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Course F-611:CAPITAL INVESTMENT

DECISION OR CAPITAL BUDGETING

Prof. Shabbir Ahmad

Course ContentsIntroduction

Cash Flow Estimation ± Determination of cash out flow and cashinflows

Techniques of Capital Budgeting ± Discounted (NPV, IRR, MIRR, PI,and DPB) and non-discounted (PB & AAR) cash flow techniques,decision criteria, advantages and disadvantages of each technique.

Special Issues in Capital Budgeting ±Projection evaluation, cost-cutting projects, bid price setting, projects with different lives.

Project Analysis and Evaluation ± Forecasting risk, sensitivity and

scenario analysis, break-even analysis, operating leverage and capital bud etin .



Course F-611:CAPITAL INVESTMENTDECISION

Inflation and Capital Budgeting

Options in Capital Budgeting

Capital Budgeting for Levered Firm

Risk, Cost of Capital and Capital Budgeting

Risk and Capital Budgeting ± Absolute measure and relativemeasure of risk, certainty equivalent method and risk adjusteddiscount rate method.




Text Books

Fundamentals of Corporate Finance ± Ross, Westerfield,Jordan

Corporate Finance ± Ross, Westerfield, JaffeCapital Budgeting and Long-term Financing ± Neil Seitz

Intermediate Financial Management ± Brigham

Managerial Finance ± Lawrence Gitman




Course Evaluation

Class Attendance ----- 10Mid-term ± I -----------15

Mid-term ± II ----------15

Class Test/Quiz --------10Term Paper/Pres.------10

Final Exam -------------40

Total --------------------100



CAPITAL BUDGETING OR

CAPITAL INVESTMENT DECISION CAPITAL INVESTMENT DECISIONS (or Capital

Budgeting) involves company¶s long term investmentdecision. It includes evaluation of the firm¶s expenditure

decisions that involve current outlays but are likely to produce benefits or returns over a long period of time.

Capital Budgeting is the process of evaluating and selectinglong-term investments in fixed or capital assets that are

consistent with the firm¶s goal of maximizing owner wealth.

Capital Budgeting is the entire process of analyzing projectsand deciding whether they should be included in the

capital budget.



CAPITAL INVESTMENT DECISION

Why a firm makes capital investment?

In order to secure a stream of benefit in future years that

add value to the firm through inflow over future times.



FEATURES/CHARACTERISTICS

OF CID (IMPORTANCE) Long term investment decision (future profitability of

firm).

Returns or benefits are expected over number of years

Investment involves huge amount of cash outflow(determines the destiny of the firm)

Investment decision is generally irreversible (oncemade can not be changed)

Relatively high degree of risk

Relatively long time period between the initial outlayand the anticipated return



CLASSIFICATION OF PROJECTS

By Degree of Dependence:

Mutually Exclusive Projects.

Independent Projects.

By Cash Flow pattern:

Conventional Project.( - + + + + + i.e. outflow

followed by a series of inflow). Non Conventional Projects ( - + + - + - + i.e. if the

project inflows & outflows are mixed & zigzag

pattern).



CAPITAL INVESTMENT

DECISION Determination of Cash Outflow or

Investment

Projection or Forecast of Future Cash

Inflows

Determination of Appropriate Discount Rate(i.e. Cost of Capital)



CASH FLOW DETERMINATION

A project should be evaluated on the basis of

Incremental After Tax Cash Flows.

Incremental After Tax Cash Flows consist of

any or all changes in the firm¶s future cash

flows that are direct consequence of taking the

project.



CASH FLOW

DETERMINATIONOnly the relevant cash flows should be taken under

consideration in determination of cash flows (i.e.

inflows or outflows) for making capital investmentdecision.

Relevant cash flows should be included in a capital

budgeting analysis. These cash flows will only occur if

the project is accepted

Relevant cash flows are those which influence the

firm¶s decision regarding accepting or rejecting a

project.



CASH FLOW

DETERMINATIONIrrelevant cash flows are those which do not

affect the firm¶s decision regarding accepting or

rejecting a project i.e. they exist if the firms

accepts a project or it rejects a project

Irrelevant cash flows should NOT be included

in capital budgeting analysis.



