capital budgeting techniques
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Capital Capital Budgeting Budgeting TechniquesTechniques
CAPITAL BUDGETINGCAPITAL BUDGETING
The process of identifying, The process of identifying, analyzing and selecting analyzing and selecting investment projects whose investment projects whose returns (cash flows) are returns (cash flows) are expected to extend beyond one expected to extend beyond one year. year.
Capital Budgeting Capital Budgeting TechniquesTechniques
Project Evaluation and SelectionProject Evaluation and Selection Potential DifficultiesPotential Difficulties Capital RationingCapital Rationing Project MonitoringProject Monitoring Post-Completion AuditPost-Completion Audit
1.1. New product or Expansion New product or Expansion
2.2. Replacement Replacement
3.3. Research and DevelopmentResearch and Development
4.4. ExplorationExploration
5.5. Other purposes ( Advertisement, Other purposes ( Advertisement, safety or pollution related )safety or pollution related )
Key Motives for Making Key Motives for Making Capital ExpendituresCapital Expenditures
Key Motives for Making Key Motives for Making Capital ExpendituresCapital Expenditures
Project Evaluation: Project Evaluation: Alternative MethodsAlternative Methods
Payback Period (PBP)Payback Period (PBP) Internal Rate of Return Internal Rate of Return (IRR)(IRR)
Net Present Value (NPV)Net Present Value (NPV) Profitability Index (PI)Profitability Index (PI)
Project RelationshipsProject Relationships
Mutually ExclusiveMutually Exclusive -- A -- A project whose acceptance project whose acceptance precludes the acceptance of precludes the acceptance of one or more alternative one or more alternative projects. projects.
• IndependentIndependent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.
• DependentDependent -- A project whose acceptance depends on the acceptance of one or more other projects.
Payback Period (PBP)Payback Period (PBP)
PBP PBP is the period of time is the period of time required for the cumulative required for the cumulative expected cash flows from an expected cash flows from an investment project to equal the investment project to equal the initial cash outflow.initial cash outflow.
PBP PBP is the period of time is the period of time required for the cumulative required for the cumulative expected cash flows from an expected cash flows from an investment project to equal the investment project to equal the initial cash outflow.initial cash outflow.
Proposed Project DataProposed Project Data
Julie Miller is evaluating a new project Julie Miller is evaluating a new project for her firm for her firm Basket Wonders (BW)Basket Wonders (BW). . She has determined that the after-tax She has determined that the after-tax cash flows for the project will be cash flows for the project will be $10,000, $12,000, $15,000, $10,000, $10,000, $12,000, $15,000, $10,000, and $7,000 and $7,000 respectively for each of respectively for each of the the Years 1 through 5Years 1 through 5. The initial . The initial cash outlay will be cash outlay will be $40,000$40,000..
(c)10 K 22 K 37 K 47 K 54 K
Payback Solution Payback Solution
PBPPBP = = aa + ( + ( bb - - c c ) / ) / dd= = 33 + ( + (4040 - - 3737) / ) / 1010 = = 33 + +
((33) / ) / 1010 = = 3.3 3.3 YearsYears
PBPPBP = = aa + ( + ( bb - - c c ) / ) / dd= = 33 + ( + (4040 - - 3737) / ) / 1010 = = 33 + +
((33) / ) / 1010 = = 3.3 3.3 YearsYears
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K
CumulativeInflows
(a)
(-b) (d)
PBP Acceptance CriterionPBP Acceptance Criterion
The management of The management of Basket Basket Wonders Wonders has set a maximum PBP has set a maximum PBP
of of 3.5 Years 3.5 Years for projects of this for projects of this type.type.
Should this project be accepted?Should this project be accepted?
Yes! Yes! The firm will receive back the The firm will receive back the initial cash outlay in less than 3.5 initial cash outlay in less than 3.5
Years. [Years. [3.3 Years 3.3 Years < < 3.5 Year Max3.5 Year Max..]]
PBP Strengths and PBP Strengths and WeaknessesWeaknesses
StrengthsStrengths:: Easy to use and Easy to use and
understandunderstand Can be used as a Can be used as a
measure of measure of liquidityliquidity
Weaknesses:•Does not account for TVM•Does not consider cash flows beyond the PBP• Cutoff period is subjective
Net Present Value Net Present Value (NPV)(NPV)
NPV NPV is the present value of an is the present value of an investment project’s net cash investment project’s net cash
flows minus the project’s initial flows minus the project’s initial cash outflow.cash outflow.
CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n
+ . . . ++ - ICOICONPV =
Decision Criteria
If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically
indifferent
Basket Wonders Basket Wonders has determined that has determined that the appropriate discount rate (k) for the appropriate discount rate (k) for
this project is 13%.this project is 13%.
$10,000 $7,000
NPV SolutionNPV Solution
$10,000 $12,000 $15,000 (1.13)1 (1.13)2 (1.13)3
+ +
+ - $40,000$40,000(1.13)4 (1.13)5
NPVNPV = +
NPV SolutionNPV Solution
NPVNPV = = $10,000$10,000(PVIF(PVIF13%13%,,11) + ) + $12,000$12,000(PVIF(PVIF13%13%,,22) + ) + $15,000$15,000(PVIF(PVIF13%13%,,33) ) + + $10,000$10,000(PVIF(PVIF13%13%,,44) + ) +
$ 7,000$ 7,000(PVIF(PVIF13%13%,,55) - ) - $40,000$40,000
NPVNPV = = $10,000$10,000(.885) + (.885) + $12,000$12,000(.783) + (.783) + $15,000$15,000(.693) + (.693) + $10,000$10,000(.613) +(.613) +
$ 7,000$ 7,000(.543) - (.543) -
$40,000$40,000
NPVNPV = = $8,850 + $9,396 + $10,395 + $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $6,130 + $3,801 - $40,000$40,000
==- $1,428- $1,428
NPV Acceptance NPV Acceptance CriterionCriterion
No! No! The The NPVNPV is is negativenegative. This . This means that the project is reducing means that the project is reducing
shareholder wealth. [shareholder wealth. [Reject Reject as as NPVNPV < < 00 ] ]
No! No! The The NPVNPV is is negativenegative. This . This means that the project is reducing means that the project is reducing
shareholder wealth. [shareholder wealth. [Reject Reject as as NPVNPV < < 00 ] ]
The management of The management of Basket Basket Wonders Wonders has determined that the has determined that the required rate is 13% for projects required rate is 13% for projects
of this type.of this type.
Should this project be accepted?Should this project be accepted?
NPV Strengths and WeaknessesNPV Strengths and Weaknesses
StrengthsStrengths:: Cash flows Cash flows
assumed to be assumed to be reinvested at the reinvested at the
hurdle rate.hurdle rate. Accounts for TVM.Accounts for TVM. Considers all Considers all
cash flows.cash flows.
StrengthsStrengths:: Cash flows Cash flows
assumed to be assumed to be reinvested at the reinvested at the
hurdle rate.hurdle rate. Accounts for TVM.Accounts for TVM. Considers all Considers all
cash flows.cash flows.
WeaknessesWeaknesses:: May not include May not include
managerial managerial options options embedded embedded
in the in the project. project.
Profitability Index (PI)Profitability Index (PI)
PI is the ratio of the present value of PI is the ratio of the present value of a project’s future net cash flows to a project’s future net cash flows to the project’s initial cash outflow.the project’s initial cash outflow.
CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n
+ . . . ++ ICOICOPI =
PI = 1 + [ NPVNPV / ICOICO ]
<< OR >>
PI Acceptance CriterionPI Acceptance Criterion
No! No! The The PIPI is is less than 1.00less than 1.00. This. This means that the project is not means that the project is not
profitable. [profitable. [Reject Reject as as PIPI < < 1.001.00 ] ]
No! No! The The PIPI is is less than 1.00less than 1.00. This. This means that the project is not means that the project is not
profitable. [profitable. [Reject Reject as as PIPI < < 1.001.00 ] ]
PIPI = $38,572 / $40,000= $38,572 / $40,000
= .9643= .9643
Should this project be accepted?Should this project be accepted?
PI Strengths and WeaknessesPI Strengths and Weaknesses
StrengthsStrengths:: Same as NPVSame as NPV Allows Allows comparison of comparison of different scale different scale projectsprojects
StrengthsStrengths:: Same as NPVSame as NPV Allows Allows comparison of comparison of different scale different scale projectsprojects
WeaknessesWeaknesses:: Same as NPVSame as NPV Provides only relative Provides only relative
profitabilityprofitability Potential Ranking Potential Ranking
ProblemsProblems
Internal Rate of Return Internal Rate of Return (IRR)(IRR)
IRR is the discount rate that equates IRR is the discount rate that equates the present value of the future net the present value of the future net
cash flows from an investment cash flows from an investment project with the project’s initial cash project with the project’s initial cash
outflow.outflow.
