Capital Budgeting

Professor ThomsonFin 3013

2

Capital Budgeting

• Should you . . . – Build a new factory– Upgrade your current factory– Start a marketing campaign– Install in a new computer system

• How do we determine if these are good investments?

3

Review: Goal of Financial Manager

• The goal of the Financial Manager is to maximize the current stock price

• So we should ask, “Will undertaking this investment increase the current share price?”

• Another way to ask this is, “Does the increase in my Cash Flows due to this project, more than compensate for the costs of this project?”

4

Cash Flow Timing

• The cash flows (revenues) from a project flow over time (I.e. in the future), while the investment cost is today.

• This discounted cash flows have to cover the cost of the project to ensure that the marginal benefits exceed the marginal cost of investing in the project.

5

The Capital Budgeting Decision ProcessThe capital budgeting process involves

three basic steps:

1. Generating long-term investment proposals;

2. Reviewing, analyzing, and selecting from the alternative proposals, and

3. Implementing and monitoring the proposals that have been selected.

Managers should focus on the investment decision. After suitable projects have been identified, a following decision is how to to pay for it (the financing decision).

6

A Capital Budgeting Process Should:

Account for the time value of money;

Account for risk;

Focus on cash flow;

Rank competing projects appropriately, and

Lead to investment decisions that maximize shareholders’ wealth.

7

Capital Budgeting Decision Techniques

Payback period: most commonly used

Accounting rate of return (ARR): focuses on project’s impact on accounting profits (Not covered in this

course)

Net present value (NPV): best technique theoretically; difficult to calculate realistically

Internal rate of return (IRR): widely used with strong intuitive appeal

Profitability index (PI): related to NPV

8

Accounting Rate Of Return (ARR)

Can be computed from available accounting data

ARR uses accounting numbers, not cash flows; no time value of money.

vestmentAverage in

r taxesofits afteAverage prARR

Average profits after taxes

Average annual operating cash inflows

Average annual depreciation

= -

• Need only profits after taxes and depreciation

• Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.

9

Payback PeriodThe payback period is the amount of time required

for the firm to recover its initial investment.

• If the project’s payback period is less than the maximum acceptable payback period, accept the project.

• If the project’s payback period is greater than the maximum acceptable payback period, reject the project.

Management determines maximum acceptable payback period. It’s not clear how this relates

to wealth maximization

10

Global Wireless• Global Wireless is a worldwide provider of

wireless telephony devices.• Global Wireless evaluating major expansion of

its wireless network in two different regions:• Western Europe expansion• A smaller investment in Southeast U.S. to establish a

toehold

$175Year 5 inflow

$160Year 4 inflow

$130Year 3 inflow

$80Year 2 inflow

$35Year 1 inflow

-$250Initial outlay

$32Year 5 inflow

$30Year 4 inflow

$25Year 3 inflow

$22Year 2 inflow

$18Year 1 inflow

-$50Initial outlay

Western Europe ($ millions) Southeast U.S. ($ millions)

11

Computing payback

Time CF Cumulative CF

0 -250 -250

1 35 -215

2 80 -135

3 130 -5

4 160 155

5 175 330The project pays back during the 4th year. We prorate the remaining CF to be recovered to the cash generated that year to compute the fraction of a year.

12

Prorating the final year’s CF

0313.01160

5

year that CF

remaining CFfraction

So, the payback period for this project is 4.0313 years.

13

Calculating Payback Periods for Global Wireless Projects• Management selects a 2.75 years payback

period.• Western Europe project has initial outflow of -

$250 million,• But cash inflows over first 3 years only $245 million.• Global Wireless would reject Western Europe project.• Southeast U.S. project: initial outflow of -$50

million• Cash inflows over first 2 years cumulate to

$40 million.• Project recovers initial outflow after 2.40

years.• Total inflow in year 3 is $25 million. We estimate

that the projects generates $10 million in year 3 in 0.40 years ($10 million $25 million).

• Global Wireless would accept the project.

14

Pros and Cons of Payback Method

Advantages of payback method:

• Computational simplicity• Easy to understand

• Focus on cash flow

Disadvantages of payback method:

• Does not directly account for time value of money

• Does not account properly for risk• Cutoff period is arbitrary (gives no value to

CF’s that occur after the payback cutoff)• Does not link to value-maximization

15

Discounted Payback Period• Discounted payback accounts for time value.

