Capital Budgeting Techniques by Binam Ghimire
Objectives • Understand and apply various investment appraisal techniques (PBP, Discounted PBP, ARR, NPV, PI and IRR), Comparing NPV and IRR, IRR pitfalls, MIRR and Capital Rationing
Capital Budgeting: Meaning • Answer to the questions: Should an investment be made? Whether or not an investment is worth undertaking? If there are alternatives which investment option provides better cash flows and rate of return? • Tool to analyse and appraise investments. Sometimes known as investment appraisal • The process of analysing, comparing and selecting the right investment project
Capital Budgeting: Significance • Purpose: Expansion, Improvement, Replacement and Research and Development. These involve large capital investments • Making the right decision • Firms future • Sensitive to shareholders wealth
Capital Budgeting:Steps • Estimation of Cash Inflows and Outflows • Collection of relevant information • Selection of appropriate capital budgeting tool(s) • Calculation and analysis of benefit (loss) • Appraisal and Decision Making
Types of Project and decision making: Independent Projects • Independent projects: Cash Flows of one project is not affected by the Cash Flows of another. • Example, installation of brick factory and installation of sugar mill are independent projects. • Cash flows of former project do not affect the cash flows of latter one. • If budget permits, both projects can be launched provided they meet the set evaluation criteria. • Decision regarding such projects can be taken independently.
Types of Project and decision making: Dependent Projects • Dependent projects: Cash Flows of one project is affected by the Cash Flows of another. • Example: Construction of dam and canal in irrigation project.
Types of Project and decision making: Mutually Exclusive Projects • Mutually Exclusive projects: Cash Flows of one project is affected by the Cash Flows of another and selection of one rejects the other • Simple Example: Buying a car for your family (Deciding for a Toyota means not buying Honda or Ford) • Other Examples: Labour intensive production process versus capital intensive production process, frock lift versus conveyor belt, deep well versus canal irrigation
Types of Project and decision making: Replacement Projects • Replacement projects: due to the wear and tear, and advent of new technology, existing machine need to be replaced with new one. • Thus, the projects falling in this class are classified into two—maintenance of business and cost reduction. • Should the existing operation be continued? • Replace with new one due to the obsolescence. • Lower the input costs such as labor, materials, and electricity.
Types of Project and decision making: Expansion Projects • Expansion projects: Available capacity not sufficient to meet the demand. • Add production capacity. • Expand business: in different geographical regions e.g. opening new retail outlets.
Types of Project and decision making: Diversification Projects • Diversification projects. Entering either into the new products or new markets • Acquisition of new equipment and plant and latter one requires substantial amount of money.
Techniques:1. Payback Period • PBP is the number of years required to cover the cost of the project • It is calculated by adding project’s cash inflows to its cost until the cumulative Cash Flows for the project turns positive
Payback Period:Formula • When Cash Inflows are even every year • When Cash Inflows are uneven, we cumulate the Cash Inflows for all such duration that it is equal to the investment amount. The total duration that equates Cash Inflows with Investment (Cash Outflow) is the PBP • PBP is generally measured in years although we may convert it into months or weeks or even days
2.33 3 0 1 2 Project A 90 CFt-100 20 50 100 Cumulative -100 -80 0 60 -30 30 90 PaybackA= 2 + / = 2.33 years = 1.6 3 0 1 2 Project B CFt-100 70 100 20 50 Cumulative -100 0 20 40 -30 30 50 PaybackB= 1 + / = 1.6 years = Payback Period:Example
Payback Period:Decision Making • Independent Project: Compare with the target of the company (maximum acceptable period) or industry average • Mutually Exclusive Projects: Select the one with shortest PBP • Question: In the example for project A and B which project will you accept 1) they are independent 2) they are mutually exclusive
Payback Period:Advantages and Disadvantages • Advantages • Simple: Easy to calculate and understand • Provides an indication of a project’s risk and liquidity • Useful for short-term decision making • Disadvantages • Ignores the time value of money (TVM) • Ignores CFs occurring after the payback period. This also implies that the method overlooks the risk of CFs after the PBP
2.6 3 0 1 2 10% CFt -100 20 50 90 PV of CFt -100 18.18 41.32 67.62 Cumulative -100 -81.82 27.12 -40.50 Disc PaybackA= 2 + / = 2.6 years = 40.50 67.62 Capital Budgeting Techniques:2. Discounted Payback Period • Bring CF to PV and Find the Payback. Considers the TVM. For Project A: Project A
