CFA Level I Corporate Finance

Capital Budgeting

www.irfanullah.co##ContentsIntroduction

The Capital Budgeting Process

Basic Principles of Capital Budgeting

Investment Decision Criteria

www.irfanullah.co##1. IntroductionCapital budgeting is the process that companies use for decision making on long-term projects

Capital budgetinghelps decide the future of many corporationscan be adapted for many other corporate decision such as investment in working capital, leasing, mergers and acquisitions

Valuation principles used in capital budgeting are used in security valuationCorporate budgeting decisions are consistent with management goal of maximizing shareholder value

www.irfanullah.co##2. The Capital Budgeting ProcessThe process is as follows:

Generating Ideas

Analyzing Individual Proposals

Planning and Capital Budgeting

Monitoring and Post Audit

www.irfanullah.co##Project Categorieswww.irfanullah.co#Replacement projects

Expansion projects

New products and services

Mandatory projects#3. Basic Principles of Capital BudgetingDecisions are based on cash flows

Timing of cash flows is crucial

Cash flows are based on opportunity costs

Cash flows are analyzed on an after-tax basis

Financing costs are ignored

www.irfanullah.co##Key ConceptsSunk cost (not included in investment appraisal)

Incremental cash flows

Externality (positive /negative)

www.irfanullah.co##Key Concepts (Cont)Conventional versus non-conventional cash flows

Independent versus mutually exclusive projects

Project Sequencing

Unlimited funds versus capital rationing

www.irfanullah.co##4. Investment Decision CriteriaAnalysts use several important criteria to evaluate capital investments. Some known metrics are the following:

Net present value ( NPV)Internal rate of return (IRR)Payback and discounted payback periodProfitability index (PI)Average accounting rate of return (AAR)

www.irfanullah.co##4.1 Net Present ValueNet present value is the present value of the future after tax cash flows minus the investment outlay

For independent projects: positive NPV accept negative NPV reject

www.irfanullah.co##ExampleCost of Capital = 10%Expected Net After Tax Cash FlowsYear (t)Project AProject B0- $1,000- $1,0001500100240030033004004100600www.irfanullah.co#Requirement: Compute NPV for Project A and BAnswer: NPV for A = 78.82; NPV for B = 49.18#NPV Using CalculatorKey strokesDisplay[CF][2nd ] [CLR WORK]CF0= 01000 [][ENTER]CF0 = -1000[] 500 [ENTER]C01= 500[]F01= 1[] 400 [ENTER]C02= 400[]F02= 1[] 300 [ENTER]C03= 300[]F03= 1[] 100 [ENTER]C04= 100[]F04= 1[NPV] 10 [ENTER]I = 10[] [CPT]NPV= 78.82www.irfanullah.co#

#4.2 Internal Rate of ReturnIRR measures the return for a given project

IRR is the discount rate that makes the present value of the future cash flows equal to the investment outlay; we can also say that IRR is the discount rate which makes NPV equal to 0.

IRR Decision RuleIf IRR > the required rate of return, accept the projectIf IRR < the required rate of return, reject the project

www.irfanullah.co##ExampleCost of Capital = 10%Expected Net After Tax Cash FlowsYear (t)Project AProject B0- $1,000- $1,0001500100240030033004004100600www.irfanullah.co#Requirement: Compute IRR for Project A and B#IRR Using CalculatorKey strokesDisplay[CF][2nd ] [CLR WORK]CF0 = 01000 [][ENTER]CF0 = -1000[] 500 [ENTER]C01 = 500[]F01 = 1[] 400 [ENTER]C02 = 400[]F02 = 1[] 300 [ENTER]C03 = 300[]F03 = 1[] 100 [ENTER]C04 = 100[]F04 = 1[IRR] [CPT]14.49www.irfanullah.co#

Compute IRR for Project B (cash flows on previous slide)IRR of B = 11.79%#4.3 Payback PeriodThe payback period is the number of years it takes to recover the initial cost of the investment

Advantages:Easy to calculateEasy to explainIndicator of project liquidity

Drawbacks:Does not consider cash flows after payback periodDoes not consider time value of moneyDoes not consider risk of a project

www.irfanullah.co##4.4 Discounted Payback PeriodDiscounted payback method uses the present value of the estimated cash flows; it gives the number of years to recover the initial investment in present value terms

Drawbacks: Does not consider any cash flow beyond payback periodPoor measure of profitability

www.irfanullah.co##Examplewww.irfanullah.co#Year01234Project C-800340340340340Compute the payback period and discounted payback period assuming a rate of 10%.#4.5 Average Accounting Rate of ReturnThe average accounting rate of return (AAR) can be defined as:

