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Capital Budgeting

- Defined as process by which a firm decides which long term investments to make
- Decision to accept or reject a capital budgeting project depends on an analysis of the cash flows generated by the project and its cost

Five Capital Budgeting Performance Measures

- 1. Payback
- 2. Average Rate of Return
- 3. Net Present Value
- 4. Profitability Index
- 5. Internal Rate of Return

Starting with Net Cash Flow Statement

- Cash Flow Statement: sources and uses of cash for a business over a certain period of time.
- Period coincides with the reporting period of the income statement.
- Cash Flow Statement is basic to calculating performance measures

Cash Flow Statement

- A cash flow statement shows how your business is performing on a “cash” basis
- The income statement shows how your business performs on an “accrual” basis while the cash flow statement provides a source of cash receipts shown in the income statement

Cash Versus Accrual Accounting Methods

- Basic difference between the two is the timing of the income and expense recording.

Cash versus Accrual

- Cash accounting is based on real time cash flow. Revenues (expenses) are reported when received (paid).
- Accrual accounting reports income (expenses) when earned (or received) and expenses when earned and not necessarily when received (or paid).

Three General Categories of a Cash Flow Statement

- Net flows from operations activities
- Net flows from investing activities consisting primarily of purchase or sale of equipment
- Net flows from financing activities such as issuing and borrowing funds.

Steps in Preparing a Cash Flow Budget

- 1. Prepare a sales forecast
- 2. Project anticipated cash inflows
- 3. Project anticipated cash outflows
- 4. Putting the projections together to come up with your cash flow “bottom line”

Capital Budgeting Decision Rules

- 1. You must consider all the project’s cash flows
- 2.Must consider time value of money. Dollar earned next year is not the same as a dollar earned today
- 3. Must always lead to the correct decision when choosing among mutually exclusive projects

Time Value of Money

- At it’s most basic level, the time value of money demonstrates that it is better to have money now rather than later.
- Would you rather have $10,000 today or receive it next year?
- Why?

Would You Rather Receive $10,000 Today or Next Year?

- Inflation
- Could have it invested and earning money

Project Classification

- Projects being considered and evaluated can be divided into two categories:
- 1. Independent projects
- 2. Mutually exclusive projects

Independent Projects

- A project whose cash flows are not affected by the accept or reject decision of other projects.

Mutually Exclusive Projects

- Defined as a set of projects from which at most one will be accepted.
- All the projects being considered may be acceptable, but we’ll choose the “best” one.
- Can’t always do everything – often have a budget constraint

Capital/Investment Projects in Agribusiness

- Wind turbine
- New ag chemical
- Plastic reusable containers vs cardboard
- High speed wine bottling equipment
- Flash freezer vs IQF freezer for fruit
- Electronic Point of Sale systems for retail store
- Employee health insurance plan A vs B
- New line of equipment for a farm supply store
- New service division for a bank

Cash Flow Returns

- Based on project outcomes that either lead to
- New net revenue
- New net cost savings
- Typically over a period of time

The Discount Rate

It’s the firm’s cost of capital. The latter reflects the firm’s cost of acquiring capital to invest in long term assets.

Discount rate reflects future value of money. Has two components:

- An adjustment for inflation
- A risk-adjusted return on the use of the money

Investment Example

- Initial Investment: $400,000
- Cash Flow Returns
- Year 1: $115,000
- Year 2: $115,000
- Year 3: $115,000
- Year 4: $115,000
- Year 5: $115,000
- Salvage Value: $50,000

Payback Period

- A capital budget performance measure
- Defined as the length of time it takes for a capital budgeting project to recover it’s initial cost

Calculating Payback

Net Investment

Average Annual Net Cash Flow

*Note that net cash flow is after taxes

Payback =

Calculating Payback

- Using the Net Cash Flow example provided, what is the payback period?

Example Calculating Payback

Net Investment

Average Annual Net Cash Flow

$400,000

$115,000

Decision Rule: The lower the better!

Payback =

=

= 3.48 Years

Payback

- Advantages:
- Easy to calculate
- Give you a rough idea of liquidity
- Disadvantages:
- Ignores time value of money
- Ignores project profitability

Average Rate of Return

- A second capital budgeting performance measure
- Defined as:
- Average Annual Net Cash Flow – Average Annual Depreciation Net Investment

Average ROR

Calculate the Average ROR using the example net cash flow statement

Calculating Average ROR

$115,000 - $70,000

$400,000

Decision Rule: Must be positive and the higher the better!

