Transcript Financial Management for Entrepreneurs

Chapter 9
Capital Budgeting
Techniques:
Certainty and Risk
Learning Goals
1. Understand the role of capital
budgeting techniques in the capital
budgeting process.
2. Calculate, interpret, and evaluate the
payback period.
3. Calculate, interpret, and evaluate the net
present value (NPV).
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Learning Goals (cont.)
4. Calculate, interpret, and evaluate the
internal rate of return (IRR).
5. Use net present value profiles to
compare NPV and IRR techniques.
6. Discuss NPV and IRR in terms of
conflicting rankings and the theoretical
and practical strengths of each
approach.
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Learning Goals (cont.)
7. Understand the importance of
recognizing risk in the analysis of capital
budgeting projects.
8. Discuss breakeven cash flow, sensitivity
and scenario analysis, and simulation
as behavioral approaches for dealing
with risk.
9. Discuss the unique risks that
multinational companies face.
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Learning Goals (cont.)
10. Describe the determination and use of riskadjusted discount rates (RADRs), portfolio
effects, and the practical aspects of RADRs.
11. Select the best of a group of mutually
exclusive projects using annualized net
present values (ANPVs).
12. Explain the role of real options and the
objective and procedures for selecting projects
under capital rationing.
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Capital Budgeting Techniques
• Chapter Problem
Bennett Company is a medium sized metal fabricator
that is currently contemplating two projects: Project A
requires an initial investment of $42,000, project B an
initial investment of $45,000. The relevant operating
cash flows for the two projects are presented in Table
9.1 and depicted on the time lines in Figure 9.1.
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Capital Budgeting Techniques (cont.)
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Capital Budgeting Techniques (cont.)
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Payback Period
• The payback method simply measures how
long (in years and/or months) it takes to recover
the initial investment.
• The maximum acceptable payback period is
determined by management.
• If the payback period is less than the maximum
acceptable payback period, accept the project.
• If the payback period is greater than the
maximum acceptable payback period, reject
the project.
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Net Present Value (NPV)
• Net Present Value (NPV): Net Present
Value is found by subtracting the present
value of the after-tax outflows from the
present value of the after-tax inflows.
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Net Present Value (NPV) (cont.)
• Net Present Value (NPV): Net Present
Value is found by subtracting the present
value of the after-tax outflows from the
present value of the after-tax inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
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Net Present Value (NPV) (cont.)
Using the Bennett Company data from Table 9.1, assume
the firm has a 10% cost of capital. Based on the given
cash flows and cost of capital (required return), the NPV
can be calculated as shown in Figure 9.2
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Net Present Value (NPV) (cont.)
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Net Present Value (NPV) (cont.)
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Net Present Value (NPV) (cont.)
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Internal Rate of Return (IRR)
• The Internal Rate of Return (IRR) is the
discount rate that will equate the present value
of the outflows with the present value of
the inflows.
• The IRR is the project’s intrinsic rate of return.
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Internal Rate of Return (IRR) (cont.)
• The Internal Rate of Return (IRR) is the
discount rate that will equate the present value
of the outflows with the present value of
the inflows.
• The IRR is the project’s intrinsic rate of return.
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
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Internal Rate of Return (IRR) (cont.)
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Internal Rate of Return (IRR) (cont.)
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Net Present Value Profiles
• NPV Profiles are graphs that depict
project NPVs for various discount rates
and provide an excellent means of making
comparisons between projects.
To prepare NPV profiles for Bennett Company’s
projects A and B, the first step is to develop a number
of discount rate-NPV coordinates and then graph
them as shown in the following table and figure.
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Net Present Value Profiles (cont.)
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Net Present Value Profiles (cont.)
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Conflicting Rankings
• Conflicting rankings between two or more projects
using NPV and IRR sometimes occurs because of
differences in the timing and magnitude of cash flows.
• This underlying cause of conflicting rankings is the
implicit assumption concerning the reinvestment of
intermediate cash inflows—cash inflows received prior
to the termination of the project.
