8-1

Chapter 8:Capital

BudgetingTechniques

8-2

The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year.

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to firm’s future.

What is Capital Budgeting?

8-3

Generating Ideas for Capital Projects

A firm’s growth and its ability to remain competitive depend on a constant flow of ideas for new products, ways to make existing products better, and ways to produce output at a lower cost.

Procedures must be established for evaluating the worth of such projects.

8-4

Project Classifications

Replacement Decisions:Replacement Decisions: whether to purchase capital assets to take the place of existing assets to maintain or improve existing operations.

Expansion Decisions:Expansion Decisions: whether to purchase capital projects and add them to existing assets to increase existing operations.

Independent Projects:Independent Projects: Projects whose cash flows are not affected by decisions made about other projects.

Mutually Exclusive Projects:Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted.

8-5

Similarities between Capital Budgeting and Asset Valuation

1 Determine the cost, or purchase price, of the asset.

2 Estimate the cash flows expected from the project.

3 Assess the riskiness of cash flows.

4 Compute the present value of the expected cash

flows to obtain as estimate of the asset’s value to

the firm.

5 Compare the present value of the future expected

cash flows with the initial investment.

Uses same steps as in general asset valuation

8-6

Net Cash Flows for Project S and Project L

Expected After-TaxNet Cash Flows, CFT

Year (T) Project S Project L

0a $(3,000) $(3,000)

1 1,500 400

2 1,200 900

3 800 1,300

4 300 1,500

^

8-7

What is the Payback Period?

The length of time before the original cost of an investment is recovered from the expected cash flows or . . . How long it takes to get our money back.

PB =Number of years before

full recovery oforiginal investment

Uncovered cost at start

of full-recovery year Total cash flow during

full-recovery year ( ( ))

Payback =

+

8-8

Payback Period for Project S

Net Cash Flow

Cumulative Net CF

=PaybackS 2 + 300/800 = 2.375 years

1,500

-1,500

800

500

1,200

-300

-3,000

-3,000

300

800

PBS0 1 2 3 4

8-9

Payback Period for Project L

Net Cash Flow

Cumulative Net CF

=PaybackL 3 + 400/1,500 = 3.3 years

400

- 2,600

1,300

- 400

900

- 1,700

- 3,000

- 3,000

1,500

1,100

PBL0 1 2 3 4

8-10

Strengths of Payback:Strengths of Payback:Provides an indication of a project’s risk and liquidity.Easy to calculate and understand.

Weaknesses of Payback:Weaknesses of Payback: Ignores the TVM.Ignores CFs occurring after the payback period.

Strengths an Weaknesses of Payback:

8-11

Net Present Value: Sum of the PVs of Inflows and Outflows

Cost often is CF0 and is negative

NPV

CF

kt

nt

t 0 1

.^

NPV

CF

kCF

t

nt

t

0

01

.^

^

8-12

k = 10%

1,500 8001,200(3,000)

1,363.64

991.74

601.05

204.90

161.33

300

0 1 2 3 4

What is Project S’s NPV?

NPVS =

8-13

k = 10%

400 1300900(3,000)

363.60

743.40

976.30

1024.50

107.80

1500

0 1 2 3 4

What is Project L’s NPV?

NPVL =

8-14

Calculator Solution, NPV for L :

Enter in CFLO for L:

-3,000

400

900

1,300

1,500

CF0

CF1

NPV

CF2

CF3

I = 107.80 = NPVL

CF4

8-15

Rationale for the NPV method:

NPV = PV inflows - Cost= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

8-16

If Projects S and L are mutually exclusive, accept S because NPVs > NPVL

If S & L are independent, accept both; NPV > 0

Using NPV method, which project(s) should be accepted?

8-17

Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces PV inflows = cost This is the same as forcing NPV = 0

8-18

t

nt

t

CF

kNPV

0 1.

t

nt

t

CF

IRR

0 10.

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

Calculating IRR

8-19

What is Project S’s IRR?

IRR = ?

1,500 8001,200(3,000) 300

0 1 2 3 4

NPVS = IRRS = 13.1%

Enter CFs in CF register, thenpress IRR:

Sum of PVs for CF1-4 = 3,000

0

8-20

What is Project L’s IRR?

IRR = ?

400 1300900(3,000) 1500

0 1 2 3 4

NPVL =Enter CFs in CF register, thenpress IRR: IRRL = 11.4%

Sum of PVs for CF1-4 = 3,000

0

8-21

How is a Project’s IRRRelated to a Bond’s YTM?

They are the same thing.A bond’s YTM is the IRRif you invest in the bond.

90 109090

0 1 2 10IRR = ?

-1134.2

IRR = 7.08% (use TVM or CF register)

8-22

Rationale for the IRR Method:

If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns.

Example: WACC = 10%,IRR = 15%. Profitable.

8-23

If IRR > k, accept project.

If IRR < k, reject project.

IRR acceptance criteria:

8-24

Decisions on our Projects S and L per IRR:

If S and L are independent, accept both.

IRRs > k = 10%.

If S and L are mutually exclusive,

accept S because IRRS > IRRL .

8-25

Construct NPV Profiles

Enter CFs in CFLO and find NPVL andNPVS at several discount rates:

k

0

5

10

15

20

NPVL

50

33

19

7

(4)

NPVS

40

29

20

12

5

8-26

-10

0

10

20

30

40

50

60

0 5 10 15 20 23.6

NPV ($)

Discount Rate (%)

IRRL = 16.1%

IRRS = 23.6%

Crossover Point = 8.7%

k

0

5

10

15

20

NPVL

50

33

19

7

(4)

NPVS

40

29

20

12

5 S

L

NPV Profiles for Project S and Project L

8-27

NPV and IRR always lead to thesame accept/reject decision forindependent projects:

k > IRRand NPV < 0.

Reject.

NPV ($)

k (%)IRR

IRR > kand NPV > 0

Accept.

8-28

Mutually Exclusive Projects

8.7

NPV

%

IRRs

IRRL

S

k< 8.7: NPVL> NPVS , IRRS > IRRL

CONFLICT k> 8.7: NPVS> NPVL , IRRS > IRRL

NO CONFLICT

8-29

To Find the Crossover Rate:

1. Find cash flow differences between the projects. See data at beginning of the case.

2. Enter these differences in CF register, then press IRR. Crossover rate = 8.68, rounded to 8.7%.

3. Can subtract S from L or vice versa, but better to have first CF negative.

4. If profiles don’t cross, one project dominates the other.

8-30

Two Reasons NPV Profiles Cross:

1) Size (scale) differences.1) Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opp. cost, the more valuable these funds, so high k favors small projects.

2) Timing differences.2) Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS> NPVL.

8-31

Reinvestment Rate Assumptions

NPV assumes reinvest at k.

IRR assumes reinvest at IRR.

Reinvest at opp. cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.