Module 2: Principles of Capital Budgeting

1
Module 2 Principles of Capital Budgeting

• The Importance of Capital Budgeting
• Generating Ideas for Capital Projects
• Project Classifications
• Capital Budget Decision Rules

2
Importance of Capital Budgeting

• Capital Project Results Continue for Many Years.
  What are the Cost-Benefits?
• Capital Investments Can Cause a Firm to Lose
  Flexibility
• Capital Investments Define Strategic Decisions
• Satisfy Customer Needs
• Inadequate Capital Investment May Result in Loss
  of Market Share to Competitors
• Capital Projects May Require Substantial Funds
  Over a Given Period of Time. Financing Far
  Enough in Advance to Ensure Funding Will Be
  Available in the Future Is Critical

Financial Management, Theory and Practice.
Dryden Press. 1999.
3
Nonnumeric Criteria

• The Sacred Cow
• Operating Necessity
• Competitive Necessity
• Product Line Extension
• Comparative Benefit

4
Five Steps in Capital Budgeting

• Generating and gathering investment ideas
• Estimating/forecasting the investment cost and
  benefits
• Analyzing/evaluating the cost and benefits
• Selecting among alternatives and implementing the
  investment chosen
• Evaluating the implemented investment

5
Generating Ideas for Capital Projects

• A Firms Growth, and Even Its Ability to Remain
  Competitive and to Survive, Depends on a Constant
  Flow of Ideas for New Products, for Ways to Make
  Existing Products Better, and for Ways to Operate
  at a Lower Cost.
• Where Do the Ideas Come From?
• External Customers, Competition, Laws
• Internal Management, Employees, Stakeholders
• Incentives for Generating Ideas

Financial Management, Theory and Practice.
Dryden Press. 1999.
6
Project Classifications

• Replacement Maintenance of Business
• Replacement Cost Reduction
• Expansion of Existing Products or Market
• Expansion of New Product or Markets
• Safety and/or Environmental Projects
• Research and Development
• Others

Financial Management, Theory and Practice.
Dryden Press. 1999.
7
Key Point

• Its All About Cash Flows
• Cash flow analysis is the activity of estimating
  the cash flow associated with the project the
  outflows associated with developing and operating
  a project and the inflows the project will
  produce after it goes into operation

8
Capital Budgeting Decision Rules

• Payback Period
• Discounted Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index

Financial Management, Theory and Practice.
Dryden Press. 1999.
9
Payback Period

• The expected number of years required to recover
  the original investment.
• Payback(s) Year Before full Recovery
  unrecovered cost at start of year
• Cash Flow During Year
• Project A 0 1 2 3 4
• Net Cash Flow (NCF) -1,000 500 400 300 100
• Cumulative NCF -1,000 -500 -100 200 300
• Project B
• Net Cash Flow (NCF) -1,000 100 300 400 600
• Cumulative NCF -1,000 -900 -600 -200 400
• Payback for Project A 2 100/300 2.33 years
• Payback for Project B 3 200/600 3.33 years

Financial Management, Theory and Practice.
Dryden Press. 1999.
10
Discounted Payback Period

• Similar to Payback Period Except the Expected
  Cash Flows Are Discounted by the Projects Cost
  of Capital.
• Cost of Capital includes the interest rate as
  well as a provision for project risk
• Example Using Project A and B, Discounted Cash
  Flow Is Determine by Dividing Each Cash Inflow in
  a Given Year by (1R)N, Where R the Projects
  Cost of Capital and N the Year in Which the
  Cash Inflow Occurs. R 10

Financial Management, Theory and Practice.
Dryden Press. 1999.
11
Discounted Payback Period
Discounted Payback(s) Year Before full Recovery
unrecovered cost at start of year Cash Flow
During Year Project A 0 1 2 3 4 Net Cash
Flow -1,000 500 400 300 100 Discounted NCF (at
10) -1,000 455 331 225 68 Cumulative
NCF -1,000 -545 -214 11 79 Project
B Net Cash Flow -1,000 100 300 400 600 Dis
counted NCF (at 10) -1,000 91 248 301 410 Cumul
ative NCF -1,000 -909 -661 -360 50 Payback for
Project A 2 214/225 2.95 years Payback for
Project B 3 360/410 3.88 years
12
Payback and Discounted Payback Period Drawback

• Major Drawback Does not consider cash flows that
  are paid or received after the payback period.
• Example
• Project A 0 1 2 3 4 5
• Net Cash Flow -3,000 1,000 1,000 1,000 1,000
• Discounted NCF (at 10) -3,000 909 826
  751 683
• Cumulative NCF -3,000 -2,091 -1,264 -513
  170
• Project B
• Net Cash Flow -3,000 0 0 0 0 1,000,000
• Discounted NCF (at 10) -3,000 0 0 0 0
  620,921
• Cumulative NCF -3,000 -3,000 -3,000 -3,000 -3,000
  617,921
• Payback for Project A 3 513/683 3.75 years
• Payback for Project B 5 years

