Capital Budgeting Models

Handouts for Corporate Finance 1

Capital Budgeting Introduction
A logical prerequisite to the analysis of investment opportunities is the creation of investment
opportunities. Unlike the field of investments, where the analyst more or less takes the
investment opportunity set as a given, the field of capital budgeting relies on the work of people
in the areas of industrial engineering, research and development, and management information
systems among others! for the creation of investment opportunities. As such, it is important to
suggest that students keep in mind the importance of creativity in this area, as well as the
importance of analytical techniques.
Because a pro"ect is financially sound, it must be ethically sound, right# $ell . . . the question of
ethical appropriateness is less frequently discussed in the conte%t of capital budgeting than that
of financial appropriateness.
Consider the following simple e%ample&
'he American Association of Colleges and Universities estimates that () percent of all college
students cheat at some time during their postsecondary education careers. *ou might pose the
ethical question of whether it would be proper for a publishing company to offer a new book
+ow to Cheat& A User,s -uide. 'he company has a cost of capital of ./ and estimates it could
sell (),))) volumes by the end of year one and 0,))) volumes in each of the following two
years. 'he immediate printing costs for the 1),))) volumes would be 21),))). 'he book would
sell for 23.0) per copy and net the company a profit of 24.)) per copy after royalties which
would, of course, be quite small5!, marketing costs, and ta%es. *ear one net would be 24),))).
6rom a capital budgeting standpoint, is it financially wise to buy the publication rights# $hat is
the payback of this investment# 7ayback 8 21),)))924),))) 8 .:: years!. 'he pro"ect has a
quick payback ; looks good, right# <ow ask the class if the publishing of this book would
encourage cheating and if the publishing company would want to be associated with this te%t and
its message. =ome students may feel that one should accept these profitable investment
opportunities while others might prefer that the publication of this profitable te%t be re"ected due
to the behavior it could encourage. Although the e%ample is admittedly simplistic, this type of
issue is not particularly uncommon in real life.
Generating Ideas for Capital Budgeting
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Capital Budgeting Models
Project Classification
Replacement: Maintenance of Business
Replacement: Cost Reduction
Expansion of Existing Products or Marets
Expansion into !e" Marets
#afet$ and En%ironmental Projects
&t'er
#imilarities (et"een Capital Budgeting and #ecurit$ )aluation
<7? @ -ordon Model
ABB @ Bond Model
Capital Budgeting re*uires + components:
'he Models
'he Cash 6lows
'he $ACC
,'e Models:
<7?& Accept the pro"ect if the <7? is positive. Accept the highest
positive <7? when analyCing mutual e%clusive pro"ects.
ABB Accept the pro"ect if the ABB is greater than the $ACC. 'he ABB
model can provide conflicting results when analyCing mutual
e%clusive pro"ects.
7ayback Accept the pro"ect if the payback is less than a predetermined limit.
$e evaluate each model using the following criteria&
<7? ABB 7ayback
Does the model consider '?M#
Does the model consider risk#
Does the model provide information on
whether we are creating value for the firm#
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Capital Budgeting Models
Pa$(ac Period
7ayback period;length of time until the accumulated cash flows equal or e%ceed the original
investment.
7ayback period rule;investment is acceptable if its calculated payback is less than some pre;
specified number of years.
-d%antages
Easy to understand
Ad"usts for uncertainty of later cash flow
Biased toward liquidity
.isad%antages
Agnores time value of money
Doesn,t consider risk differences
+ow to determine the cutoff point
Biased against long;term pro"ects
Agnores cash flow beyond payback period
'eaching the payback rule seems to put one in a delicate situation, the rule is a flawed indicator
of pro"ect desirability, at best. And yet, surveys continue to suggest that it is widely used by
practitioners. +ow does one e%plain this apparent discrepancy between theory and practice#
$hile the payback rule is widely used in practice, it is not often the only measure of desirability
usedF rather, it is typically used in con"unction with one of the other GbetterG i.e., DC6! rules.
