Lecture 6 Capital Budgeting Decision The term capital refers to long-term assets used in production, while a budget is a plan that details projected inflows and outflows during some future period. Thus, the capital budget is an outline of planned investments in fixed assets, and capital budgeting is the whole process of analyzing projects and deciding which ones to include in the capital budget. 1
The Role of the Financial Manager The Capital Budgeting Decision Recall lecture 1 and the role of the financial manager, until now we have covered the financing decision of a financial manager. Lets now turn our attention towards the other decision he or she has to make the Capital budgeting Decision. Capital budgeting decision is the process of planning expenditures on assets whose cash flows are expected to extend beyond one year. There are two broad categories of assets which can be acquired by the organization: Real Assets: These are the assets which are used to produce goods or render services; Financial Assets: These are the assets which give the bearer claims on the firm s real assets and the cash those assets will produce. 2
The Capital Budgeting Decision Project Classifications Every project being considered is unique in some sense, however, depending upon the objective that is being targeted projects can be classified into the following types: Replacement (Maintenance of Business): This category is related to expenditures that are incurred to replace worn-out or damaged equipment used in the production of products or rendering of services; Replacement (Cost Reduction): This category includes expenditures related to replace serviceable but obsolete equipment with the intention of lowering the running costs; Expansion of Existing Products or Markets: The expenditures which are undertaken to increase output of existing products or to expand retail outlets or distribution facilities in markets now being served; 3
The Capital Budgeting Decision Project Classifications Expansion into New Products or Markets: These are investments to produce a new product or to expand into a geographic area not currently being served; Safety and/or Environmental Projects: Expenditures necessary to comply with government orders, labor agreements or insurance policy terms fall into this category; Other: This catch-all category includes all those project which cannot be categorized in either of the above classifications. 4
The Capital Budgeting Decision Similarities With the Valuation of Financial Assets Once a potential capital budgeting project has been identified, its evaluation involves the same steps that are used in the valuation of financial assets: First, the cost of the project must be determined. This is similar to finding the price that must be paid for the stock or bond; Next comes the estimation of expected cash flows from the project which is synonymous to estimating the future dividend or interest payment stream on a stock or a bond; The expected cash flows are then put on a present value basis to obtain an estimate of the asset s value. This is equivalent to finding the present value of a stock s expected dividends or a bond s future interest and principal payments; Finally, the present value of the expected cash inflows is compared with the required outlay. If the PV of the cash flows exceeds the cost, the project should be accepted. This is similar to the comparison of the fair value of financial assets with its market value. 5
The Capital Budgeting Decision The Mechanics While undertaking any capital budgeting decision, two cardinal rules are to be kept in mind: These decisions must be based on after-tax cash flows, not accounting income; Only incremental cash flow are relevant. Incremental cash flows are the additional cash flows that the company expects to generate if it goes ahead with the project under consideration. Project cash flow is different from accounting income as it reflects: Cash outlays for fixed assets; Tax shield provided by depreciation; Cash flows due to changes in net working capital; The impact of tax since after-tax cash flows are considered. 6
The Capital Budgeting Decision The Mechanics While determining incremental cash flows, there are certain rules which must be kept in mind: Include All Externalities: You must forecast and include all the indirect effects of accepting the project on the existing business profile of the company. For example sales cannibalization or acquisition of business synergies; Forget Sunk Costs: Sunk costs are outlays that have already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected; Include Opportunity Costs: Resources are almost never free, even when no cash changes hands. For example, the decision to either use the land for manufacturing operation or selling it for additional proceeds; Don t Include Interest Payments: Interest payments are not included while estimating incremental cash flows as their impact is already reflected in the cost of capital used to discount the cash flows. 7
The Capital Budgeting Decision The Mechanics Following are the methods used to rank projects and decide whether or not they should be accepted for inclusion in the capital budget: The Payback Period; The Discounted Payback Period; Net Present Value (NPV); Internal Rate of return (IRR). Its foolish to assume that the above list is exhaustive as modern theories involve new methodologies used to appraise the projects. Moreover, it is never a good idea to make the capital budgeting decision based on a single method rather it should be based on a combination of several methodologies. 8
Capital Budgeting Decision Rules The Payback Period The payback period is the number of years required to recover the original investment. Payback Period Year Before Full Recovery Unrecovered Cost at Start of the Cash Flow During the Year year Example: The projected cash flows from project X are: Year 1 2 3 4 Cash Flow (PKR) 100 200 500 400 The cost of the project is PKR 500. What is the payback period for this investment? Payback Period 2 200 500 2.4 years 9
