Capital Budgeting Analysis Financial Management B 642
Outline • Meaning of Capital Budgeting • Types of Capital Budgeting Decisions • Significance of Capital Budgeting Analysis • Traditional Capital Budgeting Techniques • Payback Period Approach • Discounted Payback Period Approach • Discounted Cash Flow Techniques • Net Present Value • Internal Rate of Return • Profitability Index
Meaning of Capital Budgeting • Capital budgeting addresses the issue of strategic long-term investment decisions. • Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. • Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.
Types of Capital Budgeting Decisions • Should we add a new product to our existing product line? • Should we expand into a new market? • Should we replace our existing machinery? • Should we buy fully automatic or semiautomatic machinery • Where to locate manufacturing facility? • Should we outsource components and parts?
Why Capital Budgeting is so Important? • Involve massive investment of resources • Are not easily reversible • Have long-term implications for the firm • Involve uncertainty and risk for the firm
Due to the above factors, capital budgeting decisions become critical and must be evaluated very carefully. • Any firm that does not follow the capital budgeting process will not be maximizing shareholder wealth and management will not be acting in the best interests of shareholders. • RJR Nabisco’s smokeless cigarette project example • Similarly, Euro-Disney, Concorde Plane, Saturn of GM all faced problems due to bad capital budgeting, while Intel became global leader due to sound capital budgeting decisions in 1990s.
Techniques of Capital Budgeting Analysis • Payback Period Approach • Discounted Payback Period Approach • Net Present Value Approach • Internal Rate of Return • Profitability Index
Which Technique should we follow? • A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization. • A technique is considered consistent with wealth maximization if • It is based on cash flows • Considers all the cash flows • Considers time value of money • Is unbiased in selecting projects
Payback Period Approach • The amount of time needed to recover the initial investment • The number of years it takes including a fraction of the year to recover initial investment is called payback period • To compute payback period, keep adding the cash flows till the sum equals initial investment • Simplicity is the main benefit, but suffers from drawbacks • Technique is not consistent with wealth maximization—Why?
Discounted Payback Period • Similar to payback period approach with one difference that it considers time value of money • The amount of time needed to recover initial investment given the present value of cash inflows • Keep adding the discounted cash flows till the sum equals initial investment • All other drawbacks of the payback period remains in this approach • Not consistent with wealth maximization
Net Present Value Approach • Based on the dollar amount of cash flows • The dollar amount of value added by a project • NPV equals the present value of cash inflows minus initial investment • Technique is consistent with the principle of wealth maximization—Why? • Accept a project if NPV > 0
Internal Rate of Return • The rate at which the net present value of cash flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment • Consistent with wealth maximization • Accept a project if IRR > Cost of Capital
Profitability Index (PI) • A part of discounted cash flow family • PI = PV of Cash Inflows/initial investment • Accept a project if PI > 1.0, which means positive NPV • Usually, PI consistent with NPV • PI may be in conflict with NPV if • Projects are mutually exclusive • Scale of projects differ • Pattern of cash flows of projects is different • When in conflict with NPV, use NPV