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Reading 32: Capital Budgeting (Basic principles (decisions are made based…
Reading 32: Capital Budgeting
Process and categories
Capital budgeting process
Step 2: Analyze project ideas
Step 3: Create firm-wide capital budget
Step 4: Monitor decisions and conduct a post-audit
Step 1: Generate investment ideas
Capital project categories
Replacement projects (for maintaining business, or cost reduction)
Expansion projects
New products or market development project
Mandatory projects (to meet environmental or regulatory requirements)
Other projects (R&D, senior management projects)
Basic principles
decisions are made based on the changes in after-tax cash flow
Do NOT consider sunk costs or any project-specific financing costs
Consider cash opportunity cost
Consider externalities-cannibalization
Timing of cash flows is important
Mutually exclusive projects, project sequencing & capital rationing
Acceptable independent projects can all be taken
For mutually exclusive project, firm can only choose 1
Project sequencing: concerns the opportunities for future capital project that may be created by taking a current project.
Capital rationing: firm should prefer the group of fundable positive NPV projects with the highest NPV
NPV, IRR, Payback period, Discounted payback period, profitability index (PI)
NPV: Net Present Value
Positive NPV projects should be taken. Negative NPV would reduce the value of the firm.
\(NPV=\sum_{0}^{i} \frac{CF_{i}}{(1+k)^{i}}\)
IRR
IRR: the discount rate that equates the present values of the project's expected cash inflow and outflow (NPV = 0)
Projects with unconventional cash flow pattern can produce multiple IRRs or no IRR.
IRR decision rule: accept all projects with IRR > Cost of capital (hurdle rate)
Payback period & Discounted payback period
The time taken to recover the project original cost (with or without considering time value of money)
Primarily a measure of liquidity
Projects with payback periods longer than an arbitrary number of years are rejected
Limitations
Not a measure of value
Ignores time value of money
Ignores Cos beyond he payback period
Payback period = \(A+\frac{B}{C}\)
A: Last period with negative cumulative cash flow
C: Cash flow in (A+1) period
B: Absolute value of negative cumulative cash flow at beginning of (A+1) period
Profitability Index (PI)
ratio of PV(project's future cash flow) and its initial outlay
PI > 1 for positive-NPV project, < 1 for negative-NPV Project
\(PI=\frac{PV(Future.CF)}{CF_{0}}=1+\frac{NPV}{CF_{0}}\)
for independent projects: except all projects where PI >1
design to rank project
NPV profile
NPV profile plots a project's NPV as a function of the discount rate (Vertical axis is NPV, horizontal is discount rate, NPV is a line).
If 2 NPV profiles (2 lines) intersect at some discount rate, that is the crossover rate, and the different project are preferred at discount rate higher or lower than the crossover rate.
Purpose
Capital Budgeting Process is used to determine and select profitable (or the most profitable) long-term projects (>1year)
IRR vs. NPV Project Rankings
Independent projects:
IRR and NPV give the same accept/reject decisions
Mutually exclusive projects: IRR and NPV project rankings may differ when
Projects have different timing of Cost
Projects are different sizes \(CF_{0}\)
Different reinvestment rate assumptions
IRR assumes CF reinvestment at project's IRR, while
NPV assumes CF reinvestment at cost of capital (more conservatives)