Capital Budgeting Capital Budgeting Long term investment decisions the by mumeora

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									Capital Budgeting

  Long-term investment decisions - the
     key to long run profitability and
  (Part I - Methods of Project Analysis)
While long-term investment
decisions may take less of a
typical finance manager’s time
than working capital decisions,
capital budgeting decisions affect
the business for years to come,
and are critical to strategic
success and survival.
The main idea:

 We want to invest in projects where the
  value of the future returns is greater than the

 If value is greater than cost, the extra value
  enhances stockholders’ wealth.
The greatest difficulty:
 While the initial cost of a project may be known,
  future cash flow benefits from the project are
  usually uncertain.
 Any of several mathematical models can be used
  to compute the advantage in accepting an
  investment when the cash flows are certain, but
  none can guarantee success if the cash flows are
 There are ways to understand the implications of
  risk, but no ways to eliminate uncertainty.
Lets consider some ways to
identify a “good” investment
 Decision method number 1:
 The Net Present Value method (NPV):
 NPV =
     PV of Future Benefits - PV of the Cost
 Logically, if NPV > 0, benefits exceed
     costs, and the project should be
     accepted. If NPV < 0, the project should
     be rejected.
An example:
 Assume a manufacturer could invest
     $250,000 in new machines to speed up
     its production lines.
 The new machines would allow sales to
     increase by $75,000 per year over their
     useful life of 8 years.
 The annual cash operating cost of the new
     machines is $10,000. The annual
     depreciation expense would be $31,250
     (using straight-line depreciation
     method). The corporate tax rate is 30%.
In the rest of this slide
     presentation, don’t worry too
     much about …
 The exact way to estimate the annual cash
     flows resulting from the project.
 How to mathematically calculate the IRR.

 These things are explained in the next
     presentation (capbud2), and in the text.
Assume that the cost of capital to
finance the investment is 12%.
What is the project’s NPV?
 Annual cash flow benefits = ($75,000 -
     $10,000 - $31,250)x(1 - .3) + $31,250 =
 The present value of these cash flows over
     eight years = PV of an annuity =
 NPV = $272,600 - $250,000 = $22,600.
If the projected cash flows are
accurate, then the acceptance of
this project should increase
stockholders’ wealth by $22,600.
The NPV represents the benefit
to stockholders from accepting
the project. In this case, the
positive NPV indicates an
attractive investment.
Method number 2 for making
capital budgeting decisions:
 The IRR method
 IRR = the rate of return earned on the
 Logically, if IRR > the cost of capital to
      finance the project, the project should be
 If IRR < cost of capital, the project should
      be rejected
Returning to the example project:
 Notice that if the NPV of the project had
  been 0 when the cost of capital was 12%,
  we would have known that the project
  earned a rate of return of 12%. [Since the
  ROR = cost of capital, the project is neither
  attractive nor unattractive to accept.]
 This understanding shows that the IRR can
  be calculated by finding the interest rate that
  would make the NPV of the project = 0.
For the example project, the NPV
is 0 when the interest rate is
14.5%. Thus, the project has an
IRR = 14.5%.
 If, as before, the cost of capital is 12%, the
       project is attractive because it has an IRR >
       cost of capital.
 Note that stockholders’ wealth is increased
       by the project. It earns a rate of return
       (IRR) greater than the cost of financing
       it. The excess return flows to the
It should be noted that for any
     individual investment
     project, the NPV will be > 0
     only when IRR > cost of
 Thus, for any individual project, NPV and
     IRR methods will give the same
     accept/reject decision.
One other method can be used to
get the same decision:

 Method number 3:
 The Profitability index (PI)

 PI = (PV of Future Benefits)/(PV of the
Comparing the PI formula to the
NPV formula, we note that PI > 1
when NPV > 0.
 NPV =
     PV of Future Benefits - PV of the Cost
 PI = (PV of Future Benefits)/(PV of the

 Logically, we should accept projects when
     PI >1 and reject projects when PI < 1.
Calculating PI for the example

 PI = (PV of Future Benefits)/(PV of the
 PI = $272,600/$250,000
 PI = 1.09
 Since PI >1.00, the project should be
One other evaluation technique
before we leave this topic:

 The payback period
 Payback period is recognized today to be an
     inappropriate way to make capital
     budgeting decisions. However, it is still
     a number that is useful to some decision
     makers in combination with one of the
     three other methods already explained.
The payback period:
 Payback period = the number of years it
     will take to return the original
 Calculation of payback period ignores the
     time value of money. (This is a critical
For the example project:
 Annual cash flow benefits were already
    calculated to be $54,875.

 It will take 250,000/54,875 years to return
      the original investment cost.

 Thus, the payback period = 4.56 years.
Besides ignoring the timing of
the cash flows, the payback
period has two other flaws:
 The payback period does not indicate whether the
  project should be accepted or rejected. For
  example, we don’t know whether 4.56 years is a
  good payback period, or not.
 Cash flows that occur after the end of the payback
  time are ignored in the calculation of payback
  period. Yet, these latter cash flows may be
  significant in making the decision.
In summary:

 Either the NPV, IRR, or PI methods can be
     used to make good decisions about
     capital budgeting investments.
 Uncertainty about the future cash flow
     estimates is problematic.
 Payback period is often calculated for
     investment projects, but it should not be
     used by itself to make accept/reject

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