Capital Budgeting Decision Tools 051706 Introduction Capital Budgeting
Capital Budgeting Decision Tools 05/17/06
Introduction • Capital Budgeting is the process of identifying, evaluating, and implementing a firm’s longer term (greater than a year) investment opportunities. • It seeks to identify investments that will increase a firm’s shareholder wealth. • The typical capital budgeting decision involves evaluating a project that requires a large up-front investment followed by a series of smaller cash inflows.
Motives for capital expenditures • Expansion or growth of the firm will typically entail increased investment in fixed or capital assets. • Replacement of obsolete or worn-out assets. • Renewal of an existing asset.
Basic terminology • Mutually Exclusive Projects are investments that compete in some way for a company’s resources. A firm can select one or another but not both. • Independent Projects, on the other hand, do not compete with the firm’s resources. A company can select one, or the other, or both -- so long as they meet minimum profitability thresholds.
Basic terminology • If the firm has unlimited funds for making investments, then all independent projects that are acceptable projects (i. e. , determined to add value to the firm) can be accepted and implemented. • However, in most cases firms face capital rationing restrictions since they only have a given amount of funds to invest in potential investment projects at any given time. • Capital rationing is particularly applicable to high- growth firms as they will typically have numerous good projects and will have to choose amongst them.
Basic terminology • The accept-reject decision involves the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criteria. • The ranking decision involves the ranking of capital expenditures on the basis of some predetermined measure, such as the rate of return.
Basic terminology • The relevant cash flows to evaluate a project are the incremental cash flows that are all changes in the firm’s future cash flows that are a direct consequence of accepting the project. • The appropriate discount rate (to evaluate a project, if needed) is the risk-adjusted required rate of return for the project which reflects the riskiness of the cash flows of the project. • This rate of return is also referred to as the project’s cost of capital or hurdle rate.
Capital budgeting techniques • Once a project’s relevant cash flows have been determined, a firm must determine a method to analyze whether the project is acceptable and/or to rank projects. • The preferred approach would consider the time value of money, risk and return, and the effect on shareholder wealth.
Payback period • The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. • The maximum acceptable payback period is determined by management. • Payback period decision rule: – If the payback period is less than the maximum acceptable payback period, the project is acceptable. – Ranking: Projects with shorter payback periods are ranked higher.
Pros and cons of payback period • It is simple and intuitive. • It is biased towards liquidity, i. e. , short-term projects. • It adjusts for uncertainty of later cash flows. • The appropriate payback period is a subjectively determined number. • It ignores the time value of money. • It ignores cash flows beyond the cut-off date. • It is biased against long -term projects.
Discounted payback period • The discounted payback method simply measures how long (in years and/or months) it takes, using discounted cash flows, to recover the initial investment. • The maximum acceptable discounted payback period is determined by management.
Discounted payback period • Discounted payback period decision rule: – If the discounted payback period is less than the maximum acceptable payback period, the project is acceptable. – Ranking: Projects with shorter payback periods are ranked higher.
Pros and cons of discounted payback period • It is biased towards liquidity, i. e. , short-term projects. • It adjusts for uncertainty of later cash flows. • The appropriate payback period is a subjectively determined number. • It ignores cash flows beyond the cut-off date. • It is biased against long -term projects.
Net present value (NPV) • The Net Present Value (NPV) is a measure of how much value is created or added for the firm today by undertaking an investment or project. • NPV is the present value of the incremental cash flows generated by the project. • NPV can be calculated as: where CFt is the cash flow in year t and r is the hurdle rate for the project.
Net present value (NPV) • NPV decision rule: – If the NPV of a project is greater than zero, the project is acceptable. – Ranking: Projects with higher NPVs are ranked higher. • NPV always provides the correct accept/reject decision and considers the time value of money, risk and return as well as effect on owner’s wealth. • The model is most appropriate when there are no capital rationing constraints.
Pros and cons of NPV • It accurately assesses the value of a project to a firm. • It incorporates all cash flows, cash flow riskiness and time value of money in its calculation. • Absolute (dollar) returns are more difficult to understand for some managers. • It is biased towards larger projects. If projects can be replicated (or are scalable) this may result in incorrect rankings of projects.
Internal rate of return (IRR) • The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows, i. e. , the rate of return for which the NPV is equal to zero. • The IRR is the project’s intrinsic rate of return and can be calculated by solving the following equation (setting the NPV to zero):
Internal rate of return (IRR) • IRR decision rule: – If the project’s IRR exceeds the project’s hurdle rate (required rate of return), the project is acceptable. – Ranking: Projects with higher IRRs are ranked higher. • When capital rationing is an issue, the IRR may be the best method for ranking projects.
Pros and cons of IRR • It is closely related to NPV, and generally leads to identical decisions. • It is easy to understand communicate (percentage returns). • It is not biased towards selecting smaller or larger projects. • It may result in multiple answers or no answers with non-conventional cash flows. • It may lead to incorrect decisions in comparisons of mutually exclusive projects as it assumes cash flow are reinvested at the IRR. • Difficult to calculate by hand.
Profitability index (PI) • The Profitability Index (PI) is a modification of NPV that evaluates projects using a “return” measure. • The PI is calculated as: • PI decision rule: – If PI > 1 the project is acceptable. – Ranking: Projects with higher PI are ranked higher.
Pros and cons of PI • It is closely related to NPV, and generally leads to identical decisions. • It is easier to understand communicate than NPV. • It is not biased towards selecting smaller or larger projects. • The actual value is less meaningful than a percentage return (such as IRR).
Capital budgeting techniques in practice • A recent survey 1 cites CFOs as using IRR (76%) and NPV (75%) the most for evaluating projects. The payback period was used by 57% of those surveyed. The discounted payback period was used 30% and the profitability index was used 12%. • However, small firms and severely capital constrained firms use payback period more than the NPV and IRR. • Payback periods also tend to be used more frequently for smaller projects. • Companies with older CEOs without MBAs tended to use the payback method more frequently. 1 How do CFOs make capital budgeting and capital structure decisions? Graham and Harvey, Journal of Applied Corporate Finance 15 (2002).
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