What is Capital Budgeting

1
What is Capital Budgeting?

• The process of planning and evaluating
  expenditures on assets whose cash flows are
  expected to extend beyond one year
• Analysis of potential additions to fixed assets
• Long-term decisions involve large expenditures
• Very important to firms future

2
Generating Ideas for Capital Projects

• A firms growth and its ability to remain
  competitive depend on a constant flow of ideas
  for new products, ways to make existing products
  better, and ways to produce output at a lower
  cost.
• Procedures must be established for evaluating the
  worth of such projects.

3
Project Classifications

• Replacement Decisions whether to purchase
  capital assets to take the place of existing
  assets to maintain or improve existing operations
• Expansion Decisions whether to purchase capital
  projects and add them to existing assets to
  increase existing operations
• Independent Projects Projects whose cash flows
  are not affected by decisions made about other
  projects
• Mutually Exclusive Projects A set of projects
  where the acceptance of one project means the
  others cannot be accepted

4
Similarities between Capital Budgeting and Asset
Valuation
Uses same steps as in general asset valuation

• Determine the cost, or purchase price, of the
  asset.
• Estimate the cash flows expected from the
  project.
• Assess the riskiness of cash flows. Note that we
  will explicitly address the risk issue in the
  next chapter. For now, risk is taken as given.
• Compute the present value of the expected cash
  flows to obtain as estimate of the assets value
  to the firm.
• Compare the present value of the future expected
  cash flows with the initial investment.

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Net Cash Flows for Project S and Project L
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What is the Payback Period?
The length of time before the original cost of an
investment is recovered from the expected cash
flows or . . . How long it takes to get our
money back.
7
Payback Period for Project S
8
Payback Period for Project L
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Strengths and Weaknesses of Payback

• Strengths of Payback
• Provides an indication of a projects risk and
  liquidity
• Easy to calculate and understand
• Weaknesses of Payback
• Ignores TVM
• Ignores CFs occurring after the payback period

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Net Present Value Sum of the PVs of Inflows and
Outflows
Cost is CF0 and is generally negative.
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What is Project Ss NPV?
12
What is Project Ls NPV?
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Calculator Solution, NPV for L
Enter in CF for L
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Rationale for the NPV method
NPV PV inflows - Cost Net gain in
wealth. Accept project if NPV gt 0. Choose
between mutually exclusive projects on basis of
higher NPV. Which adds most value?
15
Using NPV method, which project(s) should be
accepted?

• If Projects S and L are mutually exclusive,accept
  S because NPVS gt NPVL.
• If S L are independent, accept both NPV gt 0.

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Internal Rate of Return IRR
IRR is the discount rate that forces PV inflows
cost. This is the same as forcing NPV 0.
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Calculating IRR
NPV Enter k, solve for NPV.
IRR Enter NPV 0, solve for IRR.
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What is Project Ss IRR?
Enter CFs in CF register, then press IRR
NPVS
IRRS 13.1
0
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What is Project Ls IRR?
Enter CFs in CF register, then press IRR
IRRL 11.4
NPVL
0
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How is a Projects IRR Related to a Bonds YTM?
They are the same thing. A bonds YTM is the
IRR if you invest in the bond.
IRR 7.08 (use TVM or CF register)
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Rationale for the IRR Method
If IRR (projects rate of return) gt the firms
required rate of return, k, then some return is
left over to boost stockholders
returns. Example k 10, IRR 15.
Profitable.
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IRR acceptance criteria

• If IRR gt k, accept project.
• If IRR lt k, reject project.

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Decisions on Projects S and L per IRR

• If S and L are independent, accept both. IRRs gt
  k 10.
• If S and L are mutually exclusive, accept S
  because IRRS gt IRRL .