FinQuiz - Curriculum Note, Study Session 11, Reading 35

Reading 35 Capital Budgeting

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1. INTRODUCTION

Capital budgeting refers to an investment decision-making process used by an organization to evaluate and select long-term investment projects. Basically, capital budgeting is associated with the justification of capital expenditures. Capital expenditures are long-term in nature and are amortized over period of years. For example, investments in capital equipment, purchase or lease of buildings, purchase or lease of vehicles, etc. The specific capital budgeting procedures used by a manager depend on following factors:

• Manager’s level in the organization.

• Size and complexity of the project being evaluated.

• Size of the organization.

Importance of Capital Budgeting process: It indicates two things regarding the quality of management of a firm:

a) The degree to which management focuses on the goal of maximizing wealth of shareholders.

b) Management’s effectiveness in pursuing that goal.

2. THE CAPITAL BUDGETING PROCESS

The typical steps in the capital budgeting process are as follows: 1) Generating ideas: It is the most important part of the

process. Investments ideas can be generated from:

• Top or the bottom of the organization • Any department or functional area • Outside the company.

2) Analyzing individual proposals: This step involves

forecasting cash flows and evaluating the project. 3) Planning the capital budget: This step involves

organizing the profitable proposals by taking into account firm’s financial and real resource constraints, project’s timing; and deciding which projects fit into the firm’s overall strategies.

4) Monitoring and post-auditing: In post-audit, actual

results are compared to planned or predicted results and any differences between them are explained.

Post-auditing capital projects is important for several reasons i.e.

i. It helps in monitoring the forecasting process and to identify systematic errors i.e. overly optimistic forecasts.

ii. It helps to improve business operations by focusing attention on costs or revenues that are not in accordance with expectations.

iii. It facilitates to generate concrete ideas for future investments i.e. organization can decide to invest in profitable projects and scale down or cancel unprofitable investments.

Capital budgeting projects may be divided into the

following categories:

1. Replacement projects: They include:

i. Replacement of old equipment for the maintenance of business. • They may not require careful analysis.

ii. Replacement of old/out-of-date equipment with newer, more efficient equipment for cost savings purposes. • They may require very detailed analysis.

2. Expansion projects: Expansion projects refer to

projects which are undertaken to increase the size of the business. Expansion includes expansion of product line or market-expansion decisions.

• These expansion decisions may involve more uncertainties compared to replacement decisions.

• These expansion decisions require more careful analysis.

3. New products and services: These investments are

relatively more complex and involve more uncertainties than expansion projects. They require very detailed and careful analysis and involve more people in the decision-making process.

4. Regulatory, Safety, and Environmental projects: These

projects are usually mandatory projects for a firm i.e. required by a governmental agency, an insurance company or some other external party.

• They may or may not generate any revenue. • Typically, they are not undertaken to maximize

own private interests of a firm. • These projects may be quite expensive; thus, a firm

may find it more feasible to either cease operating altogether or to shut down any part of the business

Reading 35 Capital Budgeting FinQuiz.com

that is related to the project.

5. Other:They include pet projects or high risk projects.

• They may be difficult to analyze using standard techniques.

3. BASIC PRINCIPLES OF CAPITAL BUDGETING

Capital budgeting usually uses the following assumptions:

1. Decisions are based on cash flows:

• In addition, intangible costs and benefits are often ignored because it is assumed that if these benefits or costs are real, they will eventually be reflected in cash flows.

• The relevant cash flows to be considered are incremental cash flows. Sunk costs should be ignored in the analysis.

2. Timing of cash flows is critical i.e. cash flows that are

received earlier are more valuable than cash flows that are received later.

3. Cash flows are based on opportunity costs:

Opportunity costs should be included in project costs. These costs refer to the cash flows that could be generated from an asset if it was not used in the project.

4. Cash flows are analyzed on an after-tax basis. Cash

flows on after-tax basis should be incorporated in the analysis.

5. Financing costs are ignored. Financing costs are

reflected in the required rate of return which is used to discount after-tax cash flows and investment outlays to estimate net present value(NPV) i.e. only projects with expected return > cost of the capital (required return) will increase the value of the firm.

• Financing costs are not included in the cash flows; because when financing costs are included in both cash flows and in the discount rate, it results in double-counting of the financing costs.

