Capital Budgeting

- What fixed assets should we buy? What projects should we invest in?
- Goal of Management: Maximize shareholder value
- How do we evaluate capital budgeting decision rules?
- Does the decision rule adjust for the timing of the cash flows? (TVM)
- Does the decision rule appropriately adjust for risk?
- Does the decision rule provide information on value creation?

- How does capital budgeting differ from valuing stocks and bonds?
- Unlike stocks, projects have cash flows that end.
- Project cash flows typically vary through time, unlike a fixed coupon or a dividend that grows at a constant rate.

Example

- You are reviewing a new project and have estimated the following cash flows:
- Year 0: CF = –165,000
- Year 1: CF = 63,120; NI = 13,620
- Year 2: CF = 70,800; NI = 3,300
- Year 3: CF = 91,080; NI = 29,100
- Average Book Value = 72,000

- Your required return for assets of this risk level is 12%.

Capital Budgeting Decision Rules

- Net Present Value (NPV)
- Does the PV of cash inflows exceed the PV of cash outflows?
- If the NPV is positive, accept the project.
- In the case of our example, NPV is $12,627.41.
- Use financial calculator’s CF registry.
- Do we accept or reject the project?

- Does this rule meet our criteria for a good capital budgeting decision rule?
- Does the decision rule adjust for the timing of the cash flows? Yes.
- Does the decision rule appropriately adjust for risk? Yes.
- Does the decision rule provide information on value creation? Yes.

- Payback Period
- How long does it take to get the initial cost back in a nominal sense?
- If the payback period is shorter than some preset limit (typically 3–4 years), accept the project.
- In the case of our example, payback occurs in 3 years (2.34 if cash flows are evenly spaced throughout the year).
- Consider a benchmark payback period of 3 years.
- Do we accept or reject the project?

- Does this rule meet our criteria for a good capital budgeting decision rule?
- Does the decision rule adjust for the timing of the cash flows? No.
- Does the decision rule appropriately adjust for risk? No.
- Does the decision rule provide information on value creation? No.

- Consider two projects. One project costs $250 and pays out $100 each year over the next 4 years. The other project costs $250, pays out $100 in year one, and pays out $200 in year two. Assume a required rate of return of 15 percent.
- Payback period: 2.5 years vs. 1.75 years
- NPV: $35.50 vs. $–11.81

- Features:
- Easy
- Biased toward liquidity (short-term projects)
- Accounts for the uncertainty of long-term cash flows by ignoring them entirely

- Discounted Payback Period
- How long does it take to get the initial cost back after discounting the cash flows?
- If the discount payback period is shorter than some preset limit, then accept.
- In the case of our example, payback occurs in 3 years.
- Consider a benchmark payback period of 2 years.
- Do we accept or reject the project?

- Does this rule meet our criteria for a good capital budgeting decision rule?
- Does the decision rule adjust for the timing of the cash flows? Yes.
- Does the decision rule appropriately adjust for risk? Yes.
- Does the decision rule provide information on value creation? No. The cutoff period is arbitrary.

- Average Accounting Return
- What is the ratio of average net income to average book value?
- If the average accounting return exceeds some threshold, accept the project.
- In the case of our example, AAR is 21%.
- Consider a benchmark AAR of 25%.
- Do we accept or reject the project?

- Does this rule meet our criteria for a good capital budgeting decision rule?
- Does the decision rule adjust for the timing of the cash flows? No.
- Does the decision rule appropriately adjust for risk? No.
- Does the decision rule provide information on value creation? No.

- This rule doesn’t even account for cash flows.

- Internal Rate of Return (IRR)
- What rate of return makes the NPV zero?
- If the IRR exceeds the required rate of return, then accept.
- In the case of our example, IRR is 16.13%.
- CF registry on financial calculator
- Trial and error, otherwise
- Remember relationship between price and rate of return.
- If NPV > 0, then increase the IRR.
- If NPV < 0, then decrease the IRR.

- Do we accept or reject the project?

- See Figure 9.5
- Does this rule meet our criteria for a good capital budgeting decision rule?
- Does the decision rule adjust for the timing of the cash flows? Yes.
- Does the decision rule appropriately adjust for risk? Yes.
- Does the decision rule provide information on value creation? Yes.

- Generally, NPV and IRR give the same decision, except:
- CFs that change sign more than once
- Consider a strip mine that costs $60. The cash flows are $155 in the first year and -$100 in the second year.
- The NPV is zero when the IRR is 25% and when the IRR is 33.33%.

- Mutually exclusive investments
- A situation in which taking one investment prevents the taking of another.
- See Example
- See Figure 9.8
- Crossover Rate
- The discount rate that makes the NPVs of the two projects equal
- Example
- Investment A CFs: -$400, $250, $280
- Investment B CFs: -$500, $320, $340
- Work with NPV(B-A) to find crossover.

- In the case of conflicts, always use NPV.

- CFs that change sign more than once

- Modified IRR
- Return to our previous example
- Consider a strip mine that costs $60. The cash flows are $155 in the first year and -$100 in the second year.
- The NPV is zero when the IRR is 25% and when the IRR is 33.33%.
- The required rate of return is 20%.

- Method 1: Discounting Approach
- Discount negative cash flows to present at the required rate of return.
- Now the initial cash flow is -$129.44, and the MIRR is 19.74%.

- Method 2: Reinvestment Approach
- Reinvest cash flows at the required rate of return.
- Now the only inflow is $86 at year two, and the MIRR is 19.72%.

- Method 3: Combination Approach
- Discount negative cash flows to present.
- Compound positive cash flows to end.
- CF0 is -$129.44, CF2 is $186, and the MIRR is 19.87%.

- Return to our previous example
- Profitability Index
- What is the ratio of the present value of cash flows to the cost of the project? (this is equal to 1 + NPV/Cost)
- If PI > 1, then accept.
- Can lead to ranking problems in mutually exclusive investments.
- Investment A: $5 cost, $10 PV of cash flows
- Investment B: $100 cost, $150 PV of cash flows

In Practice

- Multiple criteria are used (NPV/IRR primary, Payback Period secondary)
- Why?
- Liquidity may be an issue
- NPV calculations can be costly/time consuming
- Cash flows may be uncertain (``soft’’ NPV)

- Tie performance to firm value

Practice Problem

- An investment project has the following cash flows: CF0 = –1,000,000; C01 – C08 = 200,000 each
- If the required rate of return is 12%, what decision should be made using NPV?
- How would the IRR decision rule be used for this project, and what decision would be reached?
- How are the above two decisions related?