CF1 CF2 CFn (1+IRR)1 (1+IRR)2 (1+IRR)n
+ . . . ++ICO =
$15,000 $10,000 $7,000
IRR SolutionIRR Solution
$10,000 $12,000
(1+IRR)1 (1+IRR)2
Find the interest rate (Find the interest rate (IRRIRR) that causes the ) that causes the discounted cash flows to equal discounted cash flows to equal $40,000$40,000..
+ +
++$40,000 =
(1+IRR)3 (1+IRR)4 (1+IRR)5
IRR Solution (Try 10%)IRR Solution (Try 10%)
$40,000$40,000 = = $10,000(PVIF$10,000(PVIF10%10%,,11) + ) + $12,000(PVIF$12,000(PVIF10%10%,,22) )
+ $15,000(PVIF+ $15,000(PVIF10%10%,,33) + ) + $10,000(PVIF$10,000(PVIF10%10%,,44) + ) +
$ 7,000(PVIF$ 7,000(PVIF10%10%,,55) )
$40,000$40,000 = = $10,000(.909) + $12,000(.826) $10,000(.909) + $12,000(.826) + + $15,000(.751) + $15,000(.751) + $10,000(.683) + $10,000(.683) + $ $ 7,000(.621)7,000(.621)
$40,000$40,000 = = $9,090 + $9,912 + $11,265 + $9,090 + $9,912 + $11,265 + $6,830 + $4,347$6,830 + $4,347 = = $41,444$41,444
[[Rate is too low!!Rate is too low!!]]
IRR Solution (Try 15%)IRR Solution (Try 15%)
$40,000$40,000 = = $10,000(PVIF$10,000(PVIF15%15%,,11) + ) + $12,000(PVIF$12,000(PVIF15%15%,,22) + ) + $15,000(PVIF$15,000(PVIF15%15%,,33) + $10,000(PVIF) + $10,000(PVIF15%15%,,44) + ) +
$7,000(PVIF$7,000(PVIF15%15%,,55) )
$40,000$40,000 = = $10,000(.870) + $12,000(.756) + $10,000(.870) + $12,000(.756) + $15,000(.658) + $15,000(.658) +
$10,000(.572) + $ 7,000(.497)$10,000(.572) + $ 7,000(.497)
$40,000$40,000 = = $8,700 + $9,072 + $9,870 + $8,700 + $9,072 + $9,870 + $5,720 + $3,479$5,720 + $3,479 = = $36,841$36,841 [[Rate Rate is too high!!is too high!!]]
IRR Solution (Interpolate)IRR Solution (Interpolate)
IRRIRR = .10 + = .10 + .0157.0157 = = .1157 .1157 or or 11.57%11.57%
Decision Criteria
If IRR > cost of capital, accept the project
If IRR < cost of capital, reject the project
If IRR = cost of capital, technically indifferent
IRR Acceptance IRR Acceptance CriterionCriterion
No! No! The firm will receive The firm will receive 11.57%11.57% for each dollar invested in this for each dollar invested in this
project at a cost of project at a cost of 13%13%. [ . [ IRRIRR < < Hurdle Rate Hurdle Rate ]]
No! No! The firm will receive The firm will receive 11.57%11.57% for each dollar invested in this for each dollar invested in this
project at a cost of project at a cost of 13%13%. [ . [ IRRIRR < < Hurdle Rate Hurdle Rate ]]
The management of The management of Basket Basket Wonders Wonders has determined that the has determined that the hurdle rate hurdle rate is is 13% 13% for projects of for projects of
this type.this type.
Should this project be accepted?Should this project be accepted?
IRR Strengths and WeaknessesIRR Strengths and Weaknesses
StrengthsStrengths: : Accounts for Accounts for
TVMTVM Considers all Considers all
cash cash flowsflows Less Less
SubjectivitySubjectivity
StrengthsStrengths: : Accounts for Accounts for
TVMTVM Considers all Considers all
cash cash flowsflows Less Less
SubjectivitySubjectivity
WeaknessesWeaknesses: : Assumes all cash Assumes all cash
flows reinvested at flows reinvested at the IRRthe IRR
Difficulties with Difficulties with project rankings project rankings
and and Multiple IRRsMultiple IRRs
Evaluation SummaryEvaluation Summary
Basket Wonders Independent Project
9-30
Which Approach is Which Approach is Better?Better?