6. Capital budgeting cash flows are not accounting net

income.

Differences between Accounting Net Income and

Economic Income

Accounting Net Income Economic Income

1) Noncash charges (i.e. accounting depreciation) are subtracted from accounting net income.

2) Interest expenses

Economic income = cash inflows + ∆ in market value of the firm. i. Cost of debt is not

subtracted from economic income.

ii. Economic income is

Accounting Net Income Economic Income

(reflecting cost of debt) are subtracted from accounting net income.

based on changes in market value of the firm rather than changes in its book value (accounting depreciation).

Required rate of return: The required rate of return represents the discount rate that is required by investors given the riskiness of the project.

Opportunity cost of funds: When a firm can invest elsewhere and earn a return “r” or when a firm can save a cost of “r” by repaying its sources of capital, discount rate is referred to as the Opportunity cost of funds. A firm should not invest when return earned <

opportunity cost of funds. Cost of capital: It refers to the cost of funds that is supplied by firm’s suppliers of capital.

A firm should not invest when return earned < cost of

capital.

Important Capital Budgeting Concepts:

Sunk costs: These refer to costs that have already been incurred regardless of whether a project is taken on or not e.g. consulting fees paid to prepare a report on the feasibility of a project. These costs should not to be included in cost; decisions should be based on current and future cash flows.

An opportunity cost: These costs refer to the cash flows that could be generated from an asset if it was not used in the project. Opportunity costs should be taken into account.

Examples:

• If a company uses some idle property, opportunity costs will be the current market value of that property.

• If a company replaces an old machine with a new one, opportunity cost will be the cash flows generated by old machine.

• If a company invests $10 million; $10 million represents opportunity costs.


Incremental cash flow: Only incremental cash flows should be considered. They refer to total cash flows that occur as a direct result of undertaking a specific project.

Incremental cash flow = Cash flow with a decision - Cash

flow without that decision

Externality: An externality refers to effect of a project on other parts of a firm (either positive or negative effect). It should be taken into account in the analysis. For example, cannibalization is a type of externality which occurs when new investment takes customer and sales away from another part of the company.

Conventional versus nonconventional cash flows:

• A conventional cash flow pattern is one with an initial cash outflow followed by a series of cash inflows i.e. cash flows change signs once.

• A nonconventional cash flow pattern is one in which the initial cash outflow is not followed by cash inflows only i.e. cash inflows are followed by cash outflows and so on. In nonconventional pattern, cash flows change signs two or more

times.

Effects of project interactions on the evaluation of a

capital project:

1) Independent versus mutually exclusive projects:

• Independent projects are projects whose cash flows are independent of each other. Since projects are unrelated, each project is evaluated on the basis of its own profitability.

• Mutually exclusive projects compete directly with each other e.g. if Projects A and B are mutually exclusive, you can choose A or B, but you cannot choose both.

2) Project sequencing: It refers to projects that are

sequenced through time i.e. investing in a project creates the option to invest in future projects e.g.

• A company may invest in a project today and then in invest in a second project after one year only if the financial results of the first project or new economic conditions are favorable; otherwise, investment in the second project is avoided.

3) Unlimited funds versus capital rationing:

• When unlimited funds are available to a firm, it can invest in all profitable projects.

• In capital rationing, a firm has constraints on the amount of capital that can be raised. Since a firm has fixed amount of capital to invest, it will invest only in those profitable projects that will maximize shareholder value subject to capital constraints.

4. INVESTMENT DECISION CRITERIA

Measures used to determine whether a project is profitable or unprofitable are as follows:

• Net present value (NPV) • Internal rate of return (IRR) • Payback period • Discounted payback period • Average accounting rate of return (AAR) • Profitability index (PI)

4.1 Net Present Value

NPV = Present value of cash inflows – initial investment

�� = � ��1 + � − ��

�

��

where,

CFt = After-tax cash flow at time t

r = required rate of return for the investment

CF0 = investment cash outflow at time zero

Decision Rule:

• Accept a project if NPV ≥ 0 • Do not Accept a project if NPV< 0

Independent projects: All projects with positive NPV are accepted.

Mutually exclusive projects: A project with the highest NPV is accepted. Positive NPV investments increase shareholders wealth. Advantages:

1) NPV directly measures the increase in value of the firm.

