4-1 Business Finance (MGT 232) Lecture 17. 4-2 Capital Budgeting.

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Business Finance(MGT 232)

Lecture 17

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Capital BudgetingCapital BudgetingCapital BudgetingCapital Budgeting

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– Creation of Value– Overall Cost of Capital of the Firm

• Cost of Debt• Cost of P. Stock• Cost Common Stock

– Calculating WACC– Limitations of WACC

Overview of the Last Lecture

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Capital Budgeting and Estimating Cash FlowsCapital Budgeting and Estimating Cash Flows

– The Capital Budgeting Process– Classification of Investment Project Proposals– Capital Budgeting Techniques• Payback Period• Discounted Payback Period• Net Present Value• Internal Rate of Return• Modified Internal rate of return• Profitability index

– The Capital Budgeting Process– Classification of Investment Project Proposals– Capital Budgeting Techniques• Payback Period• Discounted Payback Period• Net Present Value• Internal Rate of Return• Modified Internal rate of return• Profitability index

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What is Capital Budgeting?

What is Capital Budgeting?

The process of identifying, analyzing, and selecting investment projects

whose returns (cash flows) are expected to extend beyond one year.

The process of identifying, analyzing, and selecting investment projects

whose returns (cash flows) are expected to extend beyond one year.

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The Capital Budgeting Process

The Capital Budgeting Process

• Generate investment proposals consistent with the firm’s strategic objectives.

• Estimate after-tax incremental operating cash flows for the investment projects.

• Evaluate project incremental cash flows.

• Generate investment proposals consistent with the firm’s strategic objectives.

• Estimate after-tax incremental operating cash flows for the investment projects.

• Evaluate project incremental cash flows.

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The Capital Budgeting Process

The Capital Budgeting Process

• Select projects based on a value-maximizing acceptance criterion.

• Reevaluate implemented investment projects continually and perform postaudits for completed projects.

• Select projects based on a value-maximizing acceptance criterion.

• Reevaluate implemented investment projects continually and perform postaudits for completed projects.

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Classification of Investment Project Proposals

Classification of Investment Project Proposals

1. New products or expansion of existing products

2. Replacement of existing equipment or buildings

3. Research and development4. Exploration5. Other (e.g., safety or pollution related)

1. New products or expansion of existing products

2. Replacement of existing equipment or buildings

3. Research and development4. Exploration5. Other (e.g., safety or pollution related)

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Screening Proposals and Decision Making

Screening Proposals and Decision Making

1. Section Chiefs

2. Plant Managers

3. VP for Operations

4. Capital Expenditures Committee

5. President

6. Board of Directors

1. Section Chiefs

2. Plant Managers

3. VP for Operations

4. Capital Expenditures Committee

5. President

6. Board of Directors

AdvancementAdvancementto the nextto the next

level depends level depends on cost on cost

and strategicand strategicimportance.importance.

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Project Evaluation: Alternative MethodsProject Evaluation:

Alternative Methods

– Payback Period (PBP)– Discounted Payback Period (DPP)– Net Present Value (NPV)– Internal Rate of Return (IRR)– Modified Internal Rate of Return (MIRR)– Profitability Index (PI)

– Payback Period (PBP)– Discounted Payback Period (DPP)– Net Present Value (NPV)– Internal Rate of Return (IRR)– Modified Internal Rate of Return (MIRR)– Profitability Index (PI)

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Proposed Project DataProposed Project Data

Mariam is evaluating a new project for her firm, Basket Wonders (BW). She has

determined that the after-tax cash flows for the project will be Rs.10,000;

Rs.12,000; Rs.15,000; Rs.10,000; and Rs.7,000, respectively, for each of the

Years 1 through 5. The initial cash outlay will be Rs.40,000.

Mariam is evaluating a new project for her firm, Basket Wonders (BW). She has

determined that the after-tax cash flows for the project will be Rs.10,000;

Rs.12,000; Rs.15,000; Rs.10,000; and Rs.7,000, respectively, for each of the

Years 1 through 5. The initial cash outlay will be Rs.40,000.

