Topic 2 - fm2

Capital Budgeting Techniques

LG1 Understand the key elements of the capital budgeting process.

LG2 Calculate, interpret, and evaluate the payback period.
LG3 Calculate, interpret, and evaluate the net present value (NPV) and economic value added (EVA)
LG4 Calculate, interpret, and evaluate the internal rate of return (IRR).
LG5 Use net present value profiles to compare NPV and IRR techniques.
LG6 Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of
each approach.

- Capital budgeting, which is also called investment appraisal, is the planning process used to determine
whether an organization’s long term investments, major capital, or expenditures are worth pursuing.

- The methods for capital budgeting include:-

- Net present value (NPV),
• Considering the time value of money is important when evaluating projects with different costs,
different cash flows, and different service lives. Discounted cash flow techniques, such as the net
present value method, consider the timing and amount of cash flows. To use the net present value
method, you will need to know the cash inflows, the cash outflows, and the company's required rate of
return on its investments. The required rate of return becomes the discount rate used in the net present
value calculation
• When NPV is used to make accept–reject decisions, the decision criteria are as follows:
- If the NPV is greater than $0, accept the project.
- If the NPV is less than $0, reject the project.
• If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action
should increase the market value of the firm, and therefore the wealth of its owners, by an amount
equal to the NPV.

NPV = Present value of cash inflows - initial investments

- Net present value (NPV) & Profitability Index (PI)

PI = PV of cash inflows/initial investment (cash outflow)

- Net Present Value (NPV) & Economic Value Added (EVA)

• EVA determines whether a project earns a pure economic profit - a profit above and beyond the normal
competitive rate of return in a line of business

EVA=(Net investment) x (Actual return on investment – Percentage cost of capital)

 - Payback period,
• The payback measures the length of time it takes a company to recover in cash its initial investment.

This concept can also be explained as the length of time it takes the project to generate cash equal to
the investment and pay the company back. It is calculated by dividing the capital investment by the net
annual cash flow. If the net annual cash flow is not expected to be the same, the average of the net
annual cash flows may be used.
• The length of the maximum acceptable payback period is determined by management.
- If the payback period is less than the maximum acceptable payback period, accept the
project.
- If the payback period is greater than the maximum acceptable payback period, reject the
project.

- Internal rate of return,

• is the discount rate that equates the NPV of an investment opportunity with $0 (because the present
value of cash inflows equals the initial investment). It is the rate of return that the firm will earn if it
invests in the project and receives the given cash inflows.
• When IRR is used to make accept–reject decisions, the decision criteria are as follows:
- If the IRR is greater than the cost of capital, accept the project.
- If the IRR is less than the cost of capital, reject the project.

Use net present value profiles to compare NPV and IRR techniques
A net present value profile is a graph that depicts projects’ NPVs for various discount rates.
The NPV profile is prepared by developing a number of “discount rate–net present value”
coordinates (including discount rates of 0 percent, the cost of capital, and the IRR for each project)
and then plotting them on the same set of discount rate–NPV axes.

Capital budgeting process:

1. Proposal generation. Proposals for new investment projects are made at all levels within a business
organization and are reviewed by finance personnel. Proposals that require large outlays are more
carefully scrutinized than less costly ones.
2. Review and analysis. Financial managers perform formal review and analysis to assess the merits of
investment proposals.

3. Decision making. Firms typically delegate capital expenditure decision making on the basis of dollar
limits. Generally, the board of directors must authorize expenditures beyond a certain amount. Often,
plant managers are given authority to make decisions necessary to keep the production line moving.
4. Implementation. Following approval, expenditures are made and projects implemented. Expenditures
for a large project often occur in phases.
5. Follow-up. Results are monitored, and actual costs and benefits are compared with those that were
expected. Action may be required if actual outcomes differ from projected ones.

10–6 Explain the similarities and differences between NPV, PI, and EVA
EVA is closely related to NPV in both valuation should result with the same estimate for the value of a firm. In
their full forms, the information that is required for both approaches is exactly the same - expected cash
flows over time and costs of capital over time. However EVA makes top managers responsible for a measure
that they have more control over - the return on capital and the cost of capital are affected by their decisions
- rather than one that they feel they cannot control as well - the market price per share.

10–10 Do the net present value (NPV) and internal rate of return (IRR) always agree with respect to
accept–reject decisions? With respect to ranking decisions? Explain.
Considering the acceptance-rejection decision, the net present value and internal rate of return will usually
agree and come to a mutual conclusion about whether a single project, considered in isolation, is acceptable
or not. However, with respect to ranking decisions the NPV and IRR do not guarantee ranking projects in the
same order. Reading ahead, I must also acknowledge the fact that the NPV and IRR have conflicts in
rankings due to their differences in reinvestment rate assumptions, the timing of each project’s cash flows,
and the magnitude of the initial investment.The NPV and PI both consider the time value of money and result
in the same accept or reject decision when considering an independent project. The main difference between
the two is that the PI may be useful in determining which projects to accept if funds are limited. Meaning
that a project can have same profitability index with different investments and vast difference in absolute
dollar return. NPV has an upper hand in this case.