Capital Budgeting Decision Rules The Payback Period Decision Rule In case of independent projects, an investment is acceptable if its calculated payback period is less than some pre-specified number of years. In case of mutually exclusive projects, the project with the lowest payback period gets selected. Advantages & Disadvantages of the Payback Period Rule Advantages It is easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity Disadvantages Ignores time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long-term projects 10
Capital Budgeting Decision Rules The Discounted Payback Period Discounted payback period is similar to the regular payback period except that the expected cash flows are discounted by the project s cost of capital. Thus, it is defined as the number years required to recover the investment from discounted cash flows. Discounted Payback Period Year Before Full Recovery Unrecovered Cost at Start of the year PV of Cash Flow During the Year Example: Calculate the discounted payback period for project X given that the project s cost of capital is 14%. Year 1 2 3 4 Cash Flow (PKR) 100 200 500 400 PV of Cash Flows 87.72 153.89 337.49 236.83 DiscountedPayback Period 2 258.39 337.49 2.8years 11
Capital Budgeting Decision Rules The Discounted Payback Period Decision Rule In case of independent projects, an investment is acceptable if its calculated discounted payback period is less than some pre-specified number of years. In case of mutually exclusive projects, the project with the lowest discounted payback period gets selected. Advantages & Disadvantages of the Discounted Payback Period Rule Advantages It is easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity Includes time value of money Disadvantages May yield conflicting results Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long-term projects 12
Capital Budgeting Decision Rules Net Present Value (NPV) The NPV method follows the discounted cash flow technique in which a project s NPV is equal to present value of future net cash flows, discounted at the cost of capital. NPV PV (Inflows) PV (Outflows) Example: Calculate the net present value of project X given that the project s cost of capital is 14%. Year 1 2 3 4 Cash Flow (PKR) 100 200 500 400 PV of Cash Flows 87.72 153.89 337.49 236.83 NPV NPV NPV PV (Inflows) 815.37 500 315.37 PV (Outflows) 13
Capital Budgeting Decision Rules Net Present Value (NPV) Decision Rule In case of independent projects, an investment is acceptable if its net present value is greater than zero i.e. positive. In case of mutually exclusive projects, the project with the highest net present value gets selected. Advantages & Disadvantages of the Net Present Value Rule Advantages It is easy to understand Includes time value of money Takes into account all the cash flows Biased towards liquidity Disadvantages Does not take into account the project s size Does not signify anything in terms of project s profitability 14
Capital Budgeting Decision Rules Internal rate of Return (IRR) The IRR method is a method of ranking investment proposals using the rate of return, calculated by finding the discount rate that equates the present value of future cash inflows to the present value of cash outflows. That is, IRR is the rate of return at which: PV(Inflows) PV(Outflows) Example: Calculate the internal rate of return of project X. The IRR of project X is 35.75%. 15
Capital Budgeting Decision Rules Internal Rate of Return (IRR) Decision Rule In case of independent projects, an investment is acceptable if its internal rate of return is greater than its cost of capital. In case of mutually exclusive projects, the project with the highest internal rate of return gets selected. Advantages & Disadvantages of the Internal Rate of Return Rule Advantages Easy to understand and communicate Closely related to NPV and often leading identical results Disadvantages May result in multiple answers or no answers because of its inability to handle nonconventional cash flows May lead to incorrect decisions in comparison of mutually exclusive investments 16
Capital Budgeting Decision Food For Thought If a project with conventional cash flows has a payback period less than the project s life, Can you definitively state the algebraic sign of the NPV? Why or why not? If you know that the discounted payback period is less than the project s life, what can you say about the NPV? Suppose a project has conventional cash flows and a positive NPV. What do you know about its Payback Period? Discounted Payback Period? IRR? Respond to the following comment, Company X likes the IRR rule. It can use it to rank projects without having to specify a discount rate. Unfortunately, your chief executive officer refuses to accept any investments in plant expansion that do not return their original investment in four years or less. That is, he insists on a payback rule with a cutoff period of four years. As a result, attractive long-lived projects are being turned down. The CEO is willing to switch to a discounted payback rule with the same four-year cutoff period. Would this be an improvement? Explain. 17
Capital Budgeting Decision A Few Examples Consider the following two mutually exclusive projects: Year Cash Flow (Project A) Cash Flow (Project B) 0-170,000-18,000 1 10,000 10,000 2 25,000 6,000 3 25,000 10,000 4 380,000 8,000 Whichever project you choose, if any, you require a 15 percent return on your investment. If you apply the payback criterion, which investment will you choose? If you apply the discounted payback criterion, which investment will you choose? If you apply the NPV criterion, which investment will you choose? If you apply the IRR criterion, which investment will you choose? Based on your answers to the above four parts, which project will you finally choose? Why? 18
Capital Budgeting Decision Food For Thought An investment has an installed cost of PKR 412,670 and has annual cash inflows of PKR 153,408 for four years coming at the end of the each year. If the discount rate is zero, what is the NPV of the investment? If the discount rate is infinite, what is the NPV? At what discount rate is the NPV just equal to zero? 19