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Independent Project

• IndependentIndependent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.

For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.

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Other Project Relationships

• Mutually ExclusiveMutually Exclusive -- A project whose acceptance prevent the acceptance of one or more alternative projects.

DependentDependent -- A project whose acceptance depends on the acceptance of one or more other projects.

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Payback Period (PBP)Payback Period (PBP)

PBPPBP is the period of time required for the cumulative expected cash flows from an

investment project to equal the initial cash outflow.

The period in which the project initial investment will be back

PBPPBP is the period of time required for the cumulative expected cash flows from an

investment project to equal the initial cash outflow.

The period in which the project initial investment will be back

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7 K

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Payback SolutionPayback Solution

PBPPBP = 3 + ( 3K ) / 10K= 3.3 Years3.3 Years

Note: Take absolute value of last negative cumulative cash flow value.

PBPPBP = 3 + ( 3K ) / 10K= 3.3 Years3.3 Years

Note: Take absolute value of last negative cumulative cash flow value.

CumulativeCash Flows

-40 K 10 K 12 K 15 K 10 K 7 K

0 1 2 3 4 5

-40 K -30 K -18 K -3 K 7 K 14 K

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Payback PeriodPayback Period

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PBP Acceptance CriterionPBP Acceptance Criterion

Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years <

3.5 Year Max.]

Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years <

3.5 Year Max.]

The management of Basket Wonders has set a maximum PBP of 3.5 years for

projects of this type.Should this project be accepted?

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PBP Strengths and WeaknessesPBP Strengths and Weaknesses

StrengthsStrengths::– Easy to use and understand– Can be used as a measure of liquidity– Easier to forecast ST than LT flows

StrengthsStrengths::– Easy to use and understand– Can be used as a measure of liquidity– Easier to forecast ST than LT flows

WeaknessesWeaknesses::– Does not account

for TVM– Does not consider cash flows beyond the PBP– Cutoff period is

subjective

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Discounted Payback Period (DPP)

Discounted Payback Period (DPP)

DPPDPP is the period of time required for the cumulative expected cash flows from an

investment project to equal the initial cash outflow at a discount rate.

The period in which the project initial investment will be back

DPPDPP is the period of time required for the cumulative expected cash flows from an

investment project to equal the initial cash outflow at a discount rate.

The period in which the project initial investment will be back

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7 K

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Discounted Payback PeriodDiscounted Payback Period

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DPP Acceptance CriterionDPP Acceptance Criterion

No! The firm is not geetting the initial outlay in projects life time

No! The firm is not geetting the initial outlay in projects life time

The management of Basket Wonders has set a maximum DPP of 3.5 years for

projects of this type.Should this project be accepted?

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Net Present Value (NPV)Net Present Value (NPV)

NPV is the present value of an investment project’s net cash flows

minus the project’s initial cash outflow.

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Basket Wonders has determined that the appropriate discount rate (r) for this project is

13%.

NPV Solution NPV Solution

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NPV SolutionNPV Solution

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NPV Acceptance CriterionNPV Acceptance Criterion

No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject Reject

as NPVNPV < 00 ]

No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject Reject

as NPVNPV < 00 ]

The management of Basket Wonders has determined that the required rate is 13%

for projects of this type.Should this project be accepted?

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NPV Strengths and Weaknesses

NPV Strengths and Weaknesses

StrengthsStrengths::– Cash flows

assumed to be reinvested at the

hurdle rate.– Accounts for TVM.– Considers all

cash flows.

StrengthsStrengths::– Cash flows

assumed to be reinvested at the

hurdle rate.– Accounts for TVM.– Considers all

cash flows.

WeaknessesWeaknesses::– May not include

managerial options

embedded in the project. See Chapter 14.

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Summary

– The Capital Budgeting Process– Classification of Investment Project Proposals– Capital Budgeting Techniques• Payback Period• Discounted Payback Period• Net Present Value