As $illiam Baumol pointed out in the early (>4)s, the payback rule serves as a crude Grisk
screeningG device ; the longer one,s funds are Gout thereG, the greater the likelihood, they will not
be returned, all else equal.
'he payback technique is particularly useful in comparing mutually e%clusive pro"ects. -iven
two similar pro"ects, the one which returns the initial investment sooner is likely to be though
certainly not always! the better pro"ect.
=imple to use mostly by ignoring the long run! ; Bias for short;term promotes liquidity ; Can be
ad"usted for risk in some sense altering the cutoff!
Anterestingly, enough, the payback period technique is used quite heavily in determining the
viability of certain investment pro"ects in the health care industry. $hy#
Consider the nature of the health care industry& the technology is rapidly changing, some of the
equipment e.g., magnetic resonance imaging ; MBA ; machines! tends to be e%tremely
e%pensive, and the industry itself is increasingly competitive. $hat this means is that, in many
cases, an equipment purchase is complicated by the fact that, while the machine may be able to
perform its function for, say, 4 years or more, new and improved equipment is likely to be
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developed and announced in the press! which will supersede the ,old, equipment long before its
useful life is over. Demand from patients and physicians for ,cutting edge technology, can drive a
push for new investment. An the face of such a situation, many hospital administrators then focus
on how long it will take to recoup the initial outlay, in addition to the <7? and ABB of the
equipment.
'he payback period can be interpreted as a naive form of discounting if we consider the class of
investments with level cash flows over arbitrarily long lives. =ince the present value of a
perpetuity is the payment divided by the discount rate, a payback period cut;off can be seen to
imply a certain discount rate. 'hat is,
Cost9annual cash flow 8 payback period cut;off
Cost 8 annual cash flow % payback period cut;off.
=ince the 7? of a perpetuity is& 7? 8 annual cash flow % (9r!, the correspondence between the
discount rate, r, and the payback period cut;off is obvious. 'he longer the payback period, the
lower the implied value of r, and vice versa.
Consider the manufacture of oilfield equipment. 'he firm had plants in several politically
unstable countries e.g., Hibya and ?eneCuela!. Because of the possibility that the firm,s assets
would be confiscated by foreign governments via GnationaliCationG at any given time, the firm
was quite concerned with how long the foreign plants would have to operate before they Gpaid
themselves backG. 'hus, the payback period approach was heavily relied upon as a decision tool.
An these cases, the term cash flow Gcut;offG was taken literally5
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!et Present )alue
+ere,s another perspective on the meaning of <7?. Af we accept a pro"ect with a negative <7?
of ;21,I11, this is financially equivalent to investing 21,I11 today and receiving nothing in
return. 'herefore, the total value of the firm would decrease by 21,I11. 'his, of course, assumes
that the various components cash flow estimates, discount factor, etc.! used in the computation
are correct.
An practice, financial managers are rarely presented with Cero;<7? pro"ects for at least two
reasons. 6irst, in an abstract sense, Cero is "ust another of the infinite number of values the <7?
can takeF as such, the likelihood of obtaining any particular number is small. =econd, and more
pragmatically!, in most large firms, capital investment proposals are submitted to the 6inance
group from other areas e.g., the industrial engineering group! for analysis. 'hose submitting
proposals recogniCe the ambivalence associated with Cero <7?s and are less likely to send them
to the 6inance group in the first place.
Conceptually, a Cero;<7? pro"ect earns e%actly its required return. Assuming that risk has been
adequately accounted for, investing in a Cero;<7? pro"ect is equivalent to purchasing a financial
asset in an efficient market. An this sense, one would be indifferent between the capital
e%penditure pro"ect and the financial asset investment. 6urther, since firm value is completely
unaffected by the investment, there is no reason for shareholders to prefer either one.
+owever, several real;world considerations make comparisons such as the one above difficult.