Capital Budgeting Techniques:Payback Period • Choose the correct for PBP: • A) Does not account properly for time value of money • B) Does not account properly for risk • C) Cutoff period is arbitrary • D) Does not lead to value-maximizing decisions • E) A, B and C • F) All of the above
Capital Budgeting Techniques:3. Accounting Rate of Return • ARR is: • the average annual profit/ initial cost of investment • Sometimes instead of initial cost of investment, average cost of investment is also used. To find the average cost, we need to sum the initial cost + the residual value and divide by 2
Accounting Rate of Return:Formula • ARR (%) = • When Cash Flows are given, profit is the difference between the total of Cash Inflows and Cash Outflows. If depreciation is available it should be deducted from Cash Inflows to find the profit
3 3 0 0 1 1 2 2 Project B Project A 20 90 CFt-100 70 50 CFt-100 20 50 • ARRA = 20/100 x 100 = 20% • ARRB = 13.33/100 x 100 = 13.33% Accounting Rate of Return:Example
Accounting Rate of Return:Decision Making • Independent Project: Compare with the target/ expected rate of return of the company. Compare with industry average • Mutually Exclusive Projects: Select the one with highest ARR • Question: In the example for project A and B which project will you accept 1) they are independent 2) they are mutually exclusive
Accounting Rate of Return: Advantages and Disadvantages • Advantages • Easy to calculate and understand • Easy to compare with target and or other investment projects • Disadvantages • Is based on profit and not Cash Inflows. So affected by noncash items such as depreciation • Ignores timing of profit
Capital Budgeting Techniques:4. Net Present Value (NPV) • NPV is the sum of PV of Cash Inflows and PV of Cash Outflows of a company. • If the investment is made today NPV is the difference between the PV of all Cash Inflow streams of the future less the investment amount
Net Present Value :Formula • The investment or cash outflow is often CFo. Hence the formula may be written as
Net Present Value :Example Project A YearCFtPV of CFt 0 -100 -£100 1 20 18.18 2 50 41.32 3 90 67.62 NPVA = £27.12 • NPVB = ?
Net Present Value :In Microsoft Excel • In Microsoft Excel, NPV function wizard can be used to calculate NPV. • NPV(Rate, Value1) + Investment Amount. Here the Rate is Discount Rate in %. Value means Cash Flow Stream which can be selected for all rows. Close the bracket and add the investment as: + Investment Amount which is a negative value. In the example above for Project A it is: NPV(10%, 20+50+90)+(-100)
Net Present Value : An Example in Microsoft Excel • Consider three alternative projects, A, B and C. • They all cost $1,000,000 to set up but project’s A and C returns $800,000 per year for two years starting one year from set up. Projects B also returns $800,000 per year for two years, but the cash flows begin two years after set up. • Whilst project C costs $1,000,000 to set up it requires $500,000 initially and $500,000 at termination (a clean up cost for example). • If the firm uses a discount rate of 20% which is the better project?
NPV Example in Microsoft Excel • Project A: • Project B:
NPV Example in Microsoft Excel • Project C:
NPV Example Decision Making • Project C has the highest NPV and therefore if only one project can be undertaken it should be C. • However if more than one project can be undertaken then both A and C should be selected since they both have positive NPV’s. • Project B should be rejected since it has a negative NPV and would therefore destroy wealth. • It makes sense that project C should have the highest NPV, since its cash outflows are deferred relative to the other projects, and its cash flows are early. • In contrast project B has all the costs up front but the cash inflows are deferred.
Net Present Value:Decision Making • Independent Project: Accept when NPV > 0 • Mutually Exclusive Projects: Select the one with highest NPV • Suppose a project has a positive NPV, but the NPV is small, say, only a few hundred dollars then the firm should still undertake that project if there are no alternative projects with higher NPV as a firms wealth is increased every time it undertakes a positive NPV project.
Net Present Value:Decision Making • A small NPV, as long as it is positive, is net of all input costs and financing costs so even if the NPV is low it still provides additional returns. • A firm that rejects a positive NPV project is rejecting wealth! • Question: In the example for project A and B which project will you accept 1) they are independent 2) they are mutually exclusive
Net Present Value:True or False? • Discuss: A) A key input in NPV analysis is the discount rate. B) In the formula - r represents the minimum return that the project must earn to satisfy investors. C) r varies with the risk of the firm and /or the risk of the project. Above – Advantages or Disadvantages??
