The Basics of Capital Budgeting: Evaluating Cash Flows

Should we build this plant?

By: Dr Pawan Gupta

Indian School of Petroleum

Capital Budgeting: the process of planning for purchases of longterm assets.

s example:

Suppose our firm must decide whether to purchase a new plastic molding machine for Rs125,000. How do we decide? s Will the machine be profitable? s Will our firm earn a high rate of return on the investment?
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Decision-making Criteria in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected?
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Decision-making Criteria in Capital Budgeting

s The Ideal Evaluation Method should:

a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project.
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Future value

FVn = PV(1 + i) .
n

Whats the FV of an initial Rs 100 after 3 years if i = 10%?

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After 3 years: FV3 = PV(1 + i)3 = Rs 100(1.10)3 = Rs 133.10.

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Present value
s

Whats the PV of Rs 100 due in 3 years if i = 10%?

FVn 1+ n ( i) 1 = FVn 1+ i
3
n

PV

1 PV = 100 1.10

= Rs 75.13.
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Payback Period
s The number of years needed to

recover the initial cash outlay. s How long will it take for the project to generate enough cash to pay for itself?

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Payback Period
s How long will it take for the project

to generate enough cash to pay for itself?

(500) 150 150 150 150 150 150 150 150

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Payback Period
s How long will it take for the project

to generate enough cash to pay for itself?

(500) 150 150 150 150 150 150 150 150

Payback period = 3.33 years.

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s Is a 3.33 year payback period good? s Is it acceptable? s Firms that use this method will

compare the payback calculation to some standard set by the firm. s If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? s Accept the project.
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Drawbacks of Payback Period:

s Firm cutoffs are subjective. s Does not consider time value of money. s Does not consider any required rate of

return. s Does not consider all of the projects cash flows.

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Drawbacks of Payback Period:

s Does not consider all of the projects

cash flows.
(500) 150 150 150 150 150 (300) 0 0

Consider this cash flow stream!

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Drawbacks of Payback Period:

s Does not consider all of the projects

cash flows.
(500) 150 150 150 150 150 (300) 0 0

This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!
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Discounted Payback
s Discounts the cash flows at the firms

required rate of return. s Payback period is calculated using these discounted net cash flows. s Problems: s Cutoffs are still subjective. s Still does not examine all cash flows.
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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 -500 250

CF (14%)
-500.00 219.30

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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 -500 250

CF (14%)
-500.00 219.30 280.70 1 year

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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 -500 250 250

CF (14%)
-500.00 219.30 280.70 192.38 1 year

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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 -500 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 1 year 2 years

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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 3 -500 250

CF (14%)
1 year 2 years

-500.00 219.30 280.70 250 192.38 88.32 250 School of Petroleum 168.75 Indian

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 3 -500 250

CF (14%)
1 year 2 years .52 years

-500.00 219.30 280.70 250 192.38 88.32 250 School of Petroleum 168.75 Indian

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 3

The Discounted -500 -500.00 Payback 250 219.30 is 2.52 years 280.70
280.70 250 192.38 88.32 250 School of Petroleum 168.75 Indian

CF (14%)
1 year 2 years .52 years

Other Methods
1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Each of these decision-making criteria: s Examines all net cash flows, s Considers the time value of money, and s Considers the required rate of return.
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Net Present Value

NPV = the total PV of the annual net cash flows - the initial outlay.

Decision Rule:

If NPV is positive, ACCEPT. If NPV is negative, REJECT.

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NPV Example
s

Suppose we are considering a capital investment that costs Rs276,400 and provides annual net cash flows of Rs 83,000 for four years and Rs116,000 at the end of the fifth year. The firms required rate of return is 15%. 83,000 83,000 83,000 116,000

83,000 (276,400)

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Profitability Index

NPV =

t=1

ACFt t (1 + k)

- IO

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Profitability Index

NPV =

t=1

ACFt t (1 + k)

- IO

PI

t=1

ACFt (1 + k) t

IO

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Profitability Index

Decision Rule:

If PI is greater than or equal to 1, ACCEPT. If PI is less than 1, REJECT.

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Internal Rate of Return (IRR)

s IRR:

the return on the firms invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

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Internal Rate of Return (IRR)

NPV =

t=1

ACFt (1 + k) t

- IO

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Internal Rate of Return (IRR)

NPV =

t=1 n

ACFt (1 + k) t

- IO

IRR:

t=1

ACFt t (1 + IRR)
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= IO

Internal Rate of Return (IRR)

IRR:

t=1

ACFt t (1 + IRR)

= IO

s IRR is the rate of return that makes the

PV of the cash flows equal to the initial outlay.

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Calculating IRR
s Looking again at our problem: s The IRR is the discount rate that

makes the PV of the projected cash flows equal to the initial outlay.
83,000 (276,400) 83,000 83,000 83,000 116,000

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83,000 83,000 83,000 83,000 116,000 (276,400)

0 1 2 3 4 s This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400

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83,000 83,000 83,000 83,000 116,000 (276,400)

s This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400 You should get IRR = 17.63%! s This way, we have to solve for IRR by trial and error.
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IRR

Decision Rule: If IRR is greater than or equal to the required rate of return, ACCEPT. If IRR is less than the required rate of return, REJECT.
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Capital Rationing
Capital rationing occurs when a company chooses not to fund all positive NPV projects. s The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
s

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Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.

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Reason: Companies dont have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.

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Reason: Companies believe that the projects managers forecast unreasonably high cash flow estimates, so companies filter out the worst projects by limiting the total amount of projects that can be accepted. Solution: Implement a post-audit process and tie the managers compensation to the subsequent performance of the project.

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Thanks

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