Capital Badgeting

WHAT IS CAPITAL BUDGETING?

Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.

I. CAPITAL IS A LIMITED RESOURCE

In the form of either debt or equity, capital is a very limited resource. There is a limit to the volume of credit that the banking system can create in the economy. Commercial banks and other lending institutions have limited deposits from which they can lend money to individuals, corporations, and governments. In addition, the Federal Reserve System requires each bank to maintain part of its deposits as reserves. Having limited resources to lend, lending institutions are selective in extending loans to their customers. But even if a bank were to extend unlimited loans to a company, the management of that company would need to consider the impact that increasing loans would have on the overall cost of financing.

In reality, any firm has limited borrowing resources that should be allocated among the best investment alternatives. One might argue that a company can issue an almost unlimited amount of common stock to raise capital. Increasing the number of shares of company stock, however, will serve only to distribute the same amount of equity among a greater number of shareholders. In other words, as the number of shares of a company increases, the company ownership of the individual stockholder may proportionally decrease.

The argument that capital is a limited resource is true of any form of capital, whether debt or equity (short-term or long-term, common stock) or retained earnings, accounts payable or notes payable, and so on. Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital.

Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital budgeting.

II. Basic Steps of Capital Budgeting

1. Estimate the cash flows

2. Assess the riskiness of the cash flows.

3. Determine the appropriate discount rate.

4. Find the PV of the expected cash flows.

5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or

payback < policy

Definitions:

Independent versus mutually exclusive projects.

Normal versus nonnormal projects.

Basic Data

Expected Net Cash Flow

Year Project L Project S

0

1

2

3 ($100)

10

60

80 ($100)

70

50

20

III. Evaluation Techniques

A. Payback period

B. Net present value (NPV)

C. Internal rate of return (IRR)

D. Modified internal rate of return (MIRR)

E. Profitability index

A. PAYBACK PERIOD

Payback period = Expected number of years required to recover a project’s cost.

Project L

Expected Net Cash Flow

Year Project L Project S

0

1

2

3 ($100)

10

60

80 ($100)

(90)

(30)

50

PaybackL = 2 + $30/$80 years

= 2.4 years.

PaybackS = 1.6 years.

Weaknesses of Payback:

1. Ignores the time value of money. This weakness is eliminated with the discounted payback method.

2. Ignores cash flows occurring after the payback period.

B. NET PRESENT VALUE

Project L:

9.09

49.59

60.11

NPVL = $ 18.79

NPVS = $19.98

If the projects are independent, accept both.

If the projects are mutually exclusive, accept Project S since NPVS > NPVL.

Note: NPV declines as k increases, and NPV rises as k decreases.

C. INTERNAL RATE OF RETURN

.

Project L:

8.47

43.02