Learning Outcomes Describe the capital budgeting process, including the typical steps of the process, and distinguish among the various categories of capital projects Describe the basic principles of capital budgeting, including cash flow estimation Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing Calculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) 8/3/2014 Corporate Finance- Capital Budgeting 2 Learning outcomes Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods Describe and account for the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock price Describe the expected relations among an investments NPV, company value, and share price
8/3/2014 Corporate Finance- Capital Budgeting 3 Introduction Capital budgeting is the process of planning expenditures on assets (fixed assets) whose cash flows are expected to extend beyond one year. Managers analyze projects and decide which ones to include in the capital budget. The "capital" refers to long-term assets. The "budget" is a plan which details projected cash inflows and outflows during future period.
8/3/2014 Corporate Finance- Capital Budgeting 4 The broader steps in the capital budgeting process Generating good investment ideas to consider. Analyzing individual proposals - forecast cash flows, evaluate profitability, etc. Planning the capital budget - how does the project fit within the company's overall strategies? What's the timeline and priority? Monitoring and post-auditing - decision makers can: Improve forecasts, based on which you can make good capital budgeting decisions. Improve operations, thus making capital decisions well implemented.
8/3/2014 Corporate Finance- Capital Budgeting 5 Steps in analyzing the individual proposals 8/3/2014 Corporate Finance- Capital Budgeting 6 Estimate cash flows (inflows & outflows) Assess risk of cash flows. Determine appropriate discount rate (r = WACC) for project. Evaluate cash flows. (Find NPV or IRR etc.) Make Accept/Reject Decision Project classifications Replacement projects Replacement decisions to maintain the business Replacement decisions to reduce costs Expansion projects Regulatory, safety and environmental projects New Product and services Others R&D) 8/3/2014 Corporate Finance- Capital Budgeting 7 Assumptions of capital budgeting Capital budgeting decisions must be made on cash flows, not accounting income Cash flow timing is critical because money is worth more the sooner you get it The opportunity cost should be charged against a project Expected future cash flows must be measured on an after-tax basis Ignore how the project is financed
8/3/2014 Corporate Finance- Capital Budgeting 8 Capital Budgeting Concepts Sunk cost is a cash outlay that has already been incurred and which cannot be recovered regardless of whether the project is accepted or rejected Incremental cash flow is the net cash flow attributable to an investment project. It represents the change in the firm's total cash flow that occurs as a direct result of accepting the project Opportunity cost is the return on the best alternative use of an asset or the highest return that will not be earned if funds are invested in a particular project. Externalities are the effects of a project on cash flows in other parts of the firm (Cannibalization) 8/3/2014 Corporate Finance- Capital Budgeting 9 Concepts cont.. Conventional versus non-conventional cash flows` 8/3/2014 Corporate Finance- Capital Budgeting 10 Concepts cont.. Independent versus mutually exclusive projects Project sequencing Unlimited funds versus capital rationing 8/3/2014 Corporate Finance- Capital Budgeting 11 Investment decision criteria When a firm is embarking upon a project, it needs tools to assist in making the decision of whether to invest in the project or not NPV IRR Payback Period Discounted payback ARR PI 8/3/2014 Corporate Finance- Capital Budgeting 12 NPV This method discounts all cash flows (including both inflows and outflows) at the project's cost of capital and then sums those cash flows CF t = Expected cash flow at period t K = Project's cost of capital n = Life of the project 8/3/2014 Corporate Finance- Capital Budgeting 13 Ex.
8/3/2014 Corporate Finance- Capital Budgeting 14 NPV cont.. Decision Rules The higher the NPV, the better Reject if NPV is less than or equal to 0
NPV measures the dollar benefit of the project to shareholders
8/3/2014 Corporate Finance- Capital Budgeting 15 IRR It is the discount rate that forces a project's NPV to equal to zero IRR = L+(H-L) +NPV +NPV--NPV 8/3/2014 Corporate Finance- Capital Budgeting 16 IRR cont.. Decision Rules The higher the IRR, the better. Define the hurdle rate, which typically is the cost of capital. Reject if IRR is less than or equal to the hurdle rate IRR does provide "safety margin" information 8/3/2014 Corporate Finance- Capital Budgeting 17 Payback Period It is the expected number of years required to recover the original investment. Payback occurs when the cumulative net cash flow equals 0
Decision rules The shorter the payback period, the better. A firm should establish a benchmark payback period. Reject if payback is greater than benchmark.