6or e%ample, ad"usting for risk in capital budgeting pro"ects can be problematic. And, some
investment pro"ects may be associated with benefits that are difficult to quantify, but e%ist,
nonetheless. Consider, for e%ample, an investment with a low or Cero <7? but which enhances
a firm,s image as a good corporate citiCen.! Additionally, the secondary market for most physical
assets is substantially less efficient than the secondary market for financial assets. $hile, in
theory, one could ad"ust for differences in liquidity, the ad"ustment is, again, problematic.
6inally, some would argue that, all else equal, some investors prefer larger firms to smallerF if
true, investing in any pro"ect with a nonnegative <7? may be desirable.
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Internal Rate of Return
Anternal rate of return ABB! is the rate that makes the present value of the future cash flows equal
to the initial cost or investment. An other words, it is the discount rate that gives a pro"ect a 2)
<7?.
ABB rule;the investment is acceptable if its ABB e%ceeds the required return.
Assume& 'o comply with the Air Juality Control Act of (>.>, a company must install three
smoke stack scrubber units to its ventilation stacks at an installed cost of 2:00,))) per unit. An
estimated 2()),))) per unit could be saved each year over the five;year life of the ventilation
stacks. 'he cost of capital is (I/ for the firm. 'he analysis of the investment results in a <7? of
;2((,4>1.
Despite the financial assessment dictating re"ection of the investment, public policy might
suggest acceptance of the pro"ect. By fiat, certain types of pollution controls are required. But
should the firm e%ceed the minimum legal limits and be responsible for the environment, even if
this responsibility leads to a wealth reduction for the firm# As environmental damage merely a
cost of doing business# Could investment in a healthier working environment result in lower
long;term costs in the form of lower future health costs# Af so, might this decision result in an
increase in shareholder wealth# <otice that if the answer to this second question is yes, it
suggests that our original analysis omitted some side benefits to the pro"ect.
-d%antages
7eople seem to prefer talking about rates of return to dollars of value.
<7? requires a market discount rateF ABB relies only on the pro"ect cash
flows.
.isad%antages
<onconventional cash flows; Multiple rates of return;if cash flows alternate
back and forth between positive and negative in and out!, more than one ABB
is possible. <7? rule still works "ust fine. Also,if the cash flows are of loan
type, meaning money in at first and cash out later, the ABB is really a
borrowing rate and lower is better. 'he ABB is sometimes called the ABB
internal borrowing rate! in this case.
Mutually e%clusive investment decisions;if taking one pro"ect means another
is not taken, the pro"ects are mutually e%clusive. 'he ABB can provide
conflicting rankings when mutual e%clusive pro"ects are analyCed.
Comparison of t'e !P) and IRR Met'ods
!P) Profiles
<et present value profile is a graph of an investment,s <7? at various discount rates. 'he graph
illustrates the <7? changes as the cost of capital changes. 'he ABB is not a function of the cost
of capital.
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Capital Budgeting Models
Conclusions on Capital Budgeting Met'ods
Capital budgeting decisions are analyCed using computer programs and it is easy to calculate all
of the measure we have talked about. Although <7? is a strong model, the other models provide
information that is useful. 7ayback and discounted payback provide an indication of the risk and
liquidity of a pro"ect. 'he longer the payback means that the investment dollars will be tied up
for more years, therefore the pro"ect is relative illiquid. An addition, the longer payback indicates
that pro"ect cash flows must be forecast far into the future increasing the risk of the pro"ect.
<7? is important because it gives a direct measure of the dollar benefit of the pro"ect to the
shareholders. 'his makes <7? the best single measure of profitability. ABB is a measure of
profitability, but it is e%pressed as a rate of return. ABB provides a measure of a pro"ectKs safety
margin. Consider the following two pro"ects.
'ime 7ro"ect = Cash 6low 7ro"ect H Cash 6low
) ;2(),))) ;2()),)))
( (4,0)) ((0,0))
<7? 20,))) 20,)))
ABB 40.)/ (0.0/
'here is a greater margin of error for 7ro"ect = relative to H and the ABB provides an indication
safety margin.