• NPV assumes intermediate cash flows are reinvested at
the cost of capital, while IRR assumes that they are
reinvested at the IRR.
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Conflicting Rankings (cont.)
A project requiring a $170,000 initial investment is
expected to provide cash inflows of $52,000, $78,000
and $100,000. The NPV of the project at 10% is
$16,867 and it’s IRR is 15%. Table 9.5 on the following
slide demonstrates the calculation of the project’s future
value at the end of it’s 3-year life, assuming both a 10%
(cost of capital) and 15% (IRR) interest rate.
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Conflicting Rankings (cont.)
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Conflicting Rankings (cont.)
If the future value in each case in Table 9.5 were
viewed as the return received 3 years from today from
the $170,000 investment, then the cash flows would be
those given in Table 9.6 on the following slide.
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Conflicting Rankings (cont.)
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Conflicting Rankings (cont.)
Bennett Company’s projects A and B were found to have
conflicting rankings at the firm’s 10% cost of capital as
depicted in Table 9.4. If we review the project’s cash inflow
pattern as presented in Table 9.1 and Figure 9.1, we see
that although the projects require similar investments, they
have dissimilar cash flow patterns. Table 9.7 on the
following slide indicates that project B, which has higher
early-year cash inflows than project A, would be preferred
over project A at higher discount rates.
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Conflicting Rankings (cont.)
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Which Approach is Better?
• On a purely theoretical basis, NPV is the better
approach because:
– NPV assumes that intermediate cash flows are
reinvested at the cost of capital whereas IRR
assumes they are reinvested at the IRR,
– Certain mathematical properties may cause a project
with non-conventional cash flows to have zero or
more than one real IRR.
• Despite its theoretical superiority, however,
financial managers prefer to use the IRR
because of the preference for rates of return.
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Recognizing Real Options
• Real options are opportunities that are embedded in
capital projects that enable managers to alter their cash
flows and risk in a way that affects project acceptability
(NPV).
• Real options are also sometimes referred to as
strategic options.
• Some of the more common types of real options are
described in the table on the following slide.
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Recognizing Real Options (cont.)
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Recognizing Real Options (cont.)
NPVstrategic = NPVtraditional + Value of Real Options
Assume that a strategic analysis of Bennett Company’s
projects A and B (see Table 10.1) finds no real options
embedded in Project A but two real options embedded
in B:
1. During it’s first two years, B would have downtime that
results in unused production capacity that could be used
to perform contract manufacturing;
2. Project B’s computerized control system could control two
other machines, thereby reducing labor costs.
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Recognizing Real Options (cont.)
Bennett’s management estimated the NPV of the contract manufacturing
option to be $1,500 and the NPV of the computer control sharing option to
be $2,000. Furthermore, they felt there was a 60% chance that the
contract manufacturing option would be exercised and a 30% chance that
the computer control sharing option would be exercised.
Value of Real Options for B = (60% x $1,500) + (30% x $2,000)
$900 + $600 = $1,500
NPVstrategic = $10,924 + $1,500 = $12,424
NPVA = $12,424; NPVB = $11,071; Now choose A over B.
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Capital Rationing
• Firm’s often operate under conditions of capital
rationing—they have more acceptable independent
projects than they can fund.
• In theory, capital rationing should not exist—firms
should accept all projects that have positive NPVs.
• However, research has found that management
internally imposes capital expenditure constraints to
avoid what it deems to be “excessive” levels of new
financing, particularly debt.
• Thus, the objective of capital rationing is to select the
group of projects within the firm’s budget that provides
the highest overall NPV or IRR.
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Capital Rationing
Tate Company, a fast growing plastics company with a
cost of capital of 10%, is confronted with six projects
competing for its fixed budget of $250,000. The initial
investment and IRR for each project are shown below:
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Capital Rationing: IRR Approach
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Capital Rationing: NPV Approach
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Behavioral Approaches
for Dealing with Risk
• In the context of the capital budgeting projects
discussed in this chapter, risk results almost entirely
from the uncertainty about future cash inflows,
because the initial cash outflow is generally known.
• These risks result from a variety of factors including
uncertainty about future revenues, expenditures and
taxes.
• Therefore, to asses the risk of a potential project, the
analyst needs to evaluate the riskiness of the cash
inflows.
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Behavioral Approaches for Dealing
with Risk: Risk and Cash Inflows
Treadwell Tire, a tire retailer with a 10% cost of capital, is
considering investing in either of two mutually exclusive
projects, A and B. Each requires a $10,000 initial
investment, and both are expected to provide equal
annual cash inflows over their 15-year lives. For either
project to be acceptable, NPV must be greater than zero.
We can solve for CF using the following:
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Behavioral Approaches for Dealing
with Risk: Risk and Cash Inflows (cont.)
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Behavioral Approaches for Dealing
with Risk: Risk and Cash Inflows (cont.)
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Behavioral Approaches for Dealing
with Risk: Sensitivity Analysis
The risk of Treadwell Tire Company’s investments can be
evaluated using sensitivity analysis as shown in Table 10.2
on the following slide. For this example, assume that the
financial manager made pessimistic, most likely, and
optimistic estimates of the cash inflows for each project.
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Behavioral Approaches for Dealing
with Risk: Sensitivity Analysis (cont.)
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Behavioral Approaches for Dealing
with Risk: Scenario Analysis
• Scenario analysis is a behavioral approach similar to
sensitivity analysis but is broader in scope.
• This method evaluates the impact on the firm’s return of
simultaneous changes in a number of variables, such as
cash inflows, outflows, and the cost of capital.
• NPV is then calculated under each different set of
variable assumptions.
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Behavioral Approaches for Dealing
with Risk: Simulation
• Simulation is a statistically-based behavioral
approach that applies predetermined probability
distributions and random numbers to estimate
risky outcomes.
• Figure 10.1 presents a flowchart of the
simulation of the NPV of a project.
• The use of computers has made the use of
simulation economically feasible, and the
resulting output provides an excellent basis for
decision-making.
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Behavioral Approaches
for Dealing with Risk
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International Risk Considerations
• Exchange rate risk is the risk that an unexpected
change in the exchange rate will reduce NPV of a
project’s cash flows.
• In the short term, much of this risk can be hedged by
using financial instruments such as foreign currency
futures and options.
• Long-term exchange rate risk can best be minimized by
financing the project in whole or in part in the local
currency.
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International
Risk Considerations (cont.)
• Political risk is much harder to protect against once a
project is implemented.
• A foreign government can block repatriation of profits
and even seize the firm’s assets.
• Accounting for these risks can be accomplished by
adjusting the rate used to discount cash flows—or
better—by adjusting the project’s cash flows.
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International
Risk Considerations (cont.)
• Since a great deal of cross-border trade
among MNCs takes place between
subsidiaries, it is also important to
determine the net incremental impact of
a project’s cash flows overall.
• As a result, it is important to approach
international capital projects from a
strategic viewpoint rather than from a
strictly financial perspective.
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Risk-Adjusted Discount Rates
• Risk-adjusted discount rates are rates of
return that must be earned on given projects to
compensate the firm’s owners adequately—that
is, to maintain or improve the firm’s share price.
• The higher the risk of a project, the higher the
RADR—and thus the lower a project’s NPV.
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Risk-Adjusted Discount Rates:
Review of CAPM
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Risk-Adjusted Discount Rates:
Using CAPM to Find RADRs
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Risk-Adjusted Discount Rates:
Applying RADRs
Bennett Company wishes to apply the Risk-Adjusted
Discount Rate (RADR) approach to determine whether to
implement Project A or B. In addition to the data
presented earlier, Bennett’s management assigned a
“risk index” of 1.6 to project A and 1.0 to project B as
indicated in the following table. The required rates of
return associated with these indexes are then applied as
the discount rates to the two projects to determine NPV.
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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)
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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)
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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)
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Risk-Adjusted Discount Rates:
Applying RADRs (cont.)
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Risk-Adjusted Discount Rates:
RADRs in Practice
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