1 CHAPTER 5 Capital Budgeting Techniques

2 Introduction to capital budgeting Payback period Discounted payback period Net Present value (NPV) Profitability index (PI) Internal rate of return (IRR) Complications in capital budgeting: Capital rationing and mutually exclusive projects –Time disparity –Size disparity –Unequal lives

3 INTRODUCTION: What is Capital Budgeting? Capital Budgeting is the process of analyzing investment opportunities and making long-term investment decisions. –Accept of reject? There are numerous types of investment decisions that involve capital expenditures.

4 A capital expenditure is an outlay whose benefits are expected to extend beyond one year. Capital expenditures are important to the firm because they often require substantial expenditures that affect the firm’s future profitability and direction.

5 Types of investment decisions: Purchase of fixed assets; –land, buildings, equipment, etc…. Expenditures for an advertising campaign A research & development program Etc…..

6 Basic Terminology: Independent versus Mutually Exclusive Projects Independent Projects, do not compete with the firm’s resources. A company can select one, or the other, or both—so long as they meet minimum profitability thresholds. Mutually Exclusive Projects are investments that compete in some way for a company’s resources—a firm can select one or another but not both.

7 Basic Terminology: Unlimited Funds versus Capital Rationing If the firm has unlimited funds for making investments, then all independent projects that provide returns greater than some specified level can be accepted and implemented. However, in most cases firms face capital rationing restrictions since they only have a given amount of funds to invest in potential investment projects at any given time.

8 Basic Terminology: Accept-Reject versus Ranking Approaches The accept-reject approach involves the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criteria. The ranking approach involves the ranking of capital expenditures on the basis of some predetermined measure, such as the rate of return.

9 Basic Terminology: Conventional versus Non-conventional Cash Flows (cont.) Conventional Cash Flow

10 Non-conventional Cash Flow

11 Capital Budgeting Process Generating project proposals Estimating cash flows Evaluating project proposals Selecting projects Implementing and reviewing projects

12 Evaluating project proposals using several Techniques Payback period Discounted payback period Net Present value (NPV) Profitability index (PI) Internal rate of return (IRR)

13 Copyright © 2009 Pearson Prentice Hall. All rights reserved Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1. Chapter Problem

14 Table 5.1 Capital Expenditure Data for Bennett Company

15 Figure 5.1 Bennett Company’s Projects A and B

16 Payback Period (PP) The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. The maximum acceptable payback period is determined by management.

17 Decision Criteria for payback period If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project.

18 Project A RM14,000 + RM14,000 + RM14,000 = RM42,000 PP is 3 years

19 Project B RM28,000 + RM12,000 = RM40,000 (2 years) 2 years + (RM5000/RM10,000) = 2.5 years PP is 2.5 years

20 Project A vs Project B Project B is better because need only 2.5 years to recover the initial cash outlay. If the firm’s management had a cut-off of 2 years for the projects, what would be the decision?

21 Pros of Payback Periods The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. It is simple, intuitive, and considers cash flows rather than accounting profits. It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.

22 Cons of Payback Periods One major weakness of the payback method is that the appropriate payback period is a subjectively determined number. It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value. Thus, payback fails to fully consider the time value of money.

23 Discounted payback period (DPP) The number of years needed to recover initial cash outlay from the discounted cash flows. Discounts the cash flows at the firm’s required rate of return or cost of capital. DPP is calculated by adding up these discounted net cash flows until they are equal to the initial outlay.

24 Using the Bennett Company data from Table 5.1, assume the firm has a 10% cost of capital.

25 Project A

26 Project A RM12, RM11, RM10, = RM34, (3 years) DPP is 3 years + (RM7,184.80/RM9,562.00) = 3.75 years

27 Project B

28 Project B RM25, RM9, RM7, = RM42, (3 years) DPP is 3 years + (RM2,115.40/RM6,830.00) = 3.31 years

29 Project A vs Project B Project B is better because need only 3.31 years to recover the initial cash outlay. If the firm’s management had a cut-off of 4 years for the projects, what would be the decision?

30 Net Present Value (NPV) Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.

31 Decision Criteria for NPV If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent

32 Using the Bennett Company data from Table 5.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 5.2

33 Figure 5.2 Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives

34 Advantages of Using the NPV It considers the magnitude and timing of cash flows The most conceptually correct capital budgeting approach.

