POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Capital Budgeting Techniques

Outline: Capital Budgeting Techniques

CAPITAL BUDGETING TECHNIQUES Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firms 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 firms earning power and value. MOTIVES FOR 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 one (1) year. Operating expenditure is an outlay resulting in benefits received within one (1) year. Fixed asset outlays are capital expenditures. But not all capital expenditures are classified as fixed assets. Example: A 60,000 outlay for a new machine with a usable life of 15 years is a capital expenditure that would appear as a fixed asset on the firms balance sheet. A 60,000 outlay for an advertising campaign that is expected to produce benefits over a long period is also a capital expenditure but would rarely be shown as a fixed asset. STEPS IN THE PROCESS The capital budgeting process consists of five distinct but interrelated steps: 1.) 2.) 3.) 4.) 5.) Proposal Generation Review and Analysis Decision Making Implementation Follow-up

Independent Projects are those whose cash flows are unrelated to (or independent of) one another; the acceptance of one project does not eliminate the others from further consideration. Mutually exclusive projects are those that have the same function and therefore compete with one another. The acceptance of one eliminates from further consideration all other projects that serve a similar function. Example: A firm in need of increased production capacity could obtain it by (1) expanding its plant, (2) acquiring another company, or (3) contracting with another company for production. Clearly, accepting any one option eliminates the immediate need for either of the others.

If Unlimited Funds exist in a company, the financial situation in which a firm is able to accept all independent projects that provide an acceptable return. Capital rationing occurs when the financial situation in which a firm has only a fixed number of dollars available for capital expenditures, and numerous projects compete for those dollars. Accept-reject approach is the evaluation of capital expenditure proposals to determine whether they meet a firms minimum acceptance criterion. Ranking approach is the ranking of expenditure projects on the basis of some predetermine measure, such as the rate of return. Payback Period Payback periods are commonly used to evaluate proposed investments. The payback period is the amount of time required for 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 recovered. Although popular, 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 acceptreject 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 pe riod, reject the project. The length of the maximum acceptable payback period is determined by management. This value is set subjectively on the basis of a number of factors, including the type of project (expansion, replacement or renewal, other), the perceived risk of the project, and the perceived relationship between the payback period and the share value. It is simply a value that management feels, on average, will result in value-creating investment decisions. The formula in calculating payback period is: Payback Period = Cost of Project / Annual Cash Inflows Pros and Cons of Payback Analysis Large firms sometimes use the payback approach to evaluate small projects, and small firms use it to evaluate most projects. 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. Because it can be viewed as a measure of risk exposure, many firms use the payback period 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 firms risk exposure. 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 firms value. Instead, the appropriate pay-back period is simply the maximum acceptable period of time over which management decides that a projects cash flows must break even (that is, just equal to the initial investment). A second weakness is that this approach fails to take fully into account the time factor in the value of money. Example of Payback Period Seema Mehdi is considering investing $20,000 to obtain a 5% interest in a rental property. Her good friend and real estate agent, Akbar Ahmed, put the deal together and he conservatively estimates that Seema should receive between $4,000 and $6,000 per year in cash from her 5% interest in the property. The deal is structured in a way that forces all investors to maintain their investment in the property for at least 10 years. Seema expects to remain in the 25% income-tax bracket for quite a while. To be acceptable, Seema requires the investment to pay itself back in terms of after-tax cash flows in less than 7 years. Seemas calculation of the payback period on this deal begins with calculation of the range of annual after-tax cash flow: After-tax cash flow=(1 -tax rate) *Pre-tax cash flow =(1 -0.25)*$6,000=$4,500 =(1 -0.25)*$4,000=$3,000 The after-tax cash flow ranges from $3,000 to $4,500. Dividing the $20,000 initial investment by each of the estimated after-tax cash flows, we get the payback period: Payback period=Initial investment / After-tax cash flow =$20,000,$4,500=4.44 years =$20,000,$3,000=6.67 years

Because Seemas proposed rental property investment will pay itself back between 4.44 and 6.67 years, which is a range below her maximum payback of 7 years, the investment is acceptable.

Net Present Value (NPV) It is the excess of the present value (PV) of future cash inflows to be generated by the project over the amount of the initial investment (I): NPV = PV - I The present value of future cash flows is computed using the so-called cost of capital (or minimum required rate of return) as the discount rate. With the annuity, the present value is: PV = A x T4 (i, n) Where A amount of annuity T4 is found in table 9.4 in chapter 9

If NPV is POSITIVE, You should ACCEPT the project. If it is NOT, You should REJECT it. Example 1: Consider the following investment: Initial investment Estimated life Annual cash inflows Cost of capital (Minimum req. % of return) 12% P 12 950 10 years P 3 000

Present value of the cash inflows is: PV = A x T4 ( 12%, 10 yrs ) = P 3 000 T4 (12%, 10 yrs ) = P 3 000 ( 5.650 ) = P 16 950

Net present value NPV = PV I = P 16950 12950 = P 4 000

Example 2: Consider the following given: Initial investment Estimated life Annual cash inflows Cost of capital (Minimum req. % of return) 10% P 50 755 8 years P 15 298

Present value of the cash inflows is: PV = A x T4 ( 10%, 8 yrs ) = P 15 298 T4 (10%, 8 yrs ) = P 15 298 ( 5.3349) = P 81 613

Net present value NPV = PV I = P 81 613 P 50 755 = P 30 858

Internal Rate of Return (IRR) The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or the rate of return (ROR) in the context of savings and loans. The IRR is also called the effective interest rate Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. In other words, IRR is the discount rate which equates the present value of the future cash flows of an investment with the initial investment. It is one of the several measures used for investment appraisal. The internal rate of return is 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 compound annual rate of return that the firm will earn if it invests in the project and receives the given cash inflows. Decision Rule A project should only be accepted if its IRR is NOT less than the target internal rate of return or the cost of capital. When comparing two or more mutually exclusive projects, the project having highest value of IRR should be accepted.

