Capital budgeting techniques For Analysis.......

CORPORATE FINANCE

1. Capital Budgeting Techniques Corporate Finance Master of Professional Finance University of Kelaniya

2. Findings; All but two respondents indicated use of at least one of these Capital Budgeting Technique’s (CBT) and almost 86% of the firms use more than one of the CBT's, with 17% using all four. The most popular CBT is PBK (used by 74% of the respondents), but only 2% use it as the only CBT. ARR is used by 58% (4% as the only CBT), IRR by 65% (6% as the only CBT), and NPV by 56% (2% as the only CBT). Over 86% of the respondents use either IRR or NPV or both, but only 16% use one or both without also using PBK or ARR. 2 Schall , L. D., Sundem , G. L., & Geijsbeek , W. R. (1978). Survey and analysis of capital budgeting methods.  The journal of finance ,  33 (1), 281-287. Capital Budgeting Practices in the USA

3. Technique Always or often (%) NPV 85.1% IRR 76.7% PB 52.6% DPB 37.6% PI 21.4% ARR 14.7% MIRR 9.3% 3 Sample: Chief Financial Officers of 120 compares from Fortune 1000 Ryan, P. A., & Ryan, G. P. (2002). Capital budgeting practices of the Fortune 1000: how have things changed.  Journal of business and management ,  8 (4), 355-364. Capital Budgeting Practices in Fortune 100 Companies

4. Number of sample 87 4 Technique Number of Companies Responses% NPV 82 94 PB 79 91 IRR 70 80 ARR 50 57 Adjusted NPV 47 54 Other techniques 11 13 Truong, G., Partington , G., & Peat, M. (2008). Cost-of-capital estimation and capital-budgeting practice in Australia.  Australian journal of management ,  33 (1), 95-121. Capital Budgeting Practices in Australia

5. Yamato (1998), Theory of Management on strategic investment Decision. 5 Techninque % NPV 18.8 IRR 25.3 PB 81 ARR 43.5 Capital Budgeting Practices in Japan

6. Leon, F. M., Isa, M., & Kester, G. W. (2008). Capital budgeting practices of listed Indonesian companies.  AJBA ,  1 (2), 175-192. A survey of executives of companies listed on the Jakarta Stock Exchange (108 SAMPLE) 6 Technique Percent NPV 63.6% IRR 63.6% PB 86.4% PI 42.1% ARR 40.9% Capital Budgeting Practices in Indonesia

7. Technique Primary Second NPV 96.9% 3.1% IRR 68.8% 31.3% MIRR - 31.3% PB 43.8% 56.3% DPB 31.3% 68.8% PI - 46.9% ARR 6.3% 40.6% 7 Nurullah , M., & Kengatharan , L. (2015). Capital budgeting practices: evidence from Sri Lanka. Journal of Advances in Management Research . A comprehensive primary survey was conducted of 32 out of 46 chief financial officers (CFOs) of manufacturing and trading companies listed on the Colombo Stock Exchange in Sri Lanka. Capital Budgeting Practices in Sri Lanka

8. 8 Steps in Project Evaluation

9. It should consider all cash flows to determine the profitability of the project. It should provide an objective and unambiguous way of separating good projects from bad projects. It should help ranking projects according to their true profitability. It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. It should help to choose among mutually exclusive projects that maximizes the shareholder wealth. 9 Characteristics of a sound Investment Evaluation Criteria

10. Payback Discounted payback Net Present Value (NPV) Internal Rate of return (IRR) Modified IRR (MIRR) Profitability Index (PI) 10 Investment Appraisal Techniques

11. Projects are: mutually exclusive, If you choose one, you can’t choose the other Example: You can choose to attend graduate school at either Harvard or Stanford, but not both independent , otherwise. 11 How does independent projects differ from mutually exclusive projects?

12. The number of years required to recover a project’s cost, or How long does it take to get the business’s money back? Year Cash flow Project L Project S -100 -100 1 10 70 2 60 50 3 80 20 12 Payback Period Method

13. 13 10 80 60 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback L 2 + 30/80 = 2.375 years 100 2.4 Payback Period for Project L

14. 14 70 20 50 1 2 3 -100 CF t Cumulative -100 -30 20 40 Payback S 1 + 30/50 = 1.6 years 100 1.6 = Payback Period for Project S

15. Advantages Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity Disadvantages Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long-term projects, such as research and development, and new projects Even negative NPV projects may be accepted 15 Advantages and Disadvantages of Payback Period

16. 16 10 80 60 1 2 3 CF t Cumulative -100 -90.91 -41.32 18.79 Discounted payback 2 + 41.32/60.11 = 2.7 yrs PVCF -100 -100 10% 9.09 49.59 60.11 = Recover invest. + cap. costs in 2.7 yrs. Discounted Payback: Uses discounted rather than raw CFs. (Ex. Project L)