AAR = Average net income/ average book valuewww.irfanullah.co##4.6 Profitability IndexProfitability index (PI) is the present value of a projects future cash flows divided by the initial investmentPI = PV of future cash flows/Initial investmentPI = 1+ (NPV/Initial investment)

Investment decision rule for PI is:Invest if : PI > 1.0Do not invest if: PI < 1.0

www.irfanullah.co##4.7 NPV ProfileThe NPV profile shows a projects NPV graphed as a function of various discount rates. The NPV is graphed on the y-axis and discount rates on the x-axis respectively. Create the NPV profile for Project X. www.irfanullah.co#Year01234Project X-400160160160160#Crossoverwww.irfanullah.co#Year01234Project X-400160160160160Project Y-400000800Draw the NPV profiles for Projects X and Y. Discuss the significance of the cross over point. #Examplewww.arifirfanullah.com#The initial investment on a project is 200. The after-tax cash flows from this project are 80 annually for four years. Improvements on the project equipment increase the cost by 30 and the after-tax cash flows by 10. What is the impact on the NPV profile?Vertical intercept shifts up and horizontal intercept shifts leftVertical intercept shifts up and horizontal intercept shifts rightVertical intercept shifts down and horizontal intercept shifts right#4.8 Ranking Conflicts between NPV and IRRwww.irfanullah.co#Project A

Conventional Cash FlowsNo conflict between NPV and IRR decision rules

Project A

Conventional Cash FlowsProject B

Conventional Cash FlowsA and B are independentNo conflict between NPV and IRR decision rules

Project CProject DORA and B are mutually exclusivePossible conflict between NPV and IRR decision rulesReasons: 1) Different cash flow patterns and 2) Different scale

#Ranking Conflict Due to Differing Cash Flow PatternsYear01234NPVIRRProject X-400160160160160Project Y-400000800www.irfanullah.co#Which project do you select according to the NPV rule using a rate of 10%?Which project do you select according to the IRR rule?Show the NPV profile for both projects.#Ranking Conflict Due to Differing Project ScaleYear01234NPVIRRProject C-200100100100100Project D-800340340340340www.irfanullah.co#Which project do you select according to the NPV rule using a rate of 10%?Which project do you select according to the IRR rule?Show the NPV profile for both projects.#ExampleYear01234NPVIRRProject C-20010010010010011735%Project D-80034034034034027825%www.irfanullah.co#For the projects shown below what discount rate would result in the same NPV? The required rate of return is 10%. A rate between 0% and 10%A rate between 10% and 25%A rate between 25% and 35%#4.9 The Multiple IRR Problem and No IRR ProblemTime012Cash Flow-2001,000-1,200www.irfanullah.co#Show the NPV profile for this project? Hint: use these rates: 0%, 50%, 100%, 150%, 200%, 250%Time012Cash Flow100-300250Show the NPV profile for this project? Hint: use these rates: 0%, 50%, 100%, 150%, 200%, 250%# Comparison between NPV and IRRNPVAdvantages:Direct measure of expected increase in value of firmTheoretically the best method

Disadvantage:Does not consider project size

www.irfanullah.co#IRRAdvantagesShows the return on each dollar investedAllows us to compare return with the required rate

Disadvantage:Incorrectly assumes that money is reinvested at IRR rateMight conflict with NPV analysisPossibility of multiple IRRs or no IRR for a project

#4.10 Popularity and Usage of The Capital Budgeting Methodswww.irfanullah.co#See Table 13 in the curriculum; this gives an indication of the popularity of various capital budgeting techniques in different parts of the world

NPV and IRR more likely to be used at larger firms and where management has MBA degrees

Payback method is also quite popular, especially at private companies#Relationship between NPV and Stock PriceNPV is a direct measure of the expected change in firm value from undertaking a capital project

NPV is the criterion most related to stock prices

A positive NPV project should cause a proportionate increase in a companys stock value

www.irfanullah.co##Examplewww.irfanullah.co#A company is undertaking a project with a NPV of $500 million. The company currently has 100 million shares outstanding and each share has a price of $50. What is the likely impact of the project on the stock price?

#SummaryCapital budgeting process

NPV calculation and NPV rule

IRR calculation and IRR rule

Issues with IRR

NPV profilewww.irfanullah.co##ConclusionRead summary

Review learning objectives

Practice problems: good but not enough

Practice questions from other sources

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