In Feb. 2000, Corning Inc., announced plans to spend $750 million to expand by 50% its manufacturing capacity of optical fiber, a crucial component

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1 CAPITAL BUDGETING

2 In Feb. 2000, Corning Inc., announced plans to spend $750 million to expand by 50% its manufacturing capacity of optical fiber, a crucial component of today s high speed communications networks. Of that $650 would be spend to expand its facilities in North Carolina while another $100 m would be spent to double the size of a smaller plant near Melbourne, Australia. At the time, Corning was the world's leading maker of optical fiber with about 40 percent of the market. The expansion plans were made amid a worldwide shortage of optical fiber stemming from the rapid expansion of telephone and data communications networks.

3 Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc. The large amounts spent for these types of projects are known as capital expenditures. Capital budgeting usually involves the calculation of each project's future accounting profit by period, the cash flow by period, the present value of the cash flows after considering the time value of money, the number of years it takes for a project's cash flow to pay back the initial cash investment, an assessment of risk, and other factors. Capital budgeting is a tool for maximizing a company's future profits since most companies are able to manage only a limited number of large projects at any one time.

4 Capital expenditure proposals Replacement needed to continue current operations Replacement for cost reduction Expansion of existing products or markets Expansion into new products or markets Safety or environmental projects Mergers and Acquisitions

5 Criteria for accepting or rejecting projects Net Present Value Internal Rate of Return Modified Internal Rate of Return Regular payback Discounted Payback

6 Net Present Value A method of ranking investment proposals using NPV, which is equal to the present value of future net cash flows, discounted at the cost of capital Investment proposals maybe independent or mutually exclusive. Independent projects are projects whose cash flows are not affected by one another. Wal-Mart is considering a new store in New York and another one in Atlanta, the projects would be independent Mutually exclusive projects are projects where if one project is accepted, the other must be rejected. A conveyor belt system to move goods in a warehouse and a fleet of forklifts used for the same purpose would be mutually exclusive accepting one implies rejecting the other

7 Internal Rate of Return A project s IRR is the discount rate that forces the PV of the inflows to equal the cost This is the equivalent of forcing the NPV to equal zero IRR is an estimate of the project s rate of return If this return exceeds the cost of the funds used to finance the project, the difference will be a bonus that goes to the firm s stockholders and causes the stock price to rise Independent projects: if IRR exceeds the projects WACC, accept the project Mutually exclusive projects: accept the project with the highest IRR, provided that IRR is greater than WACC

8 Modified Rate of Return Managers want to know the expected rate of return on investments and this is what the IRR is supposed to tell them. But IRR is based on the assumption that projects cash flows can be reinvested at IRR. This causes IRR to overstate the project s true return, which is incorrect MIRR assumes that cash flows are reinvested at the cost of capital or some other explicit rate, hence a better indicator of a project s true profitability