CHAPTER 10 The Fundamentals of Capital Budgeting Learning Ob e!

ti"es
1# $is!uss %h& !apital budgeting de!isions are the most important de!isions made b& a firm's management# (# E)plain the benefits of using the net present "alue *+P,- method to anal&.e !apital e)penditure de!isions/ and be able to !al!ulate the +P, for a !apital pro e!t# 0# $es!ribe the strengths and %ea1nesses of the pa&ba!1 period as a !apital e)penditure de!ision2ma1ing tool/ and be able to !ompute the pa&ba!1 period for a !apital pro e!t# 3# E)plain %h& the a!!ounting rate of return *ARR- is not re!ommended for use as a !apital e)penditure de!ision2ma1ing tool# 4# Be able to !ompute the internal rate of return *5RR- for a !apital pro e!t/ and dis!uss the !onditions under %hi!h the 5RR te!hni6ue and the +P, te!hni6ue produ!e different results# 7# E)plain the benefits of a postaudit re"ie% of a !apital pro e!t#

5#
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Chapter Outline
An 5ntrodu!tion to Capital Budgeting A. The Importance of Capital Budgeting

Capital budgeting decisions are the most important investment decisions made by management.

The goal of these decisions is to select capital projects that will increase the value of the firm.

Capital investments are important because they involve substantial cash outlays and, once made, are not easily reversed.

Capital budgeting techniques help management to systematically analyze potential business opportunities in order to decide which are worth undertaking.

B.

Sources of Information ost of the information needed to make capital budgeting decisions is generated internally, beginning likely with the sales force. Then the production team is involved, followed by the accountants. !ll this information is then reviewed by the financial managers, who evaluate the feasibility of the project.

C.

Classification of Investment Projects Capital budgeting projects can be broadly classified into three types" #1$ independent projects% #&$ mutually e'clusive projects% and #($ contingent projects. 1# 5ndependent Pro e!ts )rojects are independent when their cash flows are unrelated. *f two projects are independent, accepting or rejecting one project has no bearing on the decision on the other. &

(# 8utuall& E)!lusi"e Pro e!ts +hen two projects are mutually exclusive, accepting one
automatically precludes the other.

utually e'clusive projects typically perform the same function.

0# Contingent Pro e!ts Contingent projects are those in which the acceptance of one
project is dependent on another project.

There are two types of contingency situations" )rojects that are mandatory )rojects that are optional

D.

Basic Capital Budgeting Terms The !ost of !apital is the minimum return that a capital budgeting project must earn for it to be accepted. *t is an opportunity cost since it reflects the rate of return investors can earn on financial assets of similar risk. Capital rationing implies that a firm does not have the resources
necessary to fund all of the available projects.

*t implies that funding needs exceed funding resources. Thus, the available capital will be allocated to the set of
projects that will benefit the firm and its shareholders the most.

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+et Present ,alue *t is a capital budgeting technique that is consistent with the goal of ma'imizing shareholder wealth. The method estimates the amount by which the benefits or cash flows from a project e'ceeds the cost of the project in present value terms. A. Valuation of Real Assets ,aluing real assets calls for the same steps as valuing financial assets. -stimate future cash flows. .etermine the investor/s cost of capital or required rate of return. Calculate the present value of the future cash flows.

1owever, there are some practical difficulties in following the process for real assets. 2irst, cash flow estimates have to be prepared in3house and are not readily available as they are for financial assets in legal contracts. 4econd, estimates of required rates of return are more difficult than it is for financial assets because no market data is available for real assets.

B.

PV!The Basic Concept The present value of a project is the difference between the present value of the e'pected future cash flows and the initial cost of the project. !ccepting a positive 5), project leads to an increase in shareholder wealth, while accepting a negative 5), project leads to a decline in shareholder wealth. )rojects that have an 5), equal to zero imply that management will be indifferent between accepting and rejecting the project.

C. "rame#or$ for Calculating PV The 5), technique uses the discounted cash flow technique.
Our goal is to compute the net cash flow (NCF) for each time period t, where NCFt = (Cash inflows Cash outflows! for the period t.

! five"step approach can be utili#ed to compute the N$%. 1# .etermine the cost of the project. *dentify and add up all e'penses related to the cost of the project. +hile we are mostly looking at projects whose entire cost occurs at the start of the project, we need to recognize that some projects may have costs occurring beyond the first year also.

The cash flow in year 7 #5C27$ is negative, indicating a cost.

