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Slide 1

CHAPTER 2
CAPITAL BUDGETING
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Slide 2 LOS: Describe the capital budgeting


1. INTRODUCTION process, including the typical steps
• Capital budgeting is the allocation of funds to long-lived capital projects.
• A capital project is a long-term investment in tangible assets. of the process, and distinguish
• The principles and tools of capital budgeting are applied in many different
aspects of a business entity’s decision making and in security valuation and
portfolio management. among the various categories of
• A company’s capital budgeting process and prowess are important in valuing a
company. capital projects.
Page 48

1. Introduction
Copyright © 2013 CFA Institute 2

The word “capital” implies long term.


• Capital funds are long-term
sources of funds (notes, bonds,
and stocks).
• Capital budgeting is investing in
long-lived assets.
• Working capital are the funds
necessary to support the
operation of the long-lived assets.
Slide 3 LOS: Describe the capital
2. THE CAPITAL BUDGETING PROCESS

Step 1 Generating Ideas


budgeting process, including
• Generate ideas from inside or outside of the company
the typical steps of the
Step 2 Analyzing Individual Proposals
• Collect information and analyze the profitability of alternative projects process, and distinguish
Step 3 Planning the Capital Budget
• Analyze the fit of the proposed projects with the company’s strategy
among the various categories
Step 4 Monitoring and Post Auditing of capital projects.
• Compare expected and realized results and explain any deviations

Page 49
Copyright © 2013 CFA Institute 3

2. The Capital Budgeting


Process

• The capital budgeting process


requires analyzing many ideas
and identifying the profitable
projects that fit with the
company’s strategy.

Slide 4 LOS: Describe the capital


CLASSIFYING PROJECTS
budgeting process, including
Replacement Expansion New Products
the typical steps of the
Projects Projects and Services
process, and distinguish
Regulatory,
Safety, and
among the various categories
Other
Environmental
Projects of capital projects.
Pages 49–50
Copyright © 2013 CFA Institute 4

Classifying Projects

• Replacement projects: Existing


assets are replaced with similar
assets.
• Example: A manufacturing
company replacing
equipment on an assembly
line
• Expansion projects: Increase
the size of the business.
• Example: Wal-Mart
opening a new retail outlet
• New products and services:
These create greater
uncertainties; hence, more
attention may be required in the
analysis of these projects.
• Example: Apple’s initial
introduction of the iPhone
• Regulatory, safety, and
environmental projects:
Generally are mandatory projects,
but the company may have
choices in how to satisfy
requirements. If sufficiently costly,
shutdown is an alternative.
• Also referred to as
mandated projects.
• Other: These may include
projects that are difficult to
analyze (e.g., research and
development [R&D]).
• Note: R&D expenses are
sunk costs, but the
decision to embark on
R&D for the development
of a project is itself a
capital project.

Slide 5 LOS: Describe the basic


3. BASIC PRINCIPLES OF CAPITAL BUDGETING
principles of capital budgeting,
Decisions are
based on cash
flows.
The timing of cash
flows is crucial. including cash flow estimation.
Pages 50–52
Cash flows are Cash flows are on
incremental. an after-tax basis.

Financing costs 3. Basic Principles of Capital


are ignored.
Budgeting
Copyright © 2013 CFA Institute 5

Principles
• Decisions are based on cash
flows, not accounting income.
• The timing of cash flows is
crucial; that is, the time value of
money is important.
• Cash flows are incremental; that
is, cash flows are based on
opportunity costs.
• Cash flows are on an after-tax
basis because cash flows related
to taxes (payments or benefits)
are part of the cash flows that
must be analyzed.
• Financing costs are ignored in
the cash flow analysis. Financing
costs enter the decision making
through the required rate of
return.

