BAFI 355 - Week 4 (Tues and Thurs) - Capital Budgeting Decisions

BAFI 355 Overview

• Week 4 Schedule: Classes on Tuesday and Thursday focusing on Capital Budgeting.

Capital Budgeting Decision Rules

• Definition: Capital budgeting involves making investment decisions about which long-term projects or investments to undertake.

• Importance of Value Creation: Understanding what value creation means and assessing project attractiveness through various techniques and tools.

Key Learning Objectives

• Explore concepts of capital budgeting and its role in strategic and financial project evaluation.

Limited Resources in Companies

• Companies must prioritize due to limited resources: human and financial capital.

• Trade-offs: Strategic focus on certain opportunities over others.

• Capital budgeting is the framework for these critical investment decisions.

Capital Budgeting Process

1. Raise Capital: Obtain funding for new initiatives.

2. Invest in Assets: Allocate funds to valuable projects.

3. Generate Sales and Profits: Convert investments into revenue.

4. Return Value to Shareholders: Distribution of dividends versus reinvestment.

5. Repeat the Cycle: Continuous investment and growth.

Understanding Value Creation

• Cost vs. Benefit Concept: Similar to cost/benefit analysis in economics but refined to net present value (NPV).

• Components:

  • Cost = Investment

  • Benefits = Present Value of future cash flows

  • Value Creation = PV of Benefits - PV of Investment

Example of Value Creation

• Scenario: Purchase of record collection for $1,000 with potential resale value of $3,000.

• Value Calculation: Each of 4 shares gains $500, demonstrating net positive value from investments.

Project Evaluation Framework

• Key Variables in Valuation:

  • Cash flow for each time period (CFt)

  • Life of the asset (n)

  • Risk-adjusted return rate (r), often used as a discount rate.

Evaluating Projects

• Importance of identifying cash flows and applying the correct discount rate in project valuation.

Attributes of Good Capital Budgeting Tools

1. Comprehensive cash flow consideration.

2. Focus on value creation metrics.

3. Incorporation of time value of money.

4. Risk reflection in investment decisions.

5. Ease of analysis and explanation.

Capital Budgeting Tools

• Net Present Value (NPV): Accept projects with positive NPV.

• Payback Methods: Simple payback and discounted payback.

• Internal Rate of Return (IRR): Decision rule based on achieving a minimum return.

• Profitability Index: Benefits-to-cost ratio assessment.

• Average Accounting Return and Equivalent Annuity Cost: Less commonly used.

NPV Example Calculation

• New Product Case: Initial investment of $10,000 with defined cash flows over subsequent years. Calculate NPV using future values of cash flows discounted to present value. Positive NPV indicates pursuit of the project.

Fertilizer Business Example

• Investment Evaluation: Project requiring $30,000 upfront with defined cash flows and salvage value. Perform NPV calculation to assess investment viability.

Payback Period Review

• Definition: Time to recover investment costs.

• Decision Rule: Accept projects with payback periods under a set threshold (usually 3-4 years).

• Examples of Multiple Projects analyzed for payback timings to determine project feasibility.

Discounted Payback Period

• Improvements on the traditional payback method by including time value of money for more accurate project timing evaluations.

Internal Rate of Return (IRR)

• Definition: Rate at which NPV = 0; used for assessing project attractiveness.

• Application: Differentiate between projects based on their IRR relative to a predetermined hurdle rate.

Mutually Exclusive Projects

• Only one project can be chosen among alternatives based on cash flows and investment returns.

• Crossover Rate: Identify changes in preference based on different hurdle rates affecting project attractiveness.

Conclusion on Capital Budgeting Decision Making

• NPV generally preferred due to dollar impact clarity, whereas IRR provides percentage returns with limitations.

• Profitability Index: Can indicate efficiency relative to investment size, guiding capital project selection better for quantifying investment effectiveness.

• Capital budgeting tools and metrics inform investment strategies ensuring optimal resource allocation.