Unit 3: Capital Budgeting

1. Introduction to Capital Budgeting

Capital budgeting is the process of making investment decisions in long-term assets or capital expenditures. It involves the planning and analysis of projects where the expenditure is made today, but the returns are expected to occur over a series of years in the future.

Key Concepts

• Capital Expenditure (Capex): Spending on assets that will provide benefits for a period exceeding one year (e.g., buying new machinery, building a new plant, R&D).
• Time Value of Money: The recognition that a dollar received today is worth more than a dollar received in the future due to its potential earning capacity.
• Goal: To maximize the wealth of the shareholders by selecting projects where the value of benefits exceeds the cost.

2. Nature of Capital Budgeting

Capital budgeting is distinct from working capital management due to the following characteristics:

1. Long-Term Implications

Capital budgeting decisions have consequences that extend far into the future. A decision to build a factory determines the company's cost structure and production capacity for 10-20 years.

2. Substantial Commitment of Funds

These decisions usually involve large sums of money. Significant funds are blocked for a long period, which affects the liquidity and financial stability of the firm.

3. Irreversibility

Decisions are generally irreversible or reversible only at a substantial loss. Once a specialized machine is custom-built, there is often no second-hand market for it.

4. High Degree of Risk and Uncertainty

Because the benefits occur in the distant future, they are difficult to predict. Changes in technology, consumer preferences, government policy, and economic conditions introduce significant risk.

5. Impact on Profitability

These decisions determine the long-term profitability of the firm. A bad capital budgeting decision can lead to high operating costs and low revenue, potentially bankrupting a firm.

3. Types of Capital Budgeting Decisions

Firms generally face three specific categories of project selection decisions:

1. Accept-Reject Decisions

This applies to independent projects (projects that do not compete with one another).

• Criteria: If the project meets a minimum standard (e.g., return is higher than the cost of capital), it is accepted.
• Example: A firm can choose to buy a new truck and upgrade its software if both are profitable and funds are available.

2. Mutually Exclusive Decisions

These are "either/or" decisions where acceptance of one project automatically implies the rejection of the other.

• Criteria: The firm must select the best project among the alternatives.
• Example: Choosing between a gas-powered forklift or an electric forklift. You need one forklift; you cannot buy both to do the same job.

3. Capital Rationing Decisions

This occurs when a firm has profitable projects but limited funds (budget constraints).

• Criteria: Projects must be ranked to maximize total shareholder value within the available budget.
• Example: A company has $1 million to invest but has identified three profitable projects costing $600,000 each. It must prioritize which combinations to fund.

4. Evaluation Techniques: Overview

The methods used to evaluate capital budgeting proposals are categorized into two groups based on whether they consider the time value of money.

A. Non-Discounting Techniques (Traditional Methods)

• Payback Period (PBP)
• Accounting Rate of Return (ARR)

B. Discounting Techniques (Modern Methods)

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
• Discounted Payback Period

5. Non-Discounting Techniques

These methods do not consider the time value of money. They assume a dollar received in year 10 is equal in value to a dollar received in year 1.

A. Payback Period (PBP)

The length of time required to recover the initial cost of the investment.

Formulas:

1. For constant annual cash flows:
   
2. For uneven cash flows: Calculate cumulative cash flows year by year until the initial investment is recovered.

Decision Rule:

• Accept: If Actual PBP < Target (Standard) PBP.
• Mutually Exclusive: Choose the project with the shorter payback period.

Pros:

• Simple to calculate and understand.
• Focuses on liquidity (how fast money comes back).

Cons:

• Ignores Time Value of Money.
• Ignores Cash Flows after the payback period: A project might recover costs in 3 years but generate zero profit afterward, yet PBP would favor it over a project that pays back in 4 years but generates massive profits for 20 years.

B. Accounting Rate of Return (ARR)

Also known as the Average Rate of Return. It measures the profitability of the project using accounting profits (Net Income) rather than cash flows.

Formula:

• Note: Average Investment = (Initial Investment + Scrap Value) / 2

Decision Rule:

• Accept: If ARR > Minimum Required Rate of Return.
• Mutually Exclusive: Choose the project with the highest ARR.

Pros:

• Uses accounting data which is readily available.
• Considers savings over the entire life of the project.

Cons:

• Ignores Time Value of Money.
• Uses "Accounting Profit" (which includes non-cash items like depreciation) rather than "Cash Flow," making it less accurate for liquidity analysis.

6. Discounting Techniques

These methods account for the Time Value of Money (TVM) by discounting future cash flows back to their Present Value (PV) using a discount rate (Cost of Capital, denoted as or ).

A. Net Present Value (NPV)

NPV is the difference between the Present Value of Cash Inflows and the Present Value of Cash Outflows. It represents the absolute addition to shareholder wealth.

Formula:

• = Cash flow in period
• = Cost of capital (Discount rate)
• = Time period

Decision Rule:

• NPV > 0 (Positive): Accept (Project adds value).
• NPV < 0 (Negative): Reject (Project destroys value).
• NPV = 0: Indifferent (Project covers costs but adds no extra value).

Pros:

• Considers TVM.
• Considers all cash flows over the project life.
• Consistent with the goal of wealth maximization.

Cons:

• Calculation is complex.
• Sensitive to the choice of the discount rate.

B. Internal Rate of Return (IRR)

The IRR is the specific discount rate that makes the NPV of a project equal to zero. It represents the project's break-even rate of return.

Concept:

Decision Rule:

• Accept: If IRR > Cost of Capital ().
• Reject: If IRR < Cost of Capital ().

Pros:

• Easily understood by management (expressed as a percentage).
• Considers TVM.

Cons:

• Multiple IRRs: Non-conventional cash flows (negative-positive-negative) can result in multiple solutions.
• Reinvestment Assumption: Assumes cash flows are reinvested at the IRR rate (which may be unrealistic high), whereas NPV assumes reinvestment at the cost of capital.

C. Profitability Index (PI)

Also known as the Benefit-Cost Ratio. It measures the present value of returns per dollar invested.

Formula:

Decision Rule:

• PI > 1: Accept (NPV is positive).
• PI < 1: Reject (NPV is negative).

Significance:

• Extremely useful in Capital Rationing. When funds are limited, firms should choose projects with the highest PI to get the most "bang for the buck."

D. Discounted Payback Period

Similar to the traditional Payback Period, but cash flows are discounted before calculating the recovery time.

Method:

1. Discount all future cash flows to present value.
2. Calculate how long it takes for the discounted sum to equal the initial investment.

Pros:

• Overcomes the "Time Value of Money" flaw of the traditional PBP.
• Still provides a measure of liquidity/risk.

Cons:

• Still ignores cash flows that occur after the payback period.

Summary Comparison Table