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Brad SimonCapital Budgeting

Overview of Capital Budgeting2Companies add value predominantly through what projects they choose to undertake.These are generally long-term activities and so require the long-term allocation of capital.For example:Expanding operationsIntroducing new products or product linesExpanding into new countriesFinancial managers need tools to evaluate which projects to undertake and which to avoid. This is the job of capital budgeting.

Time Value of Money3But first, a quick review of the TVM.The TVM attempts to translate financial values from one period to another, accounting for such things asExpected future cash flows (the numerator)The risks associated with those cash flows (the denominator)

Time Value of Money4With the TVM we frequently will discount the future to the present to compare different cash flow streams.For example, which is the better option to choose?

Option 1Option 2Year 1$100$200Year 2$100$150Year 3$100$100Year 4$200$50

Assume a discount rate of 12%

Time Value of Money5In Excel we can use the NPV function:Option 1: PV = NPV(12%,$100,$100,$100,$200) = $367Option 2: PV = NPV(12%,$200,$150,$100,$50) = $401

Conclusion: Option 2 is preferred!

Time Value of Money6What if the discount rate of Option 1 was 7%?

Conclusion: Now Option 1 is preferred.

Capital Budgeting: From TVM to NPV7Maybe Option 1 and Option 2 from the previous examples are different projects that a company is considering undertaking. The TVM lets us decide which is worth more today.Such an analysis is known as capital budgeting because it helps companies decide how to make capital (i.e. long-term) investments.Typically, there is an initial investment with a project. This investment occurs before the project begins (Year 0) and is an outflow.Lets continue with our examples and say the initial investment is $150 for both projects.

Capital Budgeting: From TVM to NPV8

The present values of these flows are $217 and $251 for Projects 1 and 2, respectively.Because these net out our initial investment we call the results the Net Present Value or NPV

Capital Budgeting: NPV9Now, what if Project 1 uses a discount rate of 10% and has an initial cost of $125?

Now Project1 is preferred.

Capital Budgeting: From NPV to IRR10We saw from the previous examples that changing the discount rate changes our decision about which project to choose.It would be nice to have a tool that doesnt require us to specify a discount rate in advance but lets us evaluate the intrinsic return of a project simply by looking at its cash flow stream.Internal Rate of Return

Capital Budgeting: IRR11The IRR calculates the rate of return assuming an NPV of 0.

As with our first example when both projects had the same discount rates, we prefer Project 2.

Capital Budgeting: IRR12What if we increase the initial cost of Project 2 to $200?

Now we prefer Project 1.

Capital Budgeting: From IRR to MIRR13One problem with the IRR is it assumes any intermediary cash flows earn a return equal to the IRR. However, this is not realistic.A more realistic assumption is that we can reinvest the capital at the companys cost of capital.We can define a modified IRR calculation that does exactly this. We call it the MIRR (Modified IRR).In order to apply this tool we need to know the companys cost of capital.

Capital Budgeting: MIRR14Lets say the companys cost of capital is 9%. What is the MIRR for Projects 1 and 2?

We still prefer Project 1 but the benefits of the project are lower and more realistic.Still, many analysts dont use the MIRR and prefer the IRR.

Capital Budgeting: From NPV to PI15All things being equal, we prefer projects with higher NPVs.

The NPV tells us to choose Project 1But intuitively something seems unbalanced here. With Project 1 we will risk $100,000 to only get $1,616 of excess economic value.With Project 2 we risk $100 to get $916 of excess economic value.It would be nice to have a tool help us measure such an imbalance

Capital Budgeting: PI16The Profitability Index (PI) solves this problem.We define the PI as the PV (future inflows) / - Initial OutflowFor ease of use we make the ratio positive by negating the initial outflow.

The PI shows us that Project 2 is preferable and is roughly 10 times better in terms of the risk/reward trade-off.

Capital Budgeting: From NPV to Payback Period17The NPV (and PI) tells us to undertake Project 2 below

But for Project 2 we need to wait around to receive the benefit. What if we are extra sensitive to this time.It would be good to know how long it takes to get our initial investment paid back.

Capital Budgeting: Payback Period18We can calculate how long a project takes to payback its initial investment:

For Project 1 we can see that somewhere between years 1 and 2 the initial investment is paid back.For simplicity we interpolate this value:$200 remaining after Year 1 divided by $500 received during Year 2$200 / $500 = 0.4After 0.4 amount of time of Year 2 has elapsed we will be paid back. Therefore the initial investment is paid back after 1.4 years

Capital Budgeting: Payback Period19Heres the combined analysis for Projects 1 and 2:

In this case, it takes less time to get our initial investment back from Project 1. While Project 2 has a higher NPV (per earlier slide) we may want to use this additional information from the Payback Period when making the final analysis of which project to undertake.

Capital Budgeting: From Payback Period to Discounted Payback Period20One problem with the payback period analysis is it doesnt account for the time value of money.As we know, the TVM is important in evaluating cash flows.We can extend the Payback Period analysis by discounting each periods cash flow to the present value.This is known as the Discounted Payback Period analysis.

Capital Budgeting: Discounted Payback Period21With the Discounted Payback Period analysis the initial investments of both projects are paid back a little later than in the prior analysis.

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Capital Budgeting Take-Aways22There is no perfect capital budgeting tool.Typically, we will use a combination of the tools weve seen to decide what projects to invest in:NPVIRRMIRRPIPayback Period analysisDiscounted Payback Period analysis

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