Capital Budgeting Analysis

Financial Policy and Planning MB 29

OutlineMeaning of Capital BudgetingSignificance of Capital Budgeting AnalysisTraditional Capital Budgeting Techniques

Payback Period ApproachDiscounted Payback Period ApproachDiscounted Cash Flow Techniques

• Net Present Value• Internal Rate of Return• Profitability Index• Net Present Value versus Internal Rate of Return

Meaning of Capital BudgetingCapital budgeting addresses the issue of strategic long-term investment decisions.Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not.Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.

Significance of Capital Budgeting

Considered to be the most important decision that a corporate treasurer has to make.So much is the significance of capital budgeting that many business schools offer a separate course on capital budgeting

Why Capital Budgeting is so Important?

Involve massive investment of resourcesAre not easily reversibleHave long-term implications for the firmInvolve uncertainty and risk for the firm

Due to the above factors, capital budgeting decisions become critical and must be evaluated very carefully. Any firm that does not follow the capital budgeting process will not be maximizing shareholder wealth and management will not be acting in the best interests of shareholders. RJR Nabisco’s smokeless cigarette project exampleSimilarly, Euro-Disney, Concorde Plane, Saturn of GM all faced problems due to bad capital budgeting, while Intel became global leader due to sound capital budgeting decisions in 1990s.

Techniques of Capital Budgeting Analysis

Payback Period ApproachDiscounted Payback Period ApproachNet Present Value ApproachInternal Rate of ReturnProfitability Index

Which Technique should we follow?

A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization.A technique is considered consistent with wealth maximization if

It is based on cash flowsConsiders all the cash flowsConsiders time value of moneyIs unbiased in selecting projects

Payback Period ApproachThe amount of time needed to recover the initial investmentThe number of years it takes including a fraction of the year to recover initial investment is called payback periodTo compute payback period, keep adding the cash flows till the sum equals initial investmentSimplicity is the main benefit, but suffers from drawbacksTechnique is not consistent with wealth maximization—Why?

Discounted Payback PeriodSimilar to payback period approach with one difference that it considers time value of moneyThe amount of time needed to recover initial investment given the present value of cash inflowsKeep adding the discounted cash flows till the sum equals initial investmentAll other drawbacks of the payback period remains in this approachNot consistent with wealth maximization

Net Present Value Approach

Based on the dollar amount of cash flowsThe dollar amount of value added by a projectNPV equals the present value of cash inflows minus initial investmentTechnique is consistent with the principle of wealth maximization—Why?Accept a project if NPV ≥ 0

Internal Rate of Return

The rate at which the net present value of cash flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investmentProject’s promised rate of return given initial investment and cash flowsConsistent with wealth maximizationAccept a project if IRR ≥ Cost of Capital

NPV versus IRRUsually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the projectIRR can be in conflict with NPV if

Investing or Financing DecisionsProjects are mutually exclusive

• Projects differ in scale of investment• Cash flow patterns of projects is different

If cash flows alternate in sign—problem of multiple IRR

If IRR and NPV conflict, use NPV approach

Profitability Index (PI)A part of discounted cash flow familyPI = PV of Cash Inflows/initial investmentAccept a project if PI ≥ 1.0, which means positive NPVUsually, PI consistent with NPVPI may be in conflict with NPV if

Projects are mutually exclusive• Scale of projects differ• Pattern of cash flows of projects is different

When in conflict with NPV, use NPV

Evaluating Projects with Unequal Lives

Replacement Chain AnalysisEquivalent Annual Cost MethodIf two machines are unequal in life, we need to make adjustment before computing NPV.

Which technique is superior?Although our decision should be based on NPV, but each technique contributes in its own way.Payback period is a rough measure of riskiness. The longer the payback period, more risky a project isIRR is a measure of safety margin in a project. Higher IRR means more safety margin in the project’s estimated cash flowsPI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment