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Capital Budgeting

Engineering Economy

Wednesday, May 25, 16


Capital Budgeting Overview
o Investment capital represents a scarce resource;
o Generally more projects for funding consideration
than there are funds available to fund.
o Some projects may be funded and some may not!
o We have, then, the independent project selection
problem.
Independent Projects
o Independent Projects:
n A set of projects ( two or more) are independent if:
o The cash flows of one project do not in anyway impact
the cash flows of any other project in the set.
o Selection of one project in the set does not
impact to accept or reject any other project in
the set.
Project Bundles
o A bundle is a collection of independent projects.
o Independent-type projects tend to be quite different
from each other.
o The candidate set of projects is all projects under
consideration for funding from a given budget
amount.
o Not all projects can be selected budget constraints
may exist.
Capital Budgeting Characteristics
o Identify independent projects and their
estimated cash flows;
o Each project is selected entirely, or it is not
selected at all;
o Partial projects are not permitted;
o A given budget constraint restricts the total
amount available for investment;
o Objective: maximize the return on
investment using a measure of worth.
Selection Guidelines
o Accept projects with the best PW values
determined at the MARR;
o Over the project life;
o Provided the investment capital limit is not
exceeded.
The Capital Budgeting Problem
(A) $$ Cash Flow Profile

$$
(B) $$ Cash Flow Profile

Budget

(C) $$ Cash Flow Profile

Objective: Max. PW of the selected bundles


Max Present Worth
o Previous Assumption:
o Equal Life for the alternatives;
o No longer valid for capital budgeting;
o No life cycle beyond the estimated life of each
bundle;
o PW over the respective life of each independent
project;
o Implicit Reinvestment Assumption is in place.
Reinvestment Assumption
o The following is assumed for the capital budgeting
problem

All positive net cash flows of a project


(bundle) are reinvested at the MARR from
the time they are realized until the END of
the LONGEST-LIVED project!
With this assumption, projects (bundles) with
unequal lives can be accommodated in the
analysis.
Use of ROR To Select
o ROR can be used to select projects;
o However must apply the incremental ROR method
(cumbersome);
o Recall, ROR and NPV may not rank (select) projects
the same;
o Different reinvestment assumptions within the two
methods;
o Use incremental ROR to select!
Suggested Objective Function
o It is suggested that PV be used as the criteria in the
associated objective function as opposed to ROR.
o Probably best to not use the incremental ROR
ranking;
o Easier to apply PV at the MARR to all of the
projects.
Rationing for Equal-Life Projects
o Given a set of candidate projects whose lives are all
equal;
o Calculate the PV(MARR) for each project;
o Formulate all of the mutually exclusive bundles from
the set;
Mutually Exclusive Bundles
o Assume you have 4 projects having equal lives;
o Candidate set = { A, B, C, D};
o The Do-Nothing (DN) alternative is also an option:
Set = { DN, A, B, C, D };
o Given 4 projects, how many mutually exclusive
bundles can be formed?
Number of Bundles
o Given m projects (independent), how many
possible bundles are there?
o Rule: Total no. of bundles = 2m;
o 2m 1 bundles if you cut out the DN option;
o If m = 4 then 24 1 = 15 bundles (excluding the DN
option).
Number of Bundles
o Manual approaches are not well suited for
large numbers of candidate projects.
o If m = 6 then 26 = 64 bundles to evaluate;
o If m = 30 then 230 bundles to evaluate;
o Equal 1,073,741,824 bundles!
o Require a more sophisticated approach other than
a manual analysis.
Example of Bundling: m =4
Assume:
Project Investment $
A $10,000
B 5,000
C 8,000
D 15,000
$38,000 Total
Assume a b = $25,000 (The budget max.)

One cannot have all 4 projects because of the budget limitation.


What, then, is the optimal combination of projects?
Example of Bundling: m =4
Assume:
Project Investment $
A $10,000
B 5,000
C 8,000
D 15,000
$38,000 Total
Assume a b = $25,000 (The budget max.)