On a purely theoretical basis, NPV is the On a purely theoretical basis, NPV is the better approach because:better approach because: NPV assumes that intermediate cash flows are NPV assumes that intermediate cash flows are
reinvested at the cost of capital whereas IRR reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR,assumes they are reinvested at the IRR,
Certain mathematical properties may cause a Certain mathematical properties may cause a project with non-conventional cash flows to have project with non-conventional cash flows to have more than one real IRR. more than one real IRR.
Despite its theoretical superiority, however, Despite its theoretical superiority, however, financial managers prefer to use the IRR financial managers prefer to use the IRR because of the preference for rates of because of the preference for rates of return.return.
Potential Ranking Problems Potential Ranking Problems Under Mutual ExclusivityUnder Mutual Exclusivity
A. Scale of InvestmentA. Scale of Investment
B. Cash-flow PatternB. Cash-flow Pattern
C. Project LifeC. Project Life
A. Scale of InvestmentA. Scale of Investment
B. Cash-flow PatternB. Cash-flow Pattern
C. Project LifeC. Project Life
Ranking of project proposals Ranking of project proposals may may create create contradictory results.contradictory results.
A. Scale DifferencesA. Scale Differences
Compare a small (S) and a large (L) Compare a small (S) and a large (L) project.project.
NET CASH FLOWSProject S Project LEND OF YEAR
0 -$100 -$100,000
1 0 0
2 $400 $156,250
S S .50 Yrs 100% .50 Yrs 100% $231 $231 3.31 3.31
L 1.28 Yrs 25%L 1.28 Yrs 25% $29,132 $29,132 1.291.29 S S .50 Yrs 100% .50 Yrs 100% $231 $231 3.31 3.31
L 1.28 Yrs 25%L 1.28 Yrs 25% $29,132 $29,132 1.291.29
Scale DifferencesScale Differences
Calculate the PBP, IRR, NPV@10%, Calculate the PBP, IRR, NPV@10%, and PI@10%.and PI@10%.
Which project is preferred? Why?Which project is preferred? Why?ProjectProject PBPPBP IRRIRR NPVNPV PIPI
B. Cash Flow PatternB. Cash Flow Pattern
Let us compare a Let us compare a decreasingdecreasing cash-flow (D) cash-flow (D) project and an project and an increasingincreasing cash-flow (I) project. cash-flow (I) project.
NET CASH FLOWSProject D Project IEND OF YEAR
0 -$1,200 -$1,200 1 1,000 100
2 500 600
3 100 1,080
DD 23%23% $198 1.17 $198 1.17
II 17% 17% $198 1.17 $198 1.17 DD 23%23% $198 1.17 $198 1.17
II 17% 17% $198 1.17 $198 1.17
Cash Flow PatternCash Flow Pattern
Calculate the IRR, NPV@10%, and Calculate the IRR, NPV@10%, and PI@10%.PI@10%.
Which project is preferred? Which project is preferred?
ProjectProject IRRIRR NPVNPV PIPI
Examine NPV ProfilesExamine NPV Profiles
Discount Rate (%)0 5 10 15 20 25-2
00
0
200
400
600
IRR
NPV@10%
Plot NPV for eachproject at various
discount rates.
Net
Pre
sen
t V
alu
e ($
)
Fisher’s Rate of Fisher’s Rate of IntersectionIntersection
Discount Rate ($)0 5 10 15 20 25-2
00
0
200
400
600
Net
Pre
sen
t V
alu
e ($
)
At k<10%, I is best!At k<10%, I is best! Fisher’s Fisher’s RateRate of ofIntersectionIntersection
At k>10%, D is best!At k>10%, D is best!
Let us compare a Let us compare a longlong life (X) life (X) project and a project and a shortshort life (Y) project. life (Y) project.
NET CASH FLOWSProject X Project YEND OF YEAR
0 -$1,000 -$1,000 1 0 2,000
2 0 0
3 3,375 0
C. Project Life DifferencesC. Project Life Differences
Project Life DifferencesProject Life Differences
X 50% X 50% $1,536 2.54$1,536 2.54
YY 100% 100% $ 818 1.82$ 818 1.82 X 50% X 50% $1,536 2.54$1,536 2.54
YY 100% 100% $ 818 1.82$ 818 1.82
Calculate the PBP, IRR, NPV@10%, Calculate the PBP, IRR, NPV@10%, and PI@10%.and PI@10%.
