Capital Budgeting

Capital budgeting (or investment appraisal) is the process of determining the viability to long-term investments on purchase or replacement of property plant and equipment, new product line or other projects.

NPV Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500 in the 3rd year. Use 10% Interest Rate.
Let us work year by year (remembering to subtract what you pay out): Now: PV = -$2,000 Year 1: PV = $100 / 1.10 = $90.91 Year 2: PV = $100 / 1.102 = $82.64 Year 3: PV = $100 / 1.103 = $75.13 Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29 Adding those up gets: NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29 = $126.97 Looks like a good investment.

Example of Average Accounting Return:

Step 1: Annual Depreciation = ( 220 10 ) / 3 = 70 Step 2: Year Cash Inflow Salvage Value Depreciation* -70 91 1 2 3

130 105 10 -70 -70 60 45

Accounting Income 21

Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3 = 42 Step 4: Accounting Rate of Return = 42 / 220 = 19.1%

Example of Discounted Pay Back period:

An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted payback period of the investment if the discount rate is 11%. Solution Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by present value factor. Create a cumulative discounted cash flow
column. Year n 0 1 2 3 4 5 6 Cash Flow CF $ 2,324,000 600,000 600,000 600,000 600,000 600,000 600,000 Present Value Factor PV$1=1/(1+i) 1.0000 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346
n

Discounted Cash Flow CFPV$1 $ 2,324,000 540,541 486,973 438,715 395,239 356,071 320,785

Cumulative Discounted Cash Flow $ 2,324,000 1,783,459 1,296,486 857,771 462,533 106,462 214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 5.32 years

Advantages and Disadvantages

Advantage: Discounted payback period is more reliable than simple payback period since it accounts for time value of money. It is interesting to note that if a project has negative net present value it won't pay back the initial investment. Disadvantage: It ignores the cash inflows from project after the payback period.

Pay Back Period:

Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2,

$16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Solution (cash flows in millions) Year 0 1 2 3 4 5 Payback Period = 3 + (|-$11M| $19M) = 3 + ($11M $19M) 3 + 0.58 3.58 years Cash Flow (50) 10 13 16 19 22 Cumulative Cash Flow (50) (40) (27) (11) 8 30

Advantages and Disadvantages

Advantages of payback period are: 1. Payback period is very simple to calculate. 2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are. 3. For companies facing liquidity problems, it provides a good ranking of projects that would return money early. Disadvantages of payback period are: 1. Payback period does not take into account the time value of money which is a serious drawback since it can lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted payback period method. 2. It does not take into account, the cash flows that occur after the payback period.

Profitability Index
Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project.

Formula:
Profitability Index Present Value of Future Cash Flows = Initial Investment Required

Net Present Value =1+ Initial Investment Required

Explanation:
Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profibality index is a relative measure (i.e. it gives as the figure as a ratio).

Decision Rule
Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is zero and don't accept a project if the profitability index is below 1. Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return.

Example
Company C is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a present value of $65 million. Calculate the profitability index. Solution Profitability Index = PV of Future Net Cash Flows / Initial Investment Required Profitability Index = $65M / $50M = 1.3 Net Present Value = PV of Net Future Cash Flows Initial Investment Rquired Net Present Value = $65M-$50M = $15M.

The information about NPV and initial investment can be used to calculate profitability index as follows: Profitability Index = 1 + (Net Present Value / Initial Investment Required) Profitability Index = 1 + $15M/$50M = 1.3