(# -stimate the project/s future cash flows over its e'pected life. 8oth cash inflows #C*2$ and cash outflows are likely in each year of the project. -stimate the net cash flow #5C2t$ 9 C*2t : C;2t for each year of the project. <emember to recognize any salvage value from the project in its terminal year. 0# .etermine the riskiness of the project and the appropriate cost of capital. The cost of capital is the discount rate used in determining the present value of the future e'pected cash flows. The riskier the project, the higher the cost of capital for the project.

3# Compute the project/s 5),. .etermine the difference between the present value of the e'pected cash flows from the project and the cost of the project. 4# ake a decision. !ccept the project if it produces a positive 5), or reject the project if 5), is negative. D. Concluding Comments on PV 8eware of optimistic estimates of future cash flows. <ecognize that the estimates going into calculating 5), are estimates and not market data. -stimates based on informed judgments are considered acceptable. The 5), method of determining project viability is the recommended approach for making capital investment decisions.

The 5), decision criteria can be summed up as follows"

9ummar& of +et Present ,alue *+P,- 8ethod $e!ision Rule& N$% ' (& )ccept the project.
N$% * (& +eject the project. :e& Advantages :e& $isad"antages the discounted cash flow 1. .ifficult to understand without

1. >ses

an

valuation techni,ue.

accounting and finance background.

&. )rovides a direct measure of how

much a capital project will increase the value of the firm.

(. Consistent with the goal of

maximi#ing shareholder wealth.

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The Pa&ba!1 Period *t is one of the most widely used tools for evaluating capital projects. The pa&ba!1 period represents the number of years it takes for the cash flows from a project to recover the project/s initial investment. ! project is accepted if its payback period is below some prespecified threshold. This technique can serve as a risk indicator?the more quickly you recover the cash, the less risky is the project. A. Computing the Pa%&ac$ Period To compute the payback period, we need to know the project/s cost and to estimate its future net cash flows. -quation 17.& shows how to compute the payback period.

)8 = Aears before cost recovery +

<emaining cost to recover Cash flow during the year

There is no economic rationale that links the payback method to shareholder wealth ma'imization.

*f a firm has a number of projects that are mutually e'clusive, the projects are selected in order of their payback rank" projects with the lowest payback period are selected first.

B. 'o# the Pa%&ac$ Period Performs The payback period analysis can lead to erroneous decisions because the rule does not consider cash flows after the payback period. ! rapid payback does not necessarily mean a good investment. 4ee -'hibit 17.= ?)rojects . and -. C. The Discounted Pa%&ac$ Period ;ne weakness of the ordinary payback period is that it does not take into account the time value of money. The dis!ounted pa&ba!1 period calculation calls for the future cash flows to be discounted by the firm/s cost of capital. The major advantage of the discounted payback is that it tells management how long it takes a project to reach a positive 5),. 1owever, this method still ignores all cash flows after the arbitrary cutoff period, which is a major flaw. D. (valuating the Pa%&ac$ Rule The standard payback period is widely used in business.

*t provides a simple measure of an investment/s liquidity risk. The greatest advantage of the payback period is its simplicity. *t ignores the time value of money. *t does not adjust or account for differences in the overall, or total, risk for a project, which could include operating, financing, and foreign e'change risk.

The biggest weakness of either the standard or discounted payback methods is their failure to consider cash flows after the payback.

The following table summarizes this capital budgeting technique.

9ummar& of Pa&ba!1 8ethod $e!ision Rule& $aybac- period . $aybac- cutoff point / !ccept the
project. )ayback period C )ayback cutoff point / <eject the project.

:e& Ad"antages 1. -asy to calculate and understand for people without strong finance backgrounds. &. ! simple measure of a project0s
li,uidity.

1.

:e& $isad"antages ost common version does not account for time value of money.

&. .oes not consider cash flows past the payback period (. 8ias against long3term projects such as research and development and new product launches. 0. !rbitrary cutoff point.

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The A!!ounting Rate of Return *t is sometimes called the book rate of return.

This method computes the return on a capital project using accounting numbers?the project/s net income #5*$ and book value #8,$ rather than cash flow data.

The most common definition is the one given in -quation 17.("

!<< = !verage 5* !verage 8,

*t has a number of major flaws as a tool for evaluating capital e'penditure decisions. 2irst, the !<< is not a true rate of return. !<< simply gives us a number based on average figures from the income statement and balance sheet. *t ignores the time value of money. There is no economic rationale that links a particular acceptance criterion to the goal of ma'imizing shareholders/ wealth.

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5nternal Rate of Return The 5RR is an important and legitimate alternative to the 5), method. The 5), and *<< techniques are similar in that both depend on discounting the cash flows from a project. +hen we use the *<<, we are looking for the rate of return associated with a project so we can determine whether this rate is higher or lower than the firm/s cost of capital. The *<< is the discount rate that makes the 5), to equal zero.

