Capital Budgeting For Project Appraisal

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Capital Budgeting


Capital budgeting (or project/ investment appraisal) is the process of planning, evaluating and selecting long-term investment decisions that are in line with the goal of investors wealth maximization. Firms long-term investment decisions generally include expansion, acquisition, modernization and replacement of long-term assets and research and development projects. It is used to compare and evaluate alternative projects financial and nonfinancial criteria short and long-term benefits fit with existing technology effect on marketing and cost management.

Capital Budgeting: Scholars Points of View

Project appraisal is a process of investigation and reasoning designed to assist a decision maker to reach an informed and rational choice. (Sugden & Williams) A capital investment appraisal is a means of ensuring value for money in relation to developing an estate strategy and capital project. A capital investment appraisal is not meant to provide an indication of profit or loss for the institution as a whole, but rather a comparison of costs in relation to those areas of the estate where there is an opportunity or an inclination for change. (Baum T., & Mudambi R.)

Scope of Capital Budgeting

Capital Budgeting involves: Evaluation of investment project proposals that are strategic to businesss overall objectives.  Estimation of after-tax incremental operating cash flows for investment projects.  Estimation and evaluation of how much cash flows incurred for each of the investment proposals.  Selection of an investment proposal that maximizes the return to the investors.  Reevaluation of implemented investment projects continually and performing post audits for completed projects.

Types of Investment Decisions

There are typically two types of investment decisions: Selection decisions in terms of obtaining new facilities or expanding existing facilities. Examples include: 1. Investment in long term assets such as property, plant and equipment. 2. Resource commitments in the form of new product development, market research, refunding of long term debt, introduction of a computer, etc. Replacement decisions in terms of replacing existing facilities with new facilities. Examples include: 1. Replacing a manual bookkeeping system with a computerized system. 2. Replacing an inefficient lathe with one that is numerically controlled.

Good Investment Decision

Nature:  The exchange of current funds for future benefits  The funds are invested in long-term assets  The future benefits will occur to the firm over a series of years. Criteria: We need to ask ourselves the following questions when evaluating capital budgeting decision rules:  Does the decision rule adjust for the time value of money?  Does the decision rule adjust for risk?  Does the decision rule provide information on whether we are creating value for the firm?

Capital Budgeting Considerations

The capital budgeting decision, under any technique, depends in part on a variety of considerations:  The availability of funds  The relationships among proposed projects  The companys basic decision-making approach  The risk associated with a particular project

Phases of Capital Budgeting

Capital budgeting is a multi-faceted activity. There are several sequential stages in the process. Planning Analysis Selection Financing Implementation Review

Phases of Capital Budgeting contd contd

Planning: A firms mission and vision is encapsulated in its strategic planning framework. A strategic plan is the grand design of the firm and clearly identifies the business the firm is in and where it intends to position itself in the future. Strategic planning translates the firms corporate goal into specific policies and directions, sets priorities, specifies the structural, strategic and tactical areas of business development, and guides the planning process in the pursuit of solid objectives. Analysis: The focus of this phase of capital budgeting is on gathering, preparing, and summarizing relevant information about various project proposals which are being considered for inclusion in the capital budget.

Phases of Capital Budgeting contd contd

Selection: In the selection phases project worthwhileness is being judged by applying various appraisal criteria. The selection rules associated with these criteria are as follows:
Criterion Payback period (PBP) Accounting rate of return (ARR) Net present value (NPV) Internal rate of return (IRR) Benefit cost ratio (BCR) Accept PBP< target period ARR>target rate NPV>0 IRR>cost of capital BCR>1 Reject PBP> target period ARR<target rate NPV<0 IRR<cost of capital BCR<1

Phases of Capital Budgeting contd contd

Financing: Once a project is selected, suitable financing arrangements have to be made. The two broad sources of finance for a project are equity and debt. Implementation: The implementation phase for an industrial project, consists of several stages: i. ii. iii. iv. v. Project and engineering designs, Negotiations and contracting, Construction, Training and Plant commissioning.

Phases of Capital Budgeting contd contd

Review: Performance review should be done periodically to compare actual performance with projected performance. It is useful in the following ways: i. ii. iii. iv. v. It throws light on how realistic were the assumptions underlying the project; It provides a documented log of experience that is highly valuable in future decision making; It suggests corrective action to be taken in the light of actual performance; It helps in uncovering judgmental biases; It induces a desired caution among project sponsors.

Capital Budgeting: Importance & Limitations

Importance
Capital budgeting decisions influence the firms growth in the long run. They affect the risk of the firm.

Limitations
Poor alignment between strategy and capital budgeting, Deficiencies in analytical techniques Poorly identified base case  Inadequately treated risk  Improperly evaluated options  Lack of uniformity in assumptions  Side effects are ignored No linkage between compensation and financial measures, Reverse financial engineering, Weak integration between capital budgeting and expense  budgeting, Inadequate post-audits.