Formula [(
) ( ) ( )

Where, r is the internal rate of return; CF1 is the period one net cash inflow; CF2 is the period two net cash inflow, CF3 is the period three net cash inflow, and so on... But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the above equation. However, there are alternative procedures which can be followed to find IRR. The simplest of them is described below: 1. Guess the value of r and calculate the NPV of the project at that value. 2. If NPV is close to zero then IRR is equal to r. 3. If NPV is greater than 0 then increase r and jump to step 5. 4. If NPV is smaller than 0 then decrease r and jump to step 5. 5. Recalculate NPV using the new value of r and go back to step 2.

Example Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows during the first, second, third and fourth years are expected to be $65,200, $98,000, $73,100 and $55,400 respectively. Solution Assume that r is 10%. NPV at 10% discount rate = $18,372 Since NPV is greater than zero we have to increase discount rate, thus NPV at 13% discount rate = $4,521 But it is still greater than zero we have to further increase the discount rate, thus NPV at 14% discount rate = $204 NPV at 15% discount rate = ($3,975) Since NPV is fairly close to zero at 14% value of r, therefore IRR 14% Comparing NPV and IRR Techniques To understand the differences between the NPV and IRR techniques and decision makers preferences in their use, we need to look at net present value profiles, conflicting rankings, and the question of which approach is better. NET PRESENT VALUE PROFILES Projects can be compared graphically by constructing net present value profiles that depict the projects NPVs for various discount rates. These profiles are useful in evaluating and comparing projects, especially when conflicting rankings exist. They are best demonstrated via an example. To prepare net present value profiles for Bennett Companys two projects, A and B, the first step is to develop a number of discount ratenet present value coordinates. Three coordinates can be easily obtained for each project; they are at discount rates of 0%, 10% (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. Using the data in Table 10.1 and Figure 10.1, we get

For project A: ($14,000 + $14,000 + $14,000 + $14,000 + $14,000) - $42,000 = $28,000 For project B: ($28,000 + $12,000 + $10,000 + $10,000 + $10,000) - $45,000 = $25,000 The net present values for projects A and B at the 10% cost of capital are $11,071 and $10,924, respectively (from Figure 10.2). Because the IRR is the discount rate for which net present value equals zero, the IRRs (from Figure 10.3) of 19.9% for project A and 21.7% for project B result in $0 NPVs. The three sets of coordinates for each of the projects are summarized in Table 10.4. Plotting the data from Table 10.4 results in the net present value profiles for projects A and B shown in Figure 10.4. The figure reveals three important facts: 1. The IRR of project B is greater than the IRR of project A, so managers using the IRR method to rank projects will always choose B over A if both projects are acceptable.

2. The NPV of project A is sometimes higher and sometimes lower than the NPV of project B; thus, the NPV method will not consistently rank A above B or vice versa. The NPV ranking will depend on the firms cost of capital. 3. When the cost of capital is approximately 10.7%, projects A and B have identical NPVs. The cost of capital for Bennett Company is 10%, and at that rate project A has a higher NPV than project B (the red line is above the blue line in Figure 10.4 when the discount rate is 10%). Therefore, the NPV and IRR methods rank the two projects differently. If Bennetts cost of capital were a little higher, say 12%, the NPV method would rank project B over project A and there would be no conflict in the rankings provided by the NPV and IRR approaches.

Conflicting Rankings Ranking is an important consideration when projects are mutually exclusive or when capital rationing is necessary. When projects are mutually exclusive, ranking enables the firm to determine which project is best from financial standpoint. When capital rationing is necessary, ranking projects will provide a logical starting point for determining which group of projects to accept. The underlying cause of conflicting rankings is different implicit assumptions about 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 projects IRR. These differing assumptions can be demonstrated with an example.

Example: A project requiring a $170,000 initial investment is expected to provide operating cash inflows of %52,000, $78,000 and $100,000 at the end of each of the next 3 years. The NPV of the projects (at the firms 10% cost of capital) is $16,867 and its IRR is 15%. Clearly, the project is acceptable (NPV = $16,867 > $0 and IRR = 15% > 10% cost of capital). A future value of $248,720 results from reinvestment at the 10% cost of capital, and a future value of $258,496 results from reinvestment at the 15% IRR.

Which Approach is Better? Many companies use both the NPV and IRR techniques because current technology makes them easy to calculate. But it is difficult to choose one approach over the other, because the theoretical and practical strength of the approaches differ. Clearly, it is wise to evaluate NPV and IRR techniques from both theoretical and practical points of view. Theoretical View On a purely theoretical basis, NPV is the better approach to capital budgeting as a result of several factors. Most important, the use of NPV implicitly assumes that firms cost of capital. The use of IRR assumes investment at the often high rate specified by the IRR. Because the cost of capital tends to be a reasonable estimate of the rate at which the firm could actually reinvest intermediate cash inflows, the use of NPV, with its more conservative and realistic reinvestment rate, is I theory preferable.

Practical View Evidence suggests that in spite of the theoretical superiority of NPV, financial managers prefer to use IRR. The preference for IRR is due to the general disposition of business people toward 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 varieties 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 their IRR before the decision makers use it as a decision technique.