Which project is preferred? Why?Which project is preferred? Why?
ProjectProject IRRIRR NPVNPV PIPI
Capital RationingCapital Rationing
Capital Rationing Capital Rationing occurs when a occurs when a constraint (or budget ceiling) is constraint (or budget ceiling) is
placed on the total size of capital placed on the total size of capital expenditures during a particular expenditures during a particular
period.period.ExampleExample
Julie Miller must determine what Julie Miller must determine what investment opportunities to investment opportunities to
undertake for undertake for Basket Wonders Basket Wonders (BW)(BW). She is limited to a . She is limited to a maximum maximum
expenditure of $32,500 expenditure of $32,500 onlyonly for for 199X.199X.
Available Projects for BWAvailable Projects for BW
Project ICO IRR NPV PIProject ICO IRR NPV PI A $ 500 18%A $ 500 18% $ 50 1.10 $ 50 1.10
BB 5,000 5,000 25 25 6,500 2.30 6,500 2.30
C C 5,000 5,000 37 37 5,500 2.10 5,500 2.10 DD 7,5007,500 20 20 5,000 1.67 5,000 1.67 EE 12,50012,500
26 26 500 1.04 500 1.04
FF 15,000 15,000 28 28 21,000 2.40 21,000 2.40
GG 17,50017,500 19 19 7,500 7,500 1.43 1.43 HH 25,00025,000 15 15 6,000 1.246,000 1.24
Choosing by IRRs for BWChoosing by IRRs for BW
Project ICO IRR NPV PIProject ICO IRR NPV PI C $ 5,000C $ 5,000 37%37% $ 5,500 2.10 $ 5,500 2.10 FF 15,000 15,000 2828 21,000 2.40 21,000 2.40 EE 12,500 12,500 2626 500 1.04 500 1.04 BB 5,000 5,000 2525 6,500 2.3 6,500 2.3
Projects C, F, and E have the three Projects C, F, and E have the three largest largest IRRsIRRs..
The resulting The resulting increaseincrease inin shareholder wealth shareholder wealth is is $27,000$27,000 with a with a $32,500 outlay$32,500 outlay..
Choosing by NPVs for Choosing by NPVs for BWBW
Project ICO IRR NPV Project ICO IRR NPV PIPI
F $15,000 F $15,000 28% 28% $21,000$21,000 2.40 2.40
G 17,500G 17,500 19 19 7,5007,500 1.43 1.43
B 5,000B 5,000 25 25 6,500 2.30 6,500 2.30
Projects F and G have the two Projects F and G have the two largest largest NPVsNPVs..
The resulting The resulting increase increase inin shareholder shareholder wealthwealth is is $28,500$28,500 with a with a $32,500 outlay$32,500 outlay..
Choosing by PIs for BWChoosing by PIs for BW
Project ICO IRR NPV PIProject ICO IRR NPV PI FF $15,000 $15,000 28% 28% $21,000$21,000 2.402.40
BB 5,000 5,000 25 25 6,500 6,500 2.302.30 C C 5,000 5,000 37 37 5,500 5,500
2.102.10 DD 7,500 7,500 20 20 5,0005,000 1.671.67 GG 17,500 17,500 19 19 7,500 7,500 1.431.43
Projects F, B, C and D have the four Projects F, B, C and D have the four largest PIslargest PIs..
The resulting The resulting increaseincrease inin shareholder wealth shareholder wealth is is $38,000$38,000 with a with a $32,500 outlay$32,500 outlay..
Summary of ComparisonSummary of Comparison
MethodMethod Projects AcceptedProjects Accepted Value Value AddedAdded
PIPI F, B, C, and D $38,000 F, B, C, and D $38,000
NPVNPV F and G $28,500 F and G $28,500
IRRIRR C, F and E $27,000C, F and E $27,000
PIPI generates the generates the greatestgreatest increaseincrease in in shareholder wealth shareholder wealth when a limited when a limited
capital budget exists for a capital budget exists for a single periodsingle period..
Post-Completion AuditPost-Completion Audit
Post-completion AuditPost-completion Audit
A formal comparison of the actual costs A formal comparison of the actual costs and benefits of a project with original and benefits of a project with original
estimates.estimates. Identify any project weaknessesIdentify any project weaknesses
Develop a possible set of corrective Develop a possible set of corrective actionsactions
Provide appropriate feedbackProvide appropriate feedback
Result: Result: Making better future decisions!Making better future decisions!