L32. Capital Budgeting

Question 1

Learning Outcomes

Answer 1

a. Describe the capital budgeting process and distinguish among the various categories of capital projects
b. Describe the basic principles of capital budgeting
c. Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing and capital rationing
d. Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project
e. Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods
f. Contrast the NPV decision rule to the IRR decision rule and identify problems associated with the IRR rule
g. Describe expected relations among an investment’s NPV, company value and share price

Question 2

Capital budgeting

Answer 2

Process that companies use for decision making on capital projects - those projects with a life of a year or more

• capital projects make up a long term asset portion in balance sheet, can be so large that sound capital budgeting decisions decide the future of many coy

Question 3

Capital budgeting process

Answer 3

1. Generating ideas
   - investing ideas can come from anywhere
2. Analysing individual proposals
   - involves gathering the information to forecast cash flows for each project and then evaluating project’s profitability
3. Planning the capital budget
   - must organise profitable proposals into a coordinated whole that fits within coy’s overall strategies, and also consider projects’ timing
   - some project looks good when considered in isolation but is undesirable strategically
   - due to financial and resource issues, scheduling and prioritising of projects is important
4. Monitoring and post auditing
   - actual results are compared to planned or predicted results, and any differences must be explained
   - post auditing capital projects is important because it helps monitor the forecasts and analysis that underlie the capital budgeting process (systematic errors such as overly optimistic forecasts become apparent)
   - helps improve business operations
   - will produce concrete ideas for future investments

Question 4

Types of capital budgeting projects

Answer 4

1. Replacement projects
   - eg if piece of equipment breaks down or replacing existing equipment with newer, more efficient one
2. Expansion projects
   - to increase size of business
   - involve more uncertainties than replacement decisions
3. New products and services
   - expose to even more uncertainties
   - more complex and involve more people in the decision making process
4. Regulatory, safety and environmental projects
   - often required by governmental agency, insurance company or some external party
   - may generate no revenue
   - accept to continue operation
   - occasionally if cost of such project is significantly high, some coy will shut down any part of the business that is related to the project
5. Others

Question 5

Basic principles of capital budgeting

Answer 5

Usually uses the following assumptions:

1. Decisions are based on cash flows
   - not based on accounting concepts such as net income
   - intangible costs and benefits are often ignored because if they are real, they will result in cash flows at some time
2. Timing of cash flow is crucial
3. Cash flow are based on opportunity costs. What. are the incremental cash flows that occur with an investment compared to what they would have been without the investment?
4. Cash flows are analysed on an after-tax basis
5. Financing costs are ignored
6. Capital budgeting cash flows are not accounting net income because accounting net income is reduced by non cash charges such as accounting depreciation
   - interest expenses also subtracted from accounting net income

Other relevant terms

1. Sunk cost
   - one that has already occured
2. Opportunity cost
   - what a resource is worth in its next best use
3. Incremental cash flow
   - cash flow that is realised because of a decision
4. Externality
   - effect of an investment on other things besides the investment itself
   - can be positive or negative
   - an investment can benefit (or harm) other companies or society at large but the company is not compensated for these benefits (or charged for the costs)
   - Cannibalisation is an eg and occurs when an investment takes customers and sales away from another part of the company
5. Conventional cash flows vs non conventional cash flows
   - conventional pattern is one with an initial outflow followed by a series of inflows
   - non conventional pattern the initial outflow is not followed by inflows only, but the cash flows can flip from positive to negative again
   - if cash flows change signs once, pattern is conventional
   - if cash flows change signs two or more times, pattern is unconventional

Types of projects interaction

1. Independent projects vs mutually exclusive projects
   - independent projects are where cash flows are independent of each other
   - mutually exclusive projects compete directly with each other. eg A and B, can only choose 1 not both
2. Project sequencing
   - projects sequenced through time so that investing in a project creates the option to invest in future projects
   - eg invest in 1 project today and if results are favourable for the first year, invest in another.
3. Unlimited funds vs capital rationing
   - unlimited funds environment assumes that coy can raise the funds it wants for all profitable projects simply by paying the required rate of return
   - capital rationing exists when company has fixed amount of funds to invest
   - if coy has more profitably projects than it has funds for, must allocate the funds to achieve the max shareholder value subject to funding constraints