A. Calculating the IRR The *<< is an e'pected rate of return, much like the yield to maturity calculation that was made on bonds.

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+e will need to apply the same trial3and3error method to compute the *<<.

B. )hen the IRR and PV *ethods Agree The two methods will always agree when the projects are independent and the projects/ cash flows are conventional.
)fter the initial investment is made (cash outflow!, all the cash flows in each future year are positive (inflows!.

C. )hen the IRR and PV *ethods Disagree The *<< and 5), methods can produce different acceptEreject decisions if a project either has unconventional cash flows or the projects are mutually e'clusive. 1# ;n!on"entional Cash Flo%s >nconventional cash flows could follow several different patterns. ! positive initial cash flow followed by negative future cash flows. 2uture cash flows from a project could include both positive and negative cash flows. ! cash flow stream that looks similar to a conventional cash flow stream e'cept for a final negative cash flow. *n these circumstances, the *<< technique can provide more than one solution. This makes the result unreliable and should not be used in deciding about accepting or rejecting a project. (# 8utuall& E)!lusi"e Pro e!ts +hen you are comparing two mutually e'clusive projects, the 5),s of the two projects will equal each other at a certain discount rate. This point at

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which the 5),s intersect is called the crossover point. .epending on whether the required rate of return is above or below this crossover point, the ranking of the projects will be different. +hile it is easy to identify the superior project based on the 5),, one cannot do so based on the *<<. Thus, ranking conflicts can arise. ! second situation arises when you compare projects with different costs. +hile *<< gives you a return based on the dollar invested, it does not recognize the difference in the size of the investments. 5), doesF D. *odified Internal Rate of Return +*IRR, ! major weakness of the *<< compared to the 5), method is the reinvestment rate assumption. *<< assumes that the cash flows from the project are reinvested at the *<<, while the 5), assumes that they are invested at the firm/s cost of capital. This optimistic assumption in the *<< method leads to some projects being accepted when they should not be. !n alternative technique is the modified internal rate of return *85RR-. 1ere, each operating cash flow is reinvested at the firm/s cost of capital. The compounded values are summed up to get the project/s terminal value. The *<< is the interest rate that equates the project/s cost to the terminal value

at the end of the project. -quation 17.6 shows how to calculate the *<<.

(. IRR versus PV- A "inal Comment

1&

+hile the *<< has an intuitive appeal to managers because the output is in the form of a return, the technique has some critical problems.

;n the other hand, decisions made based on the project/s 5), are consistent with the goal of shareholder wealth maximi#ation. 1n addition, the
result shows management the dollar amount by which each project is expected to increase the value of the firm.

For these reasons, the N$% method should be used to ma-e capital budgeting decisions.

The following table summari#es the 1++ decision"ma-ing criteria.

1(

$e!ision Rule<

Re"ie% of 5nternal Rate of Return *5RR1++ ' Cost of capital / !ccept the project.
*<< G Cost of capital / <eject the project.

:e& Ad"antages 1. *ntuitively easy to understand. &. 8ased on the discounted cash flow technique.

:e& $isad"antages 1. +ith nonconventional cash flows, *<< approach can yield no or multiple answers. &. ) lower 1++ can be better if a cash
inflow is followed by cash outflows. 2. 3ith mutually exclusive projects, 1++ can lead to incorrect investment decisions.

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Capital Budgeting in Pra!ti!e A. Practitioners. *ethods of Choice

4xhibit 5(.56 summari#es surveys of practitioners on the capital budgeting methods of choice.

*n the late 1D67s, less than 6( percent of managers used the N$% or
1++ methods.

8y 1DB1, over =6 percent of financial managers surveyed used the *<<, but only 1=.6 percent of managers used the 5),.

*n a recent study of Fortune 5((( managers, 78 percent of managers

used the N$% while 99 percent used the 1++. :urprisingly, over 8( percent of managers used the paybac- method.

B. /ngoing and Postaudit Revie#s

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anagement should systematically review the status of all ongoing capital projects and perform postaudits on all completed capital projects.

*n a postaudit review, management compares the actual results of a

project with what was projected in the capital budgeting proposal.

! postaudit e'amination would determine why the project failed to achieve its e'pected financial goals.

anagers should also conduct ongoing reviews of capital projects in

progress.

The review should challenge the business plan, including the cash flow projections and the operating cost assumptions.

anagement must also evaluate people responsible for implementing a capital project.

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