Capital Budgeting Processes And Techniques

Professor XXXXX Course Name / Number

The Capital Budgeting Decision Process

The Capital Budgeting Process involves three basic steps:
Generating long-term investment proposals Reviewing, analyzing, and selecting from the proposals that have been generated Implementing and monitoring the proposals that have been selected

Managers should separate investment and financing decisions

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Capital Budgeting Decision Techniques

Payback period: most commonly used Accounting rate of return (ARR): focuses on projects impact on accounting profits Net present value (NPV): best technique theoretically Internal rate of return (IRR): widely used with strong intuitive appeal Profitability index (PI): related to NPV

A Capital Budgeting Process Should:

Account for the time value of money

Account for risk

Focus on cash flow Rank competing projects appropriately Lead to investment decisions that maximize shareholders wealth

Entropica Investment
Entropica is a provider of magnetic resonance imaging devices Entropica evaluating two investment proposals
Construction of completely new manufacturing plant Refurbishing an existing plant
Construction ($ millions) Initial outlay Year 1 inflow Year 2 inflow -$1,200 $100 $250 Refurbishing ($ millions) Initial outlay Year 1 inflow Year 2 inflow -$75 $22 $30

Year 3 inflow
Year 4 inflow
5

$400
$740 $850

Year 3 inflow
Year 4 inflow Year 5 inflow

$41
$47 $48

Year 5 inflow

Payback Period
The payback period is the amount of time required for the firm to recover its initial investment

If the projects payback period is less than the maximum acceptable payback period, accept the project
If the projects payback period is greater than the maximum acceptable payback period, reject the project

Management determines maximum acceptable payback period

Calculating Payback Periods For Entropica Projects

Management selects a 3-year payback period Construction project has initial outflow of -$1,200 million
But cash inflows over first 3 years only $750 million Entropica would reject construction project based on payback

Refurbishing project has initial outflow of -$75 million

Cash inflows over first 3 years cumulate to $93 million Project recovers initial outflow middle of year 3 Entropica would accept the project
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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 account properly for time value of money
Does not account properly for risk Cutoff period is arbitrary
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Does not lead to value-maximizing decisions

Discounted Payback Period

Discounted payback accounts for time value
Apply discount rate to cash flows during payback period Still ignores cash flows after payback period

Entropica uses a 16% discount rate

Item PV Year 1 inflow PV Year 2 inflow PV Year 3 inflow Cumulative PV
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PV Factors (16%) 0.8621 0.7432 0.6407 --

Construction project ($million) $86.21 $185.79 $256.26 $528.26

Refurbishing project ($million) $18.97 $22.29 $26.27 $67.53

Accept / reject

--

Reject

Reject

Accounting Rate Of Return (ARR)

Can be computed from available accounting data
Need only profits after taxes and depreciation Accounting ROR = Average profits after taxes Average investment

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

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

Net Present Value

The present value of a projects cash inflows and outflows Discounting cash flows accounts for the time value of money

Choosing the appropriate discount rate accounts for risk

CF3 CFN CF1 CF2 NPV CF0 ... 2 3 (1 r ) (1 r ) (1 r ) (1 r ) N
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Accept projects if NPV > 0

Net Present Value

CF3 CFN CF1 CF2 NPV CF0 ... 2 3 (1 r ) (1 r ) (1 r ) (1 r ) N

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 firm and/or the risk of the project
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Calculating NPVs For Entropicas Projects

Assuming Entropica uses 16% discount rate, NPVs are:
Construction project: NPV = $141.65 million
NPVConstruction 141 .65 1,2 00 100 250 400 740 850 (1.16 ) (1.16 ) 2 (1.16 ) 3 (1.16 ) 4 (1.16 ) 5

Refurbishing project: NPV = $41.43 million

NPV Re furbishing 41 .34 75 22 30 41 47 48 (1.16 ) (1.16 ) 2 (1.16 ) 3 (1.16 ) 4 (1.16 ) 5

Should Entropica invest in one project or both?