17. Advantages Easy to understand Includes time value of money Biased towards liquidity Does not accept negative estimated NPV investments Disadvantages Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff point Biased against long-term projects, such as R&D and new products May reject positive NPV investments 17 Advantages and Disadvantages of Discounted Payback

18. It is the present value of future cash flows, discounted at the cost of capital. Output: How much values created from undertaking an investment. Steps estimate the expected cash flows Estimate the required return for projects of this risk level Compute the net present value 18 Net Present Value: NPV

19. NPV: Sum of PVs of inflows and outflows. 19 Cost often is CF and is negative.

20. 20 10 80 60 1 2 3 10% Project L: -100.00 9.09 49.59 60.11 18.79 = NPV L What is project’s NPV

21. 21 ….. ….. ….. 1 2 3 10% Project S: ...... ………= NPV S NPV L = $18.79. What is project’s NPV

22. A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners . Since our goal is to increase owner’s wealth, NPV is a direct measure of how well this project will meet our goal. 22 NPV Decision Rule

23. NPV L = 18.79$, NPV S = 19.98$ If Project S and L are mutually exclusive, accept S because NPV s > NPV L If S & L are independent, accept both; NPV > 0. 23 NPV Decision Rule

24. 24 IRR is the discount rate that forces “ PV inflows = cost ” . This is the same as forcing NPV = 0. 1 2 3 Internal Rate of Return: IRR

25. 25 10 80 60 1 2 3 IRR% Project L: -100.00 PV1 PV2 PV3 = NPV L Method: Trial and error. What’s project L’s IRR

26. 26 IRR L = 18.13%. IRR S = 23.56%. IRR Methods – Trial and Error Method

27. Accept the project if the IRR is greater than the cost of capital. If IRR>WACC, then the project’s rate of return is greater than its cost. Some return is left over to boost stockholders’ returns. EX. If IRR=12%> WACC = 10, project is profitable. 27 Decisions Rule on IRR Method

28. 28 IRR L = 18.13% , IRR S = 23.56%. If S and L are independent, accept both. IRRs > required r = 10%. If S and L are mutually exclusive, accept S because IRR S > IRR L . Decisions on Project S and L according to IRR

29. XY Ltd purchased a special machine 1 year ago at a cost of Rs . 12,000,000. at that time the machine was estimated to have a useful life of 6 years and no salvage value. The annual cash operating cost is approximately Rs . 20,000,000. A new machine has just come on the market which will do the same job but with an annual cash operating cost of only Rs . 17,000,000. this new machine costs Rs . 21,000,000 and has an estimated life of five years with zero salvage value. The old machine can be sold for Rs . 10,000,000 to a scrap dealer. Straight-line depreciation is used, and the company’s income tax rate is 40 percent. Assuming a cost of capital of 8 percent after tax, calculate: (a) the initial investment; (b) the incremental cash flow after taxes; (c ) the NPV of the new investment and (d) the IRR on the new investment. 29 Example:

30. 30 NPV profile: Find NPV L and NPV S at different discount rates: r NPV L NPV S 50 40 5 $31.48 $27.90 10 $17.08 $18.17 15 $5.80 $10.28 20 ($3.09) $3.86 25 ($10.11) ($1.41) Compare NPV and IRR

31. 31 NPV ($) Crossover Point = 8.7% IRR S = 23.6% IRR L = 18.1% Discount Rate (%) Compare NPV and IRR

32. 32 r < 8.7: NPV L > NPV S , IRR S > IRR L CONFLICT r > 8.7: NPV S > NPV L , IRR S > IRR L NO CONFLICT For Mutually Exclusive Projects

33. 33 Find cash flow differences between the projects ( better to have first cash flow negative). Find the IRR for this new stream of differential cash that is the cross-over rate. How to Compute the Cross-over Point

34. 34 NPV assumes that cash flows can be reinvested at r (opportunity cost of capital). IRR assumes that cash flows are reinvested at IRR. Which assumption is better? Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects. Reinvestment Assumption to solve the conflict

35. 35 Project A Project B -500 -400 1 325 325 2 325 200 IRR …….. ……. NPV …….. ……. The required return for both projects is 10% Which Project should you accept and why ? Example with Mutually Exclusive Projects

36. 36 Normal projects have cost (negative CF) followed by a series of positive cash inflows. One change of signs. Non-normal projects have Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine. Normal and Non-normal Cash Flow Projects

37. 37 1 2 3 4 5 N NN - + + + + + N - + + + + - NN - - - + + + N + + + - - - N - + + - + - NN Normal and Non-normal Cash Flow Projects

38. 38 Normal projects have single IRR. Non normal projects have multiple IRR. 5,000 -5,000 1 2 r = 10% -800 Why Multiple IRR?

