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Capital Budgeting Decision Investment Valuation Criteria

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Capital Budgeting Decision

What is capital budgeting?

NPV rule for making investment decisions

Other alternative investment criteria

Payback period (traditional and discounted)

Internal rate of return

Profitability index and capital rationing

Deciding on projects with different lives

Investment criteria in corporate practice

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What is capital budgeting?

Capital budgeting deals with the analysis of potential additions to firm’s fixed assets

These are long-term decisions that generally involve large expenditures and are typically quite difficult to reverse

Capital budgeting is very important for a firm’s future

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Capital budgeting process

Idea development

Collection of data

Accounting, finance,

engineering

Project analysis

Decision making

Results

Reevaluation

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What is a project?

Any of the following decisions would qualify as projects:

Major strategic decisions to enter a new area of business or new markets

Acquisitions of other firms

Decisions on new ventures with existing business or markets

Decisions that may change the way existing ventures and projects are run

Decisions on how best to deliver a service that is necessary for the business to run smoothly

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Types of projects

Independent projects

Mutually exclusive projects

Expansion projects

Existing products / markets

New products / markets

Replacement projects

Maintenance of business

Cost reduction

Research & development projects

Other projects (safety / environmental projects)

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NPV rule illustrated – a reminder

Assume you have the following information on Project X:

Initial outlay -$1,100

Required return = 10%

Annual cash revenues and expenses are as follows:

Year Revenues Expenses

1 $1,000 $500

2 2,000 1,000 Draw a time line and compute the NPV of project X

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NPV rule concluded

0 1 2

Initial outlay ($1,100)

Revenues $1,000 Expenses 500

Cash flow $500

Revenues $2,000 Expenses 1,000

Cash flow $1,000

– $1,100.00

+454.55

+826.45

+$181.00 NPV

1 $500 x 1.10

1 $1,000 x 1.102

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Foundations of the NPV rule

Why does NPV work? And what does “work” mean?

A “firm” is created when security holders supply the funds to acquire assets that will be used to produce and sell goods and services

The market value of the firm is based on the free cash flows it is expected to generate

Thus, “good” projects are those which increase firm value “good” projects are those projects that have

positive NPVs

Moral:

INVEST ONLY IN PROJECTS WITH POSITIVE NPVs

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Why do we like NPV that much?

NPV uses cash flows, and not other accounting artificial constructs

NPV uses all the cash flows generated by the project during its life

NPV discounts the cash flows properly, since it takes into account TVM

Payback Period

Payback Period (PB): The length of time it takes to recover the original costs (of the project) from expected cash flows.

Rationale: The sooner investment costs are recovered, the better.

Process: Simply add up the expected cash flows until they equal (or exceed) the original investment. The number of years it take to do this is the payback period.

Note: no discounting of cash flows is required

PB =

Number of years before

full recovery of

original investment

Uncovered cost at start

of full-recovery year

Total cash flow during

full-recovery year

+

Cash Flow

Cumulative

Net CF

1,500

-1,500

800

500

1,200

-300

-3,000

-3,000

300

800

PB 0 1 2 3 4

Example: Find the payback period for a project which has the following cash flows

= PB 2 + 300/800 = 2.375 years

Full-recovery year

Payback Period

Payback Period

Decision Rules:

PP = payback period

MDPP = maximum desired payback period

Independent Projects:

PP MDPP - Accept

PP > MDPP - Reject

Mutually Exclusive Projects:

Select the project with the fastest payback, assuming PP MDPP.

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Pitfalls in using the payback period

Which project would you choose from the followings, given a 2 years payback?

Project C0 C1 C2 C3 Payback period

A -2,000 500 500 5000 3

B -2,000 500 1800 0 2

C -2,000 1800 500 0 2

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Pitfalls in using the payback period

Project C0 C1 C2 C3 Payback period

NPV @ 10%

A -2,000 500 500 5000 3 +2,624

B -2,000 500 1800 0 2 -58

C -2,000 1800 500 0 2 +50

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Pitfalls in using the payback period By using payback period:

You may select projects that are not acceptable under NPV rule look at project B

You won’t consider the timing of cash flows within the payback period compare project B and

project C

You won’t consider the payments after the payback period compare project A and project C

You can’t compare projects that have no initial investment

Arbitrary standard for payback period

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Use of payback period

PB is often used when making relatively small decisions

PB ensures liquidity

Nevertheless, as a decision grows in importance, the NPV becomes the order of the day

Discounted Payback Period

Similar to Payback Period Method

Expected future cash flows are discounted by the project’s cost of capital

Thus the discounted payback period is defined as the number of years required to recover the investment from discounted net cash flows.