They involve commitment of large amount of funds. They are irreversible, or reversible at substantial loss. They are among the most difficult decisions to make.

Project Appraisal Criteria

Project Appraisal Criteria

Discounted Cash Flow Criteria (DCF)

Non- discounted Cash Flow Criteria

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

Payback Period (PB)

Discounted Payback Period

Accounting Rate of Return (ARR)

Discounted Cash Flow Criteria (DCF)

 It considers what money will be worth in the

future.
 Discounting reduce value of future earnings to

reflect opportunity cost of an investment.

Net Present Value (NPV)

 Evaluates if

project rate of return is greater than, equal to, or less than the desired rate of return. is the excess of the present value (PV) of cash inflows generated by the project over the amount of initial investment (I). PV of future cash flows is computed using the cost of capital or minimum required rate of return as the discount rate.

 It

 The

Formulation of NPV
General formula for NPV is as follows:
CFt NPV ! ( 1  k )t t !0
n

Where, CFt = Expected net cash flow at Period t k = Cost of capital or Discount rate n = Life of the project

Acceptance Rules of NPV

NPV > 0 NPV < 0 NPV = 0 Accept Reject Indifferent (+) (-) ()

A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

Calculation of NPV: An Example

Assuming, a new project A of which the following cash flows have been estimated:
Tk.

Year 0: CF = -1,65,000 Year 1: CF = 63,120 Year 2: CF = 70,800 Year 3: CF = 91,080 Required rate of return for assets=12% Whether the investment should be accepted or not?

Calculation of NPV
The calculation of the NPV of Project A will be: NPV = Tk. -165,000 + 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 = Tk. -1,65,000 + 56,357 + 56,441 + 64,829 = Tk. 12,627 So, the investments NPV is positive and therefore should be accepted according to the acceptance rule of NPV.

Decision Criteria Test: NPV

Does the NPV rule account for the time value of money? Does the NPV rule account for the risk of the cash flows? Does the NPV rule provide an indication about the increase in value? Should we consider the NPV rule for our primary decision rule?
 The

answer to all of these questions is Yes.  Here, the risk of the cash flows is accounted for through the choice of the discount rate.

NPV: Benefits & Drawbacks

Benefits
 Gives the correct financial decision in all cases.  Recognizes time value of money.  Enables comparisons at different interest rates to be considered.  Useful for comparing similar projects with same cost.  Is relatively simple to calculate.

Drawbacks
 Requires detailed long- term forecasts of incremental cash flow data.  Sensitive to discount rates value of money.

Internal Rate of Return (IRR)

 The

discount rate which equates the PV of future cash inflows with the initial investment of a project and thus makes its NPV equal to zero.

Using PV tables it is computed by trial- and- error interpolation, which includes:  Computation of NPV at the cost of capital (r1).  If NPV is positive, then r2 is selected, which is higher than r1. If NPV is negative, then smaller rate r2 is selected rather than r 1.  The true IRR at which NPV= 0 must be somewhere in between these two rates.  Again NPV is calculated using r2 .  Interpolation is used for the exact rate.


Formulation of IRR
IRR is the value of r in the following equation:

CFt Investment ! t t !0 ( 1  r )
Where, CFt = Expected net cash flow at Period t r = Internal Rate of Return (IRR) n = Life of the project

Acceptance Rules of IRR

All projects should be accepted whose IRR exceeds the companys cost of capital.

IRR> Cost of Capital IRR< Cost of Capital

Accept Reject

(+) (-)

For mutually exclusive projects, the projects with the highest IRR should be chosen.

Calculation of IRR
Assuming the previously discussed example for NPV, where NPV>0 at 12% discount rate, we will now find out the IRR (NPV=0) of that project by following the trial- and- error method: First, let us try 16% as the discount rate. At 16%, the projects NPV will be: NPV= Tk. -165,000 + 63,120/(1.16) + 70,800/(1.16)2 + 91,080/(1.16)3 = Tk. 381 Since the projects NPV is still positive at 16%, a rate higher than 16% should be tried. So, when we try 17% then the projects NPV will be: NPV= Tk. -165,000 + 63,120/(1.17) + 70,800/(1.17)2 + 91,080/(1.17)3 = Tk. -2463 The true rate of return should lie between 16% and 17%.

Calculation of IRR contd contd

We can find out a close approximation of the rate of return by the method of linear interpolation as follows:
Difference

PV required PV at lower rate, 16% PV at higher rate, 17%

Tk. 1,65,000 1,65,381 1,62,537

381 2,844

IRR= 16%+ (17%- 16%) (381/2,844) = 16%+ 0.13= 16.13% Since the investments IRR is greater than the cost of capital (12%), the investment should be accepted.

