Capital Budgeting

Capital Budgeting

8/4/2014Corporate Finance- Capital Budgeting Learning OutcomesDescribe the capital budgeting process, including the typical steps of the process, and distinguish among the various categories of capital projectsDescribe the basic principles of capital budgeting, including cash flow estimationExplain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationingCalculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI)

8/4/2014Corporate Finance- Capital Budgeting 22Learning outcomesExplain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methodsDescribe and account for the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock priceDescribe the expected relations among an investments NPV, company value, and share price

8/4/2014Corporate Finance- Capital Budgeting 3IntroductionCapital budgetingis the process of planning expenditures on assets (fixed assets) whose cash flows are expected to extend beyond one year. Managers analyze projects and decide which ones to include in the capital budget.The "capital" refers to long-term assets.The "budget" is a plan which details projected cash inflows and outflows during future period.

8/4/2014Corporate Finance- Capital Budgeting 4The broader steps in the capital budgeting processGenerating good investment ideas to consider.Analyzing individual proposals - forecast cash flows, evaluate profitability, etc.Planning the capital budget - how does the project fit within the company's overall strategies? What's the timeline and priority?Monitoring and post-auditing - decision makers can:Improve forecasts, based on which you can make good capital budgeting decisions. Improve operations, thus making capital decisions well implemented.

8/4/2014Corporate Finance- Capital Budgeting 5Steps in analyzing the individual proposals8/4/2014Corporate Finance- Capital Budgeting 6Estimate cash flows (inflows & outflows)Assess risk of cash flows.Determine appropriate discount rate (r = WACC) for project.Evaluate cash flows. (Find NPV or IRR etc.)Make Accept/Reject DecisionProject classificationsReplacement projectsReplacement decisions to maintain the businessReplacement decisions to reduce costsExpansion projectsRegulatory, safety and environmental projectsNew Product and servicesOthers R&D)

8/4/2014Corporate Finance- Capital Budgeting 7Assumptions of capital budgetingCapital budgeting decisions must be made on cash flows, not accounting incomeCash flow timing is criticalbecause money is worth more the sooner you get itThe opportunity cost should be charged against a projectExpected future cash flows must be measured on an after-tax basisIgnore how the project is financed

8/4/2014Corporate Finance- Capital Budgeting 8Capital Budgeting Concepts Sunk cost is a cash outlay that has already been incurred and which cannot be recovered regardless of whether the project is accepted or rejectedIncremental cash flowis the net cash flow attributable to an investment project. It represents the change in the firm's total cash flow that occurs as a direct result of accepting the projectOpportunity costis the return on thebest alternative useof an asset or the highest return that will not be earned if funds are invested in a particular project.Externalitiesare the effects of a project on cash flows in other parts of the firm (Cannibalization)

8/4/2014Corporate Finance- Capital Budgeting 9Concepts cont..Conventional versus non-conventional cash flows`

8/4/2014Corporate Finance- Capital Budgeting 10Concepts cont..Independent versus mutually exclusive projectsProject sequencingUnlimited funds versus capital rationing8/4/2014Corporate Finance- Capital Budgeting 11Investment decision criteriaWhen a firm is embarking upon a project, it needs tools to assist in making the decision of whether to invest in the project or notNPVIRRPayback PeriodDiscounted paybackARRPI

8/4/2014Corporate Finance- Capital Budgeting 12NPVThis method discounts all cash flows (including both inflows and outflows) at the project's cost of capital and then sums those cash flows

CFt = Expected cash flow at period tK = Project's cost of capitaln = Life of the project 8/4/2014Corporate Finance- Capital Budgeting 13Ex. 8/4/2014Corporate Finance- Capital Budgeting 14

NPV cont..Decision Rules The higher the NPV, the betterReject if NPV is less than or equal to 0

NPV measures the dollar benefit of the project to shareholders

8/4/2014Corporate Finance- Capital Budgeting 15IRRIt is the discount rate that forces a project's NPV to equal to zero

IRR = L+(H-L) +NPV +NPV--NPV8/4/2014Corporate Finance- Capital Budgeting 16IRR cont..Decision RulesThe higher the IRR, the better.Define the hurdle rate, which typically is the cost of capital.Reject if IRR is less than or equal to the hurdle rateIRR does provide "safety margin" information8/4/2014Corporate Finance- Capital Budgeting 17Payback Period It is the expected number of years required to recover the original investment. Payback occurs when the cumulative net cash flow equals 0

Decision rulesThe shorter the payback period, the better.A firm should establish a benchmark payback period. Reject if payback is greater than benchmark.

