CAPITAL BUDGETING

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CAPITAL BUDGETING

• Dr. John G. Kooti
• Georgia Southwestern State University

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Should We Build this Plant?

• What is Capital Budgeting?
• Analysis of potential additions to fixed assets
• Long-term decisions, involve large expenditures
• Very important to firms future

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Steps in Capital Budgeting

• Estimate Cash Flows (Inflows/Outflows)
• Assess Riskiness of Cash Flows (CFs)
• Determine Cost of Capital --Required Rate of
  Return
• Find NPV and/or IRR
• Accept or Reject Based on Criteria

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Projects

• Mutually Exclusive Projects -- the acceptance of
  one preclude the other. Example To get a
  product across a river, you can either build a
  bridge or transport by boat. If on project is
  accepted, the other is rejected.
• Independent Projects The acceptance of one does
  not affect the other.

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Projects

• Normal Project Cost (negative cashflows)
  followed by a series of positive cash flows.
  There is only one change in sign, either from
  negative to positive or positive to negative.
• Non-Normal Project Two or more change in signs.
  Most common Cost (negative CFs), then a series
  of positive CFs, then Cost of closing project.
  Example Nuclear plant, strip mine.

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Payback Period

• The number of years to recover a projects cost
  or how long does it take to get our money back? 0
  1 2
  3
• -----------------------------------------------
  -100 10 60
  80 Cum-100 -90 -30
  50 Payback Period 2 30/80 2.375 years

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Payback Period

• Example 2 0 1 2 3 -------------------
  ------------------------------ -100 70 50
  20 Cum-100 -30 20 40 Payback Period 1
  30/50 1.60 years

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Pay back Strength and Weakness

• Strengths
• It provides an indication of a project's risk and
  liquidity
• Easy to calculate and understand
• Weakness
• It ignores the Time Value of Money
• It ignores cash flows occurring after the payback
  period

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Discounted Payback

• Uses discounted rather than raw cash flows.
• Discounted payback considers the time value of
  money, but it still fails to consider cash flows
  after the payback period, therefore, it has basic
  flaws. many firms still use payback period
  because of emphasis of liquidity especially for
  small projects.

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Accounting Rate of Return (ARR)

• Focuses on the projects contribution to the
  firms income rather than cash-flows. It is the
  ratio of average annual expected net income to
  average investment.

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Net Present Value (NPV)

• NPV is the sum of the present value of a project
  cash flows. for mutually exclusive projects, a
  project is accepted that adds most to the value
  of the firm.
• Rules
• for independent projects accept if NPVgt0
• for mutually exclusive projects accept if
  NPV1gtNPV2

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Internal Rate of Return (IRR)

• IRR is the discount rate which forces the present
  value of of a projects cash inflows to equal the
  present value of its cash outflows.
• An independent project is accepted if IRR is
  greater than the cost of capital (k).
• For mutually exclusive projects, a project is
  accepted if IRR1 gt IRR2.

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Profitability Index (PI)

• PI is the present value of cash inflows to
  present value of cash outflows. It shows the
  total dollar return per dollar of investment.
• For independent projects Accept if PI is
  greater than 1.
• For mutually exclusive, accept the one with the
  highest PI

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NPV and IRR

• For independent projects both end up with same
  decisions.
• For mutually exclusive may not make the same
  decisions. Net Present value is preferred.

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NPV Profile

• NPV profile shows the relationship between NPV
  and cost of capital. Two mutually exclusive
  projects NPV profiles may crossover. If projects
  does not crossover, then one project dominates
  the other.

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Why Crossover?

• Size (scale) differences--smaller projects frees
  up funds at time 0 for reinvestment. The higher
  the opportunity cost the more valuable these
  funds, so higher k favors small projects.
• 2. Timing differences--projects with faster
  payback provide more CFs in early years for
  reinvestment if k is high, early CFs especially
  good.

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Re-investment Rate Assumption

• NPV assumes re-investment at cost of capital (k)
• IRR assumes re-investment at IRR
• Re-investment at k is more realistic. Therefore,
  NPV method is preferred to IRR method.

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MIRR Method

• MIRR is better than IRR
• MIRR is the discount rate which causes the PV of
  a project's terminal value (TV) to equal the PV
  of costs. TV is found by compounding inflows at
  WACC. Thus MIRR assumes cash inflows are
  independent of WACC.
• MIRR is better than IRR because it assumes
  re--investment at k rather IRR. It also avoids
  the problems of multiple IRR.