THE CAPITAL BUDGETING DECISION

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CHAPTER 12

• THE CAPITAL BUDGETING DECISION

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Capital Expenditures Decision

• CE usually require initial cash outflows in hope
  of future benefits or cash inflows
• Examples new plant construction, acquisition of
  business, purchase of new machine, etc.
• Projects often last for more than a year
• The longer the time horizon, the greater the
  uncertainty

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Areas of Uncertainty in CE Decision

• Expected cash flows
• Product life
• Interest rates
• Economic conditions
• Technological change

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Capital Budgeting

• To see if the CE is economically acceptable - if
  it creates or adds value to the firm
• To examine the CE from an investment perspective
• The basic concept is to determine if it makes
  sense to commit to an initial cash outflows in
  order to receive future cash inflows

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Example - Project A
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Project A cont
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Project Evaluation

• Discount Rate Cost of Capital
• Positive NPV indicates that the yield or rate of
  return on the project exceeds the cost of capital
  (thus add value to the firm)
• Project is financially acceptable when the PV of
  the total cash inflows greater than the PV of the
  total cash outflows ( ve NPV)

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Example - Project B
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Project B cont
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Project B cont

• Both projects A and B require an initial capital
  outflow of 10000
• Both of them will generate a total return of
  12000 in the next three years
• However, project A has a positive NPV while
  project B has a negative NPV
• Why?

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Cash Flows of Project A B

• Project A
• Yr 0 -10,000
• Yr 1 5,000
• Yr 2 5,000
• Yr 3 2,000

• Project B
• Yr 0 -10,000
• Yr 1 2,000
• Yr 2 5,000
• Yr 3 5,000

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Reasons

• For Project A, the cash inflows mainly occur at
  the first two years
• For Project B, the cash inflows mainly come in at
  the last two years
• Due to the time value of money, money received
  earlier has higher value than that received later
• Hence, Project B is not acceptable -(negative NPV)

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Flexibility of NPV - Using various discount rates
across time

• The longer the time horizon, the higher the risk
• Sometimes, we may have to use a higher discount
  rate for income in the latest year
• Instead of 10, we may use 12 to discount the
  latest cash inflow at the end of third year
• NPV method provides such a flexibility

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Flexibility of NPV allow reversal of cash flows

• NPV method can be applied to any type of cash
  flows even cash flows with reversal
• Cash flows with reversal means that there are
  more than one cash outflows
• Example a 2-year project with cash flows
• Yr 0 Initial cash outflow (-1000)
• Yr 1 Cash inflow (5000)
• Yr 2 Another cash outflow (-3000)

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Profitability Index

• It is a variation of the NPV method
• Profitability index (PI)
• PV of cash inflows/PV of cash outflows
• If PI gt 1, PV of cash inflows is greater than PV
  of cash outflows. That is NPV gt 0
• Hence project with PI gt 1 is financially viable

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Another method - IRR

• IRR Internal Rate of Return
• The IRR is the discount rate at which the PV of
  cash inflows PV of the cash outflows
• I.E., IRR is the discount rate which makes the
  NPV 0
• Project is financially acceptable when the IRR is
  greater than the cost of capital

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IRR of Project A
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IRR of Project B
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Project Evaluation

• Project A has an IRR of 11.16 which is higher
  than the cost of capital, 10. Hence project A is
  financially acceptable.
• Project B has an IRR of 8.53 which is lower than
  the cost of capital, 10. Hence project B is
  financially not acceptable.

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Why bother to use IRR?

• Since both NPV and IRR generate similar results,
  why bother to use IRR
• Yield derived from IRR may be more comprehensible
  than the absolute value derived from NPV
• In fact, we use IRR when we cannot use the cost
  of capital (the risk of the project differs from
  the risk of the firm)

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Limitations of IRR method

• A single discount rate (the IRR) throughout the
  project life inability to account for cash
  flows of different risk levels
• Possibly unrealistic to assume reinvestment of
  the generated cash inflow at the IRR
• Inapplicable when more than one reversal of cash
  flows exists will generate multiple IRRs in
  that case

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Graphical Illustration of NPV and IRR

• See Examples Below

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Cash Flows of Investment AB

• Investment A
• Yr 0 -10000
• Yr 1 5000
• Yr 2 5000
• Yr 3 2000

• Investment B
• Yr 0 -10000
• Yr 1 1500
• Yr 2 2000
• Yr 3 2500
• Yr 4 5000
• Yr 5 5000

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NPV Profile NPVs at different Discounting rate
INV. B
INV. A
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Cash Flows of Investment B C

• Investment B
• Yr 0 -10000
• Yr 1 1500
• Yr 2 2000
• Yr 3 2500
• Yr 4 5000
• Yr 5 5000

• Investment C
• Yr 0 -10000
• Yr 1 9000
• Yr 2 3000
• Yr 3 1200

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NPV Profile with crossover
NPV
6000
Crossover point
INV.B
4000
2000
INV.C
IRR 14.33
0
15
20
5
10
IRR 22.49
Discount Rate
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Where are we?

• How to raise capital?
• We have learned the three ways of raising
  long-term capital for a firm. What are they?
• How to use the capital to generate more money?
• Underlying principle to generate an investment
  return that is greater than cost of capital
• The lowest required rate of return cost of
  capital

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Project Valuation

• Similar to the valuation of financial
  instruments, we must assess the fair market value
  for any capital expenditure project.
• The highest price we pay is the present value of
  expected cash flows (derived from the project)
  discounted at the rate equivalent to the cost of
  capital
• Basic concept lowest rate of return highest
  price to be paid

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Cash Flows Determination

• Net of tax i.e. after tax net cash flow
• Gross of all financing costs (they have been
  reflected in the discount rate)
• Shortfalls
• - Future projection may base on extrapolation
• - Bias built into the cash flows estimation
• - Over/under estimate of the inflation
• - Neglect other qualitative factors such as
  better corporate image, fairer treatment of
  employee, etc

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Capital Rationing

• Management, for some reasons, may impose a dollar
  constraint in certain kind of investment
• Projects become mutually exclusive
• Project is selected based on the amount of
  benefit generated by the project
• That is, projects with the greatest NPV or the
  highest IRR

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Table 12-7Capital rationing
Net Total
Present Project Investment Investment Value

• Capital A 2,000,000 400,000 rationing
  B 2,000,000 380,000
• solution C 1,000,000 5M
  150,000
• Best D 1,000,000 100,000
• solution E 800,000 6.8M 40,000
• F 800,000 (30,000.)