ROR =

= 11.25%

Average ROR

- Advantages:
- Again, simple to calculate
- Does account for salvage value
- Begins to consider profitability
- Disadvantages:
- Ignores time value of money

Net Present Value

- A third capital budgeting performance measure concept
- Net Present Value is a measure of how much value is created or added today by undertaking an investment.

Net Present Value

- It does this by accounting for the time value of money. A $ today is worth more than a $ tomorrow because of the “erosive” effects of inflation

Net Present Value

- It is the present (discounted) value of future cash inflows minus the present value of the investment and any associated future cash outflows
- It’s the net result of a multiyear investment expressed in today’s dollars

Net Present Value Key

- NCFt Net Cash Flow in Year t
- T is the life of the project
- r is the discount rate or cost of capital
- NINV is the net investment of the project
- Note that in year T, Net Cash Flow must include the salvage value of the initial investment

Calculate Net Present Value

- Using the example provided, how would you structure the equation for calculating net present value?
- Assume Discount Rate = 10%

Calculating Net Present Value

$115,000$115,000$115,000 $115,000$115,000 + $50,000

(1.1)1 (1.1)2 (1.1)3 (1.1)4 (1.1)5

$115,000$115,000$115,000$115,000$165,000

1.1 1.21 1.331 1.4641 1.61051

$104,545 + $95,041 + $86,401 + $78,547 + $102,452 - $400,000

$466,984 - $400,000

$66,987

+

+

+

+

- $400,000

+

+

+

+

- $400,000

Net Present Value

- Decision Rule: Accept project if NPV > 0
- $66,987 > 0 so we accept the project given it’s the only one we’re considering
- Note if mutually exclusive projects being considered, accept the one with the highest NPV

NPV

- Advantages:

-Accounts for time value of money correctly

-Considers firm profitability

-Consistent with notion of maximizing owner wealth

NPV

- Disadvantages:

-More complex to calculate

-Difficult to explain to non-financial managers

-Not always easy to determine the correct “discount rate”

Profitability Index (PI)or Benefit Cost Ratio (BCR)

Defined as the present value of the future cash flows divided by the initial investment

Profitability Index--Where

- NCFt = Net Cash Flow in Year t
- T = Life of the Project
- r = Discount Rate
- NINV = Net investment of Project
- Note that Net Cash flow must include the salvage value of the initial investment

Calculating PI

- Using the example provided, what is the profitability index?

Calculate PI

- Decision Rule: Accept if PI >1.0

But the bigger the PI the better

- Hence, we accept this project
- Note: PI is a unit free performance measure

Pros and Cons of PI

- Advantages:
- Accounts for time value of money
- Considers project profitability
- Considers owner wealth maximization
- Disadvantages:
- Complex to calculate
- Difficult to explain to non-financial types
- May not pick project with largest NPV

Internal Rate of Return (IRR)

- The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate
- In some ways it’s an alternative to NPV

Internal Rate of Return

- Note that NPV is some mathematical function of r (the discount rate)
- So IRR is the level of r (call it r*) such that the NPV = 0

Thus,

Internal Rate of Return

- Unfortunately, one cannot solve for IRR using algebra.
- Rather we must solve by trial and error

Calculating IRR-Using Example

- r % NPV ($)PI

6 121,785 1.3

8 93,191 1.23

10 66,987 1.17

12 42,921 1.11

14 20,773 1.05

16 349 1.0

18 -18,520 .95

20 -35,986 .91

22 -52,181 .87

24 -67,225 .83

Calculating IRR

- From previous table we note that NPV = 0 somewhere between r = 16% and r = 18%.
- Bit more trial and error and we can discover that IRR = 16.04%
- Plug 16.04% into NPV formula and you get NPV = 0

Calculating IRR

- Decision Rule says that for a single project accept if IRR > 0.
- The higher the better.

Pros and Cons of IRR

- Advantages:

Accounts for time value of money

Considers profitability

Consistent with maximizing wealth

Doesn’t require analyst to specify r

- Disadvantages:

Complex to calculate

Difficult to explain

May not pick project with largest NPV

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