Capital Budgeting Tools and Technique

What is Capital Budgeting In “Capital budgeting” capital relates to the total funds employs in an enterprise as a whole, and budgeting indicates a detailed quantified planning which guides future activities of an enterprise towards the achievement of its goals. Capital budgeting may be defined as the decision making process by which a firm evaluates the investment in major fixed assets including building, machinery and equipment.

Capital Budgeting Decisions Examples of decisions addressed: What products should the firm sell? In what markets should the firm compete? What new products should the firm introduce? Roles of managers: Identify and invest in products and business acquisitions that will maximize the current market value of equity. Learn to identify which products will succeed and which will fail.

Area of Business/ key motives where Capital Budgeting can be used 1.Expansion: The level of operation of a growing firm through acquisition of fixed assets. 2. Replacement: The level of operation of a slow growth firm or a matured firm through replacement of obsolete assets. 3. Renewal: An alternative to replacement involving rebuilding an existing fixed assets for improving assets efficiency.

Steps of Capital Budgeting 1.Proposal generation 2.Review and analysis 3.Decision making 4.Implementation 5.Follow-up

Terminologies related to Capital Budgeting Capital rationing: it occurs when a limited budget is placed on the total size of capital expenditures during a particular period. It limits the company’s capital expenditures during a given period of time. Independent projects: A project whose acceptance or rejection does not prevent the acceptance of other projects under consideration. Mutually exclusive projects: A project whose acceptance or rejection prevents the acceptance of other projects compete with one another. Conventional Cash flow: A cash flow pattern consists of an initial outflow followed by a series of inflows. Non-Conventional Cash flow: A cash flow pattern consists of a series of inflows and outflows.

Techniques of capital budgeting Conventional or Traditional Pay back period Accounting rate of return Non Conventional or Discounted Cash Flow method Net present value Internal rate of return Profitability Index

Pay Back period The pay back period is the exact amount of time required for the firm it take to recover its initial investment in a project. How to Find Pay Back period if the cash inflow is equal in each year PBP = Initial Investment/ Annual Cash Inflow if the cash flows are mixed stream, the yearly cash inflows must be accumulated until the initial investment is recovered. Where, NCO = Net Cash Outlay A = the year in which the cumulative net cash flow is nearer to NCO C = Cumulative net cash flow of the year A D = Net cash flow of the year following the year A.

Pay Back period Advantages of Pay Back period: 1.Easy to understand and calculate. 2.Less time consuming, decision can make quickly. 3.It put emphasis on liquidity principle of the firm, the shorter the payback period, the greater the project’s liquidity, other things held constant. 4.Incurs low cost in evaluating projects. 5.This method used cash flows instead of accounting profit. 6.It is fruitful to measure short run performance of a firm.

Accounting rate of return Accounting rate of return (ARR, also known as average rate of return) is used to estimate the rate of return for an investment project. ARR Rule: The higher the ARR, the more attractive the project is. If the ARR is higher than the minimum standard average rate of return, then we will accept the project. However, this technique does not take into account of the time value of money. ****ARR = Average profit / Average investment

Accounting rate of return Advantages: 1)The main advantage is that it is easy to understand and calculate. 2)This is a simple capital budgeting technique and is widely used to provide a guide to how attractive an investment project is. 3) Another advantage is familiarity. The ARR concept is a familiar concept to return on investment (ROI), or return on capital employed.

Accounting rate of return Disadvantages: 1)This technique is based on profits rather than cash flow. Therefore it can be affected by non-cash items such as the depreciation and bad debts when calculating profits. The change of methods for depreciation can be manipulated and lead to higher profits. 2) This technique does not adjust for the risk to longer term forecasts. 3)ARR does not take into account the time value of money. 4)This technique can be calculated in a wide variety of ways and hence lead to different outcomes.