NPV Profile for the Project

70,000 60,000 50,000 40,000 NPV 30,000 20,000 10,000 0 -10,000 0 -20,000 Discount Rate 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

IRR = 16.13%

Decision Criteria Test: IRR

Does the IRR rule account for the time value of money? Does the IRR rule account for the risk of the cash flows? Does the IRR rule provide an indication about the increase in value? Should we consider the IRR rule for our primary decision criteria?
 The

answer to all of these questions is yes, although it is not always as obvious.  We can consider IRR as our primary decision criteria , but not always as it has some problems that the NPV does not have.

IRR: Benefits and Drawbacks

Benefits
 Recognizes time value of money.

Drawbacks
 Difficult to compute, as a project may have multiple rates rather than a unique rate of return.  Fails to recognize the varying size of investment in competing projects and their respective profitabilities.  It may also fail to indicate a correct choice between mutually exclusive projects under certain situations.

 Allows the risk associated with an investment project to be assessed.  Helps measure the worth of an investment.  Allows the firm to assess whether an investment in the machine, etc. would yield a better return based on internal standards of return.  Allows comparison of projects with different initial outlays.

NPV vs. IRR



NPV and IRR will generally give us the same decision. Exceptions:  Nonconventional cash flows cash flow signs change more than once  Mutually exclusive projects Initial investments are substantially different (issue of scale) Timing of cash flows is substantially different

The NPV method has the advantage that the end result of the computations is expressed in amount and not in a percentage.

NPV vs. IRR contd contd

 Whenever

there is a conflict between NPV and another decision rule, NPV should always be chosen. Because:  Individual projects can be added.  It can be used in situations where the required rate of return varies over the life of the project.

 The

IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.

IRR and Nonconventional Cash Flows



When the cash flows change sign more than once, there is more than one IRR. Then problem occurs like, which one should we use to make our decision? When we solve for IRR we are solving for the root of an equation, and when we cross the x-axis more than once, there will be more than one return that solves the equation. Another type of nonconventional cash flow involves a financing project, where there is a positive cash flow followed by a series of negative cash flows. In this case, our decision rule reverses, and we accept a project if the IRR is less than the cost of capital, since we are borrowing at a lower rate.

Example : Nonconventional Cash Flows

Assuming an investment will cost Tk. 90,000 initially and will generate the following cash flows: Year 1: 132,000 Year 2: 100,000 Year 3: -150,000 y The required return is 15%. y Should we accept or reject the project?

NPV Profile
$4,000.00 $2,000.00 $0.00 NPV ($2,000.00) ($4,000.00) ($6,000.00) ($8,000.00) ($10,000.00) Discount Rate 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55

IRR = 10.11% and 42.66%

We should accept the project if the required return is between 10.11% and 42.66% because none of the two rates of IRR will work satisfactorily. So, simply we will follow NPV, which is positive at a required return of 15%, and should Accept.

IRR and Mutually Exclusive Projects

 Mutually exclusive projects

If we choose one, we cannot choose the other. Example: We can choose to get admitted in either A&IS or Finance Department, but not both.
 Intuitively, we

would use the following decision rules:  NPV project with the higher NPV should be chosen.  IRR project with the higher IRR should be chosen.

Example With Mutually Exclusive Projects

Period 0 1 2 IRR NPV Project A -500 325 325 19.43% 64.05 Project B -400 325 200 22.17% 60.74 Which project should we accept and why? The required return for both projects is 10%.

NPV Profiles
$160.00 $140.00 $120.00 $100.00 NPV $80.00 $60.00 $40.00 $20.00 $0.00 ($20.00) 0 ($40.00) Discount Rate 0.05 0.1 0.15 0.2 0.25 0.3

IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8%

A B

If the required return is less than the crossover point of 11.8%, then we should choose A, and B will be chosen in the opposite case. Here, A fulfills the condition and also has higher NPV. So, to maximize wealth and to avoid unreliability of IRR well go for the project with larger NPV, which is project A.

Modified Internal Rate of Return (MIRR)

To overcome the limitations of IRR, Modified Internal Rate of Return method (MIRR) can be adopted: Terminal value of cash inflow PV of cash outflow = --------------------------------------(1 + MIRR) Calculates the net present value of all cash outflows using the borrowing rate.  Calculates the net future value of all cash inflows using the investing rate.  Finds the rate of return that equates these values.


MIRR: Benefits and Drawbacks

Benefits
 MIRR

Drawbacks

 For choosing among mutually assumes that project cash flows are reinvested at the exclusive projects of different size, NPV is a better cost of capital. Hence it alternative in measuring the reflects better the profitability contribution of each project to of a project. the value of the firm.

 The

problem of multiple rates does not exist.

Profitability Index (PI)



PI is the ratio of the discounted cash inflows, at the required rate of return, to the initial cash outflow of the investment. It is used as a mean of ranking projects in descending order of attractiveness, especially when resources are limited. known as benefit- cost ratio.

