Post on 17-Jan-2016
transcript
7Basics of
Capital Budgeting
7.1 An Overview of Capital Budgeting
Capital BudgetingCapital budgeting is the process of analyzing
potential expenditures on fixed assets and deciding whether the firm should undertake those investments.
Capital budgeting = Strategic asset allocation
Capital budgeting decision = Strategic long-term investment decision
Capital Budgeting ProcessDetermine the cost of the project.Estimate the expected cash flows from the
project and the riskiness of those cash flows.Determine the appropriate cost of capital at
which to discount the cash flows.Determine the present values of the expected
cash flows and of the project.
7.2 Investment Criteria
Evaluation of Decision CriteriaDoes it consider all cash flows throughout the
entire life of a project?Does it consider the time value of money?Does it consider the risk?Does it provide information on whether you are
creating value for the firm?When it is used to select from a set of mutually
exclusive projects, does it choose the project which maximizes the wealth of the shareholders?
ExampleThe firm is considering a new project with
the following estimated cash flows:Year 0: CF = -158,000Year 1: CF = 54,200; NI = 12,100Year 2: CF = 66,900; NI = 5,800Year 3: CF = 89,300; NI = 27,600Average Book Value = 64,000
The required return is 11%.
Net Present Value (NPV)The NPV of an investment is the difference
between the market value of a project and its cost.
StepsThe first step is to estimate the expected future
cash flows.The second step is to estimate the required return
for projects of this risk level.The third step is to find the present value of the
cash flows and subtract the initial investment.Decision Rule : If the NPV is positive, accept the
project. If the NPV is negative, reject the project.
Net Present Value (NPV): ExampleNPV = -$158,000 + 54,200/(1.11) +
66,900/(1.11)2 + 89,300/(1.11)3 = $10,421.76NPV is positive.Do you accept the project? Yes!
Net Present Value (NPV)NPV has no serious flaws.NPV selects the project which adds the
most to shareholder wealth.NPV is the preferred decision criterion.When there is a conflict between NPV and
another decision rule, you should always use NPV.
Payback PeriodThe payback period is the length of time until
the sum of an investment’s cash flows equals to its cost.
StepsEstimate the cash flows.Subtract the future cash flows from the initial cost
until the initial investment has been recovered.Decision Rule: If the payback period is less
than some prespecified cutoff, accept the project.
Payback Period: ExampleAssume you will accept the project if it
pays back within two years.Year 1: $158,000 – 54,200 = $103,800 Year 2: $103,800 – 66,900 = $36,900Year 3: $36,900/89,300=0.41The project pays back in year 2.41 years.
The payback period is more than the prespecified cutoff.
Do you accept the project? No!
Advantages and Disadvantages of Payback Period
AdvantagesEasy to understandAdjusts for
uncertainty of later cash flows
Biased toward liquidity
DisadvantagesIgnores the time
value of moneyRequires an arbitrary
cutoff pointIgnores cash flows
beyond the cutoff date
Biased against long-term projects, such as research and development, and new projects
Discounted Payback PeriodThe discounted payback period is the
length of time until the sum of an investment’s discounted cash flows equals its cost.
Decision Rule: If the discounted payback period is less than some prespecified cutoff, accept the project.
Discounted Payback Period: ExampleAssume you will accept the project if it pays
back on a discounted basis in 2 years.Year 1: $158,000 – 54,200/1.111 =
$109,171.17Year 2: $109,171.17 – 66,900/1.112 =
$54,873.63Year 3: $54,873.63 / (89,300/1.113)= 0.84The project pays back in 2.84 years .
The discounted payback period is more than the prespecified cutoff.
Do you accept the project? No!
Advantages and Disadvantages of Discounted Payback Period
AdvantagesIncludes time value
of moneyEasy to understandDoes not accept
negative estimated NPV investments
Biased towards liquidity
DisadvantagesMay reject positive
NPV investmentsRequires an arbitrary
cutoff pointIgnores cash flows
beyond the cutoff dateBiased against long-
term projects, such as research and development, and new products
Average Accounting Return (AAR)The AAR is a measure of accounting profit
relative to book value.One form of the AAR is:
Average net income / average book valueDecision Rule: If the AAR exceeds a target
AAR, accept the project.
Average Accounting Return (AAR): ExampleAssume the firm requires an average
accounting return of 25%($12,100 + 5,800 + 27,600) / 3 =
$15,166.67AAR = 15,166.67 / 64,000 = 23.70%
The AAR is less than the target AAR.Do you accept the project? No!
