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Capital Budgeting is the process of evaluating and selecting long term investments that are consistent with the goal of shareholders (owners) wealth maximization. The investment decision of a firm are genrally known as the capital budgeting, or capital expenditure decisions. The term Capital Budgeting is used interchangeable with capital expenditure decisions, capital expenditure management, long-term investment decisions, management of fixed assets and so on.
Capital Budgeting decisions pertain to fixed/long-term assets which are in operation, and yield a return, over a period of time, usually exceeding one year. A capiatal budgeting decisions may be defined as the firms decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. The long term assets are those that affect the firms operations beyond the one-year period.
The firms investment decision would generally include : EXPANSION ACQUISITION MODERNISATION &REPLACEMENT.
Sale of a division or business (divestment) is also as an investment decision. Decisions like the change in the method of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firms expenditure and benefits, and therefore, they should also be evaluated as investment decisions. Investment in the long-term assets requires large funds.
Investment decisions affect the firms value. The firms value will increase if investments are profitable and add to the shareholders wealth maximisation. An investment will add to the shareholders wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of capital. In the analysis of investment decision or capital budgeting, we assume that the investment projects opportunity cost of capital is known. We also assume that the expenditure and benefits of the investment are known with certainty.
Growth
A firms decision to invest in long-term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to complete successfully and maintain its market share.
Risk
A long term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Thus, investment decisions shape the basic character of a firm.
Funding
Investment decisions generally involve large amount of funds, which make it imperative for the firm to plan its investment programmes very carefully and make an advance arrangement for procuring (obtaining) finances internally or externally.
Irreversibility
Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped
Complexity
Investment decisions are among the firms most difficult decisions. They are an assessment of future events, which are difficult to predict. It is really a complex problem to correctly estimate the future cash flows of an investment. Economic, political, social and technological forces cause the uncertainty in cash flow estimation.
Replacement and modernisation: The main objective of modernisation and replacement is to improve operating efficiency and reduce costs. The firm must decide to replace those assets with new assets that operate more economically. If a cement company changes from semi-automatic drying equipment, it is an example of modernisation and replacement.
Mutually Exclusive Investments If one investment is undertaken, others will have to be excluded. Ex- A company may either use a labourintensive, semi-automatic machine, or employ a more capital-intensive, highly automatic machine for production. Choosing the semi-automatic machine precludes the acceptance of the highly automatic machine.
which the acceptance of one does not preclude the acceptance of the other. Independent investments serve different purposes and do not compete with each other. Contingent investments are dependent projects; the choice of one investment necessitates undertaking one or more other investments. For ex. If a company decides to build a factory in remote, backward area, it may have to invest in houses, roads, lights etc. thus, building of a factory also requires investment in facilities for employees. The total expenditure will treated as one single investment.
Project Classifications
Replacement
Expansion
Safety/Environmental Projects
associated with a project. Evaluate the risk of the project. Evaluate the cash flows by applying one or more of the capital budgeting techniques. Allocate capital of the firm among alternative projects.
Will the machine be profitable? Will the firm earn a high rate of return on the investment?
Example
Year Project S Project L 0 -1000 -1000 1 600 400 2 300 400 3 300 500 4 200 400
Assumptions
Equally Risky They have same cost They have same life
Payback Period
Expected number of years required to recover the original investment
Decision Rules: PP = payback period MDPP = maximum desired payback period Independent Projects: PP MDPP - Accept PP > MDPP - Reject Mutually Exclusive Projects: Select the project with the fastest payback, assuming PP MDPP.
Payback Period
How long will it take for the project to generate enough cash to pay for itself? (500) 150 150 150 150 150 150 150 150
Payback Period
How long will it take for the project to generate enough cash to pay for itself? (500) 150 150 150 150 150 150 150 150
Payback Period
Is a 3.33 year payback period good? Is it acceptable? Firms that use this method will
compare the payback calculation to some standard set by the firm. If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision?
This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!
