SZABIST
Financial Management
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.
Faizan Ahmed
1
SZABIST
Financial Management
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.
Faizan Ahmed
2
SZABIST
Financial Management
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;
Faizan Ahmed
3
SZABIST
Financial Management
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.
Faizan Ahmed
4
SZABIST
Financial Management
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.
Faizan Ahmed
5
SZABIST
Financial Management
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.
Faizan Ahmed
6
SZABIST
Financial Management
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.
Faizan Ahmed
7
SZABIST
Financial Management
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.
Faizan Ahmed
8
SZABIST
Financial Management
Capital Budgeting Decision Rules
The Payback Period…
• The payback period is the number of years required to recover the original
investment.
Payback Period
Unrecovere d Cost at Start of the year
Cash Flow During the Year
Year Before Full Recovery
• 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
Faizan Ahmed
200
500
2.4 years
9
SZABIST
Financial Management
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
Disadvantages
It is easy to understand
Ignores time value of money
Adjusts for uncertainty of later cash flows
Requires an arbitrary cutoff point
Biased towards liquidity
Ignores cash flows beyond the cutoff date
Biased against long-term projects
Faizan Ahmed
10
SZABIST
Financial Management
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
Unrecovere d 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
DiscountedPaybackPeriod 2
Faizan Ahmed
258.39
2.8 years
337.49
11
SZABIST
Financial Management
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
Disadvantages
It is easy to understand
May yield conflicting results
Adjusts for uncertainty of later cash flows
Requires an arbitrary cutoff point
Biased towards liquidity
Ignores cash flows beyond the cutoff date
Includes time value of money
Biased against long-term projects
Faizan Ahmed
12
SZABIST
Financial Management
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
Faizan Ahmed
NPV
NPV
PV (Inflows)
815 .37 500
NPV
315 .37
PV (Outflows)
13
SZABIST
Financial Management
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
Disadvantages
It is easy to understand
Does not take into account the project’s size
Includes time value of money
Does not signify anything in terms of
project’s profitability
Takes into account all the cash flows
Biased towards liquidity
Faizan Ahmed
14
SZABIST
Financial Management
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%.
Faizan Ahmed
15
SZABIST
Financial Management
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
Disadvantages
Easy to understand and communicate
May result in multiple answers or no
answers because of its inability to handle
nonconventional cash flows
Closely related to NPV and often leading
identical results
May lead to incorrect decisions in
comparison of mutually exclusive
investments
Faizan Ahmed
16
SZABIST
Financial Management
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.
Faizan Ahmed
17
SZABIST
Financial Management
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?
Faizan Ahmed
18
SZABIST
Financial Management
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?
Faizan Ahmed
19