Capital Budgeting Techniques

Mona School of Business Financial Management Lecturer: Kathya Beckford

By the end of this session you will understand:

1.

What capital budgeting is

How to calculate and interpret a projects:

2.

Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI)

3.

How to choose projects when capital is rationed

What is capital budgeting?

Capital budgeting is the process of planning expenditure on assets or projects that can have a long-term impact on an institution.

Examples of capital projects

Adopting a new enterprise-wide software system Launching a new advertising campaign Replacing factory equipment Expanding sales into a new market Building a road

Why is capital budgeting important?

Helps firm make smart decisions

Capital projects large and expensive- not easy to change course Allows management team to give input and be on same page

Capital budgeting techniques include:

Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI)

Payback Period- The Concept

What is it? The payback period for a project is the expected time it will take to recover the original investment.
The decision rule: Accept project if its payback period is less than the maximum allowed.

Payback Period- An Example

A project requires a $100,000,000 investment and is expected to generate the following cash flows in the years after the investment is made
Year
1 2 3 4 5

Cashflow ($)
20,000,000 40,000,000 60,000,000 30,000,000 10,000,000

What is the payback period?

Payback Period- Example contd

Workings:
Year 1 2 3 4 5 Cashflow ($) 20,000,000 40,000,000 60,000,000 30,000,000 10,000,000 Cumulative Cashflow 20,000,000 60,000,000 120,000,000 150,000,000 160,000,000

The payback period is somewhere between the end of year 2 and the end of year 3

Payback Period- Example contd

Use linear interpolation to find the exact figure for payback period By using linear interpolation, the assumption is that cashflows occur evenly throughout the year We get: X2 = 32

100,000,000 60,000,000 120,000,000 60,000,000 (This is the payback period)

X = 2.67 years

Payback Period- Example contd

If projects with a payback period of up to 4 years are acceptable, should the firm accept this project? Answer: Yes, since the payback period is less than 4 years.

Payback Period- The Pros

It is easy to calculate

It is easy to explain
It uses cashflows (not accounting profits) It gives a measure of the liquidity of a project

Payback Period- The Cons

How

to decide maximum allowable payback period? Very subjective value of money not taken into consideration riskiness not accounted for properly

Time

Projects

Cashflows

beyond the payback period are ignored

No

connection to maximizing the firms value

Discounted Payback PeriodThe Concept

What is it? The discounted payback period for a project is the expected time it will take for the discounted cash flows to recover the original investment. The decision rule: Accept project if its discounted payback period is less than the maximum allowed.

Discounted Payback PeriodExample

A project requires a $100,000,000 investment and is expected to generate the following cash flows in the years after the investment is made
Year
1 2 3 4 5

Cashflow ($)
20,000,000 40,000,000 60,000,000 30,000,000 10,000,000

What is the discounted payback period based on a discount rate of 10%?

Discounted Payback PeriodExample contd

Workings:
Year 1 2 3 4 5 Cashflow ($) 20,000,000 40,000,000 60,000,000 30,000,000 10,000,000 PV of Cashflow ($) 18,181,818 33,057,851 45,078,888 20,490,404 6,209,213 Cumulative PV of cashflow ($) 18,181,818 51,239,669 96,318,557 116,808,961 123,018,174

The discounted payback period is somewhere between the end of year 3 and the end of year 4

Discounted Payback PeriodExample contd

Use linear interpolation to find the exact figure for the discounted payback period By using linear interpolation, the assumption is that the discounted cashflows occur evenly throughout the year We get: Y3 = 43

100,000,000 96,318,557 116,808,961 96,318,557 (This is the discounted payback period)

Y = 3.18 years

Discounted Payback PeriodExample contd

If projects with a discounted payback period of up to 5 years are acceptable, should the firm accept this project? Answer: Yes, since the discounted payback period is less than 5 years.

Discounted Payback PeriodThe Pros & Cons

The pros and cons are almost the same as with the basic payback period technique Only improvement is that cashflows are discounted However, since cashflows beyond discounted payback period are ignored, TVM still not handled adequately

Net Present Value (NPV)The Concept

What is it? The net present value of a project is the sum of the present values of its expected cash flows.

The decision rule: Accept project if its NPV > 0.

NPV- An Example
A project requires a $100,000,000 investment and is expected to generate the following cash flows in the years after the investment is made
Year
1 2 3 4 5

Cashflow ($)
20,000,000 40,000,000 60,000,000 30,000,000 10,000,000

What is the NPV for this project if the discount rate is 10%?

NPV- Example contd

Workings:
Year 0 Cashflow ($) -100,000,000 PV of Cashflow ($) -100,000,000

1
2 3 4 5

20,000,000
40,000,000 60,000,000 30,000,000 10,000,000 Total

18,181,818
33,057,851 45,078,888 20,490,404 6,209,213 23,018,174

The NPV of the project is $23,018,174

NPV- Example contd

Should this project be accepted?

Answer: Yes, since NPV > 0.

NPV Exercise
1.

Calculate the NPV of the same project we just looked at, this time using a discount rate of 20%. Would you still accept this project? Why or why not? Under what circumstances would a discount rate of 20% be more appropriate than a discount rate of 10% for this project?

2.

3.

4.

NPV Exercise Results

1.

NPV = -2,346,965
Year 0 1 Cashflow ($) -100,000,000 20,000,000 PV of Cashflow ($) -100,000,000 16,666,666 27,777,777 34,722,222 14,467,592 4,018,775 -2,346,965

2
3 4 5

40,000,000
60,000,000 30,000,000 10,000,000 Total

2. 3.