Advantages and Disadvantages of AAR
AdvantagesEasy to calculateNeeded information
will usually be available
DisadvantagesNot a true rate of
return; time value of money is ignored
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values
Internal Rate of Return (IRR)The IRR is the discount rate that makes the
estimated NPV of an investment equal to zero.It is sometimes called the discounted cash
flow (DCF) return.Decision Rule: if the IRR exceeds the required
return, accept the project.
It is the most important alternative to NPV. It is very popular in practice, more so than
even the NPV.
Internal Rate of Return (IRR): ExampleTrial and error or using a financial
calculator or using a spreadsheet. -158,000 + 54,200/(1+r) +
66,900/(1+r)2 + 89,300/(1+r)3 =0IRR = 14.45% > 11%
The IRR exceeds the required return.Do you accept the project? Yes!
NPV Profile for the Project
(30,000.00)
(20,000.00)
(10,000.00)
0.00
10,000.00
20,000.00
30,000.00
40,000.00
50,000.00
60,000.00
Discount Rate
NP
V
IRR = 14.45%
Summary of Decisions for the ProjectDo you accept the project?
Net Present Value –YesPayback Period – NoDiscounted Payback Period – NoAverage Accounting Return – NoInternal Rate of Return – Yes
The final decision should be based on the NPV.
You should accept the project.
NPV vs. IRRNPV and IRR usually lead to identical decisions.
The project’s cash flows must be conventional: the first cash flow is negative and all the rest are positive.
The project must be independent: a project whose cash flows are unaffected by the decision to accept or reject some other project.
ExceptionsNonconventional cash flowsMutually exclusive projects
IRR and Nonconventional Cash FlowsWhen the cash flows change sign more than
once, there is more than one IRR.This is the multiple rates of return problem.You need to look at the NPV profile.
IRR and Mutually Exclusive ProjectsMutually exclusive projects
A set of projects of which only one can be accepted.
Decision rulesNPV – choose the project with the
higher NPVIRR – choose the project with the higher
IRRYou need to look at the NPV profile.
Mutually Exclusive Projects: ExamplePeriod Project
AProject B
0 $-1000 $-800
1 650 650
2 650 400
IRR 19.43% 22.17%
NPV $128.10 $121.49
The required return for both projects is 10%.
Which project should you accept and why?
NPV Profiles
0 0.05 0.1 0.15 0.2 0.25 0.3
($100.00)
($50.00)
$0.00
$50.00
$100.00
$150.00
$200.00
$250.00
$300.00
$350.00
A
B
Discount Rate
NP
V
IRR for A = 19.43%
IRR for B = 22.17%
Crossover Rate = 11.8%
Mutually Exclusive Projects: ExampleThe crossover rate is the discount rate the
makes the NPVs of two projects equal.When there is a conflict between NPV and
another decision rule, you should always use NPV.
If the required return is less than the crossover rate of 11.8%, then you should choose A.
If the required return is greater than the crossover rate of 11.8%, then you should choose B.
Advantages and Disadvantages of IRR
AdvantagesClosely related to
NPV, often leading to identical decisions
Easy to understand and communicate
DisadvantagesMay result in
multiple answers or not deal with nonconventional cash flows.
May lead to incorrect decisions in comparisons of mutually exclusive investments
Modified Internal Rate of Return (MIRR) The MIRR is a modification to the IRR. Steps:
A project’s cash flows are modified by: Discounting the negative cash flows back to the
present. Compounding cash flows to the end of the
project’s life. Combining the above two.
Compute the IRR on the modified cash flows.It avoids the multiple rate of return problem,
but it is unclear to interpret them.
Profitability Index (PI)The PI is the ratio of present value to cost.It is also called the benefit-cost ratio.It measures the present value of an
investment per dollar invested.Decision rule: If the PI exceeds 1, accept the
project.
Advantages and Disadvantages of PIAdvantages
Closely related to NPV, generally leading to identical decisions
Easy to understand and communicate
May be useful when available investment funds are limited
DisadvantagesMay lead to
incorrect decisions in comparisons of mutually exclusive investments
Capital Budgeting in PracticeFirm use multiple criteria for evaluating a
proposal.NPV and IRR are the most commonly used
primary investment criteria.Payback period is a commonly used
secondary investment criteria.Less commonly used were discounted
payback period, AAR and PI.