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
success!
(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
cost.

 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
uncertain.
 There are ways to understand the implications of
risk, but no ways to eliminate uncertainty.
Lets consider some ways to
identify a “good” investment
project:
 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
 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 =
\$54,875.
 The present value of these cash flows over
eight years = PV of an annuity =
\$272,600.
 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
project
 Logically, if IRR > the cost of capital to
finance the project, the project should be
accepted.
 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
stockholders.
It should be noted that for any
individual investment
project, the NPV will be > 0
only when IRR > cost of
capital.
 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
Cost)
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
Cost)

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

 PI = (PV of Future Benefits)/(PV of the
Cost)
 PI = \$272,600/\$250,000
 PI = 1.09
 Since PI >1.00, the project should be
accepted.
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
The payback period:
 Payback period = the number of years it
will take to return the original
investment
 Calculation of payback period ignores the
time value of money. (This is a critical
flaw!)
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
decisions.

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