8/4/2014Corporate Finance- Capital Budgeting 18Discounted Payback PeriodSimilar to the regular payback method except that it discounts cash flows at the project's cost of capital8/4/2014Corporate Finance- Capital Budgeting 19ARR

8/4/2014Corporate Finance- Capital Budgeting 20Profitability Index (PI)determined by dividing the present value of each proposal by its initial investment

PI indicates the value you are receiving in exchange for one unit of currency invested8/4/2014Corporate Finance- Capital Budgeting 21

21PI contDecision RulesAn index value greater than 1.0 is acceptable and the higher the number, the more financially attractive the proposalA ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment8/4/2014Corporate Finance- Capital Budgeting 22NPV Profiles a graph showing the relationship between a project's NPV and the firm's cost of capital8/4/2014Corporate Finance- Capital Budgeting 23

Observations The IRR is the discount rate that sets the NPV to 0.The NPV profile declines as the discount rate increases.Project A has a higher NPV at low discount rates, while Project B has a higher NPV at high discount rates. The NPV profiles of Project A and B join at the crossover rate, at which the projects' NPVs are equal.The slope of Project A's NPV profile is steeper. This indicates that Project A's NPV is more sensitive to changes in the discount rates.

8/4/2014Corporate Finance- Capital Budgeting 24Ranking Conflicts b/n NPV & IRRForindependent projects, the NPV and IRR methods make the same accept or reject decisionsAccept if IRR > hurdle rateAccept if NPV > 0

Formutually exclusive projects, ranking conflicts can ariseDue to differing cash flow patternsDiffering project scales

8/4/2014Corporate Finance- Capital Budgeting 25Assuming that Project A and B are mutually exclusive, consider their NPV profilesIf the cost of capital > crossover rate, then NPVB > NPVA, and IRRB > IRRA. Thus, both methods lead to the selection of Project B.If the cost of capital < crossover rate, then NPVB < NPVA, and IRRB > IRRA. Thus, a conflict arises because now the NPV method will select Project A while the IRR method will choose B.Therefore, for mutually exclusive projects, the NPV and IRR methods lead to same decisions if the cost of capital > the crossover rate, and different decisions if the cost of capital < the crossover rate.

8/4/2014Corporate Finance- Capital Budgeting 26Which Supersedes NPV method assumes that cash flows will be reinvested at the firm's cost of capitalIRR method assumes reinvestment at the project's IRR

8/4/2014Corporate Finance- Capital Budgeting 27Multiple IRRMultiple IRRsis the situation where a project has two or more IRRs. This problem is caused by non-conventional cash flows of a project8/4/2014Corporate Finance- Capital Budgeting 28MIRRMIRR is the discount rate that causes the PV of a projects terminal value (TV) to equal the PV of costs.TV is found by compounding inflows at WACC.Thus, MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs.Managers like rate of return comparisons, and MIRR is better for this than IRR.

8/4/2014Corporate Finance- Capital Budgeting 29Find PV and TV (r = 10%)8/4/2014Corporate Finance- Capital Budgeting 3010.080.060.0012310% 66.0 12.1158.1-100.010%10%TV inflows-100.0PV outflowsFind Discount Rate that Equates PV and TV8/4/2014Corporate Finance- Capital Budgeting 31MIRR = 16.5%158.10123-100.0TV inflowsPV outflowsMIRRL = 16.5% $100 = $158.1(1+MIRRL)3Capital Budgeting and Wealth Maximization Capital budgeting is also relevant to external analysts to estimate the value of stock prices. Theoretically, if a company invests in positive NPV projects, the wealth of its shareholders should increase.The integrity of a firm's capital budgeting processes can also be used to show how the management pursues its goal of shareholder wealth maximization.

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