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Capital Budgeting

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19 views17 pages

Capital Budgeting

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fbotacion2
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© © All Rights Reserved
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Capital Budgeting

Norie L. Maniego
What is Capital Budgeting?
• The process of planning expenditures that generate cash flows
expected to extend beyond 1 year.
Importance of Capital Budgeting
• Long term investments involving risks: Capital expenditures are long-term
investments that involve more financial risks. That is why proper planning through
capital budgeting is needed.
• Huge and irreversible investments: As the investments are huge but the funds
are limited, proper planning through capital expenditure is a pre-requisite. Also, the
capital investment decisions are irreversible, i.e. once a permanent asset is purchased
its disposal shall incur losses.
• Long run in the business: Capital budgeting reduces the costs as well as brings
changes in the profitability of the company. It helps avoid over or under-
investments. Proper planning and analysis of the projects help in the long run.
Project Classification Types
1. Replacement Projects- are expenditures necessary to replace worn-out or damaged
equipment. These projects are necessary if the firm is to continue in its current
businesses.
2. Cost Reduction Projects- include expenditures to replace serviceable but obsolete plant
and equipment. The purpose of this investment is to lower production costs by reducing
expenses for labor, raw materials, heat, or electricity.
3. Expansion Projects- involves expenditures to increase the availability of existing
products or services.
Steps in Capital Budgeting
1. Cost of the Project must be determined.
2. Estimate the expected cash flows from the project.
3. The risk of projected cash flows must be estimated.
4. The firm must determine the appropriate discount rate or cost of capital.
5. Expected cash flows are converted into present values to obtain a clear estimate of the
investment’s project value to the firm.
6. The present value of expected cash flows is compared with the required capital outlay or cost of
the project. If the PV of cash flows exceeds the cost of the investment project, the project
should be accepted. Otherwise, the project should be rejected.
Capital Budgeting Techniques
• Present Value and Net Present Value Method
• Payback Period Method
• Profitability Index
• Internal Rate of Return (IRR) Method
Present Value
• is an estimation of how much a future cash flow (or stream of cash flows) is
worth right now. All future cash flows must be discounted to the present
using an appropriate rate that reflects the expected rate of return (and risk
profile) because of the “time value of money.”
Net Present Value
• The most commonly employed method for long-term investment project
evaluation.
• The difference between the marginal revenues and marginal costs for
individual investment projects, when both revenues and costs are expressed
in the present-value terms.
• Decision Criteria: If the NPV>0, the project is profitable.
Net Present Value
• EXAMPLE: The initial cost of a project is $10,000 and the after-tax , end of
year, project cash flows are as follows: Year 1-$5,000; Year 2 - $4,000; Year 3
- $3,000; Year 4 - $1,000. The projects are risky, with a risk-adjusted cost of
capital or r = 10% The equation for NPV is as follows:
Net Present Value
• In the formula, CFt is the expected net cash flow at Time t, r is the project’s
risk-adjusted cost of capital, and N is its life. Generally, projects require an
initial investment, like developing the product, buying the equipment needed
to make it, building a factory, and stocking inventory. The initial investment,
$10,000 is a negative cash flow. This means that the cost - $10,000 is not
discounted because it occurs at t=0. When we sum the PVs of the inflows
and subtract the cost, the result is $788.20, which is the NPV.
Payback Period Method

• The payback period evaluates an investment project by focusing on the payback


period. The payback period is expressed in years.
• FORMULA = Investment required / Net annual cash inflow
• EXAMPLE: Company ABC needs a food processing machine. It is considering two
machines - Machine A and Machine B. Machine A costs $15,000 and will reduce
operating cost by $5,000 per year. Machine B costs only $12,000 but will also reduce
costs by $5,000 per year. To calculate the payback period and which machine should
be purchased according to the payback method, we solve:
Payback Period Method
• Machine A’s payback period = $15,000/$5000 = 3.0 years.
• Machine B’s payback period = $12,000/$5,000 = 2.4 years.
• Company ABC should purchase Machine B, since it has a shorter payback
period than Machine A.
Profitability Index
• Profitability index measures the ratio between cash flow to investment. This
means that the higher the ratio the more cash flow to investment. We find
the profitability index by dividing the project’s present value of future cash
flows by its initial cost:
• FORMULA: Profitability of all future cash flows/ Initial Cash Invest
Profitability Index
• EXAMPLE: There are two properties in New York City, property A and property B.
Property A requires a cash investment of $150,000. James estimates the PV of all its future
cash flows at $160,000. Calculate the profitability index.
• $160,000/ $150,000 = 1.070
• Property B requires a cash investment of $90,000 and James estimates the PV of all its
future cash flows at $99,000.
• Calculate the profitability index. $99,000 $90,000 = 1.10
• Which is the better deal? Property B is more profitable than property A. A profitability
index of 1.0 means that you have exactly achieved your desired return (i.e. the price you
need to pay for the property based upon its future cash flows discounted at your rate of
return is exactly right). An index greater than 1.0 indicates that the investor has exceeded
his/her goal. An index less than 1.0 means that the investor has failed to achieve his/her
goal. Thus, an index of 1.0 or better is required for an investor to meet his/her goal.
Internal Rate of Return (IRR) Method
• The internal rate of return method is the discount rate that equates to the
present value of the expected future cash inflows and outflows. It measures
the rate of return on a project while assuming that all cash flows can be
reinvested at the IRR rate.
Problem
• Listed below are the costs and benefits of a project for 5 years with a
discount rate of 4 percent. All figures are in million pesos.

Discuss if the project should be accepted or rejected using the NPV


•Assume that you have been hired as a financial consultant to analyze two proposed
capital investments, Project A and Project B. Each has a cost of P10,000 and the cost of
capital for both projects is 12 percent. The projects’ expected net cash flows are as follows:
Calculate each project’s net present value. Should both projects be accepted?

Expected Net Cash Flow


Year
Project A Project B
0 (10,000) (10,000)
1 6,800 3,800
2 3,500 3,800
3 3,500 3,800
4 1,500 3,800

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