BBF 222 Capital Budgeting PDF

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Financial management notes. Financial management refers to the strategic planning, organizing, directing, and controlling of financial undertakings in an organization or an institute. It also includes applying management principles to the financial assets of an organization, while also playing an im...

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Capital Budgeting: Capital Budgeting Decision Tools By Sham Gad Once projects have been identified, management then begins the financial process of determining whether or not the project should be pursued. The three common capital budgeting decision tools are the payback period, net present value (NPV) method and the internal rate of return (IRR) method.

Payback Period The payback period is the most basic and simple decision tool. With this method, you are basically determining how long it will take to pay back the initial investment that is required to undergo a project. In order to calculate this, you would take the total cost of the project and divide it by how much cash inflow you expect to receive each year; this will give you the total number of years or the payback period. For example, if you are considering buying a gas station that is selling for $100,000 and that gas station produces cash flows of $20,000 a year, the payback period is five years.

As you might surmise, the payback period is probably best served when dealing with small and simple investment projects. This simplicity should not be interpreted as ineffective, however. If the business is generating healthy levels of cash flow that allow a project to recoup its investment in a few short years, the payback period can be a highly effective and efficient way to evaluate a project. When dealing with mutually exclusive projects, the project with the shorter payback period should be selected.

Net Present Value (NPV) The net present value decision tool is a more common and more effective process of evaluating a project. Perform a net present value calculation essentially requires calculating the difference between the project cost (cash outflows) and cash flows generated by that project (cash inflows). The NPV tool is effective because it uses discounted cash flow analysis, where future cash flows are discounted at a discount rate to compensate for the uncertainty of those future cash flows. The term "present value" in NPV refers to the fact that cash flows earned in the future are not worth as much as cash flows today. Discounting those future cash flows back to the present creates an apples to apples comparison between the cash flows. The difference provides you with the net present value.

The general rule of the NPV method is that independent projects are accepted when NPV is positive and rejected when NPV is negative. In the case of mutually exclusive projects, the project with the highest NPV should be accepted.

Internal Rate of Return (IRR)

The internal rate of return is a discount rate that is commonly used to determine how much of a return an investor can expect to realize from a particular project. Strictly defined, the internal rate of return is the discount rate that occurs when a project is break even, or when the NPV equals 0. Here, the decision rule is simple: choose the project where the IRR is higher than the cost of financing. In other words, if your cost of capital is 5%, you don't accept projects unless the IRR is greater than 5%. The greater the difference between the financing cost and the IRR, the more attractive the project becomes.

The IRR decision rule is straightforward when it comes to independent projects; however, the IRR rule in mutually-exclusive projects can be tricky. It's possible that two mutually exclusive projects can have conflicting IRRs and NPVs, meaning that one project has lower IRR but higher NPV than another project. These issues can arise when initial investments between two projects are not equal. Despite the issues with IRR, it is still a very useful metric utilized by businesses. Businesses often tend to value percentages more than numbers (i.e., an IRR of 30% versus an NPV of $1,000,000 intuitively sounds much more meaningful and effective), as percentages are more impactful in measuring investment success. Capital budgeting decision tools, like any other business formula, are certainly not perfect barometers, but IRR is a highly-effective concept that serves its purpose in the investment decision making process.

Capital Budgeting: The Capital Budgeting Process At Work By Sham Gad This tutorial will conclude with some basic, yet illustrative examples of the capital budgeting process at work. Example 1: Payback Period Assume that two gas stations are for sale with the following cash flows:

According to the payback period, when given the choice between two mutually exclusive projects, Gas Station B should be selected. Although both gas stations cost the same, Gas Station B has a payback period of one year, whereas Gas Station A will payback in roughly one and half years. Payback analysis is common to everyone in investment decisions, an example being the purchase of a hybrid car. Example 2: Net Present Value Method As was mentioned earlier, the payback period is a very basic capital budgeting decision tool that ignores the timing of cash flows. Since most capital investment projects have a life span of many years, a shorter payback period may not necessarily be the best project. Consider the gas station example above under the NPV method, and a discount rate of 10%: NPVgas station A = $100,000/(1+.10)2 - $50,000 = $32,644 2

