Capital Budgeting Techniques 1

What is Capital Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

The Capital Budgeting Decision Capital budgeting describes decisions where expenditures and receipts for a particular undertaking will continue over a period of time. These decisions usually involve outflows of funds in the early periods while the inflows start somewhat later and continue for a significant number of periods.

The Capital Budgeting Decision Types of capital budgeting decisions Replacement projects are expenditures necessary to replace worn-out or damaged equipment. Cost reduction projects include expenditures to replace serviceable but obsolete plant and equipment. Safety and environmental projects are mandatory investments that may not produce revenues. Expansion projects increase the availability of existing products and services

Project Classifications Independent Projects: Projects whose cash flows are not affected by decisions made about other projects. Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted. e.g. buying computers of different brands. Dependent( contingent)projects: e.g. buying a new machine may force to extend the construction

Project Evaluation: Alternative Methods Payback Period (PBP) Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI)

Net Cash Flows for Project S and Project L 1, 5 00 2 80 30 40 90 3 ^ N et C as h F lo w s , C t r e d p A Ex ct fte -T ax Y ea ( T ) P o jec S L a $ 3,00 1 4

What is the Payback Period? The length of time before the original cost of an investment is recovered from the expected cash flows or . . . How long it takes to get our money back. 7

Payback Period for Project S Net Cash Flow Cumulative Net CF 1,500 -1,500 800 500 1,200 -300 -3,000 300 PBS 1 2 3 4 = PaybackS 2 + 300/800 = 2.375 years 8

Payback Period for Project L Net Cash Flow Cumulative Net CF 400 - 2,600 1,300 - 400 900 - 1,700 - 3,000 1,500 1,100 PBL 1 2 3 4 = PaybackL 3 + 400/1,500 = 3.3 years

Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. CF1 CF2 CFn - ICO NPV = + + . . . + (1+k)1 (1+k)2 (1+k)n

Proposed Project Data Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.

NPV Solution $10,000 $12,000 $15,000 NPV = + + + Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. $10,000 $12,000 $15,000 NPV = + + + (1.13)1 (1.13)2 (1.13)3 $10,000 $7,000 + - $40,000 (1.13)4 (1.13)5

NPV Solution NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $ 7,000(PVIF13%,5) - $40,000 NPV = $10,000(.885) + $12,000(.783) + $15,000(.693) + $10,000(.613) + $ 7,000(.543) - $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000 = - $1,428

NPV Acceptance Criterion The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted? No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ]

Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. CF1 CF2 CFn ICO = + + . . . + (1+IRR)1 (1+IRR)2 (1+IRR)n

IRR Solution $10,000 $12,000 $40,000 = + + (1+IRR)1 (1+IRR)2 $10,000 $12,000 $40,000 = + + (1+IRR)1 (1+IRR)2 $15,000 $10,000 $7,000 + + (1+IRR)3 (1+IRR)4 (1+IRR)5 Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000.

IRR Solution (Try 10%) $40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5) $40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) + $ 7,000(.621) $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 = $41,444 [Rate is too low!!]

IRR Solution (Try 15%) $40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5) $40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) + $10,000(.572) + $ 7,000(.497) $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 = $36,841 [Rate is too high!!]

IRR Solution (Try 15%) NPV at Lower Rate (10%) NPV = PV - ICO NPV at Higher Rate (15%) NPV = $ 36,881 - $ 40,000 = $ - 3159

IRR Solution IRR= LR + NPv L X (HR – LR) NPVL – NPvH

IRR Solution IRR= 10 + 1444 x (15 – 10) 1444 – (-3159) IRR= 10 + 1444 x 5 4603 IRR= 10 + 0.3137 x 5 IRR= 10+ 1.57 = 11.57%

Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. PI = PV / ICO

PI Acceptance Criterion PI = $38,572 / $40,000 = .9643 Should this project be accepted? No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI < 1.00 ]

Assignment Calculate NPV,PBP,IRR and PI for the following projects. Which project should be selected.(discount rate =13%)

Years Project A Project B $ 28,000 $ 20,000 1 8000 5000 2 3 6000 4 5 7000 6 7