Capital Budgeting

It is defined as the process of determining whether or not projects such as building a new plant or investing in a long-term venture are worthwhile. It is also known as Investment Appraisal.
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Importance of Capital Budgeting

Business invest hundreds of billions of dollars in fixed assets each year

Such Investments affect fortunes for many years a firms

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Implications of Capital Budgeting

A Good Capital Budgeting Decision

Boost earning sharply Increase considerably the firms stock price

A Bad Capital Budgeting Decision

Lead to Bankruptcy
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Lockheeds Decision: Production of L-1011 Tri-Star Commercial Aircraft

The firm decided to commit $ 1 billion & commence production based on the analysis:
Estimated Break Even Volume = 200 planes Orders in hand = 180 planes

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Lockheeds Mistakes: Production of L-1011 Tri-Star Commercial Aircraft

Its analysis was flawed

The cost of capital - not estimated properly The Actual Breakeven Point = 500 planes

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Result of Lockheeds Decision: Production of L-1011 Tri-Star Commercial Aircraft

COMPANYS STOCK PRICE DECLINED FROM $ 73 PER SHARE TO $ 3

$80 $60 $40 $20 $0 Lockheed's Stock Price

Before L-1011 Production After L-1011 Production

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LESSON LEARNED FROM LOCKHEEDS TRI-STAR PRODUCTION DECISION

Had Lockheeds managers read Capital Budgeting and heeded its advice
At least some of that loss might have been avoided

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CAPITAL BUDGETING PROCESS

Identification of Potential Investment Opportunities Investment/Project Classifications Decision Making Preparation of Capital Budget and Appropriations Implementation Performance Review
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Identification of Potential Investment Opportunities

Capital Budgeting projects are created by the firms as follows:

A Sales Representative reports regarding Customers Demand for a particular product not produce now by the company R & D Department Executive Committee & Operating Executive

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Investment/Project Classifications

Investment proposals are usually classified into various categories:

Replacement Investments

Expansion Investments - Existing Products or Markets New Product/ New Market Investment Obligatory & Welfare Investments Research & Development Long-Term Contract Other
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Maintenance of Business Cost Reduction

Decision Making

A system of rupee gateways usually characterizes capital investment decision making Under this system executives are vested with the power to approve investment proposals up to certain limits
The Plant Superintendent - up to Rs. 200,000 The Work Manager - up to Rs. 500,000 The CEO - up to Rs. 2,000,000 Investment requiring higher outlays need approval of the board of directors
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Preparation of Capital Budget & Appropriations

Smaller Outlays Projects

Decided by Executives at lower levels They are covered by a blanket appropriation for expeditious action

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Preparation of Capital Budget & Appropriations

Larger Outlays Projects

These projects are usually included in the Capital Budget after necessary approvals Before undertaking such projects an appropriation order is usually required

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This ensure that the firms fund position is satisfactory at the time of implementation It further provides an opportunity to review the project at the time of implementation 13

Implementation

Translating an investment proposal into a concrete project is a complex, time-consuming, & risk-filled task For Expeditious implementation at a reasonable cost, the following are helpful
Adequate Formulation of Project Use of the Principle of Responsibility Accounting Use of Network Techniques

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Performance Review

It is a feedback device

Conducted most appropriately, when the operations of the project have stabilized It is useful in several ways
It throws light on how realistic were the assumptions underlying the project It provides a documented log of experience that is highly valuable for decision-making It helps in uncovering judgmental biases It induces a desired caution among project sponsors

Compares Actual Performance with Projected Performance

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Capital Budgeting Techniques

Popular methods of capital budgeting are

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

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Illustrations

Assumptions
Projects are equally risky CFt have been adjusted to reflect taxes, depreciation & salvage value CF0 include any necessary changes in net operating working capital All CFt occur at the end of the designated year

Expected After-Tax Net Cash Flows, CFt Year (t) 0 1 2 3 4 Project S 500 400 300 100 Project L 100 300 400 600
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($1,000) ($1,000)

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Payback Period

It is defined as the expected no. of years required to recover the original investment

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Payback Period (Contd)

Formula for Calculation of Payback Period

Payback = Yr before full recovery + (Unrecovered cost at start of year)/(Cash flow during year) Paybacks = 2 + ($100/$300) = 2.33 years PaybackL= 3 + ($200/$600) = 3.33 years The shorter the payback period, the better the project

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Discounted Payback Period

It is similar to regular payback period except that the expected cash flows are discounted by the projects cost of capital It is defined as the no. of years required to recover the investment from discounted net cash flows Same formula of PP is used to calculate DPP Except with discounted CF Same Evaluation Criteria as PP
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Discounted Payback Period

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Net Present Value (NPV)

It is a discounted cash flow capital budgeting technique NPV = S PV (Future NCF) Initial Investment Method for Calculating
Find PV of each Cash Flows Sum these discounted Cash Flows

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Net Present Value (NPV)

If NPV = +ve, then accept the project If NPV = -ve, then reject the project If two mutually exclusive projects have +ve NPV, then one with the higher NPV should be chosen If projects are independent, accept if the project NPV > 0.
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Net Present Value (NPV)

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Rationale of NPV

If the NPV = 0, then it signifies that the projects CFs are exactly sufficient
to repay the invested capital & to provide the required rate of return on that capital

If a project has +ve NPV, then it is generating more cash than needed
to service the debt & provide the required rate of return to stockholders, & this excess cash accrues solely to the firms stockholders

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Internal Rate of Return (IRR)

It is defined as that discount rate which equates PV (Inflows) to PV (Investment Costs) i.e. NPV = 0 Without a financial calculator, it can be calculate by Trial-and-Error Method or through interpolation It can also be calculated by Excel or Financial Calculator
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Internal Rate of Return (IRR)

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Internal Rate of Return (IRR)

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Rationale of IRR

The IRR on the project is its expected rate of return If IRR > the cost of the funds used to finance the project, a surplus will remain after paying for the capital, & this surplus will accrue to the firms stockholders Therefore, taking a project whose IRR > its cost of capital increases shareholders wealth It is this breakeven characteristic that makes IRR useful in evaluating capital projects
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Summary

In the case of Lockheed, the cost of capital was not estimated properly which lead to distortion of BEVOLUME

This mistake contribute to the reducing the stockholders wealth Thus reducing the stock price from $ 73 per share to $ 3

Hence, understanding and proper application of Capital Budgeting is Essential for the Success of a Firm
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