NPVgas station B = $50,000/(1+.10) + $25,000/(1+.10) - $50,000 = $16,115

In our gas station example, the net present value tool illustrates the limitations of the payback period. Under the payback period, the decision would have been to pick gas station B because it had the shorter payback period. Under the NPV criteria, however, the decision favors gas station A, as it has the higher net present value. In this particular case, the NPV of gas station A is more than twice that of gas station B, which implies that gas station A is a vastly better investment project to undertake. In the real world, however, sometimes managers will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods. For example, suppose the NPV of gas station A was only slightly higher than that of B, yet the buyer was worried about meeting his financial obligations in year one. In that case, the choice may be made to take on the project with the quicker upfront cash flows even it means a slightly lower return. When might something like this occur? It could be that the buyer had to borrow a majority of the purchase price and really had a desire to pay back the loan sooner, rather than later, to save on interest expense. In that case, a quicker payback period may be more desirable than a slightly higher net present value project. Do keep in mind, however, that all capital projects, in the case of for-profit enterprises, should be made in the context of creating long-term shareholder value. In our above example, gas station A with the higher NPV creates significantly more shareholder value than does gas station B. So even if the decision was made based on a quicker payback period, the project with greatest net present value would be the one that maximizes shareholder value. Generally speaking, accepting the project with the lower net present value would be destroying shareholder value. Example 3 – Internal Rate of Return The internal rate of return (IRR) method can perhaps be the more complicated and subjective of the three capital budgeting decision tools. Similar to the NPV, the IRR accounts for the time value of money. It is useful here to repeat the definition of the IRR: The IRR of any project is the rate of return that sets the NPV of a project zero. Since the general NPV rule is to only pick projects with an NPV greater than zero with the highest net present value, the internal rate of return, by definition, is the breakeven interest rate. In other words, the IRR decision criteria conceptually obvious: Choose projects with an IRR that is greater than the cost of financing This rule is easy to understand: if your cost of capital is 10%, projects with an internal rate of return of 8% would destroy value, while projects with an internal rate of return of 15% with increase value. While it's conceptually simple to understand the internal rate of return process, calculating IRR can be a bit tricky. The calculation of a project's IRR is essentially a trial and error one. Consider the following example of a project with the following cash flows:

There is no simple formula to calculate the IRR. It's either done by trial and error or a financial calculator. Remember, however, that the IRR is that rate where NPV is equal to zero, the equation would be set up like this: 2

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CF0 + CF1/(1+IRR) + CF 2/(1+IRR) + CF3/(1+IRR) = 0, or 2

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-$1,000+ $100/(1+IRR) + $600/(1+IRR) + $800/(1+IRR) = 0 Believe or not, from here the next step is to guess a number for IRR, plug in and see if it equals zero. When IRR = 20%, or .20, the result is a number greater than zero (you can try it yourself, just enter "0.20" in place of "IRR." Performing a trial and error calculation here would be too cumbersome but it's very simple and

good practice, to try it yourself). Thus 20% is too big a number. The next step would be to try a lower number. When IRR = 17%, the NPV is less than zero, so that IRR is too low. The IRR of this particular project is 18.1%. That is the interest where the NPV of the above project is zero. Plug it in and you should get zero or an insignificantly lower number that equates to zero. Thus, if the cost of financing the above the project is below 18.1%, the project creates value under the IRR calculation; if the cost of financing is greater than 18.1%, the project will destroy value. Just as is the case with the payback method and NPV, the IRR decision will not always agree with the NPV decision in mutually-exclusive projects. Again, this has to do with initial cash flow outlay and timing of future cash flows. However, in the end, despite the its flaws, percentages are more intuitive and useful in business, thus rendering value

Capital Budgeting: Wrapping It All Up By Sham Gad All for-profit business seemingly exist on the mandate of maximizing shareholder, or owner, value. A business is essentially a series of transactions that aim at generating greater revenue and profits. The capital budgeting process, or the methods employed by a company to invest in activities to generate additional value, is a dynamic process, to say the least.

In a way, a business is nothing more than a series of many capital budgeting decisions. Decisions to hire a new CEO, negotiate contracts, maintain efficient operations, compete in the mergers and acquisitions arena, among others, are all capital budgeting decisions, in one way or another. Even decisions to reduce employees, shut down a division or the sale of part or all the company are capital budgeting decisions. Businesses are often observed being sold under the mandate of maximizing shareholder value.

Whether minor or major, all business decisions involve an accounting of costs versus benefits. In a way, that's the essence of the capital budgeting process. Shareholders put their trust in management to constantly assess the costs versus benefits – the risk versus the reward – of their corporate actions. When a CEO is fired, it's often because a company has failed to create shareholder value. Put another way, that CEO or executive has failed to successfully engage in value-creating projects; the capital budgeting process under that CEO was ineffective.

Understanding the capital budgeting process is not only important from an intellectual standpoint, but vital to understanding how a business can and will create future value. The world's greatest executives – Sam Walton of Wal-Mart, Roberto Goizueta of Coca Cola, Warren Buffett at Berkshire Hathaway, Jack Welch at General Electric – have a long history of making value creating decisions. These executives got capital budgeting process right.

Individual investors also benefit from the capital budgeting process. Investing in a company's stock is much like

investing in a project. At a given share price, investors ought to be able to figure out if that share price is below the intrinsic value of those shares. One determines the intrinsic value by conducting a discounted cash flow analysis, essentially finding the net present value of that company. Being able to seek out undervalued investments is clearly the ultimate objective for investors and corporate executives. In one form or another, the capital budgeting process is the set of tools that facilitates that value seeking process. e to the IRR method....