From the 15 possible combinations, which one bundle of


projects will maximize the present worth of the selected bundle?
Example of Bundling: m =4
Assume:
Project Investment $
A $10,000
B Feasible bundles must have 5,000
Positive PV and a total
C Budget that does not 8,000
D Exceed $25,000/ 15,000
$38,000 Total
Assume a b = $25,000 (The budget max.)
Steps for a Manual Analysis
1. Identify the investments and cash flows for all
feasible combinations of the projects where each
combination represents an economically mutually
exclusive bundle.
Consider all possible combinations by taking the
projects one at a time, two at a time, etc., and
listing.
Possible Combinations Where m = 4
1. Do Nothing; 14. BCD
2. A 15. CD
3. B 16. ACD
4. C
5. D
6. AB TOTAL ENUMERATION OF
7. AC ALL 16 POSSIBLE
8. AD MUTUALLY EXCLUSIVE
9. ABC COMBINATIONS
10. ABCD
11. BC
12. BD
13. ABD
Ordering the Combinations
o Order the bundles from low to high based upon the
total budget requirement of the combination.
Rank-Ordered Bundles: Total Investment
PROJECT ID INVESTMENT
1 DN $0
2 B $5,000
3 C $8,000
4 A $10,000
5 BC $13,000 Eliminate Those
6 D $15,000 Mutually Exclusive
7 AB $15,000 Bundles That
8 AC $18,000 Exceed the $25,000
9 BD $20,000
10 ABC $23,000 Budget Limitation.
11 CD $23,000
12 AD $25,000
13 BCD $28,000
14 ABD $30,000
15 ACD $33,000
16 ABCD $38,000
Reduced Budget Feasible Set
PROJECT ID INVESTMENT
1 DN $0 Four bundles
2 B $5,000 are
3 C $8,000
infeasible: they
4 A $10,000
5 BC $13,000 exceed the
6 D $15,000 budget amt.
7 AB $15,000 dropped from
8 AC $18,000
9 BD $20,000
further
10 ABC $23,000 consideration.
11 CD $23,000
12 AD $25,000
13 BCD $28,000
14 ABD $30,000
15 ACD $33,000
16 ABCD $38,000
The Feasible Set
PROJECT ID INVESTMENT
1 DN $0
2 B $5,000
3 C $8,000
4 A $10,000 The feasible set
5 BC $13,000 of mutually
6 D $15,000 exclusive bundles.
7 AB $15,000
8 AC $18,000
9 BD $20,000
10 ABC $23,000
11 CD $23,000
12 AD $25,000
Bundle Selection
o The previous slide shows the feasible set;
o None of the combinations exceed the budget
limitation;
o If one has the PV of each bundle, then pick the
bundle with the maximum present value.
General Solution Technique
1. Develop all mutually exclusive bundles.
2. Eliminate those bundles whose total investment
requirement exceeds the budget amount.
3. Within each bundle, sum the NCFs for all
projects in that bundle and compute the PV of
the bundle at the MARR.
General Solution Technique
o Let j equal the bundle number;
o PWj = PW of bundles net cash flows the initial
investment.

nj

PWJ = NCFjt ( P / F , i, t ) NCFj 0


t =1

o Select the bundle with the largest PWj value.


Example 1
o Assume b = 20 million;
o Number of candidate projects = 5
o Set = {DN, A,B,C,D,E}
o No. of bundles = 25 = 32 possible combinations.
Example for m = 5 Projects
Amounts are in units of $1,000.

Initial Ann. Net Life


Project Investment Cash Flow Years
A -$10,000 $2,870 9
B $15,000 $2,930 9
C -$8,000 $2,680 9
D -$6,000 $2,540 9
E -$21,000 $9,500 9
25 Possible Bundles:E is removed $21 Million > 20 Million
Example 1: Feasible Bundles
o Max Bundle is { CD };
o Left over budget = 6 million assumed to be invested at
the MARR
Unequal-Life Projects
o It is assumed that reinvestment of positive net cash flows
occurs at the MARR from the time they are realized until
the end of the longest-lived project.
o Use of the LCM of lives is not necessary for the capital
budgeting model.
Example 2: Unequal Lives
Project Initial Ann. Net Project
Investment Cash Flows Life Yrs

A -$8,000 $3,870 6

B -15,000 2,930 9

C -8,000 2,680 5

D -8,000 2,540 4

24 = 16 Bundles to evaluate: 8 are feasible!


Example 2: PV Summary
Bundle Project(s) PV Comments
1 A $+6,646
2 B -1,019 Reject
3 C 984
4 D -748 Reject
5 AC 7,630 Max Bundle

6 AD 5,898
7 CD 235
8 Do Nothing 0
Select { AC } for $16,000: $4,000 assumed
invested at the MARR
Two Independent Bundles A and B
o Assume two independent projects, A and B;
o Life of A = nA;
o Life of B = nB;
o A B (unequal lives).
o Assume A and B have the same net cash flow each time
period.
Notation for Unequal Life Problem
o nL = life of the longer lived project;
o nj = life of the shorter lived project;
o nA = Life of A
o nB = Life of B
o Diagram the two cash flows on the next slide.
Unequal-Life Projects; A and B
FWB
PWB

nB = nL
B Investment
Longer life Project: i = MARR
For B
FWA

PWA FW

Period of reinvestment @
MARR
A nA nL
Investment
For A
Shorter Project: A with Reinvestment
FWA

PWA FW
A Period of reinvestment @
MARR
nA nL
Investment
For A
Compute the FW from nA out to nL of A.
Assumed to be reinvested at the MARR rate!
Yield FWA given reinvestment at the MARR rate.
Then, find PWA from FWA at the MARR rate.
Bundling A and B: Unequal Lives
o Now A and B have unequal lives;
o If reinvestment at the MARR is assumed for the shorter-
life project out to the life of the longer life project, then:
o One can create a bundle of A and B by computing;
o PWBundle = PWA + PWB
C and D in Example 2
Project Init. Inv. ANCF Life

C -$8,000 $2,680 5

D -8,000 2,540 4

o Find the PW of the bundle { C,D }.


o Unequal life situation.
Bundle { C, D }. Over 9 years
o Bundle Cash Flow:
FW = $57,111
$2,540/yr (D)

$2,680 (C)

0 1 2 3 4 5 6 7 8 9

FW(C,D, @ 15%) of + CFs = +$57,111.


-$16,000
PW(C,D @ 15%) = -$16,000 + 57,111(P/F,15%,9)
= +$235.00
Summary
o Capital represents a scarce resource;
o Capital is limited and must be rationed;
o Evaluate the capital budgeting from:
n Equal life projects;
n Unequal life projects.
o Apply the PW method;
o Create mutually exclusive bundles;
Summary
o For m projects there are 2m possible combinations or bundles;
o Manual solutions work only for very small problems;
o Larger problems require a mathematical programming
formulation;