Corporate Finance

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Capital budgeting Techniques

Capital budgeting refers to the process we use to make decisions concerning investments in the long-term assets of the firm . The general idea is that the capital , or long-term funds , raised by the firms are used to invest in assets that will enable the firm to generate revenues several years into the future

Often the funds raised to invest in such assets are not unrestricted , or infinitely available thus the firm must budget how these funds are invested

Capital Budgeting

Evaluation Techniques

in this section , the basic techniques that are used to make capital budgeting decisions are described . To illustrate the techniques , let 's assume a firm is considering investing in a project that has the following cash flows

Year

(t ) Net Cash Flows , t CF

0 (7 ,000

1 2 ,000

2 1 ,000

3 5 ,000

4 3 ,000

7 ,000 ) represents the net cost , or initial investment , that is required to purchase the asset - the parentheses indicate that the cash flow is negative . If the firm 's required rate of return is 15 , the cash flow time line for the asset is

0 1 2 3 4

Net present value (NPV

To determine the NPV of a project , you need to compute the present value of all the future cash flows associated with the project , sum them up and then subtract (or add a negative amount to ) the initial investment of the project . The resulting value represents the amount that the firm 's value will increase , on a present value basis , if the firm invests in the project . For example , if the NPV of a project is 1 ,000 then the value of the firm should increase by 1 ,000 today . Thus , a project is acceptable if its NPV is positive . If a project has a positive NPV , then it generates a return that is greater than the cost of the funds that are used to purchase the project

NPV -7000 2000 1000 5000 3000

1 .15e1 1 .15e2 1 .15e3 1 .15e4

NPV 498 .13

rounding difference

The result of this computation is the same as that given in the cash flow time line diagram

According to the acceptance criterion , the project in our example should be purchased

Remember that if the firm accepts a project with a positive NPV its value should increase , and vice versa . Therefore , if the project had a negative NPV it would not be acceptable because such a project would decrease the value of the firm

The easiest way to compute the NPV for a project is to use the cash flow register on your calculator . Refer to the instructions that came with your calculator to determine how to use the CF register . If you have a Texas Instruments BAII PLUS , you can use the steps given in the Time Value of Money ' section of the notes . The inputs should be CF0 -7 ,000 , CF1 2 ,000 , CF2 1 ,000 , CF3 5 ,000 , CF4 3 ,000 , and I 15 Press the NPV key (or CPT , then the NPV key ) to find NPV 498 .12

Internal rate of return (IRR

It was mentioned above that a project that has a positive NPV generates a return that is greater than the cost of the funds used to purchase the project . The IRR is defined as the rate of return the firm would earn on average , if it purchases the project . To determine the IRR , we want to compute the rate of return that causes the NPV of the project to equal zero , or where the present value of the future cash flows equals the initial investment . In other words

NPV CF0 CF1 CFn 0

1 IRRe1 1 IRRen

If this computation seems familiar , it should be , because the computation for IRR is the same as the computation for the yield to maturity (YTM ) on a bond , which was discussed in the notes about valuation

NPV -7000 2000 1000 5000 3000

1 IRRe1 1 IRRe2 1 IRRe3 1 IRRe4

It is not easy to solve for the IRR without a calculator because you have to use a trial-and error method - that is , plug in various values for IRR until the right side of the equation equals the left side of the equation . With a financial calculator , however , it is very easy to solve for IRR . Follow the same steps you would to compute the NPV , but press the IRR key (or CPT and then the IRR key ) instead of the NPV key . You should find that IRR

18 .02

Comparison of the NPV and IRR Methods

Summarizing what we have discussed to this point , we know that a project is acceptable if its NPV is greater than zero . If a project has an NPV greater than zero , then it generates a return that is greater than the cost of the funds used to purchase the project . We also know that a project is acceptable if its IRR is greater than the firm 's required rate of return . When a project has an IRR greater than the required rate of return , then it generates a return that is greater than the cost of the funds used to purchase the project

As you can see by the italicized phrases , accepting a project using the NPV technique provides the same benefit as accepting a project using the IRR technique . As a result , both the NPV technique and the IRR technique should always give the same accept /reject decision - that is , if a project is acceptable using the NPV method , it also is acceptable using the IRR method , and vice versa . As we will discover shortly , however when comparing two or more projects , the two techniques do not always agree as to which project is best . NPV pros - an NPV pro is a graph that shows the NPVs of a project at various required rates of return . To construct an NPV pro , compute the NPV of a project at different discount rates and then plot the results of computing the NPV of the project at different discounts rates , or required rates if return

Incorporating Risk in Capital Budgeting Analysis

When evaluating a capital budgeting project , we need to examine the risk associated with the project and how the existing assets of the firm will be affected if the project is purchased . The reason we need to evaluate the risk of a project is to determine if the appropriate required rate of return is used to compute the project 's NPV (or to compare to its IRR . If a firm is considering a project that is much riskier than the existing assets , then it makes sense that the firm should expect to earn a higher return on the project than on its existing assets . There are three risks that we generally identify when evaluating a project (1 stand-alone risk , which is the risk of the asset when it is held in isolation - that is , when it stands alone (2

corporate , or within-firm , risk , which is measured by the impact an asset is expected to have on the operations of the firm - that is , how an asset will affect the firm 's to existing assets and (3 ) beta , or market , risk , which is the portion of an asset 's risk that cannot be eliminated through diversification - that is , how an asset will affect the firm 's market risk , or beta , if it is purchased and added to existing assets . For a more detailed discussion of how each of these types of risks is measured , see the notes for the Risk and Return ' section

Stand-Alone Risk

Generally this is the risk that we compute when evaluating capital budgeting projects because it is easier to determine than the other two types of risk and it is usually very highly correlated to the other types of risk . To examine stand-alone risk , we need to determine how uncertain a project 's cash flows are . To do this , we often apply the following techniques : Sensitivity analysis - determine by how much the final result of a computation , such as NPV , changes when the values (inputs ) needed for the computation are changed . For example , if we examine the NPV of a project at various levels of sales and find that the result changes very little , then sales would be considered a fairly insensitive variable in the computation . Generally , if the final results are very sensitive to the value of a variable (the variable is said to be sensitive , greater care is taken to ensure an accurate forecast of the variable is attained so that the final results are more accurate Sensitivity analysis is easy to perform using a spreadsheet because you can input numerous values for the variable being evaluated

Corporate (within-Firm ) Risk

Determine how a capital budgeting project is related to the existing assets of the firm . If the firm wants to diversify its risk , it will try to invest in projects that are negatively related (or have little relationship ) to the existing assets . If a firm can reduce its overall risk , then it generally becomes more stable and its required rate of return decreases

Works Cited

Shukla .grewal . international finance : capital budgeting (2001 ) India

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