 Also

Formulation of PI
The formula for calculating PI is as follows: PV of cash inflows PV(CFt) PI= ------------------------- = ------------Initial cash outlay Co CFt = ------------- / CFo t=1 (1 + k)t n

Acceptance Rules of PI
PI> 1.0 PI< 1.0 PI= 1.0 Accept Reject Indifferent (+) (-) ()

Calculation of PI
The Profitability Index of project A will be: PI= Tk. 1,77,627/ Tk. 1,65,000 = Tk. 0.077 / Since this project generates Tk. 0.077 for each Taka invested and its PI< 1, the project should be rejected.

PI: Benefits and Drawbacks

Benefits
 It can discriminate better between large and small investments and hence is preferable to the NPV criterion.  When the capital budget is limited in the current period, PI may rank projects correctly in the order of decreasingly efficient use of capital.  Recognizes time value of money and easy to compute as well.

Drawbacks
 It provides no means for aggregating several smaller projects into a package that can be compared with a large project.  When cash outflows occur beyond the current period, the PI criterion is unsuitable as a selection criterion.

NPV vs. PI
The NPV and PI yield same accept or reject rules, because PI can be grater than one only when the projects NPV is positive.  In case of marginal projects, NPV will be zero and PI will be equal to one.  The NPV method should be preferred, except under capital rationing, because the NPV reflects the net increase in the firms wealth.  But a conflict may arise between the methods if a choice between mutually exclusive projects has to be made. In this case between projects with same NPV, the one with lower initial cost or higher PI will be selected.


Payback period
 The payback period is

the length of time required for a firm to recover its original investment ,it tells how long it will take a project to break even. Calculated by: Estimating the cash flows, and  Subtracting the future cash flows from the initial cost until the initial investment has been recovered.


Formulation of Payback Period

In case of Uniform Cash Flows, the formula of Payback period is: Net initial investment Payback period= -----------------------------------------Uniform increase in annual future cash flows Example: If a projects initial outlay= Tk. 50,000, annual cash inflow= Tk. 12,500 for 7 years, then: Tk. 50,000 PB= ------------------= 4 years Tk. 12,500

Acceptance Rules of Payback period

A project

would be accepted if its payback period is less than the maximum or standard payback period set by management. payback period gives highest ranking to a project, where lowest ranking is given to a project with highest payback period. two mutually exclusive projects, the project with shorter payback period will be selected. a payback period of 3 years or less is preferred.

Shortest

Between

Generally

According

to some advisors, project with payback period of less than a year should be considered essential.

Calculation of Payback Period: Nonuniform Cash Flows

Assuming that, project A will be accepted if it pays back within 2 years (standard payback period). So, whether we will accept or reject the project? Adding up the cash inflows (Tk. 63,120, Tk. 70,800, and Tk. 91,080), we find that in the first 2 years Tk. 1,33,920 of the original outlay of Tk. -1,65,000 is recovered. Third years cash inflow is Tk. 91,080 and only Tk. 31,080 of the original outlay remains to be recovered. Now, if the cash inflows occur evenly during the year, the time required to recover Tk. 31,080 will be: (Tk. 31,080/Tk. 91,080) X 12 months= 4 months. Thus, the payback period is 2 years and 4 months. Again, if the cash inflows occur at the end of the year, the payback period will be 3 years. As in both the cases, payback period is more than the standard period of 2 years, the project should be rejected.

Decision Criteria Test: Payback Period

Does the payback rule account for the time value of money? Does the payback rule account for the risk of the cash flows? Does the payback rule provide an indication about the increase in value? Should we consider the payback rule for our primary decision rule?


The answer to all of these questions is No.

Payback Period: Benefits and Drawbacks

Benefits
 Easy

Drawbacks
 Ignores the time

to understand.

value of

money.
 Adjusts for

uncertainty of later  Requires an arbitrary cutoff cash flows. point. towards liquidity.
 Ignores cash

 Biased

flows beyond the

cutoff date.
 Biased

against long-term projects, such as research and development, and new projects.

Discounted Payback Period

 Computes

the present value of each cash flow and then determine how long it takes to pay back on a discounted basis. to a specified required period.

 Compares

 Acceptance Rule

The project should be accepted if it pays back on a discounted basis within the specified time.

Calculation of Discounted Payback Period: An Example

Assuming that, we will accept project A if it pays back on a discounted basis in 2 years. Shall we accept or reject the project? First we will Compute the PV for each cash flow and determine the payback period using discounted cash flows: Year 1: 165,000 63,120/1.121 = 108,643 Year 2: 108,643 70,800/1.122 = 52,202 Year 3: 52,202 91,080/1.123 = -12,627 So, the project pays back in year 3 Since, it doesnt pay back on a discounted basis within the required 2-year period, we should reject the project.

