Chapter 10 Capital Budgeting Techniques

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with
the firm’s goal of maximizing owners’ wealth.
 Firms typically make a variety of long-term investments, but the most common is in fixed
assets, which include property (land), plant, and equipment. These assets, often referred to
as earning assets, generally provide the basis for the firm’s earning power and value.
Capital Expenditure
A capital expenditure is an outlay of funds by the firm that is expected to produce benefits over a period of
time greater than 1 year.
 An operating expenditure is an outlay resulting in benefits received within 1 year. Fixed-
asset outlays are capital expenditures, but not all capital expenditures are classified as
fixed assets.
Note!
The primary motives for capital expenditures are to expand operations, to replace or renew fixed assets,
and to obtain some other, less tangible benefit over a long period.

Capital Budgeting Process

Five distinct but interrelated steps:
 Proposal Generation. Proposals for new investment projects are made at all levels within a
business organization and are reviewed by finance personnel. Proposals that require large outlays
are more carefully scrutinized than less costly ones.
 Review and analysis. Financial managers perform formal review and analysis to assess the merits
of investment proposals. (Together with decision making, they consume the majority of time and
effort)
 Decision making. Firms typically delegate capital expenditure decision making on the basis of
dollar limits. Generally, the board of directors must authorize expenditures beyond a certain
amount. Often, plant managers are given authority to make decisions necessary to keep the
production line moving.
 Implementation. Following approval, expenditures are made and projects implemented.
Expenditures for a large project often occur in phases.
 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. Often ignored
step.

Independent versus Mutually Exclusive Projects

Independent projects are those with cash flows that are unrelated to (or independent of) one another; the
acceptance of one project does not eliminate the others from further consideration.
Mutually exclusive projects that compete with one another so that the acceptance of one eliminates from
further consideration all other projects that serve a similar function.
Unlimited Funds versus Capital Rationing
The availability of funds for capital expenditures affects the firm’s decisions. If a firm has unlimited funds
for investment (or if it can raise as much money as it needs by borrowing or issuing stock), making capital
budgeting decisions is quite simple: All independent projects that will provide an acceptable return
can be accepted.
Often, though, firms operate under capital rationing instead, which means that they have a fixed budget
available for capital expenditures and that numerous projects will compete for these dollars.

Accept–Reject versus Ranking Approaches (The two standard approaches to capital budgeting
decision)
The accept–reject approach involves evaluating capital expenditure proposals to determine whether they
meet the firm’s minimum acceptance criterion. This approach can be used when the firm has unlimited
funds, as a preliminary step when evaluating mutually exclusive projects, or in a situation in which capital
must be rationed.
 Only acceptable projects should be considered.
The ranking approach, involves ranking projects on the basis of some predetermined measure, such as the
rate of return. The project with the highest return is ranked first, and the project with the lowest return is
ranked last.
 Only acceptable projects should be ranked.
 Ranking is useful in selecting the “best” of a group of mutually exclusive projects and in
evaluating projects with a view of capital rationing.

Capital Budgeting Techniques

(A conventional cash flow pattern is one in which the up-front cash flow is negative and all subsequent
cash flows are positive. A nonconventional pattern occurs if the up-front cash flow is positive and
subsequent cash flows are negative).
1. Payback Period (Often for small and medium-sized firms)
 The payback period is the time it takes the firm to recover its initial investment in a project,
as calculated from cash inflows.
 In the case of an annuity, the payback period can be found by dividing the initial
investment by the annual cash inflow.
 For a mixed stream of cash inflows, the yearly cash inflows must be accumulated
until the initial investment is recover.
Note!
The payback period is generally viewed as an unsophisticated capital budgeting technique because it does
not explicitly consider the time value of money.
DECISION CRITERIA
When the payback period is used to make accept–reject decisions, the following decision criteria apply:

 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.
The length of the maximum acceptable payback period is determined by management.

PROS AND CONS OF PAYBACK ANALYSIS

Pros:

 Its popularity results from its computational simplicity and intuitive appeal.
 By measuring how quickly the firm recovers its initial investment, the payback period also gives
implicit consideration to the timing of cash flows and therefore to the time value of money.
 As a decision criterion or as a supplement to other decision techniques.
 The longer the firm must wait to recover its invested funds, the greater the possibility
of a calamity. Hence, the shorter the payback period, the lower the firm’s risk
exposure.
Cons:

 The major weakness of the payback period is that the appropriate payback period is merely a
subjectively determined number.
 It cannot be specified in light of the wealth maximization goal because it is not based on
discounting cash flows to determine whether they add to the firm’s value.
 Instead, the appropriate payback period is simply the maximum acceptable period of
time over which management decides that a project’s cash flows must break even
(that is, just equal to the initial investment).
 The second weakness of this approach is that it fails to take fully into account the time factor in the
value of money.
 A third weakness of payback is its failure to recognize cash flows that occur after the payback
period.

NET PRESENT VALUE (NPV)

NPV = Present value of cash inflows - Initial investment

 Method used by most large companies to evaluate investment projects.

 A sophisticated capital budgeting technique; 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.
 Takes into account the time value of investors’ money.
 Projects with lower returns fail to meet investors’ expectations and therefore decrease
firm value, and projects with higher returns increase firm value, and therefore the
wealth of its owners, by an amount equal to the NPV.
  When NPV is used, both inflows and outflows are measured in terms of present dollars. For a
project that has cash outflows beyond the initial investment, the net present value of a project would
be found by subtracting the present value of outflows from the present value of inflows.
DECISION CRITERIA
When NPV is used to make accept–reject decisions, the decision criteria are as follows:

 If the NPV is greater than $0, accept the project.

 If the NPV is less than $0, reject the project.