Business Practices
All large firms use some type of DC6 method. At is common practice among large firms to
employ a discounted cash flow technique such as ABB or <7? along with payback period or
average accounting return. At is suggested that this is one way to resolve the considerable
uncertainty over future events that surrounds estimating the <7?.
7ayback method is used in many large firms, but is not the primary method. Most companies
give the greatest weight to a DC6 method.
ABB is the most used method with <7? a close second.
Most firms calculate a $ACC. A few use the same $ACC for every pro"ect, but most ad"ust the
$ACC to reflect the pro"ect risk
=mall companies do not use DC6 models to the e%tent of large companies.
'he use of various financial incentives e.g., reduction or elimination of property ta%es for ten or
more years! to induce firms to locate i.e., invest! in a given municipality raises some interesting
issues in the capital budgeting area.
6rom the viewpoint of the firm,s analysts, how does one estimate the impact of such incentives#
A reduction in the initial outlay# Ancreases in future cash inflows# And what discount rate should
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Capital Budgeting Models
be assigned to these ta% reductions# Are these promises riskless# And what about the municipal
officials who offer such incentives# =tated reasons are typically related to ,employment growth,,
or ,increased economic activity., But, from a capital budgeting standpoint, have you ever seen a
fully developed cash flow analysis of the stated benefits relative to the costs#
Consider the following e%ample taken from a 6ederal Beserve publication.
GAlabama offered Mercedes;BenC a package valued at more than the cost of the plant itself. 'o
lure the 2:)) million plant, with about (,0)) "obs, the state promised to buy the site for 2:)
million, and lease it to Mercedes for 2()). =urrounding communities will contribute an
additional 20 million each, and the University of Alabama will offer -erman language and
culture classes to the children of plant employees. Ln top of this, the state will provide a package
of ta% breaks valued at more than 2:)) million, which will, among other things, allow the plan to
be paid for with money that would have been paid to the state.G
=everal of the incentives described above directly affect the costs and the benefits of the
proposed pro"ect, and would have to be accounted for in the capital budgeting analysis
performed by Mercedes. +owever, the other side of the coin is that state officials should perform
their own capital budgeting analysis ; they too are incurring economic costs in the hope for
future benefits. But at least one aspect is different& when the corporate decision;maker makes a
poor investment, shareholders suffer. $hen the state,s decision;makers foul up, all of the
residents of the state suffer. 'hus, the ethics of the capital budgeting decision come into play
more clearly in the latter case. =ituations like this provide a good springboard for discussions not
only of the financial aspects of capital budgeting, but also related issues.
$hile uncertainty about inputs and interpretation of the outputs help e%plain why multiple
criteria are used to "udge capital investment pro"ects in practice, another reason is managerial
performance assessment. $hen managers are "udged and rewarded primarily on the basis of
periodic accounting figures quarterly profits, annual earnings, etc.!, there is an incentive to
evaluate pro"ects with methods such as payback or average accounting return. Ln the other hand,
when compensation is tied to firm value, it makes more sense to use <7? as the primary
decision tool.
,'e Post/-udit
'he post;audit is an important aspect of the capital budgeting process. 'he firm compares actual
results with the forecast and e%plains any differences. Many firms require monthly reports for an
initial time period followed by quarterly reports. 'he purpose of the post audit is&
Impro%e Forecasts
$hen individuals tend to be more diligent when they know the results of their efforts will be
compare to actual results. Biases are observed and eliminatedF new techniques are test and
incorporated when appropriate when these actions are monitored.
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Capital Budgeting Models
Impro%e &perations
$hen a division has made a forecast and undertaken a pro"ect, their reputation is at risk. Af
costs are above pro"ections and sales are below pro"ection, the division can and will make an
effort to bring the results into line with the forecasts.
'his is not a simple process. 'here are many inputs to the cash flow forecast and each is sub"ect
to uncertainty. A number of pro"ects will be disappointing. 'his must be considered when
evaluating the managersK performance.
7ro"ects can fail to meet e%pectations for reasons beyond the control of the operating e%ecutives.
