Overview of Capital Budgeting • Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth. • A capital expenditure is an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year. • An operating expenditure is an outlay of funds by the firm resulting in benefits received within 1 year.
What is capital budgeting? • Analysis of potential additions to fixed assets. • Long-term decisions; involve large expenditures. • Very important to firm’s future. Categories of Capital Budgeting: • Replacements needed to continue current operations. For damaged assets. • Replacement for cost reduction due to obsolete assets. • Expansion of existing products or markets. • Expansion into new products and markets.
What is the difference between independent and mutually exclusive projects? • Independent projects – if the cash flows of one are unaffected by the acceptance of the other. • Mutually exclusive projects – if the cash flows of one are adversely impacted by the acceptance of the other.
What is the difference between normal and nonnormal cash flow streams? • Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. • Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project.
Criteria to evaluate Capital Budgeting Projects Five methods are used to evaluate projects: (1) Payback (2) Discounted payback (3) Net Present Value (NPV) (4) Internal Rate of Return (IRR) (5) Modified Internal Rate of Return (MIRR)
What is the payback period? • The number of years required to recover a project’s cost by its net revenue, or “How long does it take to get our money back?” • Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.
2.4 3 0 1 2 Project L 80 CFt-100 10 60 100 Cumulative -100 -90 0 50 -30 30 80 PaybackL = 2 + / = 2.375 years = 1.6 3 0 1 2 Project S CFt-100 70 100 20 50 Cumulative -100 0 20 40 -30 30 50 PaybackS = 1 + / = 1.6 years = Calculating payback (when uneven CF)
2.2 3 0 1 2 Project A 45 CFt-100 45 45 100 Calculating payback (When the cash flows are equal) • Pay Back Period= $100/45 = 2.22 years
Payback Period Decision criteria: The payback method is the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows. Decision criteria: • The length of the maximum acceptable payback period is determined by management. • If the payback period is less than the maximum acceptable payback period, accept the project. • If the payback period is greater than the maximum acceptable payback period, reject the project.
Strengths and weaknesses of payback • Strengths • Provides an indication of a project’s risk and liquidity. • Easy to calculate and understand. • Weaknesses • Ignores the time value of money. • Ignores CFs occurring after the payback period.
2.7 3 0 1 2 10% CFt -100 10 60 80 PV of CFt -100 10/(1+.10)^1=9.09 49.59 60.11 Cumulative -100 -90.91 18.79 -41.32 Disc PaybackL = 2 + / = 2.7 years = 41.32 60.11 Discounted payback period • Uses discounted cash flows rather than raw CFs. • The length of time required for an investment’s cash flows, discounted at the investment’s cost of capital, to cover its cost.
Net Present Value (NPV) Net present value (NPV) is a sophisticated capital budgeting technique; found by subtracting a project’s initial investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital. NPV = Present value of cash inflows – Initial investment
Net Present Value (NPV) (cont.) Decision criteria: • If the NPV is greater than $0, accept the project. • If the NPV is less than $0, reject the project. If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV.
Figure 10.2 Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives
Project Decision based on NPV NPV = PV of inflows – Cost = Net gain in wealth • If projects are independent, accept if the project NPV > 0. • If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. For example, accept Project A, if mutually exclusive (if, NPVA > NPVB) • If no project has a positive NPV, reject them all.
Internal Rate of Return (IRR) • A project’s IRR is the discount rate that forces the PV of cash inflows to equal the cost (initial outlay). • This is equivalent to forcing the NPV to equal zero . • The IRR is an estimate of the project’s rate of return, and it is comparable to the YTM on a bond.
Rationale for the IRR method • If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns.
Project decision based on IRR • Independent projects: If IRR exceeds the project’s WACC (k) accept the project and vice versa. • Mutually exclusive projects: Accept the project with the highest IRR, provided the IRR is greater than WACC. Reject all projects if the best IRR does not exceed WACC.
IRR Acceptance Criteria • If IRR > k, accept project. • If IRR < k, reject project. • If projects are independent, accept both projects, as both IRR > k • If projects are mutually exclusive, accept A, because IRRA > IRRB.
NPV vs IRR • IRR is logically appealing since it is useful to know rates of return on proposed investments. • However when NPV and IRR give conflicting conclusions then it is better to decide based on NPV. • NPV assumes cash flows are reinvested at WACC which is possible in reality. • IRR assumes cash flows are reinvested at IRR which is flawed.