Capital Budgeting

KHALID AZIZ

JOIN KHALID AZIZ

ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: 0322-3385752 0312-2302870 0300-2540827 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
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The Capital Budgeting Decision Process

The capital budgeting process involves three basic steps: Generating long-term investment proposals; Reviewing, analyzing, and selecting from the proposals that have been granted, and Implementing and monitoring the proposals that have been selected.

Managers should separate investment and financing decisions.

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Capital Budgeting Decision Techniques

Accounting rate of return (ARR): focuses on project s impact on accounting profits Payback period: most commonly used Net present value (NPV): best technique theoretically; difficult to calculate realistically Internal rate of return (IRR): widely used with strong intuitive appeal Profitability index (PI): related to NPV
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A Capital Budgeting Process Should:

Account for the time value of money; Account for risk; Focus on cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders wealth.
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Example: Global Wireless

Global Wireless is a worldwide provider of wireless telephony devices. Global Wireless is contemplating a major expansion of its wireless network in two different regions:
Western Europe expansion A smaller investment in Southeast U.S. to establish a toehold

Global Wireless
Initial Outlay Year 1 inflow Year 2 inflow Year 3 inflow Year 4 inflow Year 5 inflow -$250 $35 $80 $130 $160 $175

Initial Outlay Year 1 inflow Year 2 inflow Year 3 inflow Year 4 inflow
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-$50 $18 $22 $25 $30 $32

Year 5 inflow

Accounting Rate Of Return (ARR)

Can be computed from available accounting data

Average profits after taxes ARR ! Average investment

Need only profits after taxes and depreciation. Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.
Average profits = Average annual operating cash inflows after taxes Average annual depreciation

ARR uses accounting numbers, not cash flows; no time value of money.

Payback Period
The payback period is the amount of time required for the firm to recover its initial investment.

If the project s payback period is less than the maximum acceptable payback period, accept the project. If the project s payback period is greater than the maximum acceptable payback period, reject the project. Management determines maximum acceptable payback period.
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Payback Analysis For Global Wireless

Management s cutoff is 2.75 years. Western Europe project: initial outflow of -$250M
But cash inflows over first 3 years is only $245 million. Global Wireless will reject the project (3>2.75).

Southeast U.S. project: initial outflow of -$50M

Cash inflows over first 2 years cumulate to $40 million. Project recovers initial outflow after 2.40 years. Total inflow in year 3 is $25 million. So, the project generates $10 million in year 3 in 0.40 years ($10 million z $25 million). Global Wireless will accept the project (2.4<2.75).

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Pros and Cons of the Payback Method

Advantages of payback method: Computational simplicity Easy to understand Focus on cash flow Disadvantages of payback method: Does not account properly for time value of money Does not account properly for risk Cutoff period is arbitrary Does not lead to value-maximizing decisions

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Discounted Payback
Discounted payback accounts for time value.
Apply discount rate to cash flows during payback period. Still ignores cash flows after payback period.

Global Wireless uses an 18% discount rate.

Reject (166.2 < 250)

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Reject (46.3<50)

Net Present Value (NPV)

NPV: The sum of the present values of a project s cash inflows and outflows. Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk.

CF3 CFN CF1 CF2 NPV ! CF0     ...  2 3 (1  r ) (1  r ) (1  r ) (1  r ) N

Accept projects if NPV > 0.
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Net Present Value (NPV)

CF3 CFN CF1 CF2 NPV ! CF0     ...  2 3 (1  r ) (1  r ) (1  r ) (1  r ) N
A key input in NPV analysis is the discount rate.

r represents the minimum return that the

project must earn to satisfy investors.

r varies with the risk of the firm and /or the risk
of the project.
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NPV Analysis for Global Wireless

Assuming Global Wireless uses 18% discount rate, NPVs are: Western Europe project: NPV = $75.3 million
NPVWestern Europe ! $75.3 ! 250  35 80 130 160 175     (1.18) (1.18) 2 (1.18)3 (1.18) 4 (1.18) 5

Southeast U.S. project: NPV = $25.7 million

NPVSoutheast U .S . 18 22 25 30 32 ! $25.7 ! 50      2 3 4 (1.18) (1.18) (1.18) (1.18) (1.18)5

Should Global Wireless invest in one project or both?

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The NPV Rule and Shareholder Wealth

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Pros and Cons of NPV

NPV is the gold standard of investment decision rules. Key benefits of using NPV as decision rule:
Focuses on cash flows, not accounting earnings Makes appropriate adjustment for time value of money Can properly account for risk differences between projects

Though best measure, NPV has some drawbacks:

Lacks the intuitive appeal of payback, and Doesn t capture managerial flexibility (option value) well.

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Internal Rate of Return (IRR)

IRR: the discount rate that results in a zero NPV for a project.

CF3 CFN CF1 CF2 NPV ! 0 ! CF0     ....  2 3 (1  r ) (1  r ) (1  r ) (1  r ) N

The IRR decision rule for an investing project is: If IRR is greater than the cost of capital, accept the project. If IRR is less than the cost of capital, reject the project.
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NPV Profile and Shareholder Wealth

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IRR Analysis for Global Wireless

Global Wireless will accept all projects with at least 18% IRR. Western Europe project: IRR (rWE) = 27.8%
35 80 130 160 175 0 ! 250      2 3 4 (1  rWE ) (1  rWE ) (1  rWE ) (1  rWE ) (1  rWE )5

Southeast U.S. project: IRR (rSE) = 36.7%

18 22 25 30 32 0 ! 50      2 3 4 (1  rSE ) (1  rSE ) (1  rSE ) (1  rSE ) (1  rSE )5
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JOIN KHALID AZIZ

ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: 0322-3385752 0312-2302870 0300-2540827 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
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Pros and Cons of IRR

Advantages of IRR:
Properly adjusts for time value of money Uses cash flows rather than earnings Accounts for all cash flows Project IRR is a number with intuitive appeal

Disadvantages of IRR:
Mathematical problems : multiple IRRs, no real solutions Scale problem
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Timing problem

Multiple IRRs

IRR

IRR

When project cash flows have multiple sign changes, there can be multiple IRRs.
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Which IRR do we use?

No Real Solution
Sometimes projects do not have a real IRR solution. Modify Global Wireless s Western Europe project to include a large negative outflow (-$355 million) in year 6. There is no real number that will make NPV=0, so no real IRR. Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!
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Conflicts Between NPV and IRR:

The Scale Problem
NPV and IRR do not always agree when ranking competing projects. The scale problem:
Project Western Europe Southeast U.S. IRR 27.8% 36.7% NPV (18%) $75.3 mn $25.7 mn

The Southeast U.S. project has a higher IRR, but doesn t increase shareholders wealth as much as the Western Europe project.
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Conflicts Between NPV and IRR:

The Scale Problem Why the conflict? The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project. Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive.

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Conflicts Between NPV and IRR:

The Timing Problem

The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.
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Conflicts Between NPV and IRR:

The Timing Problem
Because of the differences in the timing of the two projects cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign.

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Profitability Index
Calculated by dividing the PV of a project s cash inflows by the PV of its initial cash outflows.

CF1 CF2 CFN   ...  2 (1  r ) (1  r ) (1  r ) N PI ! CF0

Decision rule: Accept project with PI > 1.0, equal to NPV > 0
Project Western Europe Southeast U.S. PV of CF (yrs1-5) $325.3 million $75.7 million Initial Outlay $250 million $50 million PI 1.3 1.5

Both PI > 1.0, so both acceptable if independent.

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Like IRR, PI suffers from the scale problem.

Capital Budgeting
Methods to generate, review, analyze, select, and implement long-term investment proposals: Accounting rate of return Payback Period Discounted payback period Net Present Value (NPV) Internal rate of return (IRR) Profitability index (PI)
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JOIN KHALID AZIZ

ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: 0322-3385752 0312-2302870 0300-2540827 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
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