Capital Budgeting Decision Tools

1. Capital Budgeting Decision Tools 05/17/06

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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 CFtis the cash flow in year t and r is the hurdle rate for the project.

15. 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.

16. 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.

17. 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 IRRis the project’s intrinsic rate of return and can be calculated by solving the following equation (setting the NPV to zero):

18. 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.

19. Pros and cons of IRR • 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. • It is closely related to NPV, and generally leads to identical decisions. • It is easy to understand and communicate (percentage returns). • It is not biased towards selecting smaller or larger projects.

20. 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 isacceptable. • Ranking: Projects with higher PI are ranked higher.

21. Pros and cons of PI • The actual value is less meaningful than a percentage return (such as IRR). • It is closely related to NPV, and generally leads to identical decisions. • It is easier to understand and communicate than NPV. • It is not biased towards selecting smaller or larger projects.

22. Capital budgeting techniques in practice • A recent survey1 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. 1How do CFOs make capital budgeting and capital structure decisions? Graham and Harvey, Journal of Applied Corporate Finance 15 (2002).