Net Present Value:Advantages and Disadvantages • Advantages • Considers TVM • Considers all the CFs • Tells if the investment will increase the firm’s value • Useful for comparing similar projects with same costs • Disadvantages • Requires an estimate of the cost of capital • Expressed in value and not in percentage term
Capital Budgeting Techniques:5. Profitability Index (PI) • PI is the measurement of relative profitability of the project. It shows the present value per £ of initial investment of the project. It is given by the following equation • Or PI =
Profitability Index :Decision Making • The IRR decision rule is then: • If PI > 1, accept the project • If PI < 1, reject the project • The PI equal to 1 indicates the zero NPV. Similarly the PI greater than 1 implies positive NPV of the project. Conversely, the PI less than 1, implies negative NPV • Applying the same rationale of NPV, we make a decision under PI method • Find out the PI for project A and B • In the example for project A and B which project will you accept 1) they are independent 2) they are mutually exclusive
Capital Budgeting Techniques:6. Internal Rate of Return (IRR) • IRR is the rate that equates the PV of Cash Inflows with PV of Cash Outflows. • The IRR of a project can be defined as the rate of discount which, when applied to the projects Cash Flows, produces a zero NPV i.e. it is the rate that will force NPV to be zero
Internal Rate of Return:Formula • IRR = • IRR will give youa rate of return and therefore is measured in percentage
Internal Rate of Return:Example Project A • At 10% NPVA as we saw before is > 0 so try higher percentage, say 20% • YearCFtPV of CFt • 0 -100 - £100 • 1 20 £16.67 • 2 50 £34.72 • 3 90 £52.08 • NPVA = £3.47 • At 20% NPVA > 0 so try another higher percentage say 25%
Internal Rate of Return:Example Project A • Calculation of NPVA at 25% YearCFtPV of CFt 0 -100 -£100 1 20 £16 2 50 £32 • 3 90 £46.08 NPVA = -£5.92 • At 25% NPVA is < 0 so IRR is between 20 % and 25 %
Internal Rate of Return:Example Project A • By Interpolation, we get At 20% NPV = £3.47 AT 25% NPV = - £5.92 So, by linear interpolation, IRRA = 20+[3.47/(3.47-(-5.92)]x(25-20) = 21.84% • IRRB=?
Internal Rate of Return:In Microsoft Excel • In Microsoft Excel, IRR function wizard can be used to calculate the IRR • Using the wizard in Microsoft Excel, it is simply selecting all Cash Inflows and Investment Amount (in negative) inside the parenthesis
Internal Rate of Return:For Uniform Cash Inflows • The calculation is easier than for uneven Cash Inflows • IRR can be calculated locating the Factor in Annuity Table for present value. • Factor is calculated as Initial Investment / Cash Inflow per year. • If the exact rate can not be found then you need to do the Interpolation • Example: suppose an investment of £100 will provide a benefit of £60 each year for next two years. What is the IRR?
Internal Rate of Return:For Uniform Cash Inflows • Factor = Initial Investment/ Annual Cash Flow = 100/ 60 = 1.6667. Locating the Factor in Annuity Table for present value for 2 years, we get closest value at 12% and 13 % • By interpolation, Present Value 12% 1.6901 1.6901 TR 1.6667 13% 1.6681 Difference 0.0234 0.022 IRR = 12 + 0.0234/ 0.022 x (13-12) = 13.06%
Internal Rate of Return:Decision Making • The IRR decision rule is then: • Accept if IRR greater than or equal to some predetermined cost of capital. (The cost of capital is the discount rate we would have used in a NPV analysis). • In the example for project A and B which project will you accept 1) they are independent 2) they are mutually exclusive
Internal Rate of Return:Advantages and Disadvantages • Advantages • Considers TVM. Considers all the CFs • Tells if the investment will increase the firm’s value • Disadvantages • Requires an estimate of the cost of capital
NPV and IRR: the methods • NPV positive: when cost of capital is < IRR • NPV negative: when cost of capital > IRR • Explaining above using NPV profile • CF for Year 0, 1 and 2 are -1,500, £500 and £1,500 respectively. • Calculate NPVs at Discount Factor: 0 %, 6%, 12%, 18%, 24%, 30% and 36% respectively and present the NPV profile
NPV and IRR: mutually exclusive projects • NPV and IRR: Check the NPV and IRR calculations for 2 projects given below. Assume Discount Factor of 7% for NPV calculation. Amount in £. • The NPV of Labour project > Machine. But IRR of Machine > Labour.