Capital Budgeting

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Capital Budgeting. Chapter 11. Introduction. Planning in advance for capital expenditures. Process used by companies for making decisions on long term projects. Importance of capital budgeting for a financial analyst - PowerPoint PPT Presentation

Text of Capital Budgeting

Capital Budgeting

Capital BudgetingChapter 111IntroductionPlanning in advance for capital expenditures.Process used by companies for making decisions on long term projects.Importance of capital budgeting for a financial analystPrinciples well study here will be used for valuation of projects or valuation of entire companies.Capital budgeting proper planning helps achieve the goal of maximizing shareholder wealth.

2Capital Budgeting ProcessCapital budgeting process comprises of the following steps:Generating an investment decisionForecasting cash flow for each projectScheduling and prioritizing projectsMonitoring and auditing3Categories of Capital Budgeting ProjectsReplacement ProjectsMaintaining the businessCost reductionExpansion projectsRequires complex decision makingNew products and servicesComplex decision makingHigh uncertainty4Important DefinitionsIndependent ProjectsIndependent projects basically mean that if analysis reveal that it is profitable to do both projects A and B, we will do both of them. Mutually Exclusive ProjectsA set of projects where only one project can be accepted. Even if analysis reveals it is profitable to do projects A and B we can only do one of them. Example: Warehouse fleet of forklift, conveyor belt system.Unlimited Funds vs. Capital Rationing5Companys Investment DecisionsShort term T-billsCDsBank depositSharesOtherLong term6Why Investment decisions are so important to analyze in the beginning?Two most important reasons:The value of investment is very largeIrreversible7Tools of Capital BudgetingPayback PeriodSimple PaybackDiscounted Payback periodNPVIRRMIRR

81. Payback PeriodSimple Payback PeriodDefinition: Number of years it takes for projects cumulative cash flows to recover the cost of the project. The sooner the cost is recovered the better it is.Calculation (Example)Suppose the firm requires cost to be recovered within 3 years.Formula: Years before full recovery + unrecovered cost at the start of the year cash flow during full recovery year Which project we would accept?What if the two projects are mutually exclusive?What if the two projects are independent?What if cash flows are received evenly during the year?Formula: Original investment cash inflows per period Cut-off payback period: It is the pre-determined (desired) length of time for an investment to be recovered.9Simple Payback PeriodAdvantagesEasy to calculate.Easy to comprehend.Easy to analyze.Very good indicator of liquidity of a project.DisadvantagesIgnores the principal of TVM.Sets off unrealistic expectations. Does not consider cash inflows after the original investment is recovered.Biased against long-term projects that take longer time periods to become lucrative .

10Discounted Payback PeriodDefinition: Number of years it takes for projects cumulative discounted cash flows to recover its costs. or Length of time required to recover original investment from the present value of expected future cash flows.

Calculation (Example)Suppose the firm requires cost to be recovered within 3 years.

Formula: Years before full recovery + unrecovered cost at the start of the year cash flow during full recovery year

Which project we would accept?What if the two projects are mutually exclusive?What if the two projects are independent?

11Discounted Payback PeriodAdvantagesA more realistic measure than simple pay back period. Takes into account the principle of time value of money (PV of cash inflows taken into consideration).DisadvantagesIgnores cash flows beyond cut-off point.

122. Net Present ValueNet Present Value (NPV)Definition: NPV is the present value of cash inflows minus the present value of cash outflows.CharacteristicsA very important capital budgeting tool.Helps firm assess the level of importance various capital budgeting projects have.Why doing such a thing is important?Capital budgeting projects normally requires expenditures in millions and billions of dollars, before embarking on any such project they want to be reasonably sure that the cash inflows generated from the project will pay off projects costs within a reasonable amount of time. Firms generally can carry out multiple projects, capital budgeting tools like NPV help firms choose the best among them.

132. Net Present Value (contd.)Formula: NPV = Present value of cash inflows - Present value of cash outflowsCash outflows: As on today (PV)Cash inflows: Discounted back (To find PV).

Decision Criteria (3 scenarios):NPV = Positive (Cash inflows than outflow) => Accept the project.NPV = Zero (Cash inflows than outflow) => IndifferentNPV = Negative (Cash inflows than outflow) => Reject the project.

