Transcript Chapter 13
Chapter 13 McGraw-Hill/Irwin Weighing Net Present Value and Other Capital Budgeting Criteria Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.1 Capital Budgeting Techniques Project evaluation methods • Net Present Value (NPV) is preferred method • Internal Rate of Return (IRR) • Payback (PB) 13-2 Capital Budgeting Techniques Project evaluation methods • Discounted Payback (DPB) • Modified Internal Rate of Return (MIRR) • Profitability Index (PI) 13-3 Choice of Decision Statistic Format • Financial decisions primarily driven by – Currency – Time – Rate of return 13-4 Capital Budgeting Decisions • Deciding on single project acceptance – Compute statistic – Compare with benchmark 13-5 Capital Budgeting Decisions • Deciding on mutually exclusive projects – Compute statistic – Conduct “runoff” between mutually exclusive projects – Compare winning project with benchmark 13-6 Payback and Discounted Payback • Payback statistic – Break-even calculation for costs of financing new project 13-7 Payback Benchmark • Benchmark can vary • Based on relevant external constraint 13-8 Discounted Payback Statistic • Compensates for time value of money 13-9 Discounted Payback Benchmark • Not recommended to compare Discounted Payback Benchmark (DPB) with Payback Benchmark (PB) • DPB will be larger than regular PB 13-10 Payback and Discounted Payback Strengths • Strengths – Easy to calculate – Intuitive • Weaknesses – accept/reject benchmarks are arbitrary – ignore cash flows after the payback period – PB ignores the time value of money 13-11 Net Present Value • Measures value created by the project 13-12 NPV Benchmark • Includes all cash flows – both inflows and outflows 13-13 NPV Strengths and Weaknesses • Strengths – Not a ratio – Works well for both independent projects and mutually-exclusive projects • Weaknesses – Managers can misinterpret the results • May compare NPV to cost even though cost already incorporated into the NPV 13-14 Internal Rate of Return and Modified Internal Rate of Return • IRR most popular technique • IRR gives same accept/reject decision as NPV when used with normal cash-flow projects 13-15 NPV vs. IRR • NPV and IRR are closely related 13-16 Internal Rate of Return Statistic • To calculate IRR, solve the NPV formula for interest rate that makes NPV equal zero 13-17 IRR Benchmark – Calculate the IRR and compare cost of capital (investors’ required return) to see if the project is acceptable 13-18 Problems with IRR • IRR will be consistent with NPV as long as project: – has normal cash flows – is independent 13-19 IRR and NPV with Non-normal Cash Flows • Recommended not to use IRR with nonnormal cash flows • Modified Internal Rate of Return is better 13-20 Differing Reinvestment Rate Assumptions of NPV and IRR • NPV and IRR assume cash flows are reinvested in firm • NPV’s reinvestment rate assumption is considered superior to IRR’s 13-21 Modified Internal Rate of Return • “Fixes” IRR reinvestment rate problem • Modification to IRR – Uses cost of capital to move cash flows • MIRR not appropriate for mutually exclusive projects 13-22 IRR, MIRR, NPV Mutually Exclusive Projects • Rate-based statistics cause problems when project cash flows have differences in – scale – timing 13-23 MIRR Strengths and Weakness Strengths: • Corrects IRR’s reinvestment rate assumption • Fixes non-normal cash flows problem Weakness: • Does not correct IRR issues with choosing the wrong mutually exclusive project for range of rates 13-24 Profitability Index • Based on NPV • Use when firm has resource constraints on capital available for new project 13-25