• Apply discount rate to cash flows during payback period (say 3 years).

• Still ignores cash flows after payback period• Global Wireless uses an 18% discount rate.

RejectReject--Accept / reject

$46.2$166.2--Cumulative PV

$15.2$79.10.6086PV Year 3 inflow

$15.8$57.40.7182PV Year 2 inflow

$15.2$29.70.8475PV Year 1 inflow

Southeast U.S. project ($million)

Western Europe project ($million)

PV Factors(18%)

Item

16

NPV: Net Present Value

• The theoretically correct investment criteria is:

If NPV > 0, then investNPV = PV of Cash Flows – Investment CostIf the NPV > 0 then the current stock price of the

firm should increase if we undertake the project (and vice versa)

NPV measure the wealth increase from implementing the project

The marginal cost is the investment costs and the marginal benefits are the discounted cash flows

17

Using NPV

•To use the NPV criterion we need to know:

1. The investment cost2. The incremental Cash Flows due

to the project (these are often the cash flows of the project).

3. The appropriate discount rate to apply to the Cash Flows which reflect the risk of the project

18

Net Present Value

NN

r

CF

r

CF

r

CF

r

CFCFNPV

)(...

)()()(

1111 33

221

0

A key input in NPV analysis is the discount rate.

r represents the minimum return that the project must earn to satisfy investors.

r varies with the risk of the project which is often related to the risk of the firm.

19

Calculating NPVs for Global Wireless Projects• Assuming Global Wireless uses 18% discount

rate, NPVs are:

5432 )18.1(

175

)18.1(

160

)18.1(

130

)18.1(

80

)18.1(

352503.75$ EuropeWesternNPV

5432.. )18.1(

32

)18.1(

30

)18.1(

25

)18.1(

22

)18.1(

18507.25$ SUSoutheastNPV

Western Europe project: NPV = $75.3 million

Southeast U.S. project: NPV = $25.7 million

Should Global Wireless invest in one project or both?

20

Computing the NPV on the HP10BII

• Set calculator to correct P/YR• Enter the CF’s.• Usually the time period 0 cash flow

will be negative• Enter the discount rate as I/YR• Press the

21

Demonstration

t CF

0 -250

1 35

2 80

3 130

4 160

5 175

P/YR=1

Type 18, press I/YRPress NPV = 75.26

22

Pros and Cons of Using NPV as Decision Rule

Key benefits of using NPV as decision rule:

• Focuses on cash flows, not accounting earnings

• Makes appropriate adjustment for time value of money

• Can properly account for risk differences between projectsThough best measure, NPV has some

drawbacks:

• Lacks the intuitive appeal of payback, and

• Doesn’t capture managerial flexibility (option value) well.

NPV is the “gold standard” of investment decision rules.

23

NPV Profile

• As we increase the discount rate, the NPV will fall.

• We give a special name for the discount rate that causes NPV to exactly equal zero

• The Internal Rate or Return (IRR) is the discount rate that cause the NPV to equal zero

• It is the return that money invested in the project earns

24

NPV Profile for Global Wireless

-50

0

50

100

150

200

250

5% 10% 15% 20% 25% 30% 35% 40%

Discount Rate

NP

V

IRR

25

Internal Rate of Return

NN

r

CF

r

CF

r

CF

r

CFCFNPV

)(....

)()()(

11110

33

221

0

• IRR found by computer/calculator or manually by trial and error.

Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project:

The IRR decision rule is:

• If IRR is greater than the cost of capital, accept the project.

• If IRR is less than the cost of capital, reject the project.

26

Calculating IRRs for Global Wireless Projects

Western Europe project: IRR (rWE) = 27.8%

5432 )1(

175

)1(

160

)1(

130

)1(

80

)1(

352500

WEWEWEWEWE rrrrr

Southeast U.S. project: IRR (rSE) = 36.7%

5432 )1(

32

)1(

30

)1(

25

)1(

22

)1(

18500

SESESESESE rrrrr

Global Wireless will accept all projects with at least 18% IRR.

27

Demonstration: Compute IRR

t CF

0 -250

1 35

2 80

3 130

4 160

5 175

P/YR=1

Press IRR/YR = 27.79

28

IRR v. NPV

• IRR and NPV are in some ways, different ways of saying the same thing

• By inspection of the NPV profile we see that if the IRR > required rate of return, the NPV is positive, so either criteria would say to accept the project as one that build wealth. (The converse is also true).

