% tat +P doesM'%calculating a pro9ects net cas &lo4s. Ho4e(er, te Eapproac su'tracts &rom tose cas &lo4s a carge tat isdesigned to capture te return tat te &irms in(estors

demand on te pro9ect. Tat is, te E calculation as$s4eter a pro9ect generates positi(e cas &lo4s a'o(e and'e%ond 4at in(estors demand. & so, ten te pro9ect is4ort underta$ing.


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3 i f L i G l ( )


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L"5 #se net present (alue pro&iles to compare +Pand tecni!ues.

net present (alue pro&ile is a grap tat depictspro9ects +Ps &or (arious discount rates. Te +Ppro&ile is prepared '% de(eloping a num'er o& Odiscount rate


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L" 3iscuss +P and in terms o& con&licting ran$ings and

te teoretical and practical strengts o& eac approac.Con&licting ran$ings o& pro9ects &re!uentl% emerge &rom +Pand as a result o& di&&erences in te rein(estment rateassumption, as 4ell as te magnitude and timing o& cas&lo4s. +P assumes rein(estment o& intermediate casin&lo4s at te more conser(ati(e cost o& capital=

assumes rein(estment at te pro9ects . n a purel%teoretical 'asis, +P is pre&erred o(er 'ecause +Passumes te more conser(ati(e rein(estment rate and doesnot e6i'it te matematical pro'lem o& multiple s tato&ten occurs 4en s are calculated &or noncon(entionalcas &lo4s. n practice, te is more commonl% used'ecause it is consistent 4it te general pre&erence o&'usiness pro&essionals &or rates o& return, and corporate&inancial anal%sts can identi&% and resol(e pro'lems 4it te 'e&ore decision ma$ers use it.

Ch t 3 /i L b


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Chapter 3esources on %/inanceLab

• Capter Cases

• "roup E6ercises

• Critical Tin$ing Pro'lems

10 - Chaper 10 Capital Budgeting Techniques

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Transcript of 10 - Chaper 10 Capital Budgeting Techniques