2) NPV assumes reinvestment at r (opportunity cost of capital).


4.2 Internal Rate of Return (IRR)

IRR is the discount rate that makes

Present value of cash inflows = initial investment

• In simple words, IRR is the discount rate where NPV = 0.

• IRR is calculated using trial and error method or by using a financial calculator.

Example:

IRR is found by solving the following:

10,000 � 2,000�1 � ��

2,500�1 � ��

3,000�1 � ��

3,500�1 � ��

� 4,000�1 � ��

Solution: IRR = 13.45%

Decision Rule:

• Accept a project if IRR ≥ Cost of Capital. • Do not Accept a project if IRR< Cost of Capital. • If projects are independent, accept both if IRR of

both projects ≥ Cost of Capital. • If projects are mutually exclusive and Project A

IRR>Project B IRR, accept Project A because IRRA>IRRB .

Advantages of IRR:

1) IRR considers time value of money. 2) IRR considers all cash flows. 3) IRR involves less subjectivity. 4) It is easy to understand. 5) It is widely accepted.

Limitations of IRR:

1) IRR is based on the assumption that cash flows are reinvested at the IRR; however, this may not always be realistic.

2) IRR provides result in percentages; however, percentages can be misleading and involves difficulty in ranking projects i.e. a firm rather earn 100% on a $100 investment, or 10% on a $10,000 investment.

3) In case of non-conventional cash flow pattern, there can be multiple IRRs or no IRR at all.

4.3 Payback Period

The payback period measures the time that a project takes to recover the cost of the investment.

Decision Rule: Shorter the payback period, better it is.

Advantages:

1) It is simple and easy to calculate and understand. 2) It is a measure of the liquidity of the project i.e.

lower payback period project is more liquid than another project with a longer payback period.

Limitations:

1) It ignores the time value of money. 2) It ignores all cash flows beyond the payback

period. 3) Its cutoff period is subjective. 4) It is a measure of payback; not a measure of

profitability. 5) It is not consistent with wealth maximization

because it focuses on short-run profits at the expense of larger long-term profits.

6) It is not economically sound.

4.4 Discounted Payback Period

Discounted payback period is similar to payback period but it uses discounted rather than raw CFs i.e. it measures the amount of time that a project takes to recover initial investment given the PV of cash inflows.

Important: Note that discounted payback period is always longer than the regular payback period.

Decision Rule: Shorter the discounted payback period, better it is.

Advantages:

1) It is simple and easy to calculate and understand. 2) It is a measure of the liquidity of the project i.e.

lower discounted payback period project is more

Practice: Example 1,

Volume 4, Reading 35.


liquid than another project with a longer discounted payback period.

3) It takes into account time value of money.

Limitations:

1) It ignores all cash flows beyond the discounted payback period.

2) Its cutoff period is subjective. 3) It is a measure of payback; not a measure of

profitability. 4) It is not consistent with wealth maximization

because it focuses on short-run profits at the expense of larger long-term profits.

5) It is not economically sound.

Discounted payback versus NPV:

• If a project has a negative NPV, it will usually not have a discounted payback period because it will not recover the initial investment.

• However, it is possible for a project to have a reasonable discounted payback period in spite of having a negative NPV due to positive cumulative discounted cash flows in the middle of its life.

4.5 Average Accounting Rate of Return

AAR = ��

��

Decision Rule: If the AAR is greater than some arbitrarily specified cutoff rate, accept the project. Advantage: It is easy to understand and easy to calculate.

Limitations:

1) AAR is based on accounting numbers and not based on cash flows.

2) AAR ignores the time value of money. 3) AAR is not adjusted for risk. 4) AAR uses an arbitrarily specified cutoff rate to

distinguish between profitable and unprofitable investments.

4.6 Profitability Index

PI = �� !�

�� = 1 +

" �

��

• It indicates the value received by a company in exchange for one unit of currency invested.

• In corporation, it is referred to as the “profitability index”.

• In governmental and not-for-profit organizations, it is referred to as a “benefit-cost ratio”.

Decision rule for the PI:

• Invest if PI > 1.0 • Do not invest if PI < 1.0

PI v/s NPV:

• PI: Ratio of the PV of future cash flows to the initial investment.