Decision Criteria Test: Discounted Payback Period

Does the discounted payback rule account for the time value of money? Does the discounted payback rule account for the risk of the cash flows? Does the discounted payback rule provide an indication about the increase in value? Should we consider the discounted payback rule for our primary decision rule?
 The  The

answer to the first two questions is Yes. answer to the third question is No because of the arbitrary cut-off date.  Since the rule does not indicate whether or not we are creating value for the firm, it should not be the primary decision rule.

Accounting Rate of Return (ARR)

 Looks

at the profit generated by the investment compared to the cost of the investment. the business a percentage figure showing the average rate of return.

 This gives

 Businesses

can then compare this figure to how much they would get with alternative investments or the bank. known as Average Rate of Return, and Return on Investment (ROI).

 Also

Formulation of ARR
ARR can be determined by the following equation: Average income ARR= ----------------------------------Average investment Or, it can be defined in terms of earnings after taxes without an adjustment for interest i.e. EBIT(1-T). Thus:
n

EBITt( 1-T) /n
t=1

ARR= -----------------------------(Io+ In)/2 Where, EBIT= earnings before interest & taxes, T= tax rate, Io= BV of investment in the beginning, In= BV of investment at the end of n number of years.

Acceptance Rules of ARR

 All

those projects are to be accepted whose ARR is higher than the minimum rate established by the management and projects are to be rejected which have ARR less than that preset rate. with highest ARR will be ranked as number one and lower rank would be assigned to the project with lowest ARR.

 Project

Calculation of ARR
Assuming a 50% tax rate for project A and, a straight- line depreciation method is also assumed to be used here. We also assume that, an average return of 15% from project A is required. Shall we accept or reject the project?
Calculation of ARR
Year 1 EBDIT Depreciation EBIT Taxes at 50% [EBIT(1-T)] Book value of investment: Beginning Ending Average 1,65,000 1,10,000 1,37,500 1,10,000 55,000 82,500 55,000 27,500 82,500 63,120 55,000 8,120 4,060 4,060 Year 2 70,800 55,000 15,800 7,900 7,900 Year 3 91,080 55,000 36,080 18,040 18,040 (Tk.) Average 75,000 55,000 20,000 10,000 10,000

Calculation of ARR contd contd

10,000 So, ARR of project A= ------------ X 100 82,500 = 12.12% Since, the ARR of the project is lower than the preset rate, the project should be rejected.

Decision Criteria Test: ARR

Does the AAR rule account for the time value of money? Does the AAR rule account for the risk of the cash flows? Does the AAR rule provide an indication about the increase in value? Should we consider the AAR rule for our primary decision rule?
 The

answer to all of these questions is No.  In fact, this rule is even worse than the payback rule in that it doesnt even use cash flows for the analysis.  Only a few large firms employ the payback and/or ARR methods exclusively.

ARR: Benefits and Drawbacks

Benefits
 Easy

Drawbacks
 Not a

to calculate.

true rate of return; time value of money is ignored. an arbitrary benchmark cutoff rate. on accounting net income and book values, not cash flows and market values.

 Needed information will

 Uses

usually be available.

 Based

ARR and IRR

 The ARR tends

to understate the IRR for earlier years and overstate it for later years.

 The ARR and

the IRR can be the same only if the depreciation schedule is equal to the economic depreciation schedule.

 Inflation

and creative accounting tend to create a discrepancy between the ARR and the IRR.

Goal Congruence Issues in Capital Budgeting

 Inconsistency between capital budgeting decision

making and management performance evaluation persists when a company uses.  NPV method for capital budgeting decisions and ARR method to evaluate performance or  ARR for both purposes  Inconsistency means managers are tempted to make capital budgeting decisions on the basis of the method by which they are being evaluated.  This conflict can be reduced by evaluating managers on a project-by-project basis and by the amount and timing of forecasted cash flows.

Assessment of Basic Evaluation Methods

Considerations Theoretical Considers all cash flows Discounts CFs at the opportunity cost of fund Satisfies the principle of value additivity From a set of mutually exclusive projects chooses the projects which maximize shareholder wealth Practical Simple method Requires limited information Gives a relative measure NPV PI IRR Payback Period No No ? ARR Yes Yes Yes Yes Yes No Yes No No ? No ?

Yes Yes No No

No Yes No Yes

No Yes No Yes

? Yes Perhaps No

? Yes Yes Yes

Post Investment Audit

A post investment audit compares the actual results for a project to the costs and benefits expected at the time the project was selected.  It provides management with feedback about performance.  It is performed after project has stabilized.  Same analysis techniques are used.  Identifies areas where results differ from expectation.  Evaluates capital budgeting process, particularly original projections, problems with implementation, and sponsors credibility.


