Capital Budgeting

Decide how to invest resources to maximize their contribution to the

organization’s objectives.

Capital Budgeting Process

• Capital budget (investment) proposals are examined on basis of their cash outlays and resulting flow of future benefits over period of time greater than one year.

Capital Budgeting Process

1. Clearly define short-term and long-term objectives

2. Identify alternative investment opportunities and the capital required for each one.

3. Assess organizations ability to generate investment capital for capital budgeting period

Capital Budgeting Process

4. Measure cash (benefit) flows from alternative capital investment opportunities

5. Evaluate pro- posals using selected criteria

Increase log inventory to reduce risk of mill downtime

during Spring breakup?

Capital Budgeting Process

6. Select alternatives to fund and implement

5. Review performance for feed-back to decision makers

Buy new skidder to reduce maintenance cost on old one and increase productivity?

Financial Criteria to Rank Alternatives

• Net Present Value

• Internal Rate of Return

• Benefit /Cost Ratio

• Payback Period

Other Criteria

• Capacity to carry out proposed projects– Management– Labor

• Sources of capital– Borrow from commercial lenders or private

parties (leverage assets)– Sell (issue) stock – corporation; or

membership interests - limited liability companies (LLC)

Notation

• ARR – alternative rate of return• MAR – minimum acceptable rate of

return (hurdle rate)• B - annual nonmarket value, dollars• B/C - benefit/cost ratio• EAA - equivalent annual annuity• IRR - internal rate of return• N - project life, years• NPV = net present value

Notation• t - index of years• Ct – cost in year t

• Rt - revenue in year t

• PV - present value at a specified point in time

• r - real interest rate• f – rate of inflation• i – nominal interest rate

Net Present Value

NPV = ∑

= ∑

Rt Ct

(1+r)t (1+r)tt=0

n

Rt - Ct

(1+r)tt=0

n

Example of NPV

Year Project D Cash Flows

0 -400

5 -100

8

15 +200

30 +6,600

Project D NPV

C0 = - $400/(1.06)0 = - $ 400.00

C5 = - $100/(1.06)5 = - $ 74.73

R15 = $200/(1.06)15 = $ 83.45

R30 = $6,600/(1.06)30 = $1,149.13

NPV = 757.85

Net Present Value Guideline• Project must at least cover the

opportunity cost as measured by the minimum acceptable rate of return (MAR) used to calculate present values

• Project is acceptable if NPV is zero or greater

• Projects with negative NPV are unacceptable, don’t cover opportunity cost

Internal Rate of Return (IRR)• The r that makes NPV = 0• Meaning – r that makes PV of costs and

PV of revenues equal• Find by

– iterating over r until NPV = 0– Use “Goal Seek” function in Excel

IRR Guideline

• Project is acceptable if its IRR is equal to or greater than the minimum acceptable rate of return (MAR)

• Relationship to NPV criteria – if MAR is the discount rate (r) used to calculate NPV, then IRR and NPV will accept same projects.

Benefit/Cost Ratio

• PV (benefits)/PV (costs), or• PV (revenues)/PV (expenses)

∑ Rt / (1+r)t

=

∑ Ct/(1+r)t

n

n

y=0

t=0

Benefit/Cost Ratio Guideline

• Accept project if B/C ≥ 1.0• If B/C ≥ 1.0 then

– NPV ≥ 0, and– IRR ≥ MAR

0

1000

2000

3000

4000

5000

6000

7000

8000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Interest Rate

Pre

se

nt

Va

lue

s $

's

PV of costs

PV of revenues

Relationship of NPV, IRR and B/C

B/C < 1

NPV < 0

B/C > 1

NPV > 0

IRR

Year 0 – ($400), Year 5 – ($100), Year 15 - $200, Year 30 - $6,600

Payback Period

• Time required for net revenue to equal invested capital

• Example,– Invest $10,000– Net revenue is $5,000 per year– Payback is 2 years, ($10,000/$5,000)

• Best used in conjunction with other criteria

Ranking Projects

• NPV, IRR, and B/C may not rank alternative projects in the same order

• Additional ranking criteria– Mutually exclusive projects – only one can

be chosen– Independent

• Opposite of mutually exclusive,• Can all be adopted

Ranking Projects

• Additional ranking criteria, cont.– Divisible – can invest in part of a project– Indivisible – all or nothing

Timing of cash flows effects rankings

• Timing of revenue and expenditures is critcal– Worst case is front-loaded costs and back-loaded

revenues

• Rankings by NPV and IRR are different depending on MAR

Example of NPV

Year Project D Cash Flows

Project N Cash Flows

0 -400 -400

5 -100 -100

8 +1,200

15 +200

30 +6,600 +2,500

Project D NPV

C0 = - $400/(1.06)0 = - $ 400.00

C5 = - $100/(1.06)5 = - $ 74.73

R15 = $200/(1.06)15 = $ 83.45

R30 = $6,600/(1.06)30 = $1,149.13

NPV = 757.85

Project N NPV

C0 = - $400/(1.06)0 = - $ 400.00

C5 = - $100/(1.06)5 = - $ 4.73

R8 = $1,200/(1.06)8 = $ 752.89

R30 = $6,600/(1.06)30 = $ 435.28

NPV = $ 713.44

Example of NPVYear Project D

Cash FlowsProject N

Cash Flows0 -400 -400

5 -100 -100

8 +1,20015 +20030 +6,600 +2,500

$2,756 gives D & N same NPV’s

NPV $758 $713

NPV project D

NPV project N

NPV same at 6.3%

2 4 6 1410IRR = 9.7%

IRR=14.5%

NPV

Interest Rate