Sunday, February 5, 2012

Reading 36 – Capital Budgeting

http://www.docertifications.com/r36_l1

a. Describe the capital budgeting process, including the typical steps of the process, and distinguish among the various categories of capital projects

Capital Budgeting Process
  1. Capital Project is a project in which cash inflow to the firm will occur over multi-year period
  2. Capital Budgeting Process is the process of identifying and evaluating capital projects
  3. Capital budgeting process is important responsibility of finance manager since decision taken during this process has direct impact on future cash flow and future success of the firm
  4. Steps in Capital Budgeting Process
    1. Generation of Idea – This is the most important step in capital budgeting process. Other 3 steps filter & select project from listed projects. All stakeholders (like management, employees, functional divisions and external sources) should be engaged in this process
    2. Analyze Project Proposals – Post generation of ideas, these projects should be analyzed in terms of economic and technical feasibility. Expected cash outflows, initial investment requirements, operating margins should be computed for these projects
    3. Create Firm Wide Capital Budget – Projects should be analyzed based on timing of cash flows, required resources and how well it fits in company’s overall strategy. Projects which doesn’t fit in overall strategy of firm should not be executed
    4. Monitor Decisions and Conduct Audit of Decisions Undertaken – This step checks the execution capability of a firm. Actual Vs. Projected cash flows should be compared and any difference should be scrutinized
Categories of Capital Budgeting Projects
  1. Replacement project for existing business division
    1. Decision about replacement is made without detailed analysis
    2. More important decision is whether existing business line is to be continued or divested off
  2. Replacement project to reduce cost
    1. Decision is to be made about existing machinery or equipment which has become obsolete but it is still usable
    2. Decision about replacement is made after detailed analysis
  3. Expansion projects to grow business
    1. Decision about expansion is made after making detailed forecast of future demand
    2. Decision making process is very detailed and complex in nature
  4. New product development or new market development
    1. These projects have high level of uncertainty and hence decision making process is very detailed and complex in nature
  5. Mandatory projects
    1. These are projects which are mandated by government or regulatory agencies
    2. For e.g. waste water treatment plants are built by chemical companies to comply with waste water discharge regulations
    3. Most of the time these projects accompany other projects which a firm undertakes
  6. Other Projects
    1. These are projects for which either cash flow estimation is not possible (like R&D) or are pet projects of management (for which capital budgeting is bypassed)

b. Describe the basic principles of capital budgeting, including cash flow estimation

  1. Decisions about undertaking a project is based on incremental cash flow that the project will generate and not on accounting income
    1. Sunk cost should not be considered in decision making process. These are costs which couldn’t be avoided. For example a market research to estimate demand is sunk cost as this has to be undertaken irrespective of whether project is executed or not
    2. Externalities should be considered. These are the effect of acceptance of project on other cash flows. Cannibalization is a negative externality which reduce cash flow of other projects
  2. Cash flows are based on opportunity cost – Opportunity cost are the cash flows that a firm will lose if project is undertaken
    1. For e.g., if a firm owns a land and constructs a building over it. Cost of land should be considered in project even if it is owned by the firm. If the project was not undertaken, firm could have generated cash inflows by selling land
  3. Timing of cash flow is important – Since capital budgeting process considers present value of cash flows, timing of cash flow is important
  4. After tax cash flows are considered for capital budgeting process
  5. Financing cost is considered as part of discount rate and thus should not be deducted from cash flows

c. Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing


  1. Mutually Exclusive Projects - If two projects are mutually exclusive, then selection of one project means that other project cannot be executed
  2. Project Sequencing – If a group of projects (say Project 1,2,3 and 4) can only be executed in a sequence, it means that project 2 can only be executed after project 1 has been executed. Execution of project 1 creates an opportunity to execute project 2, 3 and 4 in later periods
  3. Capital Rationing – If a firm has limited capital to execute project then it can execute only a limited set of projects from a group of profitable projects. Firm will have to choose projects which maximize shareholder value

d. Calculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI)