Qualitative Techniques of Project Appraisal

As well as financial methods firms need to consider: Corporate image we may reject an investment opportunity as it will reflect badly on our business. Corporate objectives also have to judge if the investment is aligned to our corporate objectives Environmental and ethical reasons is the investment environmentally and ethically sound Industrial relations what is the impact on the work force does it decrease jobs?  Some companies also consider intuition, security and social considerations as important qualitative factors.


Role of Judgement
The opportunities and constraints of selecting a project, its evaluation of qualitative and quantitative factors, and the weightage on every bit of pros and cons, cost-benefit analysis, etc., are essential elements of judgement.  Judgement and intuition should definitely be used when a decision of choice has to be made between two or more, closely beneficial projects, or when it involves changing the long-term strategy of the company. For routine matters, liquidity and profits should be preferred over judgement.  It plays a very important role in determining the reliability of figures with the help of qualitative methods as well as other known financial matters affecting the projects.  Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate.


Strategic Considerations in Capital Budgeting

Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate.  Customer Value and Capital Budgeting  NPV can also be used to evaluate the value of customers.  The higher the profitability of customer churn, the lower the NPV of the customer.  Investment in Research and Development  Real options of R&D investments increases the NPV of investment projects.

Project Cash Flow and Risk Analysis

Risks in Capital Budgeting

Three types of risk are relevant in capital budgeting:
  

Stand-alone risk Corporate risk Market (or beta) risk

StandStand- Alone Risk

The projects risk if it were the firms only asset and there were no shareholders. Ignores both firm and shareholder diversification. Measured by the W or CV of NPV, IRR, or MIRR.

Corporate Risk
Reflects the projects effect on corporate earnings stability. Considers firms other assets (diversification within firm). Depends on:  projects W, and  its correlation with returns on firms other assets. Measured by the projects corporate beta.

Market Risk
Reflects the projects effect on a well-diversified stock portfolio. Takes account of stockholders other assets. Depends on projects s and correlation with the stock market. Measured by the projects market beta.

Techniques of Risk Analysis

Statistical Techniques: To measure and incorporate risk in capital budgeting two important statistical methods are used, which are: expected monetary value, and standard deviation. Conventional Techniques: Decision- makers in practice may handle risk in conventional ways. Such as: they may use a shorter payback period, or conservative forecasts of cash flows, or discount net cash flows at the risk- adjusted discount rates.

Capital Rationing


It occurs any time there is a budget ceiling, or constraints, on the amount of funds that can be invested during a specific period, such as a year. capital is rationed over multiple periods; several alternative methods can be applied to the capital rationing problem.

 When

If capital is to be rationed for only the current period, selecting projects by descending order of profitability index generally leads to a selection of a project mix that adds most of firm value.

Sensitivity Analysis


Shows how changes in a variable such as unit sales affect NPV or IRR. Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. what if questions, e.g. What if sales decline by 30%?

 Answers

Illustration: Sensitivity Analysis

Change from Base Level __ Resulting NPV (000s)_____ Unit Sales Salvage k_

30% -20 -10 0 +10 +20 +30

$ 10 35 58 82 105 129 153

$78 80 81 82 83 84 85

$105 97 89 82 74 67 61

NPV (000s) Unit Sales

82 k

Salvage

-30

-20

-10 10 20 Base Value

30

Results of Sensitivity Analysis



Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV. Unit sales line is steeper than salvage value or k, so for this project, should worry most about accuracy of sales forecast.

Sensitivity Analysis: Benefits & Drawbacks

Benefits
 Gives some

Drawbacks
 Does  Says

idea of stand-

alone risk.
 Identifies dangerous

not reflect diversification.

variables.

nothing about the likelihood of change in a variable, i.e. a steep sales line is not a problem if sales wont fall. variables.

 Gives some

breakeven information.

 Ignores relationships among

Scenario Analysis
Examines

several possible situations, usually worst case, most likely case, and best case. a range of possible outcomes.

Provides

Illustration: Scenario Analysis

Assuming that, we know with certainty all variables except unit sales, which could range from 900 to 1,600. Scenario Probability NPV(000) NPV(000) Worst 0.25 $ 15 Base 0.50 82 Best 0.25 148 E(NPV) = $ 82 W(NPV) = 47 CV(NPV) = s(NPV)/E(NPV) = 0.57

Simulation Analysis
 A computerized version of scenario analysis which

uses continuous probability distributions.

 Computer selects values for each variable based on

given probability distributions.

 NPV and IRR are calculated.  Process is repeated many times (1,000 or more).  End result: Probability distribution of NPV and IRR

based on sample of simulated values.

 Generally

shown graphically.