Question 6

Investment Decision criteria

Answer 6

1. Net present Value (NPV)
   - PV of the future after tax cash flows minus investment outlay

NPV = sum of [CFt / (1+R)^t] - outlay

eg. Coy A considering an investment of 50 million in capital project that will return after tax cash flows of 16 million per year for next 4 years and another 20 million in year 5. Required rate of return is 10%

What is the NPV?

Solution:
[16/(1+0.1)^1 +16/(1+0.1)^2 + 16/(1+0.1)^3 + 16/(1+0.1)^4 + 20/(1-0.1)^5 ] - 50
= 13.136 million

In calculator 
Press CF 
CFo = initial outlay = -50 
Press enter and down 
CO1 = cash inflow = 16 
F01 = number of frequency = 4 
CO2 = cash inflow 2 = 20 
F01 = number of frequency = 1 
Press CPT NPV 
I = 10 
Press enter down
Press CPT 

Investment has a total value of 63.136 million (50+13.136).

Invest if NPV > 0
Do not invest if NPV < 0

2. Internal rate of return (IRR)
   - the discount rate that makes the PV of the future after tax cash flows = investment outlay

sum of [CFt / (1+IRR)^t] = outlay

Based on the above eg.
Find IRR.

Solution

In calculator
From NPV simply press IRR and cpt
IRR = 19.52

Invest if IRR > r
Do not invest if IRR < r

3. Payback period
   - the number of years required to recover the original investment in a project
   - measures payback but not profitability
   - does not account for time value of money
4. Discounted payback period
   - number of years it takes for the cumulative discounted cash flows from a project to equal the original investment
   - drawback is that it is possible for project to have a negative NPV but to have positive cumulative discounted cash flow in the middle of its life thus a reasonable discounted payback period
5. Average accounting rate of return
   - average net income / average book value
   - average book value = opening bv + closing bv / 2
   - disadvantage as it is based on accounting numbers and not cash flow
   - does not account for time value of money
6. Profitability index (PI)
   - present value of a project’s future cash flows divided by initial investment
   - also known as benefit-cost ratio

PI = PV of future cash flows / initial investment = 1 + NPV/initial investment

• the PI is the ratio of the PV of future cash flows to the initial investment whereas an NPV is the difference between the PV of the future cash flows and the initial investment

Invest if PI > 1.0
Do not invest if PI < 1.0

Using above eg.

Since we found NPV, use 1 + 13.136/50 = 1.262
or PV of future cash flow / initial investment
= 63.136/50 = 1.262

Question 7

NPV profile

Answer 7

Shows a project NPV graphed as a function of various discount rates

• NPV is graphed vertically on Y axis and discount rates graphed horizontally on X axis
• NPV declines at decreasing rates as discount rate increases
• no conflict occurs when both projects independent
• for mutually exclusive projects, two criteria will sometime disagree eg. Project A NPV > Project B but project B IRR > Project A so which should you invest?
  SOLUTION: choose project with higher NPV

Question 8

Multiple IRR and no IRR problems

Answer 8

• For conventional projects, negative cash flows followed by positive cash flows - multiple IRR cannot occur

For non conventional projects, multiple IRR can occur
- for project with 2 sign changes, could have 0, 1 or 2 IRRs

Question 9

NPVS and stock prices

Answer 9

Coy A is investing 600 million in facilities. The PV of the future after tax cash flow is estimated to be 850 million. Coy has 200 million outstanding shares with a market price of $32/share. Investment is new info and independent of other expectations about the company. What should be the effect of the project of the value of the company and the stock price?

NPV of project = 850 million - 600 million = 250 million
Shares outside value = 200 * 32 = 6,400 million
Value of company should increase by 250 million to 6650 million. Price per share should increase by 250/200 = 1.25/per share. so shares should be priced at 32+1.25 = $33.25