Lecture capital budgeting notes .pdf

11/15/2022
Capital Budgeting
Techniques
Financial management and control systems
Dr. Mahmoud Otaify
Assistant Professor of Finance
Expenditures
outlay of funds to
produce benefits
within one year
Operating
Expenditures
outlay of funds to
produce benefits more
than one year
Capital Expenditures
Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting
Capital Budgeting
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What is capital budgeting?
long-term investments
Process of
Evaluating
& Selecting
Wealth
Maximization
contribute
to the
firm’s goal
Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 3
Capital Budgeting Decision Examples
Buy a
particular
fixed asset
launch a
new
product
enter a new
market
acquire
another
company
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Capital Budgeting Process
Proposal
generation
(managers at all
levels)
Review and
analysis (Fin.
Managers)
Decision
making
(BOD/senior
executives)
Implementation
(may take
phases)
Follow-up
(actual costs&
benefits with
projections)
Mutually exclusive projects
A firm
in need of
increased
production
capacity
could obtain it by
1) expanding its
plant,
(2) acquiring
another company,
or
(3) contracting with
another company
for production
Accepting any one
option
eliminates the
immediate need for
either of the others
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Independent Projects
Buy a
particular
fixed asset in
one branch
Open new
branch
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Categories: of Investment Projects: Independent
versus Mutually Exclusive Projects
Independent
projects
Projects whose cash flows are
unrelated to (or independent of) one
another
accepting or rejecting one project does
not change the desirability of other
projects.
Mutually exclusive
projects
projects are those that have
essentially the same function and
therefore compete with one another.
so that the acceptance of one
eliminates from further consideration
all other projects that serve a similar
function
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How availability of funds for capital expenditures
affect the firm’s decisions?
Financial
Situation
If a firm has
unlimited funds for
investment
The firm should
invest in all projects
that will provide an
acceptable return.
firms operate
under capital
rationing (have a
fixed budget available for
capital expenditures)
numerous projects
compete for these
dollars
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Accept–reject
approach
involves evaluating capital
expenditure proposals to determine
whether they meet the firm’s
minimum acceptance criterion
Managers might use this approach if
they have sufficient funds to invest in
every project that creates value for
shareholders
ranking approach
involves ranking projects on the basis
of some predetermined measure,
such as how much value the project
creates for shareholders.
It is useful in selecting the “best” of a
group of acceptable projects when
firms have limited capital
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Techniques used to analyze
potential business ventures to
decide which are worth
undertaking
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CAPITAL BUDGETING TECHNIQUES
THE PAYBACK RULE NET PRESENT VALUE
(NPV)
INTERNAL RATE OF
RETURN (IRR)
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1. Payback Period
How long does it take to recover the initial cost of a project?
The payback period is the time it takes an investment to generate
cash inflows sufficient to recoup the initial outlay required to make
the investment.
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Payback Period - DECISION CRITERIA
If the
payback
period
is less than
the maximum
acceptable
payback
period
accept the
project
is greater than
the maximum
acceptable
payback
period
reject the
project
What is the
maximum
acceptable
payback period?
Managers decide what
payback period they
deem acceptable, but
that decision is quite
subjective 14
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Lecture Case: Bennett Company
 We will use one basic problem
to illustrate all the techniques
described in this chapter. The
problem concerns Bennett
Company, a medium-sized
metal fabricator that is
currently contemplating two
projects with conventional cash
flow patterns:1 Project A
requires an initial investment of
$420,000, and project B
requires an initial investment of
$450,000.
The payback period = 420,000/$140,000 = 3 years
The payback period = initial investment / annual cash inflow
Cashflows are in form of annuity (fixed annual amount)
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Year CF Cum. CFs
0 (450,000)
1 280,000
2 120,000
3 100,000
4 100,000
5 100,000
(450,0000)
-450,000+280,000= (170,000)
-170,000+120,000 = (50,000)
-50,000+100,000= 50,000
100,000 >50,000
50,000/100,000=0.5
Payback period = 2 +
(50,000/100,000) = 2.50
years
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Payback
Period
Project A = 3y Project B = 2.5
If Bennett’s maximum
acceptable payback period
were 2.75 years
Reject A
Accept
B
If the maximum
acceptable payback
period were 2.25 years,
Reject both projects
If the projects
were being
ranked
Project B would be preferred
over A because it has a
shorter pay back period.
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Payback Period Evaluation
Uses
Large firms sometimes
use the payback
approach to evaluate
small projects
small firms use it
to evaluate most
projects.