Monte Carlo Simulation



Monte Carlo simulation of capital budgeting projects is often viewed as a step beyond either sensitivity analysis or scenario analysis. Interactions between the variables are explicitly specified in Monte Carlo simulation; so, at least theoretically, this methodology provides a more complete analysis. the pharmaceutical industry has pioneered applications of this methodology, its use in other industries is far from widespread.

 While

Computation Steps: Monte Carlo Simulation

Step 1: Specify the Basic Model Step 2: Specify a Distribution for Each Variable in the Model Step 3: The Computer Draws One Outcome Step 4: Repeat the Procedure Step 5: Calculate NPV

Relevant Issues in Capital Budgeting

When

we talk about a project we have to keep full attention on the cash flows of that project . It is the most critical step. Because the cost and revenue forecasting of a large complex project often shows a big forecasting error. Suitable example may be Padma bridge.
Before

making cash flow analysis, we should keep in mind some relevant Issues.

Interest Payment: Common mistakes made by many students and financial analysts is that they subtracts interest payment in estimating project cash flows .the cost of the debt is already embedded in the WACC(weighted average cost of capital).so subtracting interest payment from the project cash flow would amount to double counting interest costs.

Relevant Issues in Capital Budgeting

Contd Contd
Sunk Cost: Cost: We focus on the cash flow if and only if we accept the project this cash flows are called incremental cash flows. For example assuming, standard chartered has considered whether to establish a branch in Sylhet and for site analysis they hired a consulting firm. For this task they paid tk. 2,00,000 and undoubtedly it is a sunk cost for that firm. Because we know a sunk cost is an outlay that has already occurred & it is not affected by the decision under condition.so Either the project accepted or rejected, should this cost be taken into consideration in project cash flow analysis ? The answer is no. because sunk cost does not fall under incremental cash flow. Opportunity cost: cost: Agrani bank owns a piece of land in Konabari, Gazipur, which is suitable for a branch location, now in project cash flow analysis should the cost of the land be disregarded in cash flow estimation in the argue that no additional cash outlay be required? The answer is no because there is an opportunity cost. If this land have a market value tk.1,50,000, then that value should be charged against the project.

Relevant Issues in Capital Budgeting

Contd Contd
Externalities: Another potential problem involves the effects of a project on the other parts on the firm. which is called externalities. A suitable example would be Mina bazar. suppose Mina bazar opened its new branch in dhanmondi-5.Now many of its customers who previously purchased their daily necessities from mohammadpur branch, will come to this new branch. Thus net income provided by this customers should not be treated as incremental cash flows in the capital budgeting decision. Cannibalization: Another problem in project cash flow estimation is cannibalization. When a new product takes away sales from existing product , then we call this situation as Cannibalization. A suitable example may clear this concept Nautica international inc. is a American company that sales sport wares. Nautica sales its products to the traditional retailers. These retailers adds a mark up &they further sales this commodities to the consumers. Now if Nautica open a new own online store , then it could potentially increase its profit margin by huge amount.

Relevant Issues in Capital Budgeting

Contd Contd
But internet sales would most probably cannibalize its existing sales. that is the new project will decrease its existing sales stream. Even worse , dealers/ retailers might react adversely by moving their product line to another brands.

Inflation Adjustment: inflation is a fact of life in Bangladesh. Recently it has been touched two digit. In the absence of inflation the real rate (rr) would be equal to nominal rate. Moreover , the real & nominal expected cash flow RCFt & NCFt would also be equal .But when the expected rate of inflation is positive then all of the projects cash flow including depreciation related items also should be rise at the rate i. in this case the nominal net cash flow NCFt will increase at the rate of i percent, result will be , NCFt =RCFt (1+i)^t Thus the cost of capital which is used as the discount rate calculation formula will be: (1+rn) = (1+rr) X (1+i)

Relevant Issues in Capital Budgeting

Contd Contd
Tax & Depreciation Effect: Tax have a major effect on cash flows. In many cases tax effect will make or break a project. therefore it is critical that taxes should be dealt with correctly. Depreciation on assets should be considered in cash flow estimation. Because accountants do not subtract the purchase price of fixed assets when calculating net income ,they do subtract a charge each year for depreciation. depreciation shelters income from taxation. Depreciation must be added to NOPAT in following estimating a projects cash flow-

FCF =EBIT(1-t)+ depreciation- gross fixed expenditure- in net operating working capital

asset

The main effect of depreciation is-higher depreciation expense results in lower taxes in the early years that shows a higher net present value in cash flow analysis.

