Capital Budgeting Decision Criteria

Capital Budgeting is the process of evaluating and selecting long term investments that are consistent with the goal of shareholders (owners) wealth maximization. The investment decision of a firm are genrally known as the capital budgeting, or capital expenditure decisions. The term Capital Budgeting is used interchangeable with capital expenditure decisions, capital expenditure management, long-term investment decisions, management of fixed assets and so on.

Capital Budgeting decisions pertain to fixed/long-term assets which are in operation, and yield a return, over a period of time, usually exceeding one year. A capiatal budgeting decisions may be defined as the firms decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. The long term assets are those that affect the firms operations beyond the one-year period.

The firms investment decision would generally include : EXPANSION ACQUISITION MODERNISATION &REPLACEMENT.

Sale of a division or business (divestment) is also as an investment decision. Decisions like the change in the method of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firms expenditure and benefits, and therefore, they should also be evaluated as investment decisions. Investment in the long-term assets requires large funds.

Features of Capital Budgeting

The exchange of current funds for future benefits The funds are invested in long term assets. The future benefits will occur to the firm over a series of years. Expenditure and benefits of an investment should be measured in cash. In the investment analysis , it is cash flow, which is important, not the accounting profit.

Investment decisions affect the firms value. The firms value will increase if investments are profitable and add to the shareholders wealth maximisation. An investment will add to the shareholders wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of capital. In the analysis of investment decision or capital budgeting, we assume that the investment projects opportunity cost of capital is known. We also assume that the expenditure and benefits of the investment are known with certainty.

Importance of Capital Budgeting

They influence the firms growth in the long run. They affect the risk of the firm. They involve large amount of funds. They are irreversible, or reversible at substantial loss. They are among the most difficult decisions to make.

Growth
A firms decision to invest in long-term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to complete successfully and maintain its market share.

Risk
A long term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Thus, investment decisions shape the basic character of a firm.

Funding
Investment decisions generally involve large amount of funds, which make it imperative for the firm to plan its investment programmes very carefully and make an advance arrangement for procuring (obtaining) finances internally or externally.

Irreversibility
Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped

Complexity
Investment decisions are among the firms most difficult decisions. They are an assessment of future events, which are difficult to predict. It is really a complex problem to correctly estimate the future cash flows of an investment. Economic, political, social and technological forces cause the uncertainty in cash flow estimation.

Types of Investment Decisions

Expansion of existing business Expansion of new business Replacement and modernisation EXPANSION and DIVERSIFICATION A company may add capacity to its existing product lines to expand existing operations. Ex. Gujarat State Fertiliser Company (GSFC) may increase its plant capacity to manufacture more urea. It is an example of related diversification. A firm may expand its activities in a new business also. If a packaging manufacturing company invests in a new plant and machinary to produce ball bearings, which the firm has not manufactured before, this represents expansion of new business or unrelated diversification. Investments in existing or new products may also be called as revenue-expansion investments.

Replacement and modernisation: The main objective of modernisation and replacement is to improve operating efficiency and reduce costs. The firm must decide to replace those assets with new assets that operate more economically. If a cement company changes from semi-automatic drying equipment, it is an example of modernisation and replacement.

Another useful way to classify investments is as follows

Mutually Exclusive Investments Independent Investments Contingent Investments

Mutually Exclusive Investments If one investment is undertaken, others will have to be excluded. Ex- A company may either use a labourintensive, semi-automatic machine, or employ a more capital-intensive, highly automatic machine for production. Choosing the semi-automatic machine precludes the acceptance of the highly automatic machine.

 Independent investments are those for

which the acceptance of one does not preclude the acceptance of the other. Independent investments serve different purposes and do not compete with each other. Contingent investments are dependent projects; the choice of one investment necessitates undertaking one or more other investments. For ex. If a company decides to build a factory in remote, backward area, it may have to invest in houses, roads, lights etc. thus, building of a factory also requires investment in facilities for employees. The total expenditure will treated as one single investment.

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. Allocate capital of the firm among alternative projects.

Decision-making Criteria in Capital Budgeting

Suppose your firm must decide whether to purchase a new machine for Rs.125,000.
How do you decide?

Will the machine be profitable? Will the firm earn a high rate of return on the investment?

Decision-making Criteria in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected?

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 = 3.4 years.

Payback Period
Is a 3.4 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

Cash Flow CF (14%)

The Discounted -500 -500.00 Payback219.30 250 is 2.52 years 280.70

250 250 192.38 88.32 168.75

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 METHOD

The net present value of classic economic method of evaluating the investment proposals. It is a DCF technique that explicitly recognises the time value of money. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents- present values are found out. The following steps are involved in the calculation of NPV.

Cash flows of the investment project should be forecasted based on realistic assumptions. Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the projects opportunity cost of capital, which is equal to the required rate of return expected by investors on investments of equivalent risk. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. The opportunity cost of capital is assumed to be known and is constant

Net Present Value should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if NPV is positive i.e. NPV>0.

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.

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 higher)

Net Present Value

Rationale for NPV

NPV= PV inflows PV outflows = Net gain in wealth. For independent projects, accept project if NPV > 0. For mutually exclusive projects, choose the one with the highest NPV. 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 Rs 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. Thus, IRR is the rate that equates the investment outlay with the present value of cash inflow received after one period. This implies that the rate of return is the discount rate which makes NPV=0

Internal Rate of Return (IRR)

NPV =

IRR:

S
t=1

t=1 n

CFt (1 + k) t

- IO

CFt t (1 + IRR)

= IO

IRR equation is the same as the one used for the NPV method. In the NPV method, the required rate of return, k, is known and the net present value is found, while in the IRR method the value of r has to be determined at which the net present value becomes zero.

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 =

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 and

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

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

1 (500) 0 200 1 100 2

2 (200) 3

3 400 4 300 5

We could find 3 different IRRs

Drawbacks of IRR

+ +) 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

Drawbacks of IRR

A B

Cash Flows 0 1 Rs.(400) 600 Rs. 400 (700)

Drawbacks of IRR
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