- 1. 11/15/2022 Capital Budgeting Techniques Financial management and control systems Dr. Mahmoud Otaify Assistant Professor of Finance Expenditures outlay of funds to produce benefits within one year Operating Expenditures outlay of funds to produce benefits more than one year Capital Expenditures Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting Capital Budgeting 2 1 2
- 2. 11/15/2022 What is capital budgeting? long-term investments Process of Evaluating & Selecting Wealth Maximization contribute to the firm’s goal Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 3 Capital Budgeting Decision Examples Buy a particular fixed asset launch a new product enter a new market acquire another company Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 4 3 4
- 3. 11/15/2022 Capital Budgeting Process Proposal generation (managers at all levels) Review and analysis (Fin. Managers) Decision making (BOD/senior executives) Implementation (may take phases) Follow-up (actual costs& benefits with projections) Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 5 Mutually exclusive projects A firm in need of increased production capacity could obtain it by 1) expanding its plant, (2) acquiring another company, or (3) contracting with another company for production Accepting any one option eliminates the immediate need for either of the others Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 6 5 6
- 4. 11/15/2022 Independent Projects Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting Buy a particular fixed asset in one branch Open new branch 7 Categories: of Investment Projects: Independent versus Mutually Exclusive Projects Independent projects Projects whose cash flows are unrelated to (or independent of) one another accepting or rejecting one project does not change the desirability of other projects. Mutually exclusive projects projects are those that have essentially the same function and therefore compete with one another. so that the acceptance of one eliminates from further consideration all other projects that serve a similar function Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 8 7 8
- 5. 11/15/2022 How availability of funds for capital expenditures affect the firm’s decisions? Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting Financial Situation If a firm has unlimited funds for investment The firm should invest in all projects that will provide an acceptable return. firms operate under capital rationing (have a fixed budget available for capital expenditures) numerous projects compete for these dollars 9 Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting Accept–reject approach involves evaluating capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion Managers might use this approach if they have sufficient funds to invest in every project that creates value for shareholders ranking approach involves ranking projects on the basis of some predetermined measure, such as how much value the project creates for shareholders. It is useful in selecting the “best” of a group of acceptable projects when firms have limited capital 10 9 10
- 6. 11/15/2022 Techniques used to analyze potential business ventures to decide which are worth undertaking Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 11 CAPITAL BUDGETING TECHNIQUES THE PAYBACK RULE NET PRESENT VALUE (NPV) INTERNAL RATE OF RETURN (IRR) Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 12 11 12
- 7. 11/15/2022 1. Payback Period How long does it take to recover the initial cost of a project? The payback period is the time it takes an investment to generate cash inflows sufficient to recoup the initial outlay required to make the investment. Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 13 Payback Period - DECISION CRITERIA Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting If the payback period is less than the maximum acceptable payback period accept the project is greater than the maximum acceptable payback period reject the project What is the maximum acceptable payback period? Managers decide what payback period they deem acceptable, but that decision is quite subjective 14 13 14
- 8. 11/15/2022 Lecture Case: Bennett Company We will use one basic problem to illustrate all the techniques described in this chapter. The problem concerns Bennett Company, a medium-sized metal fabricator that is currently contemplating two projects with conventional cash flow patterns:1 Project A requires an initial investment of $420,000, and project B requires an initial investment of $450,000. Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 15 Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting The payback period = 420,000/$140,000 = 3 years The payback period = initial investment / annual cash inflow Cashflows are in form of annuity (fixed annual amount) 16 15 16
- 9. 11/15/2022 Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting Year CF Cum. CFs 0 (450,000) 1 280,000 2 120,000 3 100,000 4 100,000 5 100,000 (450,0000) -450,000+280,000= (170,000) -170,000+120,000 = (50,000) -50,000+100,000= 50,000 100,000 >50,000 50,000/100,000=0.5 Payback period = 2 + (50,000/100,000) = 2.50 years 17 Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting Payback Period Project A = 3y Project B = 2.5 If Bennett’s maximum acceptable payback period were 2.75 years Reject A Accept B If the maximum acceptable payback period were 2.25 years, Reject both projects If the projects were being ranked Project B would be preferred over A because it has a shorter pay back period. 18 17 18