29

Advantages and Disadvantages of IRR

Advantages of IRR:

• Properly adjusts for time value of money

• Uses cash flows rather than earnings

• Accounts for all cash flows

• Project IRR is a number with intuitive appeal

Disadvantages of IRR

• “Mathematical problems”: multiple IRRs, no real solutions

• Scale problem

• Timing problem

30

Multiple IRRs

NPV ($)

NPV<0

NPV>0

NPV>0

Discount rateNPV<0

With multiple IRRs, which do we compare with the cost of capital to accept/reject the project?

IRR

IRR

When project cash flows have multiple sign changes, there can be multiple IRRs.

31

No Real Solution

Sometimes projects do not have a real IRR solution.

Modify Global Wireless’s Western Europe project to include a large negative outflow (-

$355 million) in year 6.

• There is no real number that will make NPV=0, so no real IRR.

Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!

32

Competing projects

• Competing projects are those which cannot all be chosen, even if all appear desirable. For example, say you have a chuck of commercial property and you are considering– Shopping mall– Office building– Apartments

• You cannot do them all, so can choose only one of the alternatives

33

Funding or other constraints

• If a firm feels it can only raise a limited amount of funds, or only has the managerial or other talent to take on some of the available projects, the projects will have to be ranked

• Best solution, choose the set of projects that will maximize the NPV of the sum of the projects

• This is called the “knapsack” problem of management science

34

Conflicts Between NPV and IRRNPV and IRR do not always agree when ranking

competing projects.

$25.7 mn36.7%Southeast U.S.

$75.3 mn27.8%Western Europe

NPV (18%)IRRProject

• Southeast U.S. project has higher IRR, but doesn’t increase shareholders’ wealth as much as Western Europe project.

The scale problem: Small scale projects often have higher IRR’s

35

NPV Profile for Global Wireless Projects

-50

0

50

100

150

200

250

5% 10% 15% 20% 25% 30% 35% 40%

Discount Rate

NP

V

West Europe

SE US

36

Often larger scale projects are disadvantaged by using IRR

• Example – you have land that could be developed for parking. The alternatives, listed by investment cost are:– Gravel parking lot– Paved parking lot– Parking garage

• IRR will tend to favor the one with the lowest capital cost, that generates some funds very quickly

37

Long vs. Short Term Projects

Discount rate

Short-term project

Long-term project

17%15%

NPV

13%

• The NPV of long-term project is more sensitive to the discount rate than the NPV of the short-term project is.

IRR = 15%

IRR = 17%

• Long-term project has higher NPV if the cost of capital is less than 13%. Short-term project has higher NPV if the cost of capital is greater than 13%.

38

Which is a more effective wealth builder (your alternative rate = 10%)?• You can lend your brother $100 who

will pay you back $100.06 (i.e. an extra six cents) tomorrow

• Or lend your sister $100 for a year who will pay you back $120 after one year

• What is the EAR of each investment?• P/YR=363 I/YR(PV=100, FV=100.05,

N=1) = 21.90• Press EFF% = 24.47

39

Profitability Index

Decision rule: Accept project with PI > 1.0, equal to NPV > 0

0

0

0

221

)1(...

)1()1(CF

CFNPV

CFr

CF

rCF

rCF

PIN

N

• Both projects’ PI > 1.0, so both acceptable if independent.

1.5$50 million$75.7 millionSoutheast U.S.

1.3$250 million$325.3 millionWestern Europe

PIInitial OutlayPV of CF (yrs1-5)Project

Calculated by dividing the PV of a project’s cash inflows by the PV of its outflows:

Like IRR, PI suffers from the scale problem.

Methods to generate, review, analyze, select, and implement long-term investment

proposals:

Accounting rate of returnPayback Period

Discounted payback periodNet Present Value (NPV)

Internal rate of return (IRR)Profitability index (PI)

Capital Budgeting

41

Net Present Value

Compute the present value of a project’s cash inflows and outflows

Discounting cash flows accounts for the time value of money.

Choosing the appropriate discount rate accounts for risk.

NN

r

CF

r

CF

r

CF

r

CFCFNPV

)(...

)()()(

1111 33

221

0

Accept projects if NPV > 0.