Slide 6 LOS: Describe the basic


COSTS: INCLUDE OR EXCLUDE?
• A sunk cost is a cost that has already occurred, so it cannot be part of the
principles of capital budgeting,
incremental cash flows of a capital budgeting analysis.
• An opportunity cost is what would be earned on the next-best use of the
assets.
including cash flow estimation.
• An incremental cash flow is the difference in a company’s cash flows with
and without the project.
• An externality is an effect that the investment project has on something else,
Pages 51–52
whether inside or outside of the company.
- Cannibalization is an externality in which the investment reduces cash flows
elsewhere in the company (e.g., takes sales from an existing company
project).
Costs: Include or Exclude?
Copyright © 2013 CFA Institute 6
Examples:
• Sunk cost: Using a building that
would otherwise be idle. The cost
of the building is a sunk cost.
• Opportunity cost: Using a
building that could otherwise be
rented to another business.
• Incremental cash flow: Change
in sales of the company from a
new product.
• Externality: A project has the
effect of reducing the
unemployment rate of the town in
which the company invests in this
project.
• Cannibalization: An externality
in which the investment reduces
cash flows elsewhere in the
company. For example, a soup
producer introduces a new soup
that results in lower sales of an
existing soup.
Discussion question: Suppose a
company is investing in research
and development to develop new
products. Would any of the R&D
costs be relevant for the capital
budgeting decision pertaining to a
new product that results from this
R&D?

Slide 7 CONVENTIONAL AND NONCONVENTIONAL LOS: Describe the basic


CASH FLOWS
Conventional Cash Flow (CF) Patterns
principles of capital budgeting,
Today
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including cash flow estimation.
Page 51–52
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–CF +CF +CF +CF +CF +CF

–CF –CF +CF +CF +CF +CF

–CF +CF +CF +CF +CF


Conventional and
Nonconventional Cash Flows
Copyright © 2013 CFA Institute 7

Conventional Cash Flow Patterns

What is conventional?
• Only one sign change.
• No cash flow (e.g., $0) is not
viewed as a sign change.
Slide 8 CONVENTIONAL AND NONCONVENTIONAL LOS: Describe the basic
CASH FLOWS
Nonconventional Cash Flow Patterns
principles of capital budgeting,
Today
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including cash flow estimation.
Pages 51–52
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–CF +CF +CF +CF +CF –CF

–CF +CF –CF +CF +CF +CF

–CF –CF +CF +CF +CF –CF


Conventional and
Nonconventional Cash Flows
Copyright © 2013 CFA Institute 8

Nonconventional Cash Flow


Patterns

Where do the negative cash flows


come from?
• Investment
• Shut-down costs
• Environment mitigation

Slide 9 INDEPENDENT VS. MUTUALLY LOS: Explain how the


EXCLUSIVE PROJECTS
• When evaluating more than one project at a time, it is important to identify
evaluation and selection of
whether the projects are independent or mutually exclusive
- This makes a difference when selecting the tools to evaluate the projects.
• Independent projects are projects in which the acceptance of one project
capital projects is affected by
does not preclude the acceptance of the other(s).
• Mutually exclusive projects are projects in which the acceptance of one
project precludes the acceptance of another or others.
mutually exclusive projects,
project sequencing, and capital
rationing.
Page 52
Copyright © 2013 CFA Institute 9

Independent vs. Mutually


Exclusive Projects
• Mutually exclusive projects:
The acceptance of one project
precludes the acceptance of the
other project(s).
• Example: An airline
requires a single jet for a
new route. The airline can
buy a jet from Boeing or
Airbus, but cannot buy one
from each.
• Independent projects: The
acceptance of one project does
not affect the acceptance of
another project.
• Example: A large
conglomerate is
introducing a new soup
and a new peanut butter
substitute.

Discussion question: A company


is evaluating the purchase of a new
drying system for its production line.
One system uses gas heat, whereas
the other uses electric lamps. Are
these systems mutually exclusive or
independent projects? Why?

Slide 10 LOS: Explain how the


PROJECT SEQUENCING
• Capital projects may be sequenced, which means a project contains an option
evaluation and selection of
to invest in another project.
- Projects often have real options associated with them; so the company can
choose to expand or abandon the project, for example, after reviewing the
capital projects is affected by
performance of the initial capital project.

mutually exclusive projects,


project sequencing, and capital
rationing.
Page 52
Copyright © 2013 CFA Institute 10

Project Sequencing
• Capital sequencing is a situation
in which one project’s acceptance
is conditional on another project’s
success.
• Capital sequencing is, essentially,
when a project includes an option
on future, related projects.
• Example: An entertainment
company may release a
children’s movie, but wait
to introduce the related toy
line until the performance
of the movie is assessed.
Slide 11 LOS: Explain how the
CAPITAL RATIONING
• Capital rationing is when the amount of expenditure for capital projects in a
evaluation and selection of
given period is limited.
• If the company has so many profitable projects that the initial expenditures in
total would exceed the budget for capital projects for the period, the company’s
capital projects is affected by
management must determine which of the projects to select.
• The objective is to maximize owners’ wealth, subject to the constraint on the
capital budget.
mutually exclusive projects,
- Capital rationing may result in the rejection of profitable projects.
project sequencing, and capital
rationing.
Page 52
Copyright © 2013 CFA Institute 11

