Capital Budgeting Techniques and Practice

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Capital Budgeting Techniques and Practice
Chapter 9
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Chapter Objectives

• Discuss why it is difficult to find profitable
  projects
• Use capital budget techniques to evaluate new
  projects
• Discuss Capital Rationing concerns
• Work through issues in Project rankings

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Capital Budgeting

• Capital Budgeting is the process of decision
  making with respect to investment in fixed assets
  (long term projects)
• Evaluation of the profitability of projects
• 4 methods (decision criteria) to evaluate
  projects
• Decide whether to accept or reject a project
• Projects are evaluated based on Free Cash Flows

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Finding Profitable Projects

• Remember It is much easier to evaluate projects
  than it is to find them
• The curse of Competitive markets
• Finding profitable projects is essential for the
  survival of the firm
• How does a company find profitable projects?
• Typically, a firm has a research development
  department that searches for ways of improving
  existing products or finding new projects
• Other sources?

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Capital Budgeting Decision Criteria

• Payback Period
• Net Present Value
• Profitability Index (Benefit-Cost Ratio)
• Internal Rate of Return

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Payback Period

• Number of years needed to recover the initial
  cash outlay of a project
• This criteria measures how quickly the project
  will return its original investment
• It is based on free cash flows, not accounting
  profits
• Emphasizes the early cash flows, which are less
  uncertain than later cash flows

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Payback Period Examples
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Payback Period

• Strengths
• Simple to use, easy to understand
• Focuses on free cash flows, not accounting
  profits
• Useful as a control for risk (since it emphasizes
  early cash flows)
• Drawbacks
• Ignores Time Value of Money
• Ignores Cash Flows beyond payback period,
  decision may be inconsistent with goal of the
  firm
• No objective decision rule (accept / reject)

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Net Present Value or NPV

• Present value of the free cash flows less the
  initial outlay
• Gives a measurement of the net value of a project
  in todays dollars
• Decision Criteria
• If NPV 0, Accept the project
• If NPV lt 0, Reject the project

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Discount Rate

• Cost of Capital (more in Chapter 11)
• Rate of Return necessary to justify raising funds
  to finance the project
• Required Rate of Return
• Rate of Return necessary to maintain the firms
  current market price per share
• Only NPV positive projects increase share prices
  in the long run

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NPV Example

• Project Initial Outlay 10,000
• Cash flows is 2,500 a year for 6 years
• Required rate of return 10
• PV of 2,500, 6 years, 10 is 10,888
• NPV of the project 10,888 - 10,000
• 888
• Decision Since 888 gt 0, Accept

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Net Present Value

• Advantages
• Examines cash flows, not profits
• Recognizes time value of money
• By accepting only positive NPV projects, decision
  criteria leads to increases value of the firm,
  consistent with objective of firm
• Disadvantages
• Need for detailed, long term forecasts

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Profitability Index

• Also know as the Benefit-Cost ratio
• Ratio of the present value of the future free
  cash flows to the initial outlay
• Generates same results as NPV
• Under no capital rationing constraints
• Decision Criteria
• PI 1 Accept the project
• PI lt 1 Reject the project

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Profitability Index Example

• Project Initial Outlay 10,000
• Cash flows 2,500 for 6 years
• Required rate of return 10
• PV of the cash flows 10,888
• PI 10,888/10,000 1.088
• Decision Since 1.088 gt 1 , Accept

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NPV and PI Compared

• When the present value of a projects cash flows
  are greater than the initial cash outlay
• The Project NPV will be positive.
• The Project PI will be greater than 1.
• NPV and PI will always yield the same decision,
  but does not necessarily rank acceptable projects
  in the same order
• Important distinction when there is capital
  rationing or projects are mutually exclusive
• PI has same advantages/disadvantages as NPV

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Internal Rate of Return or IRR

• Defined as the discount rate that equates the
  present value of a projects cash flows with the
  projects Initial cash outlay
• Answers the question What Rate of Return does
  this project earn?
• Decision Criteria
• If IRR gt Required rate of return, Accept
• IF IRR lt Required rate of return, Reject

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IRR Example

• Project Initial Outlay 10,000
• Cash flows 2,500 for 6 years
• Required Rate of Return 10
• CFo -10,000
• C01 2,500
• F01 6
• IRR CPT
• True IRR 12.978 via financial calculator
• Decision Since IRR gt Required ROR, Accept

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Internal Rate of Return

• Advantages
• Examines cash flows, not profits
• Recognizes time value of money
• Consistent with Goal of the Firm
• Rates are comparable across projects of different
  sizes
• Disadvantages
• Need for detailed, long term forecasts
• IRR may not exist for certain project that have
  unconventional cash flows (more than one sign
  change)

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IRR and NPV Compared

• If NPV is positive, IRR will be greater than the
  required rate of return
• If NPV is negative, IRR will be less than
  required rate of return
• If NPV 0, IRR is the required rate of return
• NPV and IRR will yield the same decision, but
  does not necessarily rank acceptable projects in
  the same order
• Important distinction when there is capital
  rationing or when projects are mutually exclusive

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NPV and IRR Compared
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Capital Rationing

• Firm may place a limit on the dollar size of the
  capital budget
• Have to choose among the pool of accepted
  projects
• Potential Reasons
• Management may think market conditions are
  temporarily adverse (Recessions)
• Shortage of qualified managers
• Intangible considerations
• Risk aversion to debt
• Rejecting projects because of capital rationing
  is contrary to the goal of the firm

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Project Selection under Capital Rationing

• Selection Criteria Select the set of projects
  with the highest NPV subject to the capital
  constraint
• Using this criteria, the result is that projects
  that increase shareholder wealth the most will be
  selected, since NPV is the amount of wealth that
  is created when a project is selected

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Capital Rationing Example

• Consider a 1 million dollar budget constraint
• Select projects A and C
• (Total outlay 200,000 800,000 1 million)
• These projects maximizes the firms NPV subject
  to the capital constraint

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Mutually Exclusive Projects

• Occur when two or more projects perform
  essentially the same task
• Different alternatives are available, but only
  one can be used accomplish the task
• Acceptance of one project will necessarily mean
  rejection of the other project(s)
• Example
• Installation of computer system
• Need to rank projects in order to select one
  project, then Ranking Problems become important
• The problem is how to choose from the pool of
  accepted projects

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Size Disparity Example
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Ranking Problems Size Disparity

• Mutually Exclusive projects of unequal sizes are
  examined
• Initial cash outlay are different between the
  alternative projects
• Without Capital Rationing
• Choose the project with the largest NPV
• With Capital Rationing
• Select the project with the largest NPV that will
  fit under the capital constraint

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Time Disparity Example
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Ranking Problems Time Disparity

• Future CF timing differences result in time
  disparity
• Time disparity of cash flows produce conflicting
  rankings between NPV and IRR methods that result
  from the differing reinvestment assumptions made
  by the NPV and the IRR
• NPV criterion assumes cash flows are reinvested
  at the required rate of return
• IRR criterion assumes cash flows are reinvested
  at the IRR
• NPV criterion preferred since it is more
  conservative assumption, since the required rate
  of return is the lowest possible reinvestment rate

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Unequal Lives Ranking Problem
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Ranking Problems Unequal Lives

• Mutually Exclusive Projects with different life
  spans
• Decision is difficult since the projects are not
  comparable
• Two methods to deal with the problem
• Replacement Chains
• Equivalent Annual Annuity