Improves over regular payback period method by taking into account the time value of money. Still ignores all cash flows received after the payback period
Drawbacks
Year
0 1
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year
0 1 year
Cash Flow
-500 250
CF (14%)
-500.00 219.30 280.70 1
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted Payback
(500) 0 Year 0 1 2 years 250 1 250 250 250 250 2 3 4 5
Discounted Payback
(500) 0 Year 0 1 2 3 250 1 250 250 250 250 2 3 4 5
Discounted CF (14%) -500.00 219.30 1 year 280.70 192.38 2 years 88.32 168.75
Discounted Payback
(500) 0 Year 0 1 2 3 250 1 250 250 250 250 2 3 4 5
Discounted CF (14%) -500.00 219.30 1 year 280.70 192.38 2 years 88.32 168.75 .52
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5 Discounted
Year
0 1 2 3
The Discounted -500 -500.00 Payback 219.30 250 1 is 2.52 years 280.70
250 250 192.38 88.32 168.75
year
Problem
Expected Net Cash Flow Year 0 1 2 3 Project L (100) 10 60 80 Project S (100) 70 50 20
Payback
Project L
0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 30/80 2
2.4
3 80 50
60 100 -30 0
= 2.375 years
Payback
Project S
0 CFt -100 1
1.6 2
3 20 40
70 100 50 -30 0 20
Discounted Payback
Project L
0 CFt PVCFt -100 -100 10% 1 10 9.09 -90.91 2 60 49.59 -41.32 3 80 60.11 18.79
Discounted Payback
Project S
0 CFt PVCFt -100 -100 10% 1 70 63.64 -36.36 2 50 41.32 4.96 3 20 15.02 19.98
Cash flows of the investment project should be forecasted based on realistic assumptions. Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the projects opportunity cost of capital, which is equal to the required rate of return expected by investors on investments of equivalent risk. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. The opportunity cost of capital is assumed to be known and is constant
Net Present Value should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if NPV is positive i.e. NPV>0.
NPV =
t =1
(1 + k )
CFt
CF0 .
NPV PROFILE
$400.00 $300.00 $200.00 $100.00 $0.00 ($100.00) 0 ($200.00)
PROJ ECT'S COS T OF CAPITAL
NPV S NPV L
0.1
0.2
0.3
Notice that NPV of the project depends on the projects cost of capital There is a cost of capital for which the NPV is zero (and negative if cost higher)
NPV= PV inflows Cost = Net gain in wealth. For independent projects, accept project if NPV > 0. For mutually exclusive projects, choose the one with the highest NPV. This adds the most value to the firm.
Problem
Expected Net Cash Flow Year 0 1 2 3 Project L (100) 10 60 80 Project S (100) 70 50 20
If Projects S and L are mutually exclusive, accept S because NPVS > NPVL . If S & L are independent, accept both since both NPVs > 0.
Problem
Suppose we are considering a capital investment that costs Rs. 276,400 and provides annual net cash flows of Rs. 83,000 for four years and Rs 116,000 at the end of the fifth year. The firms required rate of return is 15%.
83,000 (276,400)
83,000
83,000
83,000 116,000
2 3 NPV = 18,235.71
NPV =
IRR:
t=1
t=1 n
CFt t (1 + k)
- IO
CFt t (1 + IRR)
= IO
IRR equation is the same as the one used for the NPV method. In the NPV method, the required rate of return, k, is known and the net present value is found, while in the IRR method the value of r has to be determined at which the net present value becomes zero.
IRR (Continued)
1. Guess a rate.
2.
C t F Calculate: I R )t t = (1 + R 1
3. If the calculation = CF0 you guessed right If the calculation > CF0 try a higher rate If the = L + PVB - I lower Accurate IRR calculation < LCF0 try*a (U L) rate PVBL - PVBU
Calculating IRR
83,000 (276,400)
83,000
83,000
83,000 116,000
IRR = 17.63%
Decision Rule:
If IRR is greater than the cost of capital (also called the hurdle rate) accept the project. IRR is independent of cost of capital(k) Mutually Exclusive Projects Accept the project with the highest IRR, assuming IRR > k.
Problem
Expected Net Cash Flow Year 0 1 2 3 Project L (100) 10 60 80 Project S (100) 70 50 20
Project L
0 1 10 2 60 3 80
IRR = ?
18.13%
Project S
IRR = ?
1 70
2 50
3 20
23.56%
Problem
Expected Net Cash Flow Year 0 1 2 3 Project L (100) 10 60 80 Project S (100) 70 50 20
S
20 10 0 0 -10 5 10 15 20 23.6
NPVL 50 33 19 7 (4)
NPVS 40 29 20 12 5
IRRS = 23.6%
NPV and IRR will always result in the same accept/reject decision
P Rs(10000) Q Rs(50000)
20000 75000
P Rs(10000) Q Rs(50000)
20000 75000
Both are acceptable, but Q contributes more to the wealth IRR unsuitable for ranking projects of different scales
Drawbacks of IRR
2 (200) 3
3 400 4 300 5
Drawbacks of IRR
+ +) If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. + + - + +)
(500) 200 0 1
100 2
(200) 3
400 4
300 5
Drawbacks of IRR
A B
Drawbacks of IRR
IRR cannot distinguish between lending and borrowing.
Cash Flows 0 1 Rs.(400) 600 Rs. 400 (700) IRR : A = 50% B = 75% NPV: A = +VE B = -VE
A B