Capital Rationing
• Capital rationing exists when
there is a limit on how much can
be spent on capital projects.
• Capital rationing is not consistent
with owners’ wealth maximization.
• Capital rationing may be imposed
artificially (e.g., a company’s
board permits only $100 million
on capital projects per period) or
be due to capital constraints (e.g.,
credit crunch).

Slide 12 LOS: Calculate and interpret


4. INVESTMENT DECISION CRITERIA
the results using each of the
Net Present Value (NPV)

Internal Rate of Return (IRR)


following methods to evaluate
Payback Period a single capital project: net
Discounted Payback Period present value (NPV), internal
Average Accounting Rate of Return (AAR)
rate of return (IRR), payback
Profitability Index (PI)
period, discounted payback
Copyright © 2013 CFA Institute 12

period, average accounting


rate of return (AAR), and
profitability index (PI).

• Investment Decision
Criteria

• Net present value (NPV)


• Internal rate of return (IRR)
• Payback period
• Discounted payback period
• Average accounting rate of
return (AAR)
• Profitability index (PI)

Slide 13 LOS: Calculate and interpret


NET PRESENT VALUE
the results using each of the
following methods to evaluate
a single capital project: net
present value (NPV), internal
rate of return (IRR), payback
period, discounted payback
Copyright © 2013 CFA Institute 13

period, average accounting


rate of return (AAR), and
profitability index (PI).
Pages 52–53

Net Present Value


• The net present value is the
difference between the present
value of the inflows and the
present value of the outflows
(hence, net). If the outlays occur
over more than one period, they
are discounted to the present and
then this present value is used in
Equation 2-1.
• The net present value is the
estimate of how much the value
of the firm changes with the
adoption of the project.
• NPV is the estimate of the value
added (or destroyed if negative).
• Note: When NPV = 0, we are
indifferent between accepting and
rejecting the project.

Advantages
Easy to understand (i.e., value
added)
Considers the time value of money
Considers all project cash flows

Disadvantages
Result is a monetary amount, not a
return

Slide 14 LOS: Calculate and interpret


EXAMPLE: NPV
Consider the Hoofdstad Project, which requires an investment of $1 billion
the results using each of the
initially, with subsequent cash flows of $200 million, $300 million, $400 million,
and $500 million. We can characterize the project with the following end-of-year
cash flows:
Cash Flow
following methods to evaluate
Period (millions)
0
1
–$1,000
200
a single capital project: net
2 300
3
4
400
500
present value (NPV), internal
What is the net present value of the Hoofdstad Project if the required rate of
return of this project is 5%?
rate of return (IRR), payback
period, discounted payback
Copyright © 2013 CFA Institute 14

period, average accounting


rate of return (AAR), and
profitability index (PI).
Pages 52–53

Example: NPV
Slide 15 LOS: Calculate and interpret
EXAMPLE: NPV

0 1 2 3 4
the results using each of the
–$1,000
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$200
|
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$300
|
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$400
|
|

$500
following methods to evaluate
a single capital project: net
present value (NPV), internal
rate of return (IRR), payback
period, discounted payback
Copyright © 2013 CFA Institute 15

period, average accounting


rate of return (AAR), and
profitability index (PI).
Pages 52–53

Example: NPV

Slide 16 LOS: Calculate and interpret


INTERNAL RATE OF RETURN
the results using each of the
following methods to evaluate
a single capital project: net
present value (NPV), internal
rate of return (IRR), payback
period, discounted payback
Copyright © 2013 CFA Institute 16

period, average accounting


rate of return (AAR), and
profitability index (PI).
Pages 53–55

Internal Rate of Return

• The internal rate of return is the


geometric average return on a
project.

