Capital Budgeting

1. Capital Budgeting

2. Objectives • Study the purpose and importance of capital budgeting • Study different capital budgeting criteria for evaluating investment proposals • Study methods of project selection under capital rationing Richard MacMinn

3. Payback Net Present Value Profitability Index Internal Rate of Return Methods of Evaluating Projects Richard MacMinn

4. Methods of Evaluating Projects Richard MacMinn

5. 1992 Survey of Capital Budgeting Practices Richard MacMinn

6. Payback Method • The payback period of an investment is the number of years required to recover the initial investment • The payback method is calculated by adding the cash flows until they are equal to the initial fixed investment Richard MacMinn

7. Payback: Advantages and Disadvantages • Payback is easy to calculate and understand • It ignores any cash flows that occur after the payback period • This approach emphasizes earliest returns • This approach may discriminate against long term projects • Payback method does not consider the time value of money Richard MacMinn

8. Net Present Value • The net present value of an investment proposal is equal to the present value of its annual net cash flows after taxes less the initial investment outlay. The npv can be expressed as:where I0 is the initial outlay, ct is the annual after-tax cash flow at date t, r is the appropriate discount rate, and T is the expected life of the project Richard MacMinn

9. Net Present Value • The accept-reject criterion for npv method is as follows: if npv  0 accept; otherwise reject • The npv method considers the time value of money • It deals with the lifetime cash flows from the project, unlike the payback criterion • This method of selecting projects is consistent with the goal of maximization of shareholder’s wealth Richard MacMinn

10. Profitability Index • The profitability index is the ratio of the present value of the future net cash flows to the initial outlay. It can be expressed as: • The accept-reject criterion for the pi method is as follows: if pi 1 then accept; otherwise reject Richard MacMinn

11. Profitability Index • The advantages of pi method is same as those of npv method • Both, pi and npv method will give the same accept-reject reject decision to a project • However, pi and npv will not necessarily rank the acceptable projects in the same order Richard MacMinn

12. Internal Rate of Return • The internal rate of return, i.e., irr, is the discount rate that equates the present value of the project’s future cash flows with the project’s initial outlay • Mathematically, the internal rate of return is defined as the rate such that Richard MacMinn

13. Internal Rate of Return • The accept-reject criterion for the irr method is: accept if irr r; otherwise reject • The irr method deals with cash flows and considers time value of money • The irr is difficult to compute and complicated by the fact that there may be multiple internal rates for a project • The number of positive internal rates for a project is equal to the number of sign reversals in the after-tax cash flows from the project Richard MacMinn

14. Capital Rationing • Capital Rationing is the situation in which a budget ceiling or constraint is placed upon the amount of funds that can be invested during a time period. • Under capital rationing we select highest NPV projects subject to investment constraint. • Theoretically, a firm should never reject a project that yields more than the required rate of return. • Since positive NPV projects are rejected, the situation leads to less than optimal investment policy. Richard MacMinn

15. Capital Rationing Rationales • Management may think that market conditions are temporarily adverse for undertaking too many new projects. • There may be shortage of qualified managers to direct new projects. • Other intangible considerations. Richard MacMinn

16. Project Ranking • A project is mutually exclusive if acceptance of one necessarily mean rejection of other projects. In this case project’s relative ranking becomes important. • On occasions conflicts in ranking may arise. Such conflicts arise as a result of difference in assumption about the reinvestment rate on funds released from the proposal. • There are three types ranking problems: • Size disparity problems;Time disparity problems; Unequal lives problem Richard MacMinn

17. Project Ranking • Size disparity problem occurs when mutually exclusive projects of unequal sizes are examined. • Time disparity problem occurs as a result of differing reinvestment rate assumption made by the NPV and IRR decision criteria. • Unequal lives problem arises when mutually exclusive projects of different life spans are compared. Richard MacMinn

18. Project Ranking • The npv criterion assumes that the cash flows over the life of the project can be reinvested at the required rate of return. • The irr criterion implicitly assumes that the cash flows over the life of the project can be reinvested at the internal rate of return. • Projects of unequal lives can be compared using an equivalent annual annuity (eaa) method. Richard MacMinn

19. Summary • The net present value method is preferred due to its strong theoretical foundations. • Project rankings can conflict and lead to erroneous results for measures other than npv. Richard MacMinn