Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firms future.

Long term investment decision

What projects should the firm take

Marketing and advertising Research & Development (R&D) Choices among different production processes Expanding into new products, industries, or markets Investments in new technology Acquisitions Strategic investment decision

Capital budgeting decisions relate to acquisition of assets that generally have long-term strategic implications for the firm. Capital budgeting decisions become fairly intricate as it impacts other areas of corporate finance like capital structure, dividends and cost of capital.

Estimate Cash Flows (inflows & outflows).= CFs Assess riskness of CFs = Variability Determine the appropriate cost of capital. Find suitable evaluation method (Technique). Judgement = conclusion about the project Allocation of resources.

Complex mechanism

Forecasting cash flows

What cash flows are relevant? What are the differences between earnings and cash flows? How uncertain are the cash flow forecasts? How sensitive is the project

How can we take into account strategic concerns?

FORECASTING OF CASH INFLOWS IS REAL CONCERN IN CB/LTID

Independent projects if the cash flows of one are unaffected by the acceptance of the other. Serve different purpose and dont compete with each other Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other. Serve same purpose and compete with each other

Normal cash flow stream Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Non normal cash flow stream Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

Time-Adjusted OR Discounted cash flow technique Net present value NPV Internal Rate of Return- IRR Profitability Index- PI
(also referred as Benefit Cost ratio (BC)

Traditional OR Non-Discounted cash flow technique Pay back Period (PBP), discounted PBP Accounting Rate of Return

Net Present Value (NPV)

Sum of the PVs of all cash inflows and outflows of a project:

CFt NPV t t 0 ( 1 k )
n

Rationale for the NPV method

= PV of inflows Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. NPV

1. 2. 3.

4. 5.

Estimate the initial cost to implement the project, CF0, Estimate the cash flows of the project for each period over its life, CFt, Sum the discount the cash flows at an appropriate rate to arrive at present value of the cash flows, Subtract the initial investment from the present value to get the Net Present Value of the project NPV is value created by the acceptance of the project. It reflects the increase in the market value of the firm.

Simplicity of NPV Re-investment rate

Flexibility in choosing discount rate Measuring wealth creation Ranking of the project in capital rationing situation Unambiguous acceptance and rejection criterion makes NPV rule superior to IRR rule.

The implied assumption of IRR method is that interim cash flows are reinvested at IRR itself. NPV method assumes reinvestment at discount rate. This assumption of IRR is challenged as it defies conservatism

Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

CFt 0 t ( 1 IRR ) t 0
n

If IRR > WACC, the projects rate of return is greater than its costs. There is some return left over to boost stockholders returns.

Decision Rule:

The IRR of the project is 10%. It is compared with the cost of capital to make judgment about its desirability. IRR > COST OF CAPITAL < COST OF CAPITAL REJECT IF

ACCEPT IF

It is the maximum discount rate that the cash flows of the project can support.

Despite its conflicts and drawbacks, IRR remains a popular method of evaluation of projects because of
Its ability to compare projects without the consideration of discount rate, Easier comprehension.

Cost of capital not required to find IRR. It is required to make selection or rejection decision. For comparative purposes no need to know the cost of capital. Priority for early cash flows.

Comparing the NPV and IRR methods

If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive
If k > crossover point, the two methods lead to the same decision and there is no conflict. If k < crossover point, the two methods lead to different accept/reject decisions.

Reasons why NPV profiles cross

Size (scale) differences the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high k favors small projects. Timing differences the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVb > NPVa.

Accounting Rate of Return is defined as average profit as % of average investment over the life of the project It is merely a number, which reflects the worthiness of the project in absolute terms. To enable the firm make a conscious decision whether to accept or reject a proposal, it needs to be compared with some acceptance/ rejection criteria.

Accounting Rate of Return =

Average Profit Average Investment

Limitations

The advantage of the method is its simplicity of calculation

Subjective Approach Ignore Time Value of Money Not Based on Cash Flow Inconsistent definition
Pre tax or post tax Accounting basis Total investment or equity

Payback period of the project is the amount of time required to recover the original investment. When done on discounted cash flow basis it is called discounted payback period.

If payback period/ Discounted payback period of the project is

< the predetermined cut-off: Accept > the predetermined cut-off: Reject

Advantages and Disadvantages Way of resolving risks in projects Places emphasis on liquidity Arbitrary Selection of Cut-off Ignores Time Value of Money: Ignore cash flows beyond Payback Period Inability to handle Multiple Cash Out Flows

Projection of cash flows of the project is done under three broad stages: 1. Initial investment: Projection of initial cash flow; often referred as project cost is done on rather firm basis includes the cost of equipment, working capital etc 2. Cash flow for the life: Cash flow for the life of the project; most often recurring every year. 3. Terminal cash flow: At the end of the useful life the project is deemed closed even though in practice it may not happen.

INCLUDE ONLY THE RELEVANT AND INCREMENTAL CASH FLOWS

Only differential or incremental cash flows are of importance in capital budgeting decisions. Include side effects Ignore sunk cost Include opportunity costs

INCORPORATE WORKING CAPITAL CHANGES Increase or decrease in net working capital is often overlooked The changes in working capital in the life of the project should be incorporated in the following manner:
1. Project the net working capital requirement in the initial year. In most cases it will be cash out flow. 2. Project the changes in net working capital in each period. An increase means cash out flow while a decrease implies cash in flow for the period. 3. At the end of the useful life of the project treat the entire working capital as released. It will be cash inflow in most cases.