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WHAT IS CAPITAL BUDGETING?

Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.

I. CAPITAL IS A LIMITED ES!U CE


In the form of either debt or equity, capital is a very limited resource. There is a limit to the volume of credit that the banking system can create in the economy. Commercial banks and other lending institutions have limited deposits from which they can lend money to individuals, corporations, and governments. In addition, the ederal !eserve "ystem requires each bank to maintain part of its deposits as reserves. #aving limited resources to lend, lending institutions are selective in e$tending loans to their customers. %ut even if a bank were to e$tend unlimited loans to a company, the management of that company would need to consider the impact that increasing loans would have on the overall cost of financing. In reality, any firm has limited borrowing resources that should be allocated among the best investment alternatives. One might argue that a company can issue an almost unlimited amount of common stock to raise capital. Increasing the number of shares of company stock, however, will serve only to distribute the same amount of equity among a greater number of shareholders. In other words, as the number of shares of a company increases, the company ownership of the individual stockholder may proportionally decrease. The argument that capital is a limited resource is true of any form of capital, whether debt or equity &short'term or long'term, common stock( or retained earnings, accounts payable or notes payable, and so on. )ven the best'known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital. aced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value &or wealth( of the firm. This, in essence, is the basis of capital budgeting.

"!U SH!ULD EMEMBE


Capital budgeting is investment decision'making as to whether a project is worth undertaking. Capital budgeting is basically concerned with the justification of capital e$penditures. Current e$penditures are short'term and are completely written off in the same year that e$penses occur. Capital e$penditures are long'term and are amorti*ed over a period of years are required by the I!".

II. Ba#ic Step# $% Capital Budgeting +. )stimate the cash flows ,. -ssess the riskiness of the cash flows. .. /etermine the appropriate discount rate. 0. ind the 12 of the e$pected cash flows. 3. -ccept the project if 12 of inflows 4 costs. I!! 4 #urdle !ate and5or payback 6 policy De%initi$n#& Independent versus mutually e$clusive projects. 7ormal versus nonnormal projects.

Ba#ic Data "ea+ 8 + , . E'pected Net Ca#( )l$* P+$,ect L P+$,ect S &9+88( &9+88( +8 <8 :8 38 ;8 ,8

III. E-aluati$n Tec(ni.ue# -. 1ayback period %. 7et present value &712( C. Internal rate of return &I!!( /. 1rofitability inde$

A. PA"BAC/ PE I!D 1ayback period = )$pected number of years required to recover a project>s cost. P+$,ect L E'pected Net Ca#( )l$* P+$,ect L P+$,ect S &9+88( &9+88( +8 &?8( :8 &.8( ;8 38

,. Ignores cash flows occurring after the payback period. B. NET P ESENT 2ALUE
C t n 712 = t = 8 &+ + k( t

"ea+ 8 + , .

P+$,ect L&
8 +88.88 ?.8? 0?.3? :8.++ 712@ = 9 +;.<? + +8 , :8 . ;8

1ayback@ = , A 9.859;8 years = ,.0 years. 1ayback" = +.: years. Wea0ne##e# $% Pa1bac0& +. Ignores the time value of money. This weakness is eliminated with the discounted payback method.

712" = 9+?.?; If the projects are independent, accept both. If the projects are mutually e$clusive, accept 1roject " since 712" 4 712@.

N$te& 712 declines as k increases, and 712 rises as k decreases. C. INTE NAL ATE !) ETU N
I!! B C t n = 98 = 712 . t = 8 (+ + I!! ) t

If the projects are mutually e$clusive, accept 1roject " since I!!" 4 I!!@. N$te& I!! is independent of the cost of capital.
0 NP2L 8C 938 3 .. +8 +? +3 < ,8 &0(

P+$,ect L&
8 + , :8 +;.+C . ;8
712 &9( 38

NP2S 908 ,? ,8 +, 3

+88.88 +8 +;.+C ;.0< +;.+C 0..8, 0;.3< 9 8.8: 98

08 Crossover 1oint = ;.<C

.8

I!!@ = +;.+C I!!" = ,..:C If the projects are independent, accept both because I!! 4 k.

