Capital Budgeting

Goals

After completing this module, you will be able to do the following:

  • Outline the facts of the payback rule and some of its shortcomings.
  • Accounting rates of return and some of the problems with them.
  • Describe the internal rate of return criterion and its strengths and weaknesses.
  • Recognize why the net present value criterion is the best way to evaluate proposed investments.
  • Calculate the profitability index and understand its relation to net present value.
  • Interpreting how to determine the relevant cash flows for a proposed investment
  • Understand how to analyze a project’s projected cash flows.
  • Practice how to evaluate an estimated NPV.

Overview

The process of allocating, or budgeting, capital is usually more involved than just deciding whether or not to buy a particular fixed asset. We frequently face broader issues like whether or not we should launch a new product or enter a new market. Decisions such as these determine the nature of a firm’s operations and products for years to come.

For these reasons, the capital budgeting question is probably the most important issue in corporate finance. How a firm chooses to finance its operations, (the capital structure question) and how a firm manages its short-term operating activities (the working capital question) are certainly issues of concern, but it is the fixed assets that define the business of the firm.

So far, we’ve covered various parts of the capital budgeting decision. Our task in this module is to start bringing these pieces together. In particular, we show you how to “spread the numbers” for a proposed investment or project and, based on those numbers, make an initial assessment about whether or not the project should be undertaken.

In the discussion that follows, we focus on the process of setting up a discounted cash flow analysis. We know that the projected future cash flows are the key element in such an evaluation. Accordingly, we emphasize working with financial and accounting information to come up with these figures.

This module covers the different criteria used to evaluate proposed investments. The six criteria, in the order in which we described them in this module are:

– Net present value (NPV)

– Payback period

– Average accounting return (AAR)

– Internal rate of return (IRR)

– Modified internal rate of return, and

– Profitability index (PI)

We illustrate how to calculate each of these and outline the interpretation of the results. We also describe the advantages and disadvantages of each of them. Ultimately, a good capital budgeting criterion must tell us two things. First, is a particular project a good investment? Second, if we have more than one good project, but we can only take one this criterion can always provide the correct answer to both questions.

Finally, we appraise how to go about putting together a discounted cash flow analysis and evaluating the results; for example,

– The identification of relevant project cash flows. We discuss project cash flows and describe how to handle some issues that often come up, including sunk costs, opportunity costs, financing costs, net working capital, and erosion.

– Preparing and using pro forma, or projected financial statements. We show how pro forma financial statement information is useful in coming up with projected cash flows.

– The use of scenario and sensitivity analysis. These tools are widely used to evaluate the impact of assumptions made about future cash flows and NPV estimates.

Read: Essentials of Corporate Finance: Chapters 8 and 9

 

 

 

 

 

 

 

 

 

 

Assignment

 

Discussion Question:

NPV Valuation. The Yurdone Corporation wants to set up a private cemetery business. According to the CFO, Barry M. Deep, business is “looking up.” As a result, the cemetery project will provide a net cash inflow of $109,000 for the firm during the first year, and the cash flows are projected to grow at a rate of 5.1 percent per year forever. The project requires an initial investment of $1,425,000.

  1. If Yurdone requires a return of 12 percent on such undertakings, should the cemetery business be started?
  2. The company is somewhat unsure about the assumption of a 5.1 percent growth rate in its cash flows. At what constant growth rate would the company just break even if it still required a return of 12 percent on its investment?