• NPV: Difference between the PV of future cash flows and the initial investment.

• Whenever NPV is positive, the PI > 1.0. • Whenever NPV is negative, the PI < 1.0.

Advantages:

1) PI is useful in capital rationing i.e. when available investment funds are limited.

2) It is easy to understand and communicate. 3) It provides correct decisions when independent

projects are evaluated. 4) It is closely related to NPV.

Limitation: It is not a reliable measure to evaluate mutually exclusive projects.

4.7 NPV Profile

NPV profile refers to a graph that shows NPV as a function of various discount rates i.e. NPV is plotted on the vertical axis (y-axis) and discount rates are plotted on the horizontal axis (x-axis).

Vertical axis represents a discount rate of zero. Point at which the NPV profile intersects (crosses) the vertical axis represents the sum of undiscounted cash flows from a project. Horizontal axis represents an NPV of 0. Point at which the NPV profile intersects (crosses) the horizontal axis represents points where NPV = 0 i.e. project’s IRR. Cross-over rate: The rate at which two NPV profiles intersect with each other is called crossover rate. It is the point where NPVs of the projects are the same.




As shown in the graph,

• NPV decreases at a decreasing rate as the discount rate increases.

• NPV profile is convex from the origin.

It is important to note that if the cost of capital<discount rate at the cross-over point, choosing the project with the highest IRR results in selecting the project which contributes the least to the firm’s equity value.

4.8 Ranking Conflicts between NPV and IRR

No conflict exists between the decision rules for NPV and IRR when:

1) Projects are independent. 2) Projects have conventional cash flow pattern.

Conflict exists between the decision rules for NPV and IRR when: 1) Projects are mutually exclusive. 2) Projects have non-conventional cash flow pattern.

NPV and IRR rank projects differently due to following

reasons:

1) Differences in cash flow patterns. 2) Size (scale) differences: Sometimes, the larger,

low rate of return project has the better NPV.

NPV versus IRR:

• NPV assumes that cash flows are reinvested at r (opportunity cost of capital).

• IRR assumes that cash flows are reinvested at IRR. • It is more realistic to assume reinvestment at

opportunity cost ‘r’; thus, NPV method is best. It implies that whenever there is a conflict between NPV and IRR decision rule and to choose between mutually exclusive projects, we should always use NPV.

4.9 The Multiple IRR Problem and the No IRR Problem

Multiple IRRs problem: When the cash flows change sign more than once (i.e. non-conventional cash flow pattern), there can be more than one IRR. This problem is referred to as Multiple IRR problem e.g.

In this case, NPV profile of the project intersects the horizontal line twice i.e. at discount rate 100% and discount rate 200%.

No IRR problem: There maybe no IRR when the cash flow pattern is of following type:

In this case, NPV profile may never cross the horizontal axis.

• When there is no IRR, it implies that NPV is always > 0.

Various capital budgeting methods are used depending

on following four criteria:

a) Location: European countries tend to prefer payback period method to the IRR and NPV methods.

b) Size of the company: Larger companies tend to prefer discounted cash flow techniques i.e. NPV and IRR methods.

c) Public vs. private: Private companies use the payback period more often than public companies. Public companies tend to prefer discounted cash flow methods.

d) Management education: Companies managed by an MBA tend to prefer discounted cash flow techniques i.e. NPV and IRR methods.

Practice: Example 4 & 5,





The Relationship between NPV and Stock Price:

NPV investment decision criterion is considered the criterion that is most directly related to stock price of a firm. Investing in a positive NPV project leads to increase in wealth of the firm’s shareholders.

• According to theory, a positive NPV project should result in a proportionate increase in the company’s stock price.

Value of a company = value of company’s existing

investments + Net PV of all of

company’s future investments

• However, in reality, changes in the stock price will primarily result due to changes in expectations about a project’s profitability. o When NPV is positive but, its profitability <

expected profitability, stock price may decrease.

Example: Suppose NPV = $1,550and there are 1,000 shares outstanding, then

Value created per share = " �

#�� $��

= $�,�

�,�� = $1.55

• This implies that if the project is accepted, then the price of the stock should increase by $1.55.

Practice: End of Chapter Practice

Problems for Reading 35.



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FinQuiz - Curriculum Note, Study Session 11, Reading 35