CAPITAL BUDGETING – CASH FLOWES Capital Budgeting: The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year. That is, the investment decision that will provide benefits to the firm for longer than one year and will help the firm to maximize its long-term goal wealth maximization. These types of decisions are basically concerned with real assets. Real assets are those help in producing goods or providing services directly or indirectly.
Importance of capital budgeting: • The impact of capital budgeting is long-term; thus the firm losses some decision making flexibility when capital projects are purchased. • An error in the forecast of assets requirements can have serious consequences. Too much investment on assets, will be unnecessary expense, or if does not spend enough on assets, might lose opportunities. • Capital assets must be ready to come on line when they are needed; otherwise opportunity might be lost. • Effective capital budgeting can improve both the timing of asset acquisitions and the quality of assets purchased. • Capital budgeting is important because the acquisition of fixed assets typically involves substantial expenditures, so before this kind of large expenditure, the firm must have funds available.
Motives for capital budgeting: The basic motives for capital budgeting expenditures are to- Expand – capital expenditures to expand the level of operation, through acquisition of fixed asset. Replacement – capital expenditure to replace or renew obsolete or worm out asset. Renewal – an alternative of replacement, involve rebuilding, over-hauling, or retrofitting an existing fixed asset. Other purpose – capital expenditures, that is not directly on tangible assets, but are committed for long-term future return, i.e. advertisement, R&D.
Steps in the Capital Budgeting process: The capital budgeting process consist of five distinct interrelated steps: • Proposal generation: Proposal are made at all levels within a business organization and are reviewed by finance personnel. • Review and analysis: Formal review and analysis is performed to asses the appropriateness of the proposals and evaluate their economic viability. Once the analysis is complete, a summary report is submitted to decision makers. • Decision making: Firms typically delegate capital expenditure decision making on the basis of dollar limits. • Implementation: Following approval, expenditures are made and project implemented. • Follow-up: Results are monitored, and actual costs and benefits are compared with those that were expected.
Basic terminology: Before developing the concept, techniques and practice related to capital budgeting process, we need to know some basic terminology. Independent projects: Independent projects are those whose cash flows are unrelated or independent of one another; acceptance of one does not eliminate the others from future consideration. Mutually exclusive projects: Mutually exclusive projects are those that have the same functions and therefore compete with one another. The acceptance of one eliminates from future consideration all other projects that serve a similar function.
Unlimited funds: The availability of funds for capital expenditure affects the firm’s decisions. If a firm has unlimited funds for investment, all independent projects that provide an acceptable return can be accepted Capital rationing: Firms operate under capital rationing. This means that the firm have only a fixed number of dollars available for capital expenditures and that numerous projects will compete for these dollars. Accept-reject approach: The accept-reject approach involves evaluating capital expenditure proposal to determine whether they meet the firm’s minimum acceptance criterion. This approach can be used when the firm has unlimited funds.
Ranking approach: The ranking approach, involves ranking projects on the basis of some predetermined measures, such as the rate of return. The project with the highest return is ranked first, and so on. Only acceptable projects should be ranked. This approach is best for mutually exclusive projects and in capital rationing view.
CAPITAL BUDGETING TECHNIQUES Three most popular methods managers uses to evaluate capital budgeting projects: • Payback Period (PB) • Net Present Value (NPV) • Internal Rate of Return (IRR) Payback Period: The expected number of years required to recover the original investment – the cost of the asset. In case of an annuity, the payback period can be found by dividing the initial investment by annual cash inflows. For a mixed stream of cash inflows, the yearly cash inflows must be accumulated until the initial investment is recovered.
The traditional payback period ignores cash flows beyond the payback period, and it does not consider the time value of money. Decision criteria: If the payback period is less than the maximum acceptable payback period, accept the project, otherwise reject the project. The exact payback period can be found using the following formula: PB = + Amount of investment unrecovered at start of the recovery year Total cash flow generated during the recovery year Number of years before full recovery of initial investment
Discounted Payback Method: Similar to the traditional payback method except that it discount cash flows at the projects required rate of return. Using discounted payback method, a project should be accepted when its discounted payback is less than its expected life. Net Present Value (NPV): The net present value is found by subtracting a project’s initial investment from the present value of its expected cash inflows, discounted at a rate equal to the firm’s cost of capital. Because NPV gives explicit consideration to the time value of money, it is considered a sophisticated capital budgeting technique. Decision criteria: If NPV is greater than $0 accept the project, otherwise reject the project
Net present value of a project can be found by the following formula: NPV = Present value of cash inflows – Initial investment NPV = = Rational for the NPV method: an NPV of zero signifies that the project’s cash flows are just sufficient to repay the invested capital. If a project has positive NPV, then it generates a return that is greater than is needed to pay for funds provided by investors. Therefore, if a firm takes on a project with positive NPV, the position of the stockholders is improved because the firm’s value is greater.
Internal Rate of Return (IRR): The discount rate that forces the PV of a project’s expected cash flows to equal its initial investment or cost. Decision criteria: If IRR is greater than the cost of capital or required rate of return, accept the project, otherwise reject the project. We can use the following equation to solve for a project’s IRR: $0 =
Net Present Value Profiles: Projects can be compared graphically by constructing net present value profiles that depict the project’s NPV for various discount rates. These profiles are useful in evaluating and comparing project’s especially when conflict ranking is exist. IRR define as the discount rate at which a project’s NPV equals zero, the point where its NPV profile crosses the ‘X’ axis, indicates a projects internal rate return (IRR). Cross over rate: The discount rate at which the NPV profiles of two projects cross and thus, at which the projects NPV’s are equal.
Multiple IRRs: The situation in which a project has two or more IRRs, when projects have unconventional cash flow patterns. If, a project has a large cash outflow either sometime during or at the end of its life, then it has an unconventional cash flow pattern. Post – audit: The post-audit is a key element of capital budgeting. By comparing actual results with predicted results and then determine why differences occurred, decision makers can improve both their operations and their forecast of project outcomes.