By

Arthur S. Cayanan

Copyright Arthur S. Cayanan 2011

I.

Importance of Capital Budgeting

Capital Budgeting Decision Rules
A. Payback Period B. Net Present Value C. Internal Rate of Return

II.

III.

Relevant Cash Flows

Copyright Arthur S. Cayanan 2011

Capital investment decisions concern the commitment of money to resources or assets to generate future returns or benefits.
Capital investments, unlike consumer goods, are not acquired for their immediate consumption value or service. Good investments create value and enhance shareholder wealth.

Copyright Arthur S. Cayanan 2011

1.
2. 3. 4. 5. 6. 7.

8.

Acquisition of new equipment Expansion of production capacity Construction of new building Replacement of machinery and equipment Automation/mechanization of operations Establishment of new branches Acquisition of transportation equipment Construction of new warehouse

Copyright Arthur S. Cayanan 2011

Since the money available for investment is limited and there may be numerous investment opportunities, the decision to commit money must be done carefully.
Money should be committed to investment opportunities that have the greatest value. Capital budgeting analysis involves the systematic evaluation of investment opportunities to meet this objective.

Copyright Arthur S. Cayanan 2011

The payback period refers to the length of time it will take for the cash flows from an investment to cover the cost of the investment.

Copyright Arthur S. Cayanan 2011

BA Printing Press acquired a new machine for P4.5 million, including installation cost. Expected additional cash flows from the business as a result of the acquisition of this machine are as follows: Year 1 P1,500,000 2 2,000,000 3 2,500,000 4 2,500,000 5 2,500,000 The companys cost of capital is 10%.

Requirements: a. Determine the payback period of the machine b. What is the NPV of the machine? c. What is the IRR of the machine?
Copyright Arthur S. Cayanan 2011

Investment proposals are acceptable if: Value of future returns > Value of initial outlay There is another way of stating the rule. The project is acceptable if: Value of future returns - Value of initial outlay > 0 NPV > 0

Net present value or NPV is simply the difference between the two values and a proposal should be acceptable if NPV > 0 or NPV is positive.
Copyright Arthur S. Cayanan 2011

A positive NPV means that the investor is richer by that amount if he undertakes the project.

Copyright Arthur S. Cayanan 2011

To perform an NPV analysis on an investment proposal the following data must be available.
Data Initial Outlay Symbol OI Description Cash outlays required at the start of the project. If project is huge there may be cash outlays for several years before project becomes operational. Net cash flows at a time t. This comes from revenues and expenses related to the project. Inflows and outflows are netted out. Project life span. Investors required rate of return. This is related to the projects risk. If a project is risky, the investor will want a high rate of return to compensate for risk.

Net Cash Flows

NCF t

Time Horizon Required rate of return

n r

Copyright Arthur S. Cayanan 2011

Another method of analysis that uses the same information as the NPV method, is the IRR or internal rate of return method. In this method a rate of return is computed for the investment proposal. This is checked against the required rate of return (also called the Cut-off or Hurdle Rate). If the IRR is greater than the required rate, then the project is acceptable. Otherwise it should be rejected.

Condition
IRR Required rate of return (r) IRR Required rate of return (r)
Copyright Arthur S. Cayanan 2011

Signal
Acceptable Rejected

1. Set up equation and solve for i NCF1 ----------0 (1 + i)1 NCF2 + --------(1 + i)2 NCFn + ---------- - IO = (1 + i)n

2. Compare i (IRR) vs. r (required rate of return). Condition Signal i r Acceptable i r Rejected Solving for i is generally difficult without the aid of a financial calculator or a micro-computer. It can be approximated on a trial and error basis.
Copyright Arthur S. Cayanan 2011

1.

NPV and IRR are discounted cash flow (DCF) methods. This means they work with cash flows and consider time value of money. They are therefore better than non-DCF methods like the payback period or accounting measures.

Copyright Arthur S. Cayanan 2011

2.

NPV provides a direct (absolute) measure of the value created by an investment proposal and therefore provides a straightforward measure of whether the objective of value creation is being attained. Furthermore, they are additive, the NPVs of different projects can be added up to give total value created.

Copyright Arthur S. Cayanan 2011

3.

NPV can be converted into a relative measure by taking the ratio of the two values instead of their difference. This is called the profitability index (PI). Relative measures like PI and IRR are useful in certain situations, e.g., capital rationing.

Copyright Arthur S. Cayanan 2011

1.
2. 3. 4. 5. 6. 7.

Evaluate cash flows on an incremental basis, net of applicable taxes Disregard sunk costs Include opportunity costs Include working capital requirements Ignore allocated costs Consider terminal value or salvage value at the end of the projects life. Separate cash flows of the capital investment from financing cash flows.

Copyright Arthur S. Cayanan 2011

1.

Sensitivity analysis to account for:

a. b. c. d. e. inflation foreign exchange volatilities cash inflows shortages cost overruns other uncertainties

2. 3.

Impact of delays Project interdependencies

Copyright Arthur S. Cayanan 2011

1.
2. 3. 4. 5. 6. 7.

Force majeure risk Inflation risk Completion risk Operating risk Foreign exchange risk Political risk Market risk

Copyright Arthur S. Cayanan 2011

Nominal cash flows should be discounted at the nominal cost of capital Real cash flows should be discounted at the real cost of capital Note that: a. not all costs and revenues increase at the same time. b. tax savings from depreciation are unaffected by inflation c. opportunity costs of capital are normally expressed in nominal terms
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Real Discount Rate = 1 + Nominal disct. Rate -------------------- - 1 1 + Inflation Rate

Copyright Arthur S. Cayanan 2011

A project has the following projected cash flows (in millions): Yr 0 Yr 1 Yr 2 Yr 3 -150 60 75 105 Cost of capital is 20%. Required: 1. Determine NPV 2. If the cash forecasts incorporates inflationary expectation of 5%, recompute NPV.

Copyright Arthur S. Cayanan 2011

Sensitivity analysis determine effects on NPV of changes in key project variables Staying power analysis forecast financial performance that would result from the most hostile environment that might reasonably occur

Copyright Arthur S. Cayanan 2011

Ask the following questions: 1. What can possibly go wrong? 2. What dont the cash flows tell me? 3. How can we afford things to get?

Copyright Arthur S. Cayanan 2011

1.
2. 3. 4. 5.

Describe a hostile environment Estimate erosion potential Dont ignore working capital Include cost-cutting measure The following questions may be asked: Will additional financing be needed?
Will lenders/stockholders be willing to provide new money? Can the company meet terms in the loan covenants?

Copyright Arthur S. Cayanan 2011

1.

Most large capital expenditure programs encounter large problems These problems can be financially destructive if the company has invested on too grand a scale

2.

3.

Without a realistic worst case scenario, managers often dont appreciate the amount of risk their companies assume.
Staying power analysis helps managers both evaluate worst case performance and decide on a projects size.

4.

Copyright Arthur S. Cayanan 2011