CASH FLOW

DETERMINATION Asking the Right Question

Will this cash flow occur ONLY if we accept the project?´

If the answer is ³yes´, it should be included in the

analysis because it is incremental

If the answer is ³no´, it should not be included inthe analysis because it will occur anyway

If the answer is ³part of it´, then we should include

the part that occurs because of the project



CASH OUTFLOW OR

INVESTMENT DETERMINATION Cost of new asset or project

Add installation cost (if any)

Add transportation cost (if any)

Add removal cost of old asset (only if borne by the company)

Less selling price of old asset (if new asset replaces

old asset)

+ / - Tax on sale of old assetLess Amount of investment tax credit (AITC)



CASH OUTFLOW OR INVESTMENT

DETERMINATIONExample

The Sprint Inc. is trying to estimate the net cash outflow required toreplace an old machine with a new one. The new machine¶s purchase

price is $270,000. An additional $7,000 will be required for transportationand $5,000 will be required to install the machine. As the new machine

has greater capacity to produce, there will be an additional investment of $20,000 in raw material inventory in the initial year. The new machinewill be depreciated on straight-line basis over five years of useful life.The old machine was purchased two years ago at a cost of $70,000 has aremaining useful life of five years. It is also subject to straight-linedepreciation. The company is entitled to investment tax allowance of 25%. The corporate tax rate is 55% and the capital gain tax rate is 30%.Find the net cash outflow considering separately each of the followingscenarios:

i) If the old machine is sold for $40,000

ii) If the old machine is sold for $50,00. ..\NCO.xls

iii) If the old machine is sold for $60,000.

iv) If the old machine is sold for $90,000.



CASH IN FLOW DETERMINATION

Operating Cash Flow (OCF)

Opportunity Cost

Sunk CostErosion or Side Effects

Financing Cost

Change in Net Working Capital



PROJECTCASH FLOW

DETERMINATION

Year

0 1 2 3

OCFChange in NWC

Opportunity Cost

Capital Spending/CO

PCF



DecisionDecision--making Criteria inmaking Criteria in

Capital BudgetingCapital Budgeting

How do we

decide if acapital

investment

projectshould be

accepted or

rejected?



TECHNIQUES OF CAPITAL

BUDGETING

The techniques of capital budgeting are dividedinto two broad groups

A) Non discounted cash flow techniques i.e.

techniques that do not consider time value of money as such do not discount the future cashflows

B) Discount cash flow (DCF) techniques i.e.

techniques that do not consider time value of money as such do not discount the future cashflows



TECHNIQUES OF CAPITAL BUDGETING

A) Non-DCF techniques include the following:i) Payback Period Method

ii) Average Accounting Return or Accounting Rateof Return

B) DCF techniques include the following:

i) Net Present Value (NPV)

ii) Internal Rate of Return (IRR)

iii) Profitability Index (PI) or Benefit-CostRatio (BCR)

iv) Discounted Payback Period Method



The Payback Period Rule

How long does it take the project to ³pay back´

its initial investment?

Payback Period = number of years to recover initial costs

Minimum Acceptance Criteria:

set by management



The Payback Period Rule (continued)

Disadvantages:Ignores the time value of money

Ignores cash flows after the payback period

Biased against long-term projectsRequires an arbitrary acceptance criteria

A project accepted based on the payback criteria maynot have a positive NPV

Advantages:Easy to understand

Biased toward liquidity



The Discounted Payback

Period Rule How long does it take the project to ³pay back´

its initial investment taking the time value of

money into account?



The Average Accounting Return Rule

Another attractive but fatally flawed approach.

Disadvantages:

Ignores the time value of money

Uses an arbitrary benchmark cutoff rate

Based on book values, not cash flows and market values

Advantages:

The accounting information is usually available

Easy to calculate

Investentof ValueBook AverageIncome NetAverageAAR !