Pay Back period Disadvantages of Pay Back period: 1.It ignores the cash flows that are paid and received after the payback period. 2.Ignores the time value of money. 3. It is not consistent with the goal of organization, because it measures only short term performance.

Discounted Pay Back period In investment decisions, the number of years it takes for an investment to recover its initial cost after accounting for inflation, interest, and other matters affected by the time value of money, in order to be worthwhile to the investor. It differs slightly from the payback period rule, which only accounts for cash flows resulting from an investment and does not take into account the time value of money.

Discounted Pay Back period Rule The Discounted Payback Rule: An investment is accepted if its calculated discounted payback period is less than or equal to some pre-specified number of years. Analyzing the Discounted Payback Rule Involves discounting as in the NPV rule. It does not consider the risk differences between investments. Yet, we can discount with a higher interest rate for a riskier project. How do you come up with the right discounted payback period cut- off? Arbitrary number.

Discounted Pay Back period Advantages : 1. Considers the time value of money. 2. Considers the riskiness of the project's cash flows (through the cost of capital). 3. If a project ever pays back on a discounted basis, then it must have a positive NPV. Disadvantages: 1.May reject positive NPV projects 2.Arbitrary discounted payback period 3.Biased against long-term projects

Net Present Value (NPV) The net present value is the difference between the market value of an investment and its cost. NPV is a measure of the amount of market value created by undertaking an investment project. The interest rate, r, will reflect the risk of the cash flows.

Net Present Value (NPV)….cont’d Finding the market value of the investment 1.Use discounted cash flow valuation (calculate present values). 2.Compute the present values of future cash flows Net Present Value Rule (NPV): An investment should be accepted if the net present value is positive and rejected if the net present value is negative. Positive NPV projects create shareholder value.

The Internal Rate of Return (IRR) Rule IRR: The discount rate that makes the present value of future cash flows equal to the initial cost of the investment. Equivalently, the discount rate that gives a project a zero NPV. IRR Rule: An investment is accepted if its IRR is greater than the required rate of return. An investment should be rejected otherwise. Calculating IRR: “trial and error method”

Advantages and Disadvantages of the IRR Rule Advantages: 1.Closely related to NPV rule, often leading to the same decisions. 2.Easy to understand and communicate. Disadvantages: 1.May result in multiple answers with non-conventional cash flows. 2.May lead to incorrect decisions with mutually exclusive investment projects. 3.Not always easy to calculate.

Comparison of IRR and NPV IRR and NPV rules lead to identical decisions when the following conditions are satisfied: Conventional Cash Flows: The first cash flow (the initial investment) is negative and all the remaining cash flows are positive Project is independent: A project is independent if the decision to accept or reject the project does not affect the decision to accept or reject any other project. When one or both of these conditions are not met, problems with using the IRR rule can result.

Problems with the IRR Rule Unconventional Cash Flows: Cash flows come first and investment cost is paid later. In this case, the cash flows are like those of a loan and the IRR is like a borrowing rate. Thus, in this case a lower IRR is better than a higher IRR Multiple rates of return problem: The possibility that more than one discount rate makes the NPV of an investment project zero. Mutually exclusive projects: If taking one project means another project is not taken, the projects are mutually exclusive. The one with the highest IRR may not be the one with the highest NPV.

Profitability Index Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment. Profitability Index = (Net Present Value + Initial Investment) / Initial Investment Rules of Profitability Index - If PI > 1, Good Investment - If PI < 1, Bad Investment Relationship between Profitability Index & Net Present Value - If Profitability Index > 1, NPV is Positive (+) - If Profitability Index < 1, NPV is Negative (-)

Profitability Index Advantages Tells whether an investment increases the firm's value Considers all cash flows of the project Considers the time value of money Considers the risk of future cash flows (through the cost of capital) Useful in ranking and selecting projects when capital is rationed Disadvantages Requires an estimate of the cost of capital in order to calculate the profitability index May not give the correct decision when used to compare mutually exclusive projects