Capital Budgeting and its Techniques Chapter 5 Capital Budgeting and its Techniques

The Capital Budgeting Decision Process Capital Budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth. Capital expenditure- an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year. Operating expenditure- An outlay of funds by the firm resulting in benefits received within 1 year. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

MOTIVES FOR CAPITAL EXPENDITURE Capital expenditures are made for many reasons. The basic motive for capital expenditures are to expand, replace or renew fixed assets or to obtain some other less tangible benefit over a long period. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Motives for Capital Expenditures Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Steps in the capital budgeting Process Proposal Generation Review and Analysis Decision Making Implementation Follow-up Our Focus Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

proposal generation: Proposals are made at all levels within a business organization and are reviewed by finance personnel. Review and Analysis: Formal review and analysis is performed to assess the appropriateness of proposals and evaluate their economic viability. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

3. Decision Making: Firms typically delegate capital expenditure decision making on the basis of funds limits. Generally the board of directors must authorize expenditures beyond a certain limit. 4. Implementation: Following approval, expenditures are made and projects implemented. Expenditures for a large project often occur in phases. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

5. Follow up: Results are monitored, and actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Basic Terminology: Independent versus Mutually Exclusive Projects Independent Projects- Projects whose cash flows are unrelated or independent of one another. The acceptance of one does not eliminate the others from further consideration. Mutually Exclusive Projects- projects that compete with one another, so that the acceptance of one eliminates from further consideration of all other projects that serve a similar function. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Basic Terminology: Unlimited Funds versus Capital Rationing Unlimited funds- The financial situation in which a firm is able to accept all independent projects that provide an acceptable return. Capital rationing- The financial situation in which a firm has only a fixed amount available for capital expenditures and numerous projects compete for this resource. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

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. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

TECHNIQUES FOR CAPITAL INVESTMENT APPRAISAL The following are the important techniques used for capital investment appraisal: Pay back period Net Present Value Internal Rate of Return

Payback Period The payback method- The amount of time required for a firm to recover its initial investment in a project. THE DECISION CRITERIA 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. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Pros and Cons of Payback periods The payback period method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. Its popularity results from its computational simplicity and intuitive appeal. The major weakness of payback period is that the appropriate payback period is merely a subjectively determined number. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Pay back period calculation AL RASHID company, a software developer, has two investment opportunities, X and Y. Data for X and Y are given in the following table. Project X Project Y Initial investment 10,000 Year Operating cash Flows 1 5,000 3,000 2 4,000 3 1,000 4 100 5 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Solution: The pay back period for project X is 2 years and for project Y is 3 years. Strictly adhering to Pay back approach suggests that project X is preferable to project Y. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Net Present Value (NPV) Net Present Value (NPV): NPV is found by subtracting a project’s initial investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

(Cfo) = A project’s initial investment (CFt) = Present value of its cash inflows which is discounted at a rate equal to the firm’s cost of capital. (k) = Cost of capital Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

NPV DECISION CRITERIA When NPV is used to make accept-reject decisions, the decision criteria are as follows: Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

If NPV is greater than 0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

INTERNAL RATE OF RETURN (IRR) The internal rate of return (IRR) is probably the most widely used sophisticated capital budgeting technique. However it is considerably more difficult than NPV to calculate by hand. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

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. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Internal Rate of Return (IRR) (cont.) When IRR is used to make accept-reject decisions, the decision criteria are as follows: Decision Criteria If IRR > k, accept the project If IRR < k, reject the project If IRR = k, technically indifferent Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

These criteria guarantee that the firm will earn at least its required return. Such an outcome should increase the market value of the firm and therefore the wealth of the owners. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Capital Budgeting Techniques Chapter Problem 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. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Capital Budgeting Techniques (cont.) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Capital Budgeting Techniques (cont.) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Calculation of payback period Project A-Initial investment-$42000 Year Accumulated cash inflows 1 $14000 2 $ 28000 3 $ 42000 4 $ 56000 The year in which accumulated cash inflows is equal to initial investment is year 3.Hence the payback period is 3 years Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Calculation of payback period Project B-Initial investment-$45000 Year Accumulated cash inflows 1 $28000 2 $40000 3 $ 50000 At the end of year 3, $50000 is recovered. Only 50% of cash flow($10000 )is required to complete the payback of initial investment $ 45000.The payback period of Project B is 2.5 years.(2 years + 50% of year 3) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.