,8

I!!" = ,..:C

+8

+8

+3

,8

,3

k&C(

'+8

I!!@ = +;.+C

+. -/2-7T-D)" -7/ /I"-/2-7T-D)" O I!! -7/ 712 - number of surveys have shown that, in practice, the I!! method is more popular than the 712 approach. The reason may be that the I!! is straightforward, but it uses cash flows and recogni*es the time value of money, like the 712. In other words, while the I!! method is easy and understandable, it does not have the drawbacks of the -!! and the payback period, both of which ignore the time value of money. The main problem with the I!! method is that it often gives unrealistic rates of return. "uppose the cutoff rate is ++C and the I!! is calculated as 08C. /oes this mean that the management should immediately accept the project because its I!! is 08C. The answer is noE -n I!! of 08C assumes that a firm has the opportunity to reinvest future cash flows at 08C. If past e$perience and the economy indicate that 08C is an unrealistic rate for future reinvestments, an I!! of 08C is suspect. "imply speaking, an I!! of 08C is too good to be trueE "o unless the calculated I!! is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project. -nother problem with the I!! method is that it may give different rates of return. "uppose there are two discount rates &two I!!s( that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rateF The purpose of this question is not to resolve the cases where there are different I!!s. The purpose is to let you know that the I!! method, despite its popularity in the business world, entails more problems than a practitioner may think.

,. G#H T#) 712 -7/ I!! "OI)TII)" ")@)CT /I

)!)7T 1!OJ)CT"

Ghen comparing two projects, the use of the 712 and the I!! methods may give different results. - project selected according to the 712 may be rejected if the I!! method is used. "uppose there are two alternative projects, K and H. The initial investment in each project is 9,,388. 1roject K will provide annual cash flows of 9388 for the ne$t +8 years. 1roject H has annual cash flows of 9+88, 9,88, 9.88, 9088, 9388, 9:88, 9<88, 9;88, 9?88, and 9+,888 in the same period. Lsing the trial and error method e$plained before, you find that the I!! of 1roject K is +<C and the I!! of 1roject H is around +.C. If you use the I!!, 1roject K should be preferred because its I!! is 0C more than the I!! of 1roject H. %ut what happens to your decision if the 712 method is usedF The answer is that the decision will change depending on the discount rate you use. or instance, at a 3C discount rate, 1roject H has a higher 712 than K does. %ut at a discount rate of ;C, 1roject K is preferred because of a higher 712. The purpose of this numerical e$ample is to illustrate an important distinctionB The use of the I!! always leads to the selection of the same project, whereas project selection using the 712 method depends on the discount rate chosen.

PROJECT SIZE AND LIFE

There are reasons why the 712 and the I!! are sometimes in conflictB the si*e and life of the project being studied are the most common ones. - +8'year project with an initial investment of 9+88,888 can hardly be compared with a small .'year project costing 9+8,888. -ctually, the large project could be thought of as ten small projects. "o if you insist on using the I!! and the 712 methods to compare a big, long'term project with a small, short'term project, don>t be surprised if you get different selection results. &"ee the equivalent annual annuity discussed later for a good way to compare projects with unequal lives.( DIFFERENT CASH FLOWS

urthermore, even two projects of the same length may have different patterns of cash flow. The cash flow of one project may continuously increase over time, while the cash flows of the other project may increase, decrease, stop, or become negative. These two projects have completely different forms of cash flow, and if the discount rate is changed when using the 712 approach, the result will probably be different orders of ranking. or e$ample, at +8C the 712 of 1roject - may be higher than that of 1roject %. -s soon as you change the discount rate to +3C, 1roject % may be more attractive. WHEN ARE THE NPV AND IRR RELIABLE?

Denerally speaking, you can use and rely on both the 712 and the I!! if two conditions are met. irst, if projects are compared using the 712, a discount rate that fairly reflects the risk of each project should be chosen. There is no problem if two projects are discounted at two different rates because one project is riskier than the other. !emember that the result of the 712 is as reliable as the discount rate that is chosen. If the discount rate is unrealistic, the decision to accept or reject the project is baseless and unreliable. "econd, if the I!! method is used, the project must not be accepted only because its I!! is very high. Ianagement must ask whether such an impressive I!! is possible to maintain. In other words, management should look into past records, and e$isting and future business, to see whether an opportunity to reinvest cash flows at such a high I!! really e$ists. If the firm is convinced that such an I!! is realistic, the project is acceptable. Otherwise, the project must be reevaluated by the 712 method, using a more realistic discount rate.

"!U SH!ULD EMEMBE The internal rate of return &I!!( is a popular method in capital budgeting. The I!! is a discount rate that makes the present value of estimated cash flows equal to the initial investment. #owever, when using the I!!, you should make sure that the calculated I!! is not very different from a realistic reinvestment rate.