8/3/2014 Corporate Finance- Capital Budgeting 18 Discounted Payback Period Similar to the regular payback method except that it discounts cash flows at the project's cost of capital 8/3/2014 Corporate Finance- Capital Budgeting 19 ARR 8/3/2014 Corporate Finance- Capital Budgeting 20 Profitability Index (PI) determined by dividing the present value of each proposal by its initial investment
PI indicates the value you are receiving in exchange for one unit of currency invested 8/3/2014 Corporate Finance- Capital Budgeting 21 PI cont Decision Rules An index value greater than 1.0 is acceptable and the higher the number, the more financially attractive the proposal A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment 8/3/2014 Corporate Finance- Capital Budgeting 22 NPV Profiles a graph showing the relationship between a project's NPV and the firm's cost of capital 8/3/2014 Corporate Finance- Capital Budgeting 23 Observations The IRR is the discount rate that sets the NPV to 0. The NPV profile declines as the discount rate increases. Project A has a higher NPV at low discount rates, while Project B has a higher NPV at high discount rates. The NPV profiles of Project A and B join at the crossover rate, at which the projects' NPVs are equal. The slope of Project A's NPV profile is steeper. This indicates that Project A's NPV is more sensitive to changes in the discount rates.
8/3/2014 Corporate Finance- Capital Budgeting 24 Ranking Conflicts b/n NPV & IRR For independent projects, the NPV and IRR methods make the same accept or reject decisions Accept if IRR > hurdle rate Accept if NPV > 0
For mutually exclusive projects, ranking conflicts can arise Due to differing cash flow patterns Differing project scales
8/3/2014 Corporate Finance- Capital Budgeting 25 Assuming that Project A and B are mutually exclusive, consider their NPV profiles If the cost of capital > crossover rate, then NPVB > NPVA, and IRRB > IRRA. Thus, both methods lead to the selection of Project B. If the cost of capital < crossover rate, then NPVB < NPVA, and IRRB > IRRA. Thus, a conflict arises because now the NPV method will select Project A while the IRR method will choose B. Therefore, for mutually exclusive projects, the NPV and IRR methods lead to same decisions if the cost of capital > the crossover rate, and different decisions if the cost of capital < the crossover rate.
8/3/2014 Corporate Finance- Capital Budgeting 26 Which Supersedes NPV method assumes that cash flows will be reinvested at the firm's cost of capital IRR method assumes reinvestment at the project's IRR
8/3/2014 Corporate Finance- Capital Budgeting 27 Multiple IRR Multiple IRRs is the situation where a project has two or more IRRs. This problem is caused by non-conventional cash flows of a project 8/3/2014 Corporate Finance- Capital Budgeting 28 MIRR MIRR is the discount rate that causes the PV of a projects terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. Thus, MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR.
8/3/2014 Corporate Finance- Capital Budgeting 29 Find PV and TV (r = 10%) 8/3/2014 Corporate Finance- Capital Budgeting 30 10.0 80.0 60.0 0 1 2 3 10% 66.0 12.1 158.1 -100.0 10% 10% TV inflows -100.0 PV outflows Find Discount Rate that Equates PV and TV 8/3/2014 Corporate Finance- Capital Budgeting 31 MIRR = 16.5% 158.1 0 1 2 3 -100.0 TV inflows PV outflows MIRR L = 16.5% $100 = $158.1 (1+MIRR L ) 3 Capital Budgeting and Wealth Maximization Capital budgeting is also relevant to external analysts to estimate the value of stock prices. Theoretically, if a company invests in positive NPV projects, the wealth of its shareholders should increase. The integrity of a firm's capital budgeting processes can also be used to show how the management pursues its goal of shareholder wealth maximization.