Capital Budgeting Decide how to invest resources to maximize their contribution to the organization’s objectives.

Capital Budgeting Process Capital budget (investment) proposals are examined on basis of their cash outlays and resulting flow of future benefits over period of time greater than one year.

Capital Budgeting Process 1.Clearly define short-term and long-term objectives 2.Identify alternative investment opportunities and the capital required for each one. 3. Assess organizations ability to generate investment capital for capital budgeting period

Capital Budgeting Process 4. Measure cash (benefit) flows from alternative capital investment opportunities 5. Evaluate pro- posals using selected criteria Increase log inventory to reduce risk of mill downtime during Spring breakup?

Capital Budgeting Process 6. Select alternatives to fund and implement 5.Review performance for feed-back to decision makers Buy new skidder to reduce maintenance cost on old one and increase productivity?

Financial Criteria to Rank Alternatives Net Present Value Internal Rate of Return Benefit /Cost Ratio Payback Period

Other Criteria Capacity to carry out proposed projects –Management –Labor Sources of capital –Borrow from commercial lenders or private parties (leverage assets) –Sell (issue) stock – corporation; or membership interests - limited liability companies (LLC)

Notation ARR – alternative rate of return MAR – minimum acceptable rate of return (hurdle rate) B - annual nonmarket value, dollars B/C - benefit/cost ratio EAA - equivalent annual annuity IRR - internal rate of return N - project life, years NPV = net present value

Notation t - index of years C t – cost in year t R t - revenue in year t PV - present value at a specified point in time r - real interest rate f – rate of inflation i – nominal interest rate

Net Present Value NPV = ∑ = ∑ RtRt CtCt (1+r) t t=0 n R t - C t (1+r) t t=0 n

Example of NPV Year Project D Cash Flows ,600

Project D NPV C 0 = - $400/(1.06) 0 = - $ C 5 = - $100/(1.06) 5 =- $ R 15 = $200/(1.06) 15 = $ R 30 = $6,600/(1.06) 30 = $1, NPV =

Net Present Value Guideline Project must at least cover the opportunity cost as measured by the minimum acceptable rate of return (MAR) used to calculate present values Project is acceptable if NPV is zero or greater Projects with negative NPV are unacceptable, don’t cover opportunity cost

Internal Rate of Return (IRR) The r that makes NPV = 0 Meaning – r that makes PV of costs and PV of revenues equal Find by –iterating over r until NPV = 0 –Use “Goal Seek” function in Excel

IRR Guideline Project is acceptable if its IRR is equal to or greater than the minimum acceptable rate of return (MAR) Relationship to NPV criteria – if MAR is the discount rate (r) used to calculate NPV, then IRR and NPV will accept same projects.

Benefit/Cost Ratio PV (benefits)/PV (costs), or PV (revenues)/PV (expenses) ∑ R t / (1+r) t = ∑ C t /(1+r) t n n y=0 t=0

Benefit/Cost Ratio Guideline Accept project if B/C ≥ 1.0 If B/C ≥ 1.0 then –NPV ≥ 0, and –IRR ≥ MAR

PV of costs PV of revenues Relationship of NPV, IRR and B/C B/C < 1 NPV < 0 B/C > 1 NPV > 0 IRR Year 0 – ($400), Year 5 – ($100), Year 15 - $200, Year 30 - $6,600

Payback Period Time required for net revenue to equal invested capital Example, –Invest $10,000 –Net revenue is $5,000 per year –Payback is 2 years, ($10,000/$5,000) Best used in conjunction with other criteria

Ranking Projects NPV, IRR, and B/C may not rank alternative projects in the same order Additional ranking criteria –Mutually exclusive projects – only one can be chosen –Independent Opposite of mutually exclusive, Can all be adopted

Ranking Projects Additional ranking criteria, cont. –Divisible – can invest in part of a project –Indivisible – all or nothing

Timing of cash flows effects rankings Timing of revenue and expenditures is critcal –Worst case is front-loaded costs and back-loaded revenues Rankings by NPV and IRR are different depending on MAR

Example of NPV Year Project D Cash Flows Project N Cash Flows , ,600+2,500

Project D NPV C 0 = - $400/(1.06) 0 = - $ C 5 = - $100/(1.06) 5 =- $ R 15 = $200/(1.06) 15 = $ R 30 = $6,600/(1.06) 30 = $1, NPV =

Project N NPV C 0 = - $400/(1.06) 0 = - $ C 5 = - $100/(1.06) 5 =- $ 4.73 R 8 = $1,200/(1.06) 8 = $ R 30 = $6,600/(1.06) 30 = $ NPV = $

Example of NPV Year Project D Cash Flows Project N Cash Flows , ,600+2,500 $2,756 gives D & N same NPV’s NPV$758 $713

NPV project D NPV project N NPV same at 6.3% IRR = 9.7% IRR=14.5% NPV Interest Rate