142. Net Present Value (contd.)In case of:Independent projects: NPV > 0 (Accept both projects or all within budget)Mutually exclusive projects: Accept the project with highest positive NPVExample:Global Enterprises is considering two projects. Each project requires an initial outlay of $100,000 and provides the following cash flows. The firm requires a required ROR of 10% on both projects. Project A: Cash Outflow = 100,000Cash Inflows: 1st year = 30,000 2nd year = 40,000 3rd year = 50,000 4th year = 60,000Project B: Cash Outflow = 100,000Cash Inflows: 1st year = 40,000 2nd year = 30,000 3rd year = 30,000 4th year = 20,000

152. Net Present Value (contd.)Remember: For doing NPV analysis always make a timeline. AdvantagesAdjusts for the TVM.Provides a straight forward method for controlling risk of competing projects, higher risk cash flows can be discounted at higher costs whereas lower risk cash flows are discounted at lower costs. Tells whether the investment will increase firms value.Considers all the cash flows.DisadvantagesMay not be considered as simple or intuitive as some other methods. Requires an estimate of cost of capital in order to calculate NPV.Expressed in dollar terms, not as a percentage.

163. IRRIRR stands for Internal Rate of Return.Concept: IRR quite simply tells you what is the return on a project. IRR is the discount rate at which NPV of a project is equal to zero.When we say NPV of a project is equal to zero we mean PV of cash inflows = PV of cash outflows.Definition: IRR is the discount rate at which PV of cost is equal to PV of future cash inflows.

173. IRRWe stated, IRR is the discount rate at which NPV of a project is equal to zero. Using the NPV formula

In IRR we calculate the discount rate, the r at which NPV = 0

183. IRRDecision CriteriaFor Independent Projects IF IRR > cost of capital => accept the project IF IRR < cost of capital => reject the projectFor Mutually Exclusive Projects Accept the project with highest IRR provided IRR for the project is greater than cost of capital. 193. IRRAdvantagesConsiders all cash flows of the project. Considers time value of money.DisadvantagesRequires an estimate of cost of capital in order to make a decision.Cannot be used in situations where sign of the cash flows of the project change more than once during projects life.

20Class Practice Question 1

214. MIRRMIRR stands for Modified Internal Rate of Return.Definition: MIRR is the discount rate at which the present value of a projects cost is equal to the PV of its terminal value where the terminal value is found by summing up the future value of the cash inflows, compounded at companys cost of capital. Formula: PV costs = Terminal Value (1+MIRR)n224. MIRRDecision CriteriaFor Independent Projects IF MIRR > cost of capital => accept the project IF MIRR < cost of capital => reject the projectFor Mutually Exclusive Projects Accept the project with highest MIRR provided MIRR for the project is greater than cost of capital. 234. MIRRAdvantagesConsiders all cash flows of the project. Considers time value of money.A better capital budgeting tool than IRR as it assumes cash inflows are reinvested at the cost of capital.DisadvantagesRequires an estimate of cost of capital in order to make a decision.Cannot be used in situations where sign of the cash flows of the project change more than once during projects life.

24Class Practice Question 2

25Key differences between NPV, IRR and MIRRNPVCalculationWe determine the PV of future cash inflows and then subtract the initial cash outflow from them to obtain NPV.Cost of capital is used as the actual discount rate. Projects with positive NPVs are accepted. NPV assumes cash flows are reinvested at cost of capital.IRRCalculationWe calculate the rate at which NPV is zero or simply stated we calculate the rate of return on a project. IRR is the rate at which PV of cost is equal to PV of future cash inflows. IRR is compared with cost of capital to determine if it is feasible to accept the project. Projects with IRR > cost of capital are accepted.IRR assumes cash flows are reinvested at IRR.

CalculationWe calculate the terminal value (TV) by summing up the future value of the cash inflows, compounded at companys cost of capital then find the PV of the TV. MIRR is the rate at which PV of cost is equal to PV of the TV.MIRR is compared with cost of capital to determine if it is feasible to accept the project. Projects with MIRR > cost of capital are accepted.MIRR assumes cash flows are reinvested at cost of capital.

MIRR26Reinvestment Rate AssumptionIn slide no. 26 the last difference points towards an important assumption built into the three capital budgeting tools. NPV: The NPV technique assumes that cash inflows are reinvested at the cost of capital (i.e. the same rate by which they were discounted).IRR: The IRR te