CHAPTER 2

The Basics of Capital Budgeting

Finance1 Tunis Business School

CHAPTER 2
The Basics of Capital Budgeting
Should we build this plant?

Study Objectives
1. 2. Define Capital budgeting. Explain the stages of the investment process.

3.
4. 5. 6.

Classify the investments.

Compute Cash-flows. Introduce some criteria of capital budgeting. Discuss the strengths and the weaknesses of some capital budgeting criteria.

What is capital budgeting?

Capital bugeting is the process of analyzing projects and deciding which ones to include in the capital budget. Long-term decisions; involve large expenditures. Very important to firms future.

Definition of investment
An investment represents for a company a commitment of capital, under various forms, in the hope to maintain or to improve its economic situation.

Stages of the investment process

The identification of the different possibilities. The evaluation of the relevant projects. The choice of the most relevant project(s). The choice of the mode of financing. The post-audit stage.

Classification of investments
By their nature. By their rhythm of cash inflows and cash outflows. By their degree of homogeneity. By their objectives.

Classification of investments
According to their nature Merchandising and industrial investments: characterized by the acquisition of physical assets. Financial investments: acquiring of securities. Intangible investments: intangible assets (Patents, goodwill, franchises, ) as well as R&D expenses and training expenses.

Classification of investments
According to their rhythm of Cash inflows and cash outflows

Classification of investments
According to their degree of homogeneity

Mutually exclusive investments. Complementary investments. Sequential (contingent) investments.

What is the difference between independent and mutually exclusive projects?

Independent projects if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other.

Classification of investments
According to their objective

Extension investments. Replacement and modernization investments. Strategic investments. Social investments.

Steps to capital budgeting (In the case of a certain environment)

1.

Estimate CFs (inflows & outflows). Compute the appropriate criteria of investment choice. Decide whether to retain or not the project.

2.

3.

Assessment of CF
In order to well assess the financial aspects of a project, the analysis must be based on cashflows by comparing the invested flows (outflows) to the received flows (inflows). Hence, the accounting approach, since it is based on revenues and expenses, will not be retained.

Assessment of CF
CF = Net Income + Depreciation Expenses

Assessment of CF
While computing CF, we must distinguish between the expenses due to investments (the cost of acquiring an equipment, for example) and the operating expenses (the costs incurred for the maintenance of an equipment, for example). CFs will be compared to the costs of the investment.

Assessment of CF
Application: A firm intends to acquire a new machine costing 100.000 D and having a useful life of 5 years. The revenues foreseen for the first year are 25.000 D and we expect an annual increase of 3.000 D in revenues. The operating expenses foreseen for the 1st year are 3.000 D (excluding depreciation) with an expected annual increase of 1.500 D for the following years. The tax rate is 35%. Compute The expected CF for the 5 years.

Assessment of CF Special cases

1.

Disposal of equipment. Working Capital Requirement.

2.

Assessment of CF Disposal of equipment

In general, at the end of the economic life of an investment, we proceed to the disposal of several assets. In this case, we speak about residual value.

These operations are translated into gains or losses on disposal. Tax considerations must be taken into account.

Assessment of CF Disposal of equipment

Application: A firm intends to replace a machine purchased since 3 years at 140.000 D having a useful life of 7 years by a new machine costing 100.000 D depreciable on 4 years. The old machine will be sold at 90.000 D. The tax rate is 35%. During the first year, this replacement will generate an additional revenue of 8.000 D and additional operating expenses of 2.000 D (excluding depreciation expenses). Find the CF for the 1st year. (Assume that the tax on the gain on disposal is due at the end of the year). Repeat the same application when the machine will be sold at 75.000 D instead of 90.000 D.

Assessment of CF Working Capital Requirement

WCR = Inventories + customers - Suppliers WCR = Inventories + Accounts receivable Accounts payable

Assessment of CF Working Capital Requirement

Application: An investment in a production machine, costing 100.000D and depreciable on 4 years, is made in order to increase the production capacity of a firm. We expect a rise in the sales volume of 6.000 items during the first year and an annual increase of 5% in the subsequent years. The unit sale price is 36D, while the unit variable cost is 16D. The total of fixed costs (excluding depreciation) is 20.000D. The WCR represents 30 days of the turnover. The tax rate is 40%. The net proceeds (after tax) from the sale of the machine at the end of the 4th year is 2.000D. Find the total of the investment flows as well as the total of CFs.

Criteria of investment choice

1.
1.
2.

Timeless criteria
Accounting rate of Return Payback period

2.
1.
2.

Criteria based on discounting

Net Present Value (NPV) Internal Rate of Return (IRR)

Accounting Rate of Return

1 n Incomei Average. Annual.Income n ARR i 1 I 0 RV Average.Investment 2

If RV (Residual Value)=0
1 n Incomei n ARR i 1 I0 2

Accounting Rate of Return

Application: An investment costing 100.000 D and having a useful life of 5 years generates the following cash flows: 23.000D; 27.000D; 21.000D; 28.000D and 25.000D. Compute the Rate of AR when the RV=0

Strengths and weaknesses of the Accounting Rate of Return

Strengths
Easy to calculate and understand.