D. P !)ITABILIT" INDE3 4PI5


The p+$%itabilit1 inde', or 1I, method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the 1I is the ratio of the present value of cash flows &12C ( to the initial investment of the project.
PI = PVCF Initial investment

In this method, a project with a 1I greater than + is accepted, but a project is rejected when its 1I is less than +. 7ote that the 1I method is closely related to the 712 approach. In fact, if the net present value of a project is positive, the 1I will be greater than +. On the other hand, if the net present value is negative, the project will have a 1I of less than +. The same conclusion is reached, therefore, whether the net present value or the 1I is used. In other words, if the present value of cash flows e$ceeds the initial investment, there is a positive net present value and a 1I greater than +, indicating that the project is acceptable. 1I is also know as a benefit5cash ratio. P+$,ect L 8 '+88.88 12+ 12, 12. ?.8? 0?.3? :8.++ ++;.<?
1I = 12 of cash flows initial coast
+8C

+ +8

, :8

. ;8

=
-ccept project if 1I 4 +. !eject if 1I 6 +.8

++;.<? =+.+8 +88

I2. P !6ECT DECISI!N ANAL"SIS A. MA/ING G!7N!8G! P !6ECT DECISI!N


4Sugge#ti$n# b1 . B+une+5 2irtually all general managers face capital'budgeting decisions in the course of their careers. The most common of these is the simple MyesN versus MnoN choice about a capital investment. The following are some general guidelines to orient the decision maker in these situations. +. ocus on cash flows, not profits. One wants to get as close as possible to the economic reality of the project. -ccounting profits contain many kinds of economic fiction. lows of cash, on the other hand, are economic facts. ocus on incremental cash flows. The point of the whole analytical e$ercise is to judge whether the firm will be better off or worse off if it undertakes the project. Thus one wants to focus on the changes in cash flows effected by the project. The analysis may require some careful thoughtB a project decision identified as a simple go5no'go question may hide a subtle substitution or choice among alternatives. or instance, a proposal to invest in an automated machine should trigger many questionsB Gill the machine e$pand capacity &and thus permit us to e$ploit demand beyond our current limits(F Gill the machine reduce costs &at the current level of demand( and thus permit us to operate more efficiently than before we had the machineF Gill the machine create other benefits &e.g., higher quality, more operational fle$ibility(F The key economic question asked of project proposals should be, M#ow will things change &i.e., be better or worse( if we undertake the projectFN

,.

.. -ccount for time. Time is money. Ge prefer to receive cash sooner rather than later. Lse 712 as the technique to summari*e the quantitative attractiveness of the project. Ouite simply, 712 can be interpreted as the amount by which the market value of the firm>s equity will change as a result of undertaking the project. 0. -ccount for risk. 7ot all projects present the same level or risk. One wants to be compensated with a higher return for taking more risk. The way to control for variations in risk from project to project is to use a discount rate to value a flow of cash that is consistent with the risk of that flow. T(e#e 9 p+ecept# #u::a+i;e a g+eat a:$unt $% ec$n$:ic t(e$+1 t(at (a# #t$$d t(e te#t $% ti:e. !+gani;ati$n# u#ing t(e#e p+ecept# :a0e bette+ in-e#t:ent deci#i$n# t(an $+gani;ati$n# t(at d$ n$t u#e t(e#e p+ecept#.

B. THE P !CESS !) P !6ECT E2ALUATI!N


4Sugge#ti$n# b1 . B+une+5 <. Ca+e%ull1 e#ti:ate e'pected %utu+e ca#( %l$*#. =. Select a di#c$unt +ate c$n#i#tent *it( t(e +i#0 $% t($#e %utu+e ca#( %l$*#. >. C$:pute a ?ba#e8ca#e@ NP2. 9. Identi%1 +i#0# and unce+taintie#. Identify Mkey value driversN. Identify break'even assumptions. )stimate scenario values. Bo n! t"e ran#e o$ %al e& A. Identi%1 .ualitati-e i##ue#. le$ibility Ouality Pnow'how @earning B. Decide un a #en#iti-it1 anal1#i#.

C. CAPITAL ATI!NING 4Sugge#ti$n# b1 . B+une+5


)$ists whenever enterprises cannot, or choose not to, accept all value'creating investment projects. 1ossible causesB %anks and investors say M7ON Ianagerial conservatism -nalysis is required. One must consider sets of projects, or MbundlesN, rather than individual projects. The goal should be to identify the value'ma$imi*ing bundle of projects. The danger is that the capital'rationing constraint heightens the influence of nonfinancial considerations, such as the followingB Competition among alternative strategies Corporate politics %argaining games and psychology The outcome could be a sub'optimal capital budget, or, worse, one that destroys valueE "ome remedies are the followingB !ela$ and eliminate the budget constraint. Ianage the process rather than the outcomes. /evelop a corporate culture committed to value creation.