1-Capital budgeting

Capital budgeting is the making of long-run planning decisions for investments in projects and programs It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years

Capital budgeting is a six-stage process: 1. Identification stage 2. Search stage 3. Information-acquisition stage 4. Selection stage 5. Financing stage 6. Implementation and control stage

ULF-Spring 2012-Industrial Management By Georges Abboudeh

1.1-Payback Method Definition

Payback measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project. Or it calculates how long it takes to recover the initial investment Advantages It is simple Focus on cash flow Disadvantages Ignore investment after payback period Ignore time value of money Does not account properly for risk Does not lead to value-maximizing decisions
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1.1-Payback Method example 1

An assisted

Living is considering buying a machine 1 Initial investment is $210,000 Useful life is eleven years Estimated residual value is zero Net cash inflows is $35,000 per year

How long would it take to recover the investment? $210,000 $35,000 = 6 years Six years is the payback period

ULF-Spring 2012-Industrial Management By Georges Abboudeh

1.1-Payback Method example 2

Suppose that as an alternative to the $210,000 piece of equipment, there is another one (Machine 2) that also costs $210,000 but will save $42,000 per year during its five-year life

What is the payback period? $210,000 $42,000 = 5 years Five years is the payback period Machine 2 is more preferable than machine 1

ULF-Spring 2012-Industrial Management By Georges Abboudeh

1.1-Payback Method example 3

Assisted Living is considering buying Machine 3 Initial investment is $250,000 Useful life is eleven years Cash savings are $160,000, $180,000 for year 1 and 2 respectively and $110,000 over its life

What is the payback period?

Year 1 brings in $160,000, Recovery of the amount invested occurs in Year 2. Payback = 1 year + $ 90,000 needed to complete recovery / 180,000 net cash inflow in Year 2 = 1 year + 0.5 year = 1.5 years or 1 year and 6 months

ULF-Spring 2012-Industrial Management By Georges Abboudeh

1.2-Discounted cash flow (DCF)

FV= PV( 1 + r)n PV= FV/( 1 + r)n Where
FV :

future value PV : Present value r: Interest rate n: number of periods (years usually)

Investment of 10.000 with 10% interest rate Future value Year1 : (1+ 0.1) x 10.000 Year2 : (1+ 0.1)2 x 10.000 Year3 : (1+ 0.1)3 x 10.000 Year4 : (1+ 0.1)4 x 10.000 Year5 : (1+ 0.1)5 x 10.000
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1.2-Discounted cash flow (DCF)

The discounted cash flow technique compare the value of the future cost flows of the project to todays dollars

DCF

is calculated for the project for comparing alternative ways of doing it Example Project A is expected to make 100.000 $ in 2 years Project B is expected to make 120.000 $ in 3 years The cost of capital is 12% PV for A = 79.719 PV for B = 85.414 Project B is the project that will return highest investment

ULF-Spring 2012-Industrial Management By Georges Abboudeh

1.3-Net present value (NPV)

Based on the dollar amount of cash flows The dollar amount of value added by a project NPV equals the present value of cash inflows minus initial investment
NPV (CF0 ) CF3 CFN CF1 CF2 ... (1 r ) (1 r ) 2 (1 r ) 3 (1 r ) N

NPV = Pvi - Investment If NPV >0 accept the project

Project A Year 1 2 3 Total
Investment

r=12% Inflow 10.000 15.000 5.000 30.000 PV 8.929 11.958 3.559 24.446 24.000 446

Project B Year 1 2 3 Total

Investment

r=12% Inflow 7.000 13.000 10.000 30.000 PV 6.250 3.364 7.118 24.732 24.000 - 268
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NPV

NPV

Projects with high return early are better than with lower return early.
ULF-Spring 2012-Industrial Management By Georges Abboudeh

1.3-Net present value (NPV)

Initial investment is $245,000. Investment in working capital is $5,000.

Working capital will be recovered. Useful life is three years. Estimated residual value is $4,000. Net cash savings is $80,000 per year. Expected return is 10%. Net Cash Inflows $80,000 9,000 NPV of Net Cash Inflows $198,960 6,759 $205,719 250,000 ($ 44,281)
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Years 10% Col. 1-3 2.487 3 0.751

Total PV of net cash inflows Net initial investment Net present value of project

ULF-Spring 2012-Industrial Management By Georges Abboudeh

1.3-Net present value (NPV)

Advantages
Focuses on cash flows, not accounting earnings

Makes appropriate adjustment for time value of money Can properly account for risk differences between projects

Disadvantages
Lacks the intuitive appeal of payback, and Doesnt capture managerial flexibility (option value) well.

ULF-Spring 2012-Industrial Management By Georges Abboudeh

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1.4-Internal rate of return (IRR)

IRR is the discount rate when the present value of the cash inflows equal to the original investment. IRR: the discount rate that results in a zero NPV for a project
NPV (CF0 ) CF3 CFN CF1 CF2 ... (1 r ) (1 r ) 2 (1 r ) 3 (1 r ) N

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

Projects with higher IRR are better

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1.4-Internal rate of return (IRR)

Advantages
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
Mathematical problems: multiple IRRs, no real solutions

Scale problem

Timing problem

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Comparison of NPV and IRR

NPV

The NPV method has the advantage that the end result of the computations is expressed in dollars and not in a percentage Individual projects can be added It can be used in situations where the required rate of return varies over the life of the project.

IRR

The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.

IRR and NPV conflict, use NPV approach

ULF-Spring 2012-Industrial Management By Georges Abboudeh

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1.5-Accrual Accounting Rate-of-Return Method

The accrual accounting rate-of-return (AARR) method divides an accounting measure of income by an accounting measure of investment
Does not track cash flows Ignores time value of money

AARR = (Increase in expected average annual operating income)/(Initial required investment)

Initial investment is $303,280

Useful life is five years Net cash inflows is $80,000 per year IRR is 10%

What is the average operating income? Straight-line depreciation is $60,656 per year ( = 303,280/5) Average operating income is $80,000 $60,656 = $19,344 What is the AARR? AARR = ($80,000 $60,656) $303,280 = .638, or 6.4%
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Which technique is superior?

Although our decision should be based on NPV, but each

technique contributes in its own way

Payback period is a rough measure of riskiness. The longer

the payback period, more risky a project is

IRR is a measure of safety margin in a project. Higher IRR

means more safety margin in the projects estimated cash flows

ULF-Spring 2012-Industrial Management By Georges Abboudeh

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