Weaknesses
Ignores the time value of money. Relies on Net Incomes rather than CFs.

What is the payback period?

The number of years required to recover a projects cost, or How long does it take to get our money back? Calculated by adding projects cash inflows to its cost until the cumulative cash flow for the project turns positive.

Payback period

Calculating payback
Project Ls Payback Calculation
0 1 2

3
80 50

CFt Cumulative
PaybackL

-100 -100

10 -90

60 -30

= = 2

30 / 80

= 2.375 years

PaybackL = 2.375 years PaybackS = 1.600 years

Strengths and weaknesses of payback

Strengths
Provides an indication of a projects risk and liquidity. Easy to calculate and understand.

Weaknesses
Ignores the time value of money. Ignores CFs occurring after the payback period.

Discounted payback period

Uses discounted cash flows rather than raw CFs.
0 CFt PV of CFt Cumulative -100 -100 -100 2 +
10%

1 10 9.09 -90.91

2 60 49.59 -41.32

3 80 60.11 18.79 = 2.7 years

Disc PaybackL = =

41.32 / 60.11

The Net Present Value (NPV) Criterion

Sum of the PVs of all cash inflows and outflows of a project:

NPV
t 0

CFt t (1 r )

The Net Present Value (NPV) Criterion

What is Project Ls NPV?

Year 0 1 2 3 CFt -100 10 60 80 NPVL = PV of CFt -$100 9.09 49.59 60.11 $18.79

NPVS = $19.98

Rationale for the NPV method

= PV of inflows Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. In this example, accept S if mutually exclusive (NPVs > NPVL), and accept both if independent. NPV

Strengths and weaknesses of NPV

Strengths All the CFs are taken into account. The timing of CFs is considered. The cost of the various sources of financing is considered (Through the discounting rate). Weaknesses Does not allow to compare projects with different economic lives and different sizes. Is very sensitive to the choice of the discounting rate.

Choice of the discounting rate

several possibilities:
The WACC. The Risk-Free Interest Rate. The average rate of return. A target rate of return.

Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

0
t 0

CFt ( 1 IRR ) t

IRRL = 18.13% and IRRS = 23.56%.

Rationale for the IRR method

If IRR > WACC, the projects return exceeds its costs and there is some return left over to boost stockholders returns.
If IRR > WACC, accept project. If IRR < WACC, reject project.

If projects are independent, accept both projects, as both IRR > WACC = 10%. If projects are mutually exclusive, accept S, because IRRs > IRRL.

NPV Profiles
A graphical representation of project NPVs at various different costs of capital. WACC 0 5 10 15 20 NPVL $50 33 19 7 (4) NPVS $40 29 20 12 5

Drawing NPV profiles

NPV 60 ($)
50

. 40 .
30 20

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

10
0 5 -10

. .
15

20

. .

.
23.6

IRRS = 23.6% Discount Rate (%)

Comparing the NPV and IRR methods

If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive
If WACC > crossover rate, the methods lead to the same decision and there is no conflict. If WACC < crossover rate, the methods lead to different accept/reject decisions.

Reasons why NPV profiles cross

Size (scale) differences the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high WACC favors small projects. Timing differences the project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF especially good, NPVS > NPVL.

Strengths and weaknesses of IRR

Strengths It takes into account only the data specific to the investment. The target rate of return is not used (through the discounting rate). Weaknesses It assumes that the CFs are reinvested at the IRR, which might be sometimes very high. Sometimes it is not computable. Conversely, in some other cases we find multiple IRRs.

Reinvestment rate assumptions

NPV method assumes CFs are reinvested at the WACC. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects.

What is the difference between normal and nonnormal cash flow streams?
Normal cash flow stream Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal cash flow stream Two or more changes of signs. Most common: Cost (negative CF), then sequence of positive CFs, then cost to close project. EXP.: Nuclear power plant.

Project P has cash flows (in 000s): CF0 = -$0.8 million, CF1 = $5 million, and CF2 = -$5 million. Find Project Ps NPV and IRR.
0 -800
WACC = 10%

1 5,000

2 -5,000

Enter CFs into calculator CFLO register. Enter I/YR = 10. NPV = -$386.78. IRR = ERROR Why?

Multiple IRRs
NPV
IRR2 = 400% 450 0 100 IRR1 = 25% 400 WACC

-800

Why are there multiple IRRs?

At very low discount rates, the PV of CF2 is large & negative, so NPV < 0. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0. In between, the discount rate hits CF2 harder than CF1, so NPV > 0. Result: 2 IRRs.

Problem
An investment in a production machine, costing 100.000D and depreciable on 4 years, is made in order to increase the production capacity of a firm. We expect a rise in the sales volume of 1.000 items during the first year and an annual increase of 10% in the subsequent years. The unit sale price is 60D, while the unit variable cost is 15D. The total of fixed costs (excluding depreciation) is 5.000D. The WCR represents 10% of the turnover. The tax rate is 40%. The sale price of the machine at the end of the 4th year is 3.000D. 1- Find the total of the investment flows as well as the total of CFs. 2- Find the ARR and the Payback period of this project. 3- Compute the NPV and the IRR of this project.