NPV AND PROFITABILITY INDEX

 A variation of the NPV rule is called the profitability index (PI).

 For a project that has an initial cash outflow followed by cash inflows, the profitability
index (PI) is simply equal to the present value of cash inflows divided by the initial cash
outflow.
DECISION CRITERIA

 To invest in the project when the index is greater than 1.0.

 A PI greater than 1.0 implies that the present value of cash inflows is greater than the
(absolute value of the) initial cash outflow, so a profitability index greater than 1.0
corresponds to a net present value greater than 0.
 In other words, the NPV and PI methods will always come to the same conclusion
regarding whether a particular investment is worth doing or not.
Note!
It is not always true that the NPV and PI methods will rank projects in exactly the same order. Different
rankings can occur when alternative projects require initial outlays that have very different magnitudes.

NPV AND ECONOMIC VALUE ADDED

EVA = project cash flow - 3 (cost of capital) * (invested capital)

 Economic Value Added (EVA), a registered trademark of the consulting firm Stern Stewart & Co.,
is another close cousin of the NPV method.
 The EVA approach is typically used to measure an investment’s performance on a year by year
basis.
 The EVA method begins the same way that NPV does: by calculating a project’s net cash
flows. However, the EVA approach subtracts from those cash flows a charge that is
designed to capture the return that the firm’s investors demand on the project.
 The EVA calculation asks whether a project generates positive cash flows
above and beyond what investors demand. If so, the project is worth
undertaking.
 The EVA method determines whether a project earns a pure economic profit.
  Pure economic profit refers to a profit that is higher than expected given the competitive
rate of return on a particular line of business.
 If the resulting figure is positive, the project generates a positive EVA and is worth doing.

INTERNAL RATE OF RETURN (IRR)

 The discount rate that equates the NPV of an investment opportunity with $0 (because the present
value of cash inflows equals the initial investment).
 It is the rate of return that the firm will earn if it invests in the project and receives
the given cash inflows.
DECISION CRITERIA
When IRR is used to make accept–reject decisions, the decision criteria are as follows:

 If the IRR is greater than the cost of capital, accept the project.
 If the IRR is less than the cost of capital, reject the project.

Note!

 Such an outcome should increase the market value of the firm and therefore the wealth of its
owners.
 There is no guarantee that NPV and IRR will rank projects in the same order. However, both
methods usually reach the same conclusion about whether a single project, considered in
isolation, is acceptable or not.

COMPARING NPV AND IRR TECHNIQUES

1. NPV PROFILES
 Graph that depicts a project’s NPVs for various discount rates.
 These profiles are useful in evaluating and comparing projects, especially when conflicting
rankings exist.
 The first step is to develop a number of “discount rate–net present value” coordinates.
Three coordinates can be easily obtained for each project; they are at a discount rate of 0%,
at a discount rate (the cost of capital, r), and the IRR.
 The net present value at a 0% discount rate is found by merely adding all the cash
inflows and subtracting the initial investment.

2. CONFLICTING RANKINGS
 Conflicting rankings using NPV and IRR result from differences in the reinvestment rate
assumption, the timing of each project’s cash flows, and the magnitude of the initial
investment.
Reinvestment Assumption

 One underlying cause of conflicting rankings is different implicit assumptions about the
reinvestment of intermediate cash inflows, cash inflows received prior to the termination
of a project.
 NPV assumes that intermediate cash inflows are reinvested at the cost of
capital, whereas IRR assumes that intermediate cash inflows are reinvested
at a rate equal to the project’s IRR.
Note!

 Reinvestment at a rate lower than the IRR would result in an IRR lower than that
calculated.
 Reinvestment at a rate higher than the IRR would result in an IRR higher than that
calculated.
Timing of the Cash flow

 Because project A’s cash flows arrive later than project B’s cash flows do, when the firm’s cost of
capital is relatively low, the NPV method will rank project A ahead of project B.
 At a higher cost of capital, the early arrival of project B’s cash flows becomes more
advantageous, and the NPV method will rank project B over project A.
 The differences in the timing of cash flows between the two projects does not affect
the ranking provided by the IRR method.
Magnitude of the Initial Investment

 The scale problem occurs when two projects are very different in terms of how much money is
required to invest in each project.
Note!

 It is important for financial managers to keep an eye out for conflicts in project rankings provided
by the NPV and IRR methods, but differences in the magnitude and timing of cash inflows do not
guarantee conflicts in ranking.
 In general, the greater the difference between the magnitude and timing of cash
inflows, the greater the likelihood of conflicting rankings.

3. WHICH APPROACH IS BETTER?

Theoretical view

 On a purely theoretical basis, NPV is the better approach to capital budgeting as a result of
several factors:
 The NPV measures how much wealth a project creates (or destroys if the NPV is
negative) for shareholders.
 Certain mathematical properties may cause a project with a nonconventional cash flow
pattern to have multiple IRRs, or more than one IRR.
 The maximum number of IRRs for a project is equal to the number of sign changes
in its cash flows.
Practical view

 Evidence suggests that despite the theoretical superiority of NPV, financial managers use the IRR
approach just as often as the NPV method.
 The appeal of the IRR technique is due to the general disposition of business people to think in
terms of rates of return rather than actual dollar returns. Because interest rates, profitability, and so
on are most often expressed as annual rates of return, the use of IRR makes sense to financial
decision makers.
 They tend to find NPV less intuitive because it does not measure benefits relative to the
amount invested.
 Because a variety of techniques are available for avoiding the pitfalls of the IRR, its
widespread use does not imply a lack of sophistication on the part of financial decision
makers. Clearly, corporate financial analysts are responsible for identifying and
resolving problems with the IRR before the decision makers use it as a decision
technique.