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Independent versus Mutually Exclusive Projects

Independent projects accepting/rejecting one project has no impact on the accept/reject decision for the other project Mutually exclusive projects accepting one project implies rejecting another Both Entropica projects deal with production capacity
If demand is high enough, projects may be independent If demand warrants only one investment, projects are mutually exclusive

When ranking mutually exclusive projects, choose the project with highest NPV
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Pros and Cons Of Using NPV As Decision Rule

NPV is the gold standard of investment decision rules 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 projects

Though best measure, NPV has some drawbacks

Lacks the intuitive appeal of payback Doesnt capture managerial flexibility (option value) well
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Internal Rate of Return

Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project
CF3 CFN CF1 CF2 NPV 0 CF0 .... 2 3 (1 r ) (1 r ) (1 r ) (1 r ) N
IRR found by computer/calculator or manually by trial and error
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
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Calculating IRRs For Entropicas Projects

Entropica will accept all projects with at least 16% IRR:
Construction project: IRR (rC) = 19.63%
0 1,200 100 250 400 740 850 (1 rC ) (1 rC ) 2 (1 rC ) 3 (1 rC ) 4 (1 rC ) 5

Refurbishing project: IRR (rR) = 34.54%

0 75 22 30 41 47 48 (1 rR ) (1 rR ) 2 (1 rR ) 3 (1 rR ) 4 (1 rR ) 5

Which project looks better if Entropica can invest only in one?

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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
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Disadvantages of IRR
Three key problems encountered in using IRR:
Lending versus borrowing?
Multiple IRRs No real solutions IRR and NPV rankings do not always agree
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Lending Versus Borrowing

IRR can give incorrect answers for projects with non-standard cashflows
Project 1: Invest $120 today, receive $170 in one year Project 2: Receive $120 today, pay back $170 in one year Project 1 amounts to lending; project 2 to borrowing
Project #1 #2 CF today -$120 +$120 CF in one yr +$170 -$170 IRR 41.67% 41.67% NPV (20%) +$21.67 -$21.67

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Both projects have same IRR, but #1 obviously superior When borrowing, a low IRR is preferred on the loan.

Multiple IRRs
NPV ($)

IRR NPV>0 NPV<0 NPV<0

NPV>0

Discount rate

IRR

When project cash flows have multiple sign changes, there can be multiple IRRs With multiple IRRs, which do we compare with the cost of capital to accept/reject the project?

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No Real Solution
Sometimes projects do not have a real IRR solution Modify Entropicas construction project to include a large negative outflow (-$1,300 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 =16%, project has NPV= -$391.92 million, so reject!
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Conflicts Between NPV and IRR

NPV and IRR do not always agree when ranking competing projects The scale problem
Project Construction IRR 19.63% NPV (16%) $141.65 mn

Refurbishing

36.53%

$41.34 mn

Refurbishing project has higher IRR, but doesnt increase shareholders wealth as much as construction project
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The Timing Problem

NPV Long-term project Short-term project IRR = 15%

IRR = 17%

13% 15%

17%

Discount rate

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

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Reconciling NPV and IRR

Timing and scale problems can cause NPV and IRR methods to rank projects differently In these cases, calculate the IRR of the

incremental project

Cash flows of large project minus cash flows of small project Cash flows of long-term project minus cash flows of short-term project

If incremental projects IRR exceeds the cost of capital

Accept the larger project Accept the longer term project
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Profitability Index
Calculated by dividing the PV of a projects cash inflows by the PV of its outflows
CF1 CF2 CFT ... (1 r ) (1 r ) 2 (1 r ) T PI CF0
PV of CF (yrs1-5) $1341.65 mn $116.34 mn

Decision rule: Accept projects with PI > 1.0, equal to NPV > 0
Project Construction Refurbishing Initial Outlay $1.2 bn $75 mn PI 1.12 1.55

Both projects PI > 1.0, so both acceptable if independent

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Like IRR, PI suffers from the scale problem

Capital Budgeting
Generating, reviewing, analyzing, selecting, and implementing long-term investment proposals

Payback Period Discounted payback period Accounting rate of return Net Present Value (NPV) Internal rate of return (IRR) Profitability index (PI)