At is often difficult to separate the operating results of one pro"ect from those of a larger system.
A few pro"ects are stand alone types, but most pro"ects are interrelated. E%ample& computer
systems
'he individuals responsible for initiating a pro"ect may have moved on before the results are
known.
Many firms downplay the importance of a post audit because of these problems, but firms that
have post;audits tend to be the more successful organiCations.
0sing Capital Budgeting in &t'er Contexts
Capital budgeting techniques can be applied to a number of different types of decisions.
Mergers and Acquisitions
DownsiCing
=ale of assets
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Capital Budgeting Models
Examples:
Independent Projects
7ro"ect A and B have the following cash flows&
*ear A B
)
;
0))
;
I))
( :10 :10
1 :10 1))
$hich pro"ect do we accept using the ABB model when the cost of capital is () percent#
*ear A B
) ;0)) ;I))
( :10 :10
1 :10 1))
Cpt. ABB
$hich pro"ect do we accept using the <7? model when the cost of capital is () percent#
*ear A B
) ;0)) ;I))
( :10 :10
1 :10 1))
A ()/ ()/
Cpt. <7?
7ro"ect A
C6
)
;
0))
A <7?
C6
(
:10 6
(
( )
C6
1
:10 6
1
( ()
(>.I
:
1)
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Capital Budgeting Models
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Capital Budgeting Models
7ro"ect B
C6
)
;
I))
A <7?
C6
(
:10 6
(
( )
C6
1
1)) 6
1
( ()
1)
11.(
3
($50.00)
$0.00
$50.00
$100.00
$150.00
$200.00
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24 0.25
Project A Project B
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Capital Budgeting Models
Mutuall$ Exclusi%e Projects
7ro"ect A and B have the following cash flows&
*ear A B
)
;
0))
;
I))
( :10 :10
1 :10 1))
$hich pro"ect do we accept using the ABB model#
*ear A B
) ;0)) ;I))
( :10 :10
1 :10 1))
Cpt. ABB
$hich pro"ect do we accept using the <7? model when the cost of capital is () percent#
*ear A B
) ;0)) ;I))
( :10 :10
1 :10 1))
A ()/ ()/
Cpt. <7?
A am confused, which pro"ect do we accept# 7erhaps drawing the <7? 7rofile will help.
7ro"ect A
C6
)
;
0))
A <7?
C6
(
:10 6
(
( )
C6
1
:10 6
1
( ()
(>.I
:
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Capital Budgeting Models
1)
7ro"ect B
C6
)
;
I))
A <7?
C6
(
:10 6
(
( )
C6
1
1)) 6
1
( ()
1)
11.(
3
($50.00)
$0.00
$50.00
$100.00
$150.00
$200.00
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24 0.25
Project A Project B
'he point where the profiles cross is called the crossover point or crossover rate. +ow can we
calculate it#
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$e calculate the delta pro"ect and calculate the ABB of the delta pro"ect.
A B Delta
) ;0)) ;I))
( :10 :10
1 :10 1))
HetKs look at the <7? 7rofile of 7ro"ects A, B, and the Delta 7ro"ect&
($50.00)
$0.00
$50.00
$100.00
$150.00
$200.00
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22 0.23 0.24 0.25
Proj A Proj B Delta Project
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Capital Budgeting Models
!on/!ormal Cas' Flo"s
(. 7ro"ect A has the following cash flows&
) ;2>),)))
( 2(:1,)))
1 2()),)))
: ;2(0),)))
+ow many ABBs does this pro"ect have# Calculate the ABBs.
C6
)
;>),))) A <7?
C6
(
(:1,))) 6
(
( )
C6
1
()),))) 6
1
( (
)
C6
:
;
(0),)))
6
:
( 1
)
:
)
A (1/ I
)
C7' <7? 0
)
C7' ABB
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NPV
($10,000.00)
($8,000.00)
($6,000.00)
($4,000.00)
($2,000.00)
$0.00
$2,000.00
$4,000.00
0
0
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NPV
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