13
Net Present Value (NPV)

• NPV is Equal to the Present Value of Future
  Returns, Discounted at the Marginal Cost of
  Capital, Minus the Present Value of the Cost of
  the Investment
• NPV The Sum of NCF in the (Nth/(1R)N) - Inv
• Nth Year From Date of Original Investment
• R Discount Rate
• NCF Net Cash Flow Per Year
• Inv Initial Investment
• If NPV Is Positive Good If NPV Is Negative
  Bad

Financial Management, Theory and Practice.
Dryden Press. 1999.
14
NPV Utilization

• Find the Present Value of Each Cash Flow,
  Including Both Inflows and Outflows, Discounted
  at the Projects Cost of Capital
• Sum These Discounted Cash Flows This Sum Is
  Defined As the Projects NPV
• If the NPV Is Positive, the Project Should Be
  Accepted. If the NPV Is Negative, It Should Be
  Rejected. If Two Projects With Positive NPVs
  Are Mutually Exclusive, the One With the Higher
  NPV Should Be Chosen.
• Independent Project Means Both Projects Can Be
  Chosen At the Same Time.
• Mutually Exclusive Means Only One Can Be
  Selected.

Financial Management, Theory and Practice.
Dryden Press. 1999.
15
NPV Example

• Project A
• 0 1 2
  3 4
• Cash Flows -1,000 500 400 300 100
• PV 454.55 330.58 225.39 68.30
• NPV 78.82
• Project B
• 0 1 2
  3 4
• Cash Flows -1,000 100 300 400 600
• PV 90.90 247.90 300.50 409.80
• NPV 49.18

16
Rationale for the NPV Method

• Straightforward Approach
• If NPV Is Positive, Then the Project Generates
  More Cash Than Needed to Service Its Debts and to
  Provide Returns to Shareholders.

Financial Management, Theory and Practice.
Dryden Press. 1999.
17
Internal Rate of Return

• The Discount Rate Which Equates the Present Value
  of a Projects Expected Cash Inflows to the
  Present Value of the Projects Cost.
• PV (Inflows) PV (Investment Costs) Or,
• The Rate Which Forces the NPV to Equal to Zero.
• NPV Sum of NCF(n) / (1 IRR)n - INV 0
• Use Financial Calculators or Excel for Best
  Results

Financial Management, Theory and Practice.
Dryden Press. 1999.
18
Ways to Determine IRR

• Use Calculator or Computer Tools (Excel)
• Or Long Hand
• Year 0 1 2 3 4 NPV
• Project -1000.00 500.00 400.00 300.00 100.00
• _at_ 10 -1000.00 454.55 330.58 225.39 68.30 78.82
  
• _at_ 15 -1000.00 434.78 302.46 197.25 57.18 -8.33
  
• _at_ 14 -1000.00 438.60 307.79 202.49 59.21
  8.08
• _at_14.5 -1000.00 436.68 305.10 199.85 58.18 -0.18
  
• Since 14.5 makes NPV 0 (approximate), then IRR
  is equal to 14.5

19
IRR Example
Project A 0 1 2
3 4 Cash Flows -1,000 500 400
300 100 PV NPV 0 IRR 14.5 Project
B 0 1 2
3 4 Cash Flows -1,000 100 300 400 600
PV NPV 0 IRR 11.8
20
Rationale for IRR Method

• The IRR on a Project is its Expected Rate of
  Return
• If IRR Exceeds the Cost of the Funds Used to
  Finance the Project, the Difference Is Value
  Added to the Stockholders
• Taking on a Project Whose IRR Exceeds the Cost of
  Capital Increases Shareholders Wealth

Financial Management, Theory and Practice.
Dryden Press. 1999.
21
Comparison of NPV and IRR Methods

• NPV Is More User Friendly
• IRR Is Familiar to Many Executives and Is Widely
  Entrenched in Industry.
• If Independent Project, Then Both NPV and IRR
  Will Always Lead to Same Accept/Reject Decision
• If Mutually Exclusive Projects, a Review of the
  NPV and IRR Profile Should Be Examined

Financial Management, Theory and Practice.
Dryden Press. 1999.
22
NPV Profile
NPV ()
Project L NPV Profile
400
300
Crossover Rate 7.2
200
Project S NPV Profile
100
IRR(S)14.5
0
15
5
10
7.2
-100
Cost of Capital
IRR(L) 11.8
Financial Management, Theory and Practice.
Dryden Press. 1999.
23
Profitability Index

• (PI) An Index That Shows the Dollars of Present
  Value Divided by the Dollars of Cost and Is a
  Measure of Relative Profitability
• PI PV Benefits/PV Costs
• Sum CIFN /(1 R)N/Sum COFN /(1R)N
• CIF Cash Inflows
• COF Cash Outflows

Financial Management, Theory and Practice.
Dryden Press. 1999.