We would reject this project Reject since NPV <0

NPVThe Discount Rate Used:

Has a significant impact on NPV result Should be the required return on the project Should be in line with the projects risk

Are the estimated cash flows almost a certainty or very uncertain? Will the fixed costs (operating leverage) be high ? Will the amount of debt used (financial leverage) be high?

NPVThe Discount Rate Selection Contd

Projects with higher risk should use higher discount rate Many firms use WACC and adjust up or down to account for projects riskiness

Alternatively, projects beta can be calculated and used to determine projects required return via CAPM

NPV- The Pros

Relatively easy to calculate Uses cash flows (not accounting profits) Time value of money handled properly

Projects riskiness considered appropriately

Shows expected impact on companys value

Internal Rate of Return (IRR)The Concept

A projects IRR is the discount rate that causes the NPV of all project cash flows to equal zero.

Set NPV to zero, and solve for r.

IRR- Decision Rule

A typical project has outflows at the beginning For a typical project:

If IRR > Projects required return, accept project

The required return is used as a hurdle rate The required return should be in keeping with the riskiness of the project

IRR- An Example
A project requires a $100,000,000 investment and is expected to generate the following cash flows in the years after the investment is made
Year 1 2 3 4 5 Cashflow ($) 20,000,000 40,000,000 60,000,000 30,000,000 10,000,000

What is the IRR of this project?

IRR- Example contd

To find IRR we would use:

Trial and error A financial calculator, or A spreadsheet

Result is IRR = 18.9%

IRR- Example contd

If required return = 10% accept project (Since IRR > 10%)

If required return = 20%, reject project (Since IRR < 20%) Notice that IRR and NPV provide consistent accept/ reject decision here

IRR- Things to be mindful of

Projects with inflows first Multiple IRRs No real solution

The reinvestment rate assumption

Ranking projects

IRR- Projects with inflows first

The decision rule changes Accept if IRR < Projects required return Reason: Having Inflows first is equivalent to borrowing Lower rate preferred when borrowing

IRR- Multiple IRRs

When cash flows alternate between negative an positive values

Project can have more than one IRR

Incorrect conclusions can be made

Use NPV to make conclusion

IRR- No Real Solution

Sometimes, no interest rate exists that can make the PV of cash flows equal zero. The solution involves imaginary numbers In these cases, calculator/ spreadsheet shows an error message

IRR- The Reinvestment Rate Assumption

Assumption is that interim cash inflows can be invested at the IRR If IRR is high, that assumption may not be met Actual return will be lower than what IRR suggests

Exercise- IRR and Ranking Projects

1.

Given the following, which project should be ranked higher? Why?

Project Name Renovate Totally New NPV at 15% 25,000,000 53,000,000 IRR 42% 18%

2.

Why might Project Renovate have the higher IRR but the lower NPV?

Exercise- Answers
Project Totally New should be ranked higher Why? It has higher NPV NPV shows value to shareholders

Exercise- Answers contd

Project Renovate may have higher IRR but lower NPV due to:
1.

Difference in project scale Difference in timing of cash flows

2.

IRR- The Scale Problem

When projects are of different size take care when using IRR Determine IRR of incremental project to rank them Necessary when dealing with mutually exclusive projects Unnecessary otherwise (Accept both)

IRR- The Timing Problem

When the cash flow timing of two projects is significantly different, take care when using IRR Determine IRR of incremental project to rank them Necessary when dealing with mutually exclusive projects Unnecessary otherwise (Accept both)

IRR- Pros

Results intuitive Uses cash flows Takes account of time value of money

Takes account of risk

Connected to impact on firms value

IRR- The Cons

Possibility of multiple IRRs Possibility of no real solution The reinvestment rate assumption

The scale problem

The timing problem

Profitability Index (PI)

What is it? Profitability = _PV of future cash flows__ Index Initial Investment It shows the value created per dollar invested

PI- Decision Rule

If PI > 1, accept project

PI- An Example
A project requires a $100,000,000 investment and is expected to generate the following cash flows in the years after the investment is made
Year
1 2 3 4 5

Cashflow ($)
20,000,000 40,000,000 60,000,000 30,000,000 10,000,000

What is the profitability index of this project based on a discount rate of 10%?

PI- Example contd

Workings:
Year 1 2 3 4 5 Cashflow ($) 20,000,000 40,000,000 60,000,000 30,000,000 10,000,000 Total PV of Cashflow ($) 18,181,818 33,057,851 45,078,888 20,490,404 6,209,213 123,018,174

PI = 123,018,174_ = 1.23 100,000,000

PI- Example contd

Should this project be accepted?

Answer: Yes, since PI > 1.

PI- The Scale Problem

PI suffers same scale problem as IRR Thus, care required when handling mutually exclusive projects Determine PI of incremental project to make decision

Capital Rationing

Capital rationing is the act of putting a limit on the amount of money that can be spent on new projects.

Reasons for capital rationing include:

Inability or unwillingness to issue more debt or equity Limited qualified personnel to implement all projects Discouraging cash flow assumptions that are overoptimistic

Choosing projects under capital rationing

Objective: Choose combination of projects that gives the highest NPV Profitability Index can be useful in this regard But take care when using PI due to scale problem

Capital Rationing Example

Which of the following independent projects should be embarked upon if the capital constraint this year is $300,000,000?
Project
A B C D E

Investment
70,000,000 80,000,000 100,000,000 150,000,000 200,000,000

NPV
59,200,000 52,000,000 59,600,000 38,400,000 71,000,000

PI
1.8 1.6 1.6 1.3 1.4

Capital Rationing Example contd

Answer: Projects A, B & C

No other combination that adheres to the capital constraint gives a higher combined NPV

So, what have we learnt?

1.

What capital budgeting is

How to calculate and interpret a projects:

2.

Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI)

3.

How to choose projects when capital is rationed