Capital Budgeting: Capital Budgeting is the process by which the firm decides which long-term investments to make.

Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. The following three Capital Budgeting decision rules will be presented:

Payback Period Net Present Value (NPV) Internal Rate of Return (IRR)

A Capital Budgeting decision rule should satisfy the following criteria:

Must consider all of the project's cash flows. Must consider the Time Value of Money Must always lead to the correct decision when choosing among Mutually Exclusive Projects.

Project Classifications: Capital Budgeting projects are classified as either Independent Projects or Mutually Exclusive Projects. An Independent Project is a project whose cash flows are not affected by the accept/reject decision for other projects. Thus, all Independent Projects which meet the Capital Budgeting criterion should be accepted. Mutually Exclusive Projects are a set of projects from which at most one will be accepted. Thus, when choosing between "Mutually Exclusive Projects" more than one project may satisfy the Capital Budgeting criterion. However, only one, i.e., the best project can be accepted. Of these three, only the Net Present Value and Internal Rate of Return decision rules consider all of the project's cash flows and the Time Value of Money. As we shall see, only the Net Present Value decision rule will always lead to the correct decision when choosing among Mutually Exclusive Projects. This is because the Net Present Value and Internal Rate of Return decision rules differ with respect to their Reinvestment Rate Assumptions. The Net Present Value decision rule implicitly assumes that the project's cash flows can be reinvested at the firm's Cost of Capital, whereas, the Internal Rate of Return decision rule implicitly assumes that the cash flows can be reinvested at the projects IRR. Since each project is likely

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to have a different IRR, the assumption underlying the Net Present Value decision rule is more reasonable. Cost of Capital: The firm's Cost of Capital is the discount rate which should be used in Capital Budgeting. The Cost of Capital reflects the firm's cost of obtaining capital to invest in long term assets. Thus it reflects a weighted average of the firm's cost of debt, cost of preferred stock, and cost of common stock. Payback Period: The length of time required to recover the cost of an investment. The Payback Period represents the amount of time that it takes for a Capital Budgeting project to recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent projects with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred. For example, if a project costs $100,000 and is expected to return $20,000 annually, the payback period will be $100,000 / $20,000, or five years. There are two main problems with the payback period method: 1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability. 2. It ignores the time value of money. Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are generally preferred. The calculation of the Payback Period is best illustrated with an example. Consider Capital Budgeting project A which yields the following cash flows over its five year life.

Year 0 1 2 3 4 5

Cash Flow -1000 500 400 200 200 100

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To begin the calculation of the Payback Period for project A let's add an additional column to the above table which represents the Net Cash Flow (NCF) for the project in each year.

Year 0 1 2 3 4 5

Cash Flow -1000 500 400 200 200 100

Net Cash Flow -1000 -500 -100 100 300 400

Notice that after two years the Net Cash Flow is negative (-1000 + 500 + 400 = -100) while after three years the Net Cash Flow is positive (-1000 + 500 + 400 + 200 = 100). Thus the Payback Period, or breakeven point, occurs sometime during the third year. If we assume that the cash flows occur regularly over the course of the year, the Payback Period can be computed using the following equation:

Thus, the Payback Period for project A can be computed as follows: Payback Period Payback Period = 2 + (100) / (200) = 2.5 years Thus, the project will recoup its initial investment in 2.5 years. As a decision rule, the Payback Period suffers from several flaws. For instance, it ignores the Time Value of Money, does not consider all of the project's cash flows, and the accept/reject criterion is arbitrary. Discounted payback period:

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Uses discounted cash flows rather than raw CFs.

Net Present Value: The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyse the profitability of an investment or project. The Net Present Value (NPV) of a Capital Budgeting project indicates the expected impact of the project on the value of the firm. Projects with a positive NPV are expected to increase the value of the firm. Thus, the NPV decision rule specifies that all independent projects with a positive NPV should be accepted. When choosing among mutually exclusive projects, the project with the largest (positive) NPV should be selected. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company. The NPV is calculated as the present value of the project's cash inflows minus the present value of the project's cash outflows. This relationship is expressed by the following formula:

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Where CFt = the cash flow at time t and r = the cost of capital. The example below illustrates the calculation of Net Present Value. Consider Capital Budgeting projects A and B which yield the following cash flows over their five year lives. The cost of capital for the project is 10%.

Project A Project B Year Cash Flow $-1000 0 500 1 400 2 200 3 200 4 100 5

Cash Flow $-1000 100 200 200 400 700

NPV Project A:

NPV Project B:

Thus, if Projects A and B are independent projects then both projects should be accepted. On the other hand, if they are mutually exclusive projects then Project A should be chosen since it has the larger NPV. Internal Rate of Return: Amer Butt Financial Management

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The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. IRR is sometimes referred to as "economic rate of return (ERR)". You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market. The IRR decision rule specifies that all independent projects with an IRR greater than the cost of capital should be accepted. When choosing among mutually exclusive projects, the project with the highest IRR should be selected (as long as the IRR is greater than the cost of capital).

Where CFt = the cash flow at time t and The determination of the IRR for a project, generally, involves trial and error or a numerical technique. Fortunately, financial calculators greatly simplify this process. The example below illustrates the determination of IRR. Consider Capital Budgeting projects A and B which yield the following cash flows over their five year lives. The cost of capital for both projects is 10%.

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Year 0 1 2 3 4 5

Project A Project B Cash Cash Flow Flow $-1000 $-1000 500 100 400 200 200 200 200 400 100 700

Project A:

Solution of Project A 0 1 2 3 4 5 COF(-1000) 500 400 200 200 100 LDR 15% 0.8696 0.7561 0.6575 0.5717 0.4973 NPVL(1000) 435 302 131 114 50 NPVL = (+32) HDR 17% 0.8547 0.7305 0.6244 0.5336 0.4561 NPVH(1000) 427 292 125 107 46 NPVH = (-3)

Important Note: Net Present Value at low discount is positive NPVL (+tive) Net Present Value at high discount rate is negative NPVH (-tive)

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Project B:

Project B can be done exactly in the same way shown above. Reference: Bodie, Zvi, Kane, Alex, J, Alan & Marcus, 2008, Essentials of Investments, 8th Edition, McGraw-Hill, New York, United States of America Solnik, Bruno & Mcleavey Dennis, 2004, International Investments, 5th Edition, Pearson Addison Wesley, United States of America Reilly Frank K & Brown Keith C, 2005, Investment Analysis and Portfolio Management, 8th Edition, United States of America

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