35 Disadvantages of Using the NPV It is more difficult to compute Its meaning is difficult to interpret because the NPV does not provide a measure of a project’s actual rate of return.

36 Profitability index (PI) Also known as profit and cost ratio PI = Present Value of Future Cash Flow Initial Outlay PI indicates the increase in the value of the firm created by each dollar invested in the project.

37 Decision Criteria for PI Accept the project if its PI is equal or greater than one. This project will maintain or enhance the wealth of the owners.

38 Project A RM53,071/ RM42,000 = 1.26

39 Project B RM55,924/ RM45,000 = 1.24

40 Project A vs Project B

41 Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return. Using the IRR as a discount rate produces a zero NPV.

42

43 Different procedures are available for calculating a project’s IRR depending on whether or not its cash flows are in annuity form. When the net cash inflows are annuity, calculating the IRR is relatively simple. PVIFA i,n = Net Investment annual net cash inflow

44 PVIFA i,n = 42,000/14000 PVIFA i,5 = (refer to table A-4, the factor closest to for 5 years) IRR is between 19% and 20% Use interpolation between 19% and 20%

45 When the net cash inflows are unequal, calculating the IRR involves trial and error. First, summing the cash inflows for years 1 through 5, results in total cash inflows of $70,000. Second calculate average cash inflow: $70,000/ 5 years = $14,000 Third, $45,000/$14,000 = (refer to table A-4, the factor closest to for 5 years)

46 Start using18% as IRR (NPV will be +ve figures) Then try using 24% as IRR (NPV will be -ve figures) Use interpolation between 18% and 24% Notes: Try higher rates if the NPV is positive OR lower rates if the NPV is negative, a rate can be found that equates the NPV to zero.

47 Figure 5.3 Calculation of IRRs for Bennett Company’s Capital Expenditure Alternatives

48 Decision Criteria for IRR If IRR > cost of capital, accept the project If IRR < cost of capital, reject the project If IRR = cost of capital, technically indifferent

49 Advantages Is easy to interpret Considers the magnitude and timing of cash flows Provides an objective criterion for decision making which maximizes shareholder wealth.

50 Disadvantages It can be tedious to compute. Assumes reinvestment of cash inflows at an often unrealistic rate. Can produce multiple IRRs with non- conventional cash flow patterns

51 Complications in capital budgeting: The selection of the appropriate decision rules depends on the practices of the firm and the circumstances surrounding the decision. 3 Types of Capital Budgeting Decisions: –Accept-reject decisions –Mutually exclusive project decisions –Capital rationing decisions

52 Accept-reject decisions This decision occurs when an individual project is accepted or rejected without regard to any other investment alternatives. As long as a firm has unlimited funds and only independent projects, all projects meeting the minimum investment criteria should be accepted.

53 Capital Rationing Decisions Exists when the firm is unable or unwilling to finance all acceptable capital projects. A firm may place constraints on the total size of its capital budgeting during a given time period.

54 Mutually Exclusive Project Decisions The acceptance of one of these projects eliminates the others from further consideration The ranking of mutually exclusive projects may conflict based on accept-reject decision rules.

An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river.

56 4 major causes for conflicting ranking among mutually exclusive projects: The projects have different expected lives. The projects have substantially different net investment (size disparity) The projects have different timings of cash flows. Discounted cash flow techniques have different reinvestment rate assumptions.

S and L are mutually exclusive and will be repeated. k = 10%. Which is better? Expected Net CFs YearProject SProject L 0($100,000) 1 59,000 33, ,000 33, , ,500

SL CF ,000 CF 1 59,00033,500 NjNj 24 I10 NPV2,3976,190 Q. NPV L > NPV S. Is L better? A. Can’t say. Need replacement chain analysis.

Note that Project S could be repeated after 2 years to generate additional profits. Use replacement chain to calculate extended NPV S to a common life. Since S has a 2-year life and L has a 4- year life, the common life is 4 years.

L: S: % 33, % 59, , ,000 59, ,000 NPV L = $6,190 (already to Year 4) NPV S = $4,377 (on extended basis) -100, ,000