The Net Present Value (NPV) Rule

Net Present Value (NPV) =

Total PV of future CI¶s - Initial Investment

PV of Cash Inflows ± PV of Cash Outflows

Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV



Good Attributes of the NPV Rule

1. Uses cash flows

2. Uses ALL cash flows of the project

Reinvestment assumption: the NPV rule assumes

that all cash flows can be reinvested at the

discount rate or cost of capital.



The Internal Rate of Return (IRR) Rule

IRR: the discount rate that sets NPV to zero or the rateof return available from investing in a project.Minimum Acceptance Criteria:

Accept if the IRR exceeds the required return.Ranking Criteria:

Select alternative with the highest IRR Reinvestment assumption:

All future cash flows assumed reinvested at the IRR.Disadvantages:

IRR may not exist or there may be multiple IRR

Problems with mutually exclusive investmentsAdvantages:

Easy to understand and communicate



The Internal Rate of Return: Example

Consider the following project:

0 1 2 3

$50 $100 $150

-$200

The internal rate of return for this project is 19.44%

32 )1(

150$

)1(

100$

)1(

50$0

IRR IRR IRR NPV

!!



Problems with the IRR Approach

Multiple IRRs.

The Scale Problem

The Timing Problem

Investing or Financing



Multiple IRRs

There are two IRRs for this project:

0 1 2 3

$200 $800

-$200 - $800

($150.00)

($100.00)

($50.00)

$0.00

$50.00

$100.00

-50% 0% 50% 100% 150% 200%

Discount rate

N P V

100% = IRR 2

0% = IRR 1

Which one

should we use?



The Scale Problem

Would you rather make 100% or 50% on your

investments?

What if the 100% return is on a $1 investmentwhile the 50% return is on a $1,000 investment?



The Timing Problem

0 1 2 3

$10,000 $1,000 $1,000

-$10,000

Project A

0 1 2 3

$1,000 $1,000 $12,000

-$10,000

Project B

The preferred project in this case depends on the discount rate, not

the IRR.



The Timing Problem..\TimingProb.xls

($4,000.00)

($3,000.00)($2,000.00)

($1,000.00)

$0.00

$1,000.00

$2,000.00

$3,000.00

$4,000.00

$5,000.00

0% 10% 20% 30% 40%

Discount rate

N P V

Project A

Project B10.55% = crossover rate

16.04% = IRR A

12.94% = IRR B



Mutually Exclusive vs.

Independent Project Mutually Exclusive Projects: only ONE of several

potential projects can be chosen, e.g. acquiring anaccounting system.

RANK all alternatives and select the best one.

Independent Projects: accepting or rejecting one projectdoes not affect the decision of the other projects.

Must exceed a MINIMUM acceptance criteria.



The Profitability Index (PI) Rule

Minimum Acceptance Criteria:

Accept if PI > 1

Ranking Criteria:Select alternative with highest PI

Disadvantages:

Problems with mutually exclusive investments

Advantages:May be useful when available investment funds are limited

Easy to understand and communicate

Correct decision when evaluating independent projects

InvestentInitialFlowsCashFutureof PVTotalPI !



The Practice of Capital Budgeting

Varies by industry:

Some firms use payback, others use accounting rate of

return.

The most frequently used technique for large

corporations is IRR or NPV.



Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the

following two projects. Assume the required return is

10%.

Year Project A Project B

0 -$200 -$150

1 $200 $50

2 $800 $100

3 -$800 $150




Project A Project B

CF0 -$200.00 -$150.00

PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%

PI = 1.2096 1.6053




Payback Period:

Project A Project B

Time CF Cum. CF CF Cum. CF

0 -200 -200 -150 -150

1 200 0 50 -100

2 800 800 100 0

3 -800 0 150 150Payback period for project B = 2 years.

Payback period for project A = 1 or 3 years?



Relationship Between NPV and IRR

Discount rate NPV for A NPV for B

-10% -87.52 234.77

0% 0.00 150.00

20% 59.26 47.9240% 59.48 -8.60

60% 42.19 -43.07

80% 20.85 -65.64100% 0.00 -81.25

120% -18.93 -92.52

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