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## Capital Budgeting

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**Capital Budgeting**Decide how to invest money so that its value is maximized**Capital Budgeting Process**• Capital budget (investment) proposals are examined on basis of their cash outlays and resulting flow of future benefits over period of time greater than one year.**Capital Budgeting Process**• Identify alternative investment opportunities and the capital required for each one. 2. Assess organizations ability to generate investment capital for capital budgeting period**Capital Budgeting Process**3. Measure cash (benefit) flows from alternative capital investment opportunities • Evaluate proposals using selected criteria Increase log inventory to reduce risk of mill downtime during Spring breakup?**Capital Budgeting Process**• Select alternatives to fund and implement • Review performance for feed-backto decision makers Buy new skidder to reduce maintenance cost on old one and increase productivity?**Criteria to Rank Alternatives**• Net Present Value • Internal Rate of Return • Benefit /Cost Ratio • Payback Period**Notation**• ARR – alternative rate of return • B - annual nonmarket value, dollars • B/C - benefit/cost ratio • EAA - equivalent annual annuity • IRR - internal rate of return • MAR – minimum acceptable rate of return • N - project life, years • NPV = net present value**Notation**• Cy – cost in year y • PV - present value • r - real interest rate • Ry - revenue in year y • y - index of years**Net Present Value**NPV=∑ = ∑ n Ry Cy (1+r)y (1+r)y y=0 n Ry - Cy (1+r)y y=0**Project D NPV**C0 = - $400/(1.06)0 = - $ 400.00 C5 = - $100/(1.06)5 = - $ 74.73 R15 = $200/(1.06)15 = $ 83.45 R30 = $6,600/(1.06)30 = $1,149.13 NPV = 757.85**Comparison of PVC and PVR for example**PV of revenues IRR PV of costs**Net Present Value Guideline**• Project must at least cover the opportunity cost as measured by the minimum acceptable rate of return (MAR) used to calculate present values • Project is acceptable if NPV is zero or greater • Projects with negative NPV are unacceptable**Internal Rate of Return (IRR)**• The r that makes NPV = 0 • Find by iterating over r until NPV = 0 • Meaning – r that makes PV of costs and PV of revenues equal**IRR Guideline**• Project is acceptable if its IRR is equal to or greater than the minimum acceptable rate of return (MAR) • Relationship to NPV criteria – if MAR is the discount rate (r) used to calculate NPV, then IRR and NPV will accept same projects.**Benefit/Cost Ratio**• PV (benefits)/PV (costs), or • PV (revenues)/PV (expenses) ∑ Ry/(1+r)y = ∑ Cy/(1+r)y n n y=0 n y=0**Benefit/Cost Ratio Guideline**• Accept project if B/C ≥ 1.0 • If B/C ≥ 1.0 then • NPV ≥ 0, and • IRR ≥ MAR**Relationship of NPV, IRR and B/C**IRR B/C > 1 NPV = 0 B/C < 1 NPV < 0 PV of revenues PV of costs**Payback Period**• Time required for net revenue to equal invested capital • Example, • Invest $10,000 • Net revenue is $5,000 per year • Payback is 2 years, ($10,000/$5,000) • Best used in conjunction with other criteria**Ranking Projects**• NPV, IRR, and B/C may not rank alternative projects in the same order • Additional ranking criteria • Mutually exclusive projects – only one can be chosen • Independent • Opposite of mutually exclusive, • Can all be adopted**Ranking Projects**• Additional ranking criteria, cont. • Divisible – can invest in part of a project • Indivisible – all or nothing**Timing of cash flows affects rankings**• Alternatives D and N have same total cost and revenue • Rankings by NPV and IRR are different depending on MAR**NPV**NPV project D NPV same at 6.3% NPV project N IRR=14.5% IRR = 9.7% Interest Rate 2 4 6 10 14