Capital Budgeting Techniques: Evaluating Investment Proposals

1. The Capital Budgeting Decision 12 Chapter

2. What is Capital Budgeting? 4 Methods of Evaluating Investment Proposals Payback Period Net Present Value Internal Rate of Return Profitability index Accept/Reject Decision Net Present Value Profile Summary and Conclusions Chapter 12 - Outline

3. Capital Budgeting Techniques Should we build this plant?

4. What is Capital Budgeting? Capital Budgeting: • represents a long-term investment decision • for example, buy a new computer system or build a new plant • involves the planning of expenditures for a project with a life of 1 or more years • emphasizes amounts and timing of cash flows and opportunity costs and benefits • investment usually requires a large initial cash outflow with the expectation of future cash inflows • considers only those cash flows that will change as a result of the investment • all cash flows are calculated after tax

5. Table 12-1Cash flow for Alston Corporation Earnings before amortization and taxes (cash inflow) . . . $20,000 Amortization (non-cash expense) . . . . . . . . 5,000 Earnings before taxes . . . . . . . . . . . . 15,000 Taxes (cash outflow) . . . . . . . . . . . . 7,500 Earnings after taxes . . . . . . . . . . . . 7,500 Amortization . . . . . . . . . . . . . . + 5,000 Cash flow . . . . . . . . . . . . . . . $12,500

6. 4 Methods of Evaluating Investment Proposals • Payback Period (PP) • Internal Rate of Return (IRR) • Net Present Value (NPV) • Profitability Index (PI)

7. Types of Capital Projects Independent Projects • Projects whose cash flows are not affected by the acceptance or rejection of other projects. • Ex: A book publishing company trying to purchase a TV network Mutually Exclusive Projects • A set of projects where the acceptance of one project means the others cannot be accepted • Ex: Got a parcel of land: Build apartments or Amusement parks

8. Accounting, finance, engineering Decision making Idea development Collection of data Results Assign probabilities Reassign probabilities Reevaluation PPT 12-4 Figure 12-1Capital budgeting procedures

9. Payback Period Payback Period (PP): • computes the amount of time required to recoup the initial investment • a cutoff period is established • Advantages: • easy to use (“quick and dirty” approach) • emphasizes liquidity • Disadvantages: • ignores inflows after the cutoff period • fails to consider the time value of money

10. Formula For Pay Back period where, A= The year in which the cumulative net cash flow is nearer to NCO NCO= Net cash outlay C=Cumulative net cash flow of year A. D= Net cash flow of the year following the year A

11. Net Present Value Net Present Value (NPV): • the present value of the cash inflows minus the present value of the cash outflows • the future cash flows are discounted back over the life of the investment • the basic discount rate is usually the firm’s cost of capital (WACC)(assuming similar risk)

12. Net Present Value (NPV) Method • NPV is a method of evaluating capital investment proposals by finding the present value of future net cash flows, discounted at the rate of return required by the firm • One of two discounted cash flow (DCF) techniques using time value of money that we will cover NPV = PV of inflows – Cost (Initial Investment) = Net gain in wealth

13. NPV Method: Advantage • It Considers the time value of money concept. • It considers the total benefit arising out of invest proposal over its life time. • It is particularly useful for the selection of mutually exclusive project. NPV Method: Disadvantage • It involves the calculation of the required rate of return to discount the cash flows. • It is absolute measures that favors the higher present value project that may also involves a larger initial outlay. • In case of projects having different lives it may not give dependable results.

14. PPT 12-12 Internal Rate of Return Internal Rate of Return (IRR): • represents a yield on an investment or an interest rate • requires calculating the discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits) • is the discount rate where the cash outflows equal the cash inflows (or NPV = 0)

15. Formula for IRR PV of inflows = Investment Cost (Initial Investment) So the discount rate at which NPV=O is IRR.

16. IRR: Advantage • Business executives and non-technical people understand the concept of IRR much more readily than they understand the concept of NPV. • IRR recognizes the time value of money concepts. • It considers all the cash flows occurring over the entire life of the project. • It does not use the concept of required rate of return. • It is consistent with the overall objective of maximizing shareholders’ wealth.

17. IRR: Disadvantage • Multiple IRRs • Calculation is very much difficult. • It is determined based on the assumption that all intermediate cash inflows are reinvested at IRR.

18. Profitability Index Method • The method measures the present value of returns per unit of present value of investment. • The profitability index is defined as the ratio which is obtained by dividing the present value of future cash inflows by cash outflows.

19. The Profitability Index (PI) • Advantages: • May be useful when available investment funds are limited • Easy to understand and communicate • Correct decision when evaluating independent projects • Disadvantages: • Problems with mutually exclusive investments> ignores differences in scale

20. Accept/Reject Decision Payback Period (PP): • if PP < cutoff period, accept the project • if PP > cutoff period, reject the project Internal Rate of Return (IRR): • if IRR > cost of capital, accept the project • if IRR < cost of capital, reject the project Net Present Value (NPV): • if NPV > 0, accept the project • if NPV < 0, reject the project Profitability Index (PI) • if PI > 1, accept the project • if PI > 1, reject the project

21. Net Present Value Profile Net Present Value Profile: • a graph of the NPV of a project at different discount rates shows the NPV at 3 different points: • a zero discount rate • the normal discount rate (or cost of capital) • the IRR • allows an easy way to visualize whether or not an investment should be undertaken

22. Net present value ($) 6,000 4,000 2,000 0 Investment B IRRB = 14.33% Investment A 5% 10% 15% 20% 25% IRRA = 11.16% Discount rate (percent) Figure 12-2Net present value profile B A B A

23. $200 $800 0 1 2 3 - $800 -$200 100% = IRR2 0% = IRR1 Multiple IRRs (Project C) There are two IRRs for this project: Which one should we use?

24. Summary and Conclusions • Payback period indicates risk and liquidity of a project • NPV gives a direct measure of the dollar benefit to the shareholders • IRR provides information about a project’s “safety margin” • IRR reinvestment assumption may be unrealistic • Watch out for multiple IRRs

25. Summary and Conclusions • This chapter evaluates the most popular alternatives to NPV: • Payback period • Internal rate of return • Profitability index • When it is all said and done, they are not the NPV rule; for those of us in finance, it makes them decidedly second-rate.