39. 39 1. At very low discount rates, the PV of CF 2 is large & negative, so NPV < 0. 2. At very high discount rates, the PV of both CF 1 and CF 2 are low, so CF dominates and again NPV < 0. 3. In between, the discount rate hits CF 2 harder than CF 1 , so NPV > 0. 4. Result: 2 IRRs. Why Multiple IRR?

40. 40 NPV Profile 450 -800 400 100 IRR 2 = 400% IRR 1 = 25% r NPV Why Multiple IRR?

41. 41 MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC. When there are nonnormal CFs and more than one IRR, use MIRR

42. 42 PV outflows @ 10% = -800 - 4, 1 32 . 23 =-4932.23 . TV inflows @ 10% = 5,500,00. MIRR = 5500 / (1+MIRR)^2 = 4932.23 MIRR = 5.59% < r = 10%. Therefore, reject the project Also, if MIRR < r, NPV will be negative: NPV = -$351. When there are nonnormal CFs and more than one IRR, use MIRR

43. 43 MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRR s. Managers like rate of return comparisons, and therefore MIRR is better than IRR. Why MIRR is preferred to IRR ?

44. Example: Mutually Exclusive Investments The Wan-Ki Manufacturing company must decide between investment projects A and B, which are mutually exclusive. The data on these projects are as follows (in thousands rupees): Based on these cash flows: (a) calculate the projects’ NPV and IRR. (Assume that the firm’s cost of capital after taxes is 10%). (b) which of the two projects would be chosen according to the IRR criterion ?. ( c) How can you explain the differences in rankings given by the NPV and IRR methods in this case ? 44 Cash Flows Per Year Project 1 2 3 4 A (12000) 5000 5000 5000 5000 B (12000) 25000

45. 45 The PI shows the relative profitability of any project, or The present value per dollar of the initial cost. PI = PV of future cash flows / Initial cost A project is acceptable if its PI is greater than 1. PI L = 118.79 / 100 = 1.1879 PI S = 119.98 / 100 = 1.1998 Profitability Index (PI)

46. 46 Rand corporation is considering five different investment opportunities. The company’s cost of capital is 12 percent. Data on these opportunities under consideration are given below. Based on the above data: (a) rank these five projects in the descending order of preference, according to NPV, IRR and PI. (b) based on your ranking, which projects would you select if Rs . 55000 is the limit to be spent. ( all the figures are in Rs . 000) Project Investment DCF @12% NPV IRR% PI 1 35000 39325 4325 16 1.12 2 20000 22930 2930 15 1.15 3 25000 27453 2453 14 1.10 4 10000 10854 854 18 1.09 5 9000 8749 -251 11 0.97 Capital Rationing

47. 7/20/2024 Investment Decision 47 1. WACC/ Ke Vs Project Specific Discounting Factor Question is should the business organization use it’s WACC/ Ke for all projects undertaken or should they change the discounting factor? It depends on the operating and financial risk of the project. 2. Changes in Working Capital Requirement The project evaluation should consider not only the fixed capital requirement but also the working capital requirement of the project. It should consider the change in working capital requirement as a cash outflow. At the end of the project, it is assumed to recover the working capital investment. Special Cases in Investment Decision

48. 7/20/2024 Investment Decision 48 3. Changes in DF during a project period Changes in the discount factor can be incorporated into the NPV calculation over time for following reasons; If the level of interest rate changes in the economy If the risk characteristics of the project's changes If the finance mix of the project may vary with over time 4. Nominal Cash Flows Vs Real Cash Flows If the nominal cash flows of the project is been calculated for the evaluation, a nominal rate of discounting factor should be used. Thus, if the real cash flows of the project is been calculated for the evaluation, a real rate of discounting factor should be used. (1+NR) = (1+RR) * (1+ IR)

49. 7/20/2024 Investment Decision 49 5. After Tax Cash Flows Vs Pre Tax Cash Flows If the after tax cash flows of the project is been calculated for the evaluation, an after tax discounting factor should be used. Thus, if the pre-tax cash flows of the project is been calculated for the evaluation, a pre-tax discounting factor should be used.

50. 7/20/2024 Investment Decision 50 6. Mutually Exclusive Projects with Different Lives When two projects are mutually exclusive, the firm may choose one project or the other, but not both. If mutually exclusive projects have different lives, and the projects are expected to be replaced indefinitely as they wear out, an adjustment needs to be made in the decision-making process. There are two procedures to make this adjustment: 1. Least common multiple of lives approach. 2. Equivalent Annual Annuity (EAA) approach. Where: r : Project discount rate (WACC) NPV  : Net present value of project cash flows n  : project life (in years)

51. 51 Thank You