DPB =

Number of years before

full recovery of

original investment

Uncovered cost at start

of full-recovery year

Total discounted cash flow during

full-recovery year

+

Cash Flow

Cumulative

Net Discounted CF

1,500

-1,636

800

-44

1,200

-645

-3,000

-3,000

300

161

PB 0 1 2 3 4

Example: Find the discounted payback period for a project which has the following cash flows

= DPB 3 + 44/161 = 3.273 years

Full-recovery year

Discounted Payback Period

r =10%

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Discounted payback period

Although recognizes TVM, it has the same problems as the traditional payback period

Is suitable to be used in case of investments made in risky markets.

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Internal rate of return

IRR tries to find a single number that summarizes the merits of a project

This number does not depend on the interest rate that prevails in the capital market

The number is intrinsic to the project and only depends on the cash flows of the project and their timing

Internal Rate of Return (IRR)

Definition:

The discount rate for what the PV of a project’s expected cash flows is equal with the initial cost (NPV = 0)

nt

tn

t IRR

TV

IRR

CFI

111

0

Internal Rate of Return (IRR)

Decision Rules:

Independent Projects:

IRR opportunity cost of capital - Accept

IRR < opportunity cost of capital - Reject

Mutually Exclusive Projects:

Select the project with the highest IRR, assuming IRR opportunity cost of capital.

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Internal rate of return illustrated

Find r such that NPV = 0

Year 0 1 2 3

Cash flow -200 50 100 150

32r1

150

r)(1

100

r1

502000

IRR isr this19.44%r

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NPV profile

-60,00

-40,00

-20,00

0,00

20,00

40,00

60,00

80,00

100,00

1 5 9 13 17 21 25 29

Discount rate (%)

NP

V

IRR = 19.44%

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Trial and error for IRR

Trial and error Discount rates NPV

0% $100

5% 68

10% 41

15% 18

20% -2 IRR is just under 20%

19.44%

!!! In order to estimate IRR for the project you analyze, you can use Excel IRR function by selecting the column/row of the cash flows (inflows or outflows) the investment generates including the initial cost.

1,500 800 1,200 -3,000 300

0 1 2 3 4

Example: What is the IRR of a project with the following cash flows?

3000 = 1,500 + 1,200 + 800 + 300 (1+IRR) (1+IRR)2 (1+IRR)3 (1+IRR)4 NPV = 0 = -3000 + 1,500 + 1,200 + 800 + 300 (1+IRR) (1+IRR)2 (1+IRR)3 (1+IRR)4 Answer: IRR= 13.114% (Excel function IRR)

Internal Rate of Return (IRR)

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Pitfalls with the IRR approach

Pitfall 1: IRR assumes funds can be invested each year at the same rate of return (IRR)

Pitfall 2: Make no distinction between investing or financing projects

Pitfall 3: A project can have multiple rates of return

Pitfall 4: The scale problem

Pitfall 5: The timing problem

Solution to pitfall 1: Modified Internal Rate of Return (MIRR)

It is basically the same as the IRR, except it assumes that the revenue (cash flows) from the project are reinvested back into the company, and are compounded by the company's cost of capital, but are not directly invested back into the project from which they came.

MIRR assumes that the revenue is not invested back into the same project, but is put back into the general "money fund" for the company, where it earns interest. We don't know exactly how much interest it will earn, so we use the company's cost of capital as a good guess.

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Profitability index

PI Rule for independent projects:

Accept project if PI 0

Reject project if PI < 0

Look at this!

investment theofcost Initial

investment theof NPVindexity Profitabil

NPV 0 PI 0 IRR discount rate ACCEPT PROJECT

NPV < 0 PI < 0 IRR < discount rate REJECT PROJECT

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Problems with PI

Making decisions with PI for mutually exclusive projects

Cash flows

PV @ 12%

PI

NPV @ 12% Project C0 C1 C2

1 -20 70 10 70.5 2.53 50.5

2 -10 15 40 45.3 3.53 35.3

Same problems as in the case of scale problem form IRR decide using NPV

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Capital rationing

Suppose the projects above are independent, but you have only $25 mil. to invest. Which project(s) do you choose?

USE PROFITABILITY INDEX

Cash flows

PV @ 12%

PI

NPV @ 12% Project C0 C1 C2

1 -20 70 10 70.5 2.53 50.5

2 -10 15 40 45.3 3.53 35.3

3 -10 -5 60 43.4 3.34 33.4

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Capital rationing

Two types of capital rationing: Soft rationing provisional limits adopted by

management as an aid to financial control

Hard rationing the firm is unable to raise the money she desires

Profitability index does not work if funds are also limited beyond the initial time period and projects are not divisible use linear programming

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Investment criteria in practice

Capital budgeting technique

Percentage always or

almost always use

Average score

Scale is 4(always) or 0(never)

Overall Large

firms

Small

firms

Internal rate of return 76 3.09 3.41 2.87

Net present value 75 3.08 3.42 2.83

Payback period 57 2.53 2.25 2.72

Discounted payback period 29 1.56 1.55 1.58

Profitability index 12 0.83 0.75 0.88

Source: Graham & Campbell (2001) – „Theory and practice of corporate finance”