04 Capital Budgeting Decisions
Corporations face multiple decisions, but have to pick wisely due to limited capital.
Capital Budgeting¶
Process of evaluating firm’s long-term investment opportunities
Large investments usually consist of smaller investment decisions.
Framework¶
- Generation of investment idea
- Estimation of cash flows
- Select the appropriate opportunity cost of capital
- Selection of ideas based on acceptance criteria
- Re-evaluation
Types of Investments¶
- Revenue-enhancement
- Cost-reduction
- Mandatory [government] investments to meet regulations
Net Present Value (Primary)¶
It is in currency
One of
NPV | Meaning | Decision |
---|---|---|
\(>0\) | Actual returns > Minimum required return | Accept |
\(<0\) | Actual returns < Minimum required return | Reject |
\(0\) | Actual returns = Minimum required return | Doesn’t matter |
IRR (Primary)¶
Internal Rate of Return
Actual return of your project
We only know cashflows; no interest rates
Calculating
- Derive an equation in terms of
- Solve for \(r\)
Disadvantages¶
- multiple solutions can be found for the same project
- assumes that positive cash flows are reinvested at the IRR, which is considered impractical in practice
MIRR¶
Modified Internal Rate of Return
The modified internal rate of return (MIRR) is a measure of the profitability of a project or other investment.
It assumes that positive cash flows are reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's financing cost. The MIRR, therefore, more accurately reflects the cost and profitability of a project
$$ \begin{aligned} \text{MIRR} &= \Bigg( \dfrac{\text{FV}(\text{Positive cash flows} \times \text{Cost of capital})}{\text{PV}(\text{Initial outlays} \times \text{Financing cost})} \Bigg) ^{1/n} - 1 \ \textbf{where }
\text{FVCF}© &= \text{the future value of positive cash flows at the cost of capital} \ \text{PVCF}(fc) &= \text{the present value of negative cash flows at the financing cost} \ n &= \text{number of periods} \end{aligned} $$
Profitability Index (Secondary)¶
For every 1 unit of investment
NPV | Meaning | Decision |
---|---|---|
\(>1\) | Actual returns > Minimum required return | Accept |
\(<1\) | Actual returns < Minimum required return | Reject |
\(1\) | Actual returns = Minimum required return | Doesn’t matter |
Payback Period (Secondary)¶
- Simplest explanation
- If you have low DPP, that means the investement is less risky
Discounted Payback Period (Secondary)¶
Disadvantages¶
- Subjective payback period
- Only focusing on short-term gains
Required Rate of Return¶
where
- \(R_f=\) Risk Free Return
- \(\text{RP} =\)Â Risk Premium