- 10. 11/15/2022 Payback Period Evaluation Uses Large firms sometimes use the payback approach to evaluate small projects small firms use it to evaluate most projects. Pros Simple It gives at least some consideration to the timing of cash flows It offers a way to adjust for project risk if managers require a faster payback on riskier projects Cons Requires an arbitrary cutoff point No connection exists between the payback period and the goal of shareholder wealth maximization. Ignores the time value of money Ignores cash flows beyond the cutoff date Biased against long-term projects, such as research and development, and new projects Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 19 2. Net Present Value Measures an investment’s value by calculating the present value of its cash inflows and outflows. Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 20 19 20
- 11. 11/15/2022 Concept NPV Model Project Profit>Cost + Net Profit Accept Profit = Cost Zero profit Indifferent Profit < Cost - Net Profit Reject Profit - Cost Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting if the proposed investments have the same risks as firm’s existing activities, the firm useWACC to discount their future cash flows 21 NPV – Decision Criteria/Rule If the NPV > $0 accept the project. increase the market value of the firm Therefore the wealth of its owners, < $0, reject the project Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 22 21 22
- 12. 11/15/2022 Lecture Case: Bennett Company Bennett Company, a medium-sized metal fabricator that is currently contemplating two projects with conventional cash flow patterns: Project A requires an initial investment of $420,000, Project B requires an initial investment of $450,000. Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 23 Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 24 23 24
- 13. 11/15/2022 If the projects were being ranked project A would be considered superior to B because its net present value is higher than that of B. Both projects are acceptable because the net present value of each is greater than $0. Bennett discounts project cash flows at 10%. NPV for A = $110,710 NPV for B = $109,244 Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 25 NPV - Evaluation The method used by most large companies to evaluate investment projects (why) When firms make investments, they are spending money that they obtained from investors Investors expect a return on the money that they give to firms, so a firm should undertake an investment only if the present value of the cash flow is greater than the cost of making the investment NPV method takes into account the time value of investors’ money, it is more likely to identify value- increasing investments than is the payback rule. Discount rate reflects investments risk and also is minimum return to satisfy investors Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 26 25 26
- 14. 11/15/2022 Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting Required return by capital providers (creditors & owners) is Cost of capital (WACC) Used as required return on new investment project if it has same risks of existing business It will be adjusted to reflect risk of new investment project if it has more or lower risks than the existing business 27 Profitability Index (PI) For a project that has an initial cash outflow followed by cash inflows, The profitability index (PI) is simply equal to the present value of cash inflows the absolute value of the initial cash outflow the decision rule they follow is to invest in the project when the index is greater than 1.0. 28 27 28
- 15. 11/15/2022 Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 29 If the projects were being ranked project A would be considered superior to B because its net present value is higher than that of B. Both projects are acceptable (because PI > 1.0 for both) Project B PV of Cash inflow for B = $559,244 B’s Cash outflow = $450,000 PIB= $559,244 , $450,000 = 1.24 Project A PV of Cash inflow for A = $530,710 A’s Cash outflow = $420,000 PIA = $530,710 / $420,000 = 1.26 30 29 30
- 16. 11/15/2022 3. Internal Rate of Return (IRR) The discount rate that equates the present value of a project’s cash inflows to the present value of its cash outflows. Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 31 IRR Decision Criteria IRR If IRR > WACC Accept project If IRR < WACC Reject Project WACC Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 32 31 32
- 17. 11/15/2022 Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 33 Project A IRR=19.9% WACC=10% Project B IRR=21.7% WACC=10% Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting Accept Accept If these projects are mutually exclusive 34 33 34
- 18. 11/15/2022 Ranking (mutually exclusive) projects Using NPV and IRR NPV NPVA =$110,710 NPVB = $109,244 Project A is superior IRR IRRA = 19.9% IRRB = 21.7% Project B is superior Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 35 Conflicts in the ranking given a project by NPV and IRR reinvestment rate assumption Timing of each project’s cash flows the magnitude of the initial investment. resulting from differences in Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 36 35 36
- 19. 11/15/2022 WHICH APPROACH IS BETTER? Theoretical View NPV is the better approach to capital budgeting for several reasons. Most importantly, the NPV measures how much wealth a project for shareholders. Given that the financial manager’s objective is to maximize shareholder wealth, the NPV approach has the clearest link to this objective and therefore is the “gold standard” for evaluating investment opportunities. Practical View Researchers surveyed chief financial officers (CFOs) about what methods they used to evaluate capital investment projects. One interesting finding was that many companies use more than one of the approaches we’ve covered in this chapter. The most popular approaches by far were IRR and NPV, used by 76% and 75% (respectively) of the CFOs responding to the survey. Dr. Mahmoud Otaify - FMCS: Techniques of Capital budgeting 37 37