Capital Budgeting

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Copyright © 2002 Harcourt, Inc. All rights reserved.

Should we build thisplant?

The Basics of Capital Budgeting: Evaluating Cash Flows

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What is capital budgeting?

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to firm’s future.

Investment is made in present times

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Evaluate expenditure decisions benefit of which may accrue for more than one year

Irreversible

Effect for longer period

Lot of funds are required

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What is the difference between independent and mutually exclusive

projects?

Projects are:

independent, if the cash flows of one are unaffected by the acceptance of the other.

mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

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An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.

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Normal Cash Flow Project:

Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs.Most common: Cost (negativeCF), then string of positive CFs, then again negative CF.

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Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN

- + + + + + N

- + + + + - NN

- - - + + + N

+ + + - - - N

- + + - + - NN

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What is the payback period?

The number of years required to recover a project’s cost,

or how long does it take to get the business’s money back?

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Payback for Project L(Long: Most CFs in out years)

10 8060

0 1 2 3

-100

=

CFt

Cumulative -100 -90 -30 50

PaybackL 2 + 30/80 = 2.375 years

0100

2.4

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Project S (Short: CFs come quickly)

70 2050

0 1 2 3

-100CFt

Cumulative -100 -30 20 40

PaybackS 1 + 30/50 = 1.6 years

100

0

1.6

=

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Strengths of Payback:

1. Provides an indication of a project’s risk and liquidity.

2. Easy to calculate and understand.

Weaknesses of Payback:

1. Ignores the TVM.

2. Ignores CFs occurring after the payback period.

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10 8060

0 1 2 3

CFt

Cumulative -100 -90.91 -41.32 18.79

Discountedpayback 2 + 41.32/60.11 = 2.7 yrs

Discounted Payback: Uses discountedrather than raw CFs.

PVCFt -100

-100

10%

9.09 49.59 60.11

=

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Average rate of Return

ARR=

Average annual profits after taxes and depreciation__________________________________________

Average Investment

Note: Average Investment=

( Original Investment + Salvage Value)/2

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NPV

Cost often is CF0

.

10

1

CFk

CFNPV t

tn

t

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What’s Project L’s NPV?

10 8060

0 1 2 310%

Project L:

-100.00

9.09

49.59

60.1118.79 = NPVL

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Rationale for the NPV Method

NPV = PV inflows - Cost= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually exclusive projects on basis ofhigher NPV. Adds most value.

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Using NPV method, which project(s) should be accepted?

If Projects S and L are mutually exclusive, accept S because NPVs > NPVL .

If S & L are independent, accept ; NPV > 0.

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Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forcesPV inflows = cost or PV of Cash Outflows This is the same as forcing NPV = 0.

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t

nt

t

CF

kNPV

0 1.

t

nt

t

CF

IRR

0 10.

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

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IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.

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Profitability Index or Benefit Cost Ratio

PI=

Present Value of Cash Inflows

___________________________

Present Value of Cash Outflows

PI>1------Accept

PI<1------Reject

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NOTE

Pay Back/IRR/NPV/PI

= Cash Flow After Tax Before Dep

ARR= Cash Flow after tax and after Depreciation

Capital Budgeting

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