Pros
Simple
It gives at least some
consideration to the
timing of cash flows
It offers a way to adjust for
project risk if managers
require a faster payback on
riskier projects
Cons
Requires an arbitrary
cutoff point
No connection exists between the
payback period and the goal of
shareholder wealth maximization.
Ignores the time value of
money
Ignores cash flows beyond
the cutoff date
Biased against long-term projects, such as
research and development, and new
projects
2. Net Present Value
Measures an investment’s value by calculating the present value of its cash
inflows and outflows.
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Concept NPV Model
Project
Profit>Cost + Net Profit Accept
Profit = Cost Zero profit Indifferent
Profit < Cost - Net Profit Reject
Profit - Cost
if the proposed investments have
the same risks as firm’s existing
activities, the firm useWACC to
discount their future cash flows
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NPV – Decision Criteria/Rule
If the NPV
> $0 accept the project.
increase the market
value of the firm
Therefore the wealth
of its owners,
< $0, reject the project
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Lecture Case: Bennett Company
 Bennett Company, a
medium-sized metal
fabricator that is currently
contemplating two projects
with conventional cash flow
patterns:
 Project A requires an initial
investment of $420,000,
 Project B requires an initial
investment of $450,000.
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If the projects were being ranked
project A would be considered superior to B because its net present value is
higher than that of B.
Both projects are acceptable because the net present value of
each is greater than $0.
Bennett discounts project cash flows at 10%.
NPV for A = $110,710 NPV for B = $109,244
NPV - Evaluation
The method used by
most large companies
to evaluate investment
projects (why)
When firms make
investments, they are
spending money that
they obtained from
investors
Investors expect a
return on the money
that they give to firms,
so a firm should undertake
an investment only if the
present value of the cash
flow is greater than the cost
of making the investment
NPV method takes into
account the time value of
investors’ money, it is more
likely to identify value-
increasing investments than is
the payback rule.
Discount rate reflects
investments risk and
also is minimum
return to satisfy
investors
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Required return by capital
providers (creditors & owners)
is Cost of capital (WACC)
Used as required return on
new investment project if it has
same risks of existing business
It will be adjusted to reflect
risk of new investment project
if it has more or lower risks
than the existing business
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Profitability Index (PI)
For a project that has an initial cash outflow followed by cash inflows,
The profitability index (PI) is simply equal to
the present value
of cash inflows
the absolute value of
the initial cash outflow
the decision rule they follow is to invest in the
project when the index is greater than 1.0.
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If the projects were being ranked
project A would be considered superior to B because its net present value is higher than that of B.
Both projects are acceptable (because PI > 1.0 for both)
Project B
PV of Cash inflow for B
= $559,244
B’s Cash outflow =
$450,000
PIB= $559,244 ,
$450,000 = 1.24
Project A
PV of Cash inflow for A
= $530,710
A’s Cash outflow =
$420,000
PIA = $530,710 /
$420,000 = 1.26
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3. Internal Rate of
Return (IRR)
The discount rate that equates the present value of a project’s cash inflows
to the present value of its cash outflows.
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IRR Decision Criteria
IRR
If IRR > WACC Accept project
If IRR < WACC Reject Project
WACC
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Project A
IRR=19.9% WACC=10%
Project B
IRR=21.7% WACC=10%
Accept Accept
If these projects are
mutually exclusive
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Ranking (mutually exclusive) projects
Using NPV and IRR
NPV
NPVA =$110,710
NPVB = $109,244
Project A is superior
IRR
IRRA = 19.9%
IRRB = 21.7%
Project B is superior
Conflicts in the
ranking given a
project by NPV
and IRR
reinvestment rate
assumption
Timing of each
project’s cash flows
the magnitude of the
initial investment.
resulting from
differences in
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WHICH APPROACH IS BETTER?
Theoretical View
 NPV is the better approach to capital
budgeting for several reasons.
Most importantly, the NPV measures
how much wealth a project for
shareholders. Given that the financial
manager’s objective is to maximize
shareholder wealth, the NPV approach
has the clearest link to this objective
and therefore is the “gold standard” for
evaluating investment opportunities.
Practical View
 Researchers surveyed chief financial
officers (CFOs) about what methods they
used to evaluate capital investment
projects. One interesting finding was that
many companies use more than one of
the approaches we’ve covered in this
chapter. The most popular approaches by
far were IRR and NPV, used by 76% and
75% (respectively) of the CFOs
responding to the survey.
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Lecture capital budgeting notes .pdf