Conventional cash flow pattern is a cash flow pattern in which sign of cash flows changes only once while an Unconventional cash flow pattern has more than one sign change
NPV
  1. It is equal to sum of present value of all incremental cash flow if a project is undertaken
  2. Projects with positive NPV increase shareholder value while projects with negative NPV decrease shareholder value
  3. For independent projects – Select projects with positive NPV and reject projects with negative NPV. Independent projects are those projects whose inclusion or exclusion doesn’t have any effect on other projects.
  4. Steps to compute NPV using Financial Calculator
    1. Clear Cash flow memory registers [CF] [2nd] [CLR WORK]
    2. [Initial Cash Flow] [ENTER]
    3. [↓] [Period 1 Cash Flow] [ENTER]
    4. [↓][↓] [Period 2 Cash Flow] [ENTER]
    5. [↓][↓] [Period 3 Cash Flow] [ENTER]
    6. [↓][↓] [Period 4 Cash Flow] [ENTER]
    7. [NPV] [Discount Rate] [ENTER]
    8. [↓][CPT] gives NPV
    9. [↓] gives NFV (Net Future Value)
  5. For example let the discount rate be 10%, let cash flow for 4 projects be as given below. We can see that Project 1 has negative NPV while other 3 have positive NPV. Thus Project 1 cannot be selected while other 3 can be selected

IRR (Internal Rate of Return)
  1. It is the rate of return which equates present value of cash inflows and cash outflows
  2. Rule for selecting project – If IRR is greater than required rate of return then select the project
  3. Steps to compute IRR using financial calculator
    1. Clear Cash flow memory registers [CF] [2nd] [CLR WORK]
    2. [Initial Cash Flow] [ENTER]
    3. [↓] [Period 1 Cash Flow] [ENTER]
    4. [↓][↓] [Period 2 Cash Flow] [ENTER]
    5. [↓][↓] [Period 3 Cash Flow] [ENTER]
    6. [↓][↓] [Period 4 Cash Flow] [ENTER]
    7. [IRR][CPT] gives IRR Value
  4. For e.g., if required rate of return is 20%, then out of 4 projects shown above, only project 2 and project 4 qualify for selection
Payback Period
  1. It is equal to number years required to recover initial cost of investment
  2. Payback Period = Full years until recovery + Unrecovered cost at beginning of year / Cash flow during the year
  3. Payback period computation doesn’t consider discounted cash flow but the actual cash flows
  4. Payback period measures liquidity of a project, it should not be used for selection of projects since cash flows are not discounted
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Discounted Payback Period
  1. It is equal to number of years required to recover initial cost of investment in present value terms
  2. Discounted cash flows are used to estimate payback period
  3. It is primarily used as a measure of liquidity
  4. It should not be used for project selection since cash flows after payback period are not considered
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Profitability Index
  1. It is equal to present value project’s future cash flow divided by initial cash outflow
  2. Profitability index = 1 + NPV/CF0 = Present value of future cash outflow/CF0
  3. If profitability index is greater than 1, then accept the project

e. Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods

NPV Profile
  1. It is a graph which plots projects NPV at different discount rates. NPV is plotted on vertical axis and discount rate is plotted on horizontal axis
  2. If timing and size of cash flows are different for two projects, then NPV profile of these two projects might intersect. Rate at which they intersect is called as crossover rate
Independent Projects
  1. NPV – Select projects with positive NPV and reject ones with negative value
  2. IRR – Select projects when IRR is greater than required return
Mutually Exclusive Projects
  1. If there is no conflict between IRR and NPV (i.e., if both IRR and NPV say that project a is better than project b, then choose project a)
  2. If there is conflict between IRR and NPV (as in if IRR of project a is greater than project b while NPV of project b is greater than project a), then choose project with higher NPV
Problems with NPV and IRR
  1. NPV
    1. It doesn’t give any consideration to size of a project (for e.g. NPV of 100 is good for project of value 100 but not so great for project of value 10000)
  2. IRR
    1. It is possible that a project may have multiple IRR or no IRR
    2. For mutually exclusive projects, it can be at conflict with NPV (due to differences in size and timing of cash flows for different projects)

f. Describe and account for the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock price

g. Describe the expected relations among an investment’s NVP, company value, and share price

Based on surveys, it has been found that use of capital budgeting method depends on following:
  1. Location – European companies were equally likely to use payback method Vs. IRR & NPV
  2. Size of Company – Large size companies were more likely to use NPV or IRR methods
  3. Public Vs. Private – Private companies were more likely to use payback method while public companies were more likely to use discounted cash flow methods (NPV or IRR)
  4. Management Education – More educated managers were more likely to use NPV or IRR methods
Relation between NPV and company value and stock price
  1. Since projects with positive NPV increases shareholder value, it can be assumed to have positive relationship with stock price
  2. However, a company’s stock is price is a function of company’s future expected earnings. So if firm announces investment in a project with positive NPV but analysts feel that this project will have lower NPV. Then execution of this project can lead to fall in stock price even though NPV is positive
Posted by anshuman atri at 9:22 PM
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