Capital Budgeting Analysis Financial Policy and Planning MB 29

Outline Meaning of Capital Budgeting Significance of Capital Budgeting Analysis Traditional Capital Budgeting Techniques Payback Period Approach Discounted Payback Period Approach Discounted Cash Flow Techniques Net Present Value Internal Rate of Return Profitability Index Net Present Value versus Internal Rate of Return

Meaning of Capital Budgeting Capital 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 resources Are not easily reversible Have long-term implications for the firm Involve 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 example Similarly, 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 Approach Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability 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 flows Considers all the cash flows Considers time value of money Is unbiased in selecting projects

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

Discounted Payback Period Similar to payback period approach with one difference that it considers time value of money The amount of time needed to recover initial investment given the present value of cash inflows Keep adding the discounted cash flows till the sum equals initial investment All other drawbacks of the payback period remains in this approach Not consistent with wealth maximization

Net Present Value Approach Based on the dollar amount of cash flows The dollar amount of value added by a project NPV equals the present value of cash inflows minus initial investment Technique 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 investment Project’s promised rate of return given initial investment and cash flows Consistent with wealth maximization Accept a project if IRR ≥ Cost of Capital

NPV versus IRR Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project IRR can be in conflict with NPV if Investing or Financing Decisions Projects 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 family PI = PV of Cash Inflows/initial investment Accept a project if PI ≥ 1.0, which means positive NPV Usually, PI consistent with NPV PI 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 Analysis Equivalent Annual Cost Method If 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 is IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the project’s estimated cash flows PI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment