Capital Budgeting Decision Criteria

What is Capital Expenditure?

Capital expenditure involves a current outlay of funds in the expectation of a stream of benefits extending far into future. Long-term decisions Involve large expenditures

Mutually exclusive vs. Independent projects

Mutually exclusive projects are those
projects for which the selection of one requires the rejection of the others. Independent projects are those for which the acceptance of one does not preclude the acceptance of the other projects.

Project Classifications
Replacement

Maintenance of Business Cost Reduction Existing Products/Markets New Products/Markets

Expansion

Research and Development Other

Safety/Environmental Projects

Capital budgeting: stages

Identification of Potential Investment Opportunities Capital budget proposal Selection, Budget approval and Authorization Project tracking Post-completion audit

Capital budgeting: the basics

Estimate incremental cash flows

associated with a project. Evaluate the risk of the project. Evaluate the cash flows by applying one or more of the capital budgeting techniques.

Example

Year Project S Project L 0 -1000 -1000 1 600 400 2 300 400 3 300 500 4 200 400

Assumptions

Equally Risky They have same cost They have same life

Capital Budgeting Techniques

Payback Period Discounted payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Benefit Cost Ratio Accounting Rate of Return

Payback Period
Expected number of years required to recover the original investment
Decision Rules: PP = payback period MDPP = maximum desired payback period Independent Projects: PP MDPP - Accept PP > MDPP - Reject Mutually Exclusive Projects: Select the project with the fastest payback, assuming PP MDPP.

Payback Period
How long will it take for the project to generate enough cash to pay for itself? (500) 150 150 150 150 150 150 150 150

Payback Period
How long will it take for the project to generate enough cash to pay for itself? (500) 150 150 150 150 150 150 150 150

Payback period = 3.33 years.

Payback Period
Is a 3.33 year payback period good? Is it acceptable? Firms that use this method will compare the payback calculation to some standard set by the firm. If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision?

Accept the project.

Payback Period (Continued)

Advantages: Easy to calculate and understand Provides an indication of a projects liquidity Drawbacks: Ignores time value of money Ignores all cash flows received after the payback period

Consider this cash flow stream

(500) 150 150 150 150 150 (400) 100 0

Drawbacks of Payback Period:

Does not consider all of the projects cash flows.

(500) 150 150 150 150 150 (400) 100

This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!

Discounted Payback Period

Expected Cash Flows are discounted Advantages:

Improves over regular payback period method by taking into account the time value of money. Still ignores all cash flows received after the payback period

Drawbacks

Discounted Payback Period:

(500) 0 250 1 250 2 250 3 250 250 4 5

Discounted

Year
0 1

Cash Flow CF (14%)

-500 250 -500.00 219.30

Discounted Payback
(500) 0 250 1 250 2 250 3 250 250 4 5

Discounted

Year
0 1

Cash Flow
-500 250

CF (14%)
-500.00 219.30 280.70

1 year

Discounted Payback
(500) 0 250 1 250 2 250 3 250 250 4 5

Year 0 1 2

Cash Flow -500 250 250

Discounted CF (14%) -500.00 219.30 1 year 280.70 192.38

Discounted Payback
(500) 0 Year 0 1 2 250 1 Cash Flow -500 250 250 250 2 250 3 250 250 4 5

Discounted CF (14%) -500.00 219.30 280.70 192.38 88.32

1 year
2 years

Discounted Payback
(500) 250 250 250 250 250 4 5

0
Year 0 1 2 3

Cash Flow -500 250 250 250

Discounted CF (14%) -500.00 219.30 1 year 280.70 192.38 2 years 88.32 168.75

Discounted Payback
(500) 0 Year 0 1 2 3 250 1 250 2 250 3 250 250 4 5

Cash Flow -500 250 250 250

Discounted CF (14%) -500.00 219.30 1 year 280.70 192.38 2 years 88.32 168.75 .52 years

Discounted Payback
(500) 0 250 1 250 2 250 250 250 3 4 5 Discounted

Year
0 1 2 3

The Discounted -500 -500.00 Payback 250 219.30 is 2.52 years

250 250 280.70 192.38 88.32 168.75

Cash Flow CF (14%)

1 year 2 years .52 years

Problem
Expected Net Cash Flow Year 0 1 2 3 Project L (100) 10 60 80 Project S (100) 70 50 20

Discount rate : 10%

Payback
Project L
0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 30/80 2

2.4

3 80 50

60 100 -30 0

= 2.375 years

Payback
Project S
0 CFt -100 1

1.6 2

3 20 40

70 100 50 -30 0 20

Cumulative -100 PaybackS

= 1 + 30/50 = 1.6 years

Discounted Payback
Project L
0 CFt PVCFt -100 -100 10% 1 10 9.09 -90.91 2 60 49.59 -41.32 3 80 60.11 18.79

Cumulative -100 Discounted = 2 payback

+ 41.32/60.11 = 2.7 yrs

Discounted Payback
Project S
0 CFt PVCFt -100 -100 10% 1 70 63.64 -36.36 2 50 41.32 4.96 3 20 15.02 19.98

Cumulative -100 Discounted = 1 payback

+ 36.36/41.32 = 1.9 yrs

Net Present Value

Find the present values of Cash Outflows and Cash Inflows and sum them up. If NPV is positive the project is worth taking on.
N CF1 CFN CFt NPV CF0 ...... 1 2 t (1 k ) (1 k ) ( 1 k ) t 0

Theoretically the best method

NPV
t 1

1 k

CFt

CF0 .

Notice that NPV of the project depends on the projects cost of capital There is a cost of capital for which the NPV is zero (and negative if cost is higher)

Net Present Value

Rationale for NPV

NPV= PV inflows Cost = Net gain in wealth. For independent projects, accept project if NPV > 0. For mutually exclusive projects, choose the one with the highest NPV are selected. This adds the most value to the firm.

Problem
Expected Net Cash Flow Year 0 1 2 3 Project L (100) 10 60 80 Project S (100) 70 50 20

Discount rate : 10%

Net Present Value

Project L
0 -100.00 10% 1 10 2 60 3 80

9.09 49.59 60.11 18.79 = NPVL

Net Present Value

Project S
0 -100.00 10% 1 70 2 50 3 20

63.64 41.32 15.03 19.99 = NPVS

Net Present Value

If Projects S and L are mutually exclusive, accept S because NPVS > NPVL . If S & L are independent, accept both since both NPVs > 0.

Advantages & Disadvantages

Takes time value of money. Consider all the cash flows occurring over the life time. Consistent with the objective of maximizing the shareholders wealth Difficult to calculate and understand. Dependent on discount rates.

Problem
Suppose we are considering a capital investment that costs Rs. 276,400 and provides annual net cash flows of Rs. 83,000 for four years and $116,000 at the end of the fifth year. The firms required rate of return is 15%.

83,000 83,000 83,000 83,000 116,000 (276,400)

2 3 NPV = 18,235.71

Internal Rate of Return (IRR)

IRR is simply the rate of return that the firm earns on its capital budgeting projects. IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay.

Internal Rate of Return (IRR)

NPV =

IRR:

S
t=1

t=1 n

CFt (1 + k) t

- IO

CFt t (1 + IRR)

= IO

IRR (Continued)
1. Guess a rate. n 2. Calculate:

CFt t ( 1 IRR ) t 1

3. If the calculation = CF0 you guessed right If the calculation > CF0 try a higher rate If the calculation < CF0 try a lower rate L+ PVBL - I PVBL - PVBU * (U L)

Accurate IRR =

Calculate the IRR in the following project-

(10000) 2,000 3,000 4,000 5,000

At i= 10% PV = 1818.2+2479.3+3005.2+3415.1 = 10717.8 At i= 15% PV= 1739.1+2268.4+2630.1+2858.8 = 9496.4 Using interpolationIRR = 10 + 10717.8- 10000 x (15-10) = 12.94% 10717.8 9496.4

Calculating IRR

83,000 83,000 83,000 83,000 116,000 (276,400)

IRR = 17.63%

Decision Rule:
If IRR is greater than the cost of capital (also called the hurdle rate) accept the project. IRR is independent of cost of capital(k)
Mutually Exclusive Projects Accept the project with the highest IRR, assuming IRR > k.

Advantages & Disadvantages

Takes time value of money. Consider all the cash flows occurring over the life time. Easier to understand. Consistent with the objective of maximizing the shareholders wealth
Difficult to calculate

Problem
Expected Net Cash Flow Year 0 1 2 3 Project L (100) 10 60 80 Project S (100) 70 50 20

Discount rate : 10%. Find IRR

Project L
0 1 10 2 60 3 80

IRR = ?

-100.00 PV1 PV2 PV3 0 = NPV

Enter CFs in CFLO, then press IRR: IRR = 18.13% L IRRL = 18.13%.

Project S

IRR = ?

1 70

2 50

3 20

-100.00 PV1 PV2 PV3 0 = NPV

Enter CFs in CFLO, then press IRR: IRRL = 23.56% IRRS = 23.56%.

Problem
Expected Net Cash Flow Year 0 1 2 3 Project L (100) 10 60 80 Project S (100) 70 50 20

Discount rate : 10%. Draw NPV Profiles

NPV versus IRR

NPV
60 50 40

k 0 5 L Crossover Point = 8.7% 10 15

30

S
20 10 0 0 -10 5 10 15 20 23.6

20
S L

NPV L 50 33 19 7 (4)

NPV S 40 29 20 12 5

IRR S = 23.6%

Discount Rate (%)

IRR L = 18.1%

NPV versus IRR

Independent Projects

NPV and IRR will always result in the same accept/reject decision

NPV versus IRR

Mutually Exclusive Projects having substantially different outlays
Cash Flows 0 1 IRR% NPV k= 12%

P Rs(10000) Q Rs(50000)

20000
75000

NPV versus IRR

1. Mutually Exclusive Projects having
substantially different outlays
Cash Flows 0 1 IRR% NPV k= 12%

P Rs(10000) Q Rs(50000)

20000
75000

100
50

7857
16964

Both are acceptable, but Q contributes more to the wealth IRR unsuitable for ranking projects of different scales

Drawbacks of IRR

+ +) 2. If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. + + - + +)

(500) 0

200 1

100 2

(200) 3

400 4

300 5

We could find 3 different IRRs

Multiple IRRs

0 -800

k = 10%

1 5,000

2 -5,000

NPV = -386.78 IRR = ERROR. Why?

Multiple IRRs
NPV Profile
IRR2 = 400% 450 0 100 IRR1 = 25% 400 k

NPV

-800

Multiple IRRs
0 -800
k = 10%

1 5,000

2 -5,000

Logic of Multiple IRRs At very low discount rates, the PV of CF2 is large & negative, so NPV < 0. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0. In between, the discount rate hits CF2 harder than CF1, so NPV > 0. Result: 2 IRRs.

NPV versus IRR

3. IRR cannot distinguish between lending and borrowing.
Cash Flows 0 1 Rs.(400) 600 Rs. 400 (700) IRR : A = 50% B = 75% NPV: A = +VE B = -VE

A B

A company is considering the purchase of a delivery van and is evaluating the following two choices: (a) The company can buy a used van for Rs 20,000, after 4 years sell the same for Rs 2,500 and replace it with another used van which is expected to cost Rs 30,000 and last 6 years with no terminating value. (b) The company can buy a new van for Rs 40,000. the projected life of the van is 10 years and has an expected salvage value of Rs 5,000 at the end of ten years. The services provided by the vans under both choices are the same. Assuming the cost of capital 10 percent, which choice is preferable?