Advantages
Easy to understand (i.e., return)
Considers the time value of money
Considers all project cash flows

Disadvantages
Solved iteratively

Slide 17 LOS: Calculate and interpret


EXAMPLE: IRR
Consider the Hoofdstad Project that we used to demonstrate the NPV
the results using each of the
calculation:
Cash Flow
Period (millions)
0 –$1,000
following methods to evaluate
1
2
3
200
300
400
a single capital project: net
4 500

The IRR is the rate that solves the following:


present value (NPV), internal
rate of return (IRR), payback
period, discounted payback
Copyright © 2013 CFA Institute 17

period, average accounting


rate of return (AAR), and
profitability index (PI).
Pages 53–55

Example: IRR
Slide 18 LOS: Calculate and interpret
A NOTE ON SOLVING FOR IRR
• The IRR is the rate that causes the NPV to be equal to zero.
the results using each of the
• The problem is that we cannot solve directly for IRR, but rather must either
iterate (trying different values of IRR until the NPV is zero) or use a financial
calculator or spreadsheet program to solve for IRR.
following methods to evaluate
• In this example, IRR = 12.826%:
a single capital project: net
present value (NPV), internal
rate of return (IRR), payback
period, discounted payback
Copyright © 2013 CFA Institute 18

period, average accounting


rate of return (AAR), and
profitability index (PI).
Pages 53–55

A Note on Solving for IRR


If using iteration,

at 12%, NPV = $20.20


at 13%, NPV = ($4.19)

Therefore, we know that the


IRR is between 12% and
13% and likely closest to
13%.

Using a financial calculator (e.g., HP


12c):

1000 +/– CF0


200 CFt
300 CFt
400 CFt
500 CFt
IRR

Using Excel:

=IRR(B3:B7)

where B3 through B7 contain the


cash flows in time order (–1000 in
B3, 200 in B4, etc.).
Slide 19 LOS: Calculate and interpret the
PAYBACK PERIOD results using each of the following
• The payback period is the length of time it takes to recover the initial cash
outlay of a project from future incremental cash flows.
• In the Hoofdstad Project example, the payback occurs in the last year, Year 4:
methods to evaluate a single capital
Cash Flow Accumulated
project: net present value (NPV),
Period Cash flows

internal rate of return (IRR),


(millions)
0 –$1,000 –$1,000
1 200 –$800
2 300 –$500
3
4
400
500
–$100
+400 payback period, discounted payback
period, average accounting rate of
return (AAR), and profitability index
Copyright © 2013 CFA Institute 19
(PI).

Payback Period

• The payback period is how long it


takes to get the original
investment back, in terms of
undiscounted cash flows.
• Advantages
• Easy to calculate
• Easy to understand
• Disadvantages
• Ignores the time value of
money
• Ignores the cash flows
beyond the payback period
Slide 20 LOS: Calculate and interpret the
PAYBACK PERIOD: IGNORING CASH FLOWS results using each of the following
For example, the payback period for both Project X and Project Y is three years,
even through Project X provides more value through its Year 4 cash flow:
methods to evaluate a single capital
Year
Project X
Cash Flows
Project Y
Cash Flows
project: net present value (NPV),
0
1
–£100
£20
–£100
£20
internal rate of return (IRR),
2
3
£50
£45
£50
£45 payback period, discounted payback
£60 £0
4
period, average accounting rate of
return (AAR), and profitability index
Copyright © 2013 CFA Institute 20
(PI).

Payback Period: Ignoring Cash


Flows

• The payback period does not


consider projects’ cash flows
beyond the payback period.

Discussion question: Is the


payback period method consistent
with shareholder wealth
maximization? Why or why not?

Slide 21 LOS: Calculate and interpret the


DISCOUNTED PAYBACK PERIOD results using each of the following
• The discounted payback period is the length of time it
takes for the cumulative discounted cash flows to equal the methods to evaluate a single capital
initial outlay.
- In other words, it is the length of time for the project to reach NPV = 0. project: net present value (NPV),
internal rate of return (IRR),
payback period, discounted payback
period, average accounting rate of
return (AAR), and profitability index
Copyright © 2013 CFA Institute 21
(PI).
Page 57

Discounted Payback Period

• The discounted payback period is


how long it takes to recover the
initial investment in terms of
discounted cash flows.
• If a project does not payback in
terms of the discounted cash
flows, then its NPV is negative.

Advantages
• Easy to understand
• Considers the time value of
money

Disadvantages
Ignores cash flows beyond the
payback period
No criteria for making a decision
other than whether a project pays
back