Tax Effect in Bangladesh

In Bangladesh taxation system is not so critical as the MACRS of USA. There are a lot of exemption & incentives to encourage investment .Some of them are Industry engaged in agro-processing, ship building, diamond cutting. Physical Sea or river port, container terminals, container freight station, LNG terminal and transmission line, CNG terminal and transmission line, flyover, mono rail, underground rail, large water. Tourism Industry Eligible for Tax holiday. Income derived from any Small and Medium Enterprise (SME) engaged in production of any goods and having an annual turnover of not more than taka twenty four lakh is exempt from tax. Accelerated depreciation: Accelerated depreciation on cost of machinery is admissible for new industrial undertaking in the first year of commercial production 50%, in the second year 30% and in the third year 20%. Industry set up in EPZ is exempt from tax for a period of 10 years from the date of commencement of commercial production. Avoidance of Double Taxation Agreement : There are agreements on avoidance of double taxation between Bangladesh and 28 countries.

A Popular Survey
Author JOHN GRAHAM,Associate Professor of Finance at Duke Universitys Fuqua School of Business. & CAMPBELL HARVEY , J. Paul Sticht Professor of Finance at Duke Universitys Fuqua School of Business. This survey conducted in 1998 published in 2001 in the journal of financial economics & it won the best best JFE paper in 2001. The 3- page long survey was conducted on all of the Fortune-500 company CFOs . It represented a wide verity of companies , ranging from small(26% has sales less then $100 million) to very large(42% had sales at least $1 billion.) 40% of them was manufacturing firm,15% was financial ,11% retailers & 9% high tech firms. they also asked a number of questions to the CEOs because they are the ultimate decision.

Findings of the Research by Graham & Campbell

NPV has been the dominant method taught in business schools, but past surveys have suggested that IRR was for long the primary corporate criterion for evaluating investment projects. For example, a 1977 survey of 103 large companies reported that fewer than 10% of the firms relied on NPV as their primary method, while over 50% said they relied mainly on IRR. Although the two measures are similar in several respects, the critical difference is that IRR is a ratio while NPV is a dollar measure of value added. The main problem with using the former is that, in some cases, managers intent on maximizing IRR may actually reduce value by rejecting positive- NPV projects.

Findings of the Research by Graham & Campbell

Findings of the Research by Graham & Campbell

As shown in Figure 1, most respondents cited net present value and internal rate of return as their most frequently used capital budgeting techniques; 74.9% of CFOs always or almost always used NPV and 75.7% always or almost always used IRR. However, large companies were significantly more likely to use NPV than were small firms. Highly leveraged firms were significantly more likely to use NPV and IRR than firms with low debt ratios. And as in the case of highly leveraged companies, companies that pay dividends ,were also significantly more likely to use NPV and IRR than firms that do not pay dividends, regardless of firm size.

Findings of the Research by Graham & Campbell

Highly levered firms were also more likely to use sensitivity and simulation analysis, in part to assess (and limit to acceptable levels) the probability of financial distress. Utilities, too, perhaps because of regulatory requirements, were also more likely to use IRR and NPV and to perform sensitivity and simulation analyses. It also found that companies whose CEOs had MBAs were more likely to use NPV than firms whose CEOs did not. also found that, among small firms, older CEOs with long tenures and without MBAs were more likely to use the payback criterion. The simplicity of the method, combined in some cases with top managements lack of familiarity with more sophisticated techniques. Public companies were significantly more likely to use NPV and IRR than were private corporations. Other than NPV and IRR (and the hurdle rate), the payback period was the most frequently used capital budgeting technique (56.7% always or almost always used it).

Findings of the Research by Graham & Campbell

Finally the other capital budgeting techniques were used less frequently. For example, only about 20% of the companies said they used accounting rate of return; 14% always or almost always used value at risk or some other form of simulation, 12% used a profitability index, and 11% used adjusted present value (APV). Somewhat surprisingly, more than one-fourth of the companies claimed to be using real options (RO) evaluation techniques In comparison, it is also surprising that only 11% of firms used APV since the method is fairly easy to use while at the same time flexible enough to handle a wide variety of project evaluation situations.

Summary
In this chapter we have discussed about the following issues: Capital budgeting or project appraisal is the process of selecting investment projects whose returns or cash flows are expected to extend beyond one year. Project appraisal techniques aim to assess the financial feasibility of investment options and based on a number of assumptions. NPV, IRR and PI are the discounted cash flow criteria and PB, Discounted PB and ARR are the non discounted criteria for appraising the worth of an investment project. Payback method looks at how long it will take to pay back the cost of the initial investment.

Summary contd contd

Average

rate of return looks at the percentage rate of return on the investment. Discounted cash flow (NPV) looks at the present values of any future revenues from the investment. For small sized projects payback method & ARR are preferred to be used. Capital rationing occurs when a company chooses not to fund all positive NPV projects. NPV method is the most superior investment criterion as it always consistent with the wealth maximization principle. But for larger projects IRR appears to be the most commonly used method as the end result of the computations is expressed in percentage.

Group : Ever Shiners

Name of Members
Md Delowar Hossain Touhidul Islam Ashraful Islam Kazi Tasnim Afroz Fahmida Sharmin

ID No.
13055 13062 13089 13132 13149

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