Transcript Chapter 6 - Capital Budgeting Techniques

Chapter 6
Capital
Budgeting
Techniques
© 2005 Thomson/South-Western
What is Capital Budgeting?
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
 Decision that involve large expenditures
 Very important to firm’s future
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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.
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Project Classifications
 Replacement Decisions: whether to purchase
capital assets to take the place of existing assets to
maintain or improve existing operations
 Expansion Decisions: whether to purchase capital
projects and add them to existing assets to increase
existing operations
 Independent Projects: Projects whose cash
flows are not affected by decisions made about
other projects
 Mutually Exclusive Projects: A set of projects
where the acceptance of one project means the
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others cannot be accepted
Similarities between Capital
Budgeting and Asset Valuation
Uses same steps as in general 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. [Note that we will explicitly
address the risk issue in the next chapter. For now, risk is taken as
given.]
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.
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Net Cash Flows for
Project S and Project L
Expected After-Tax
^
Net Cash Flows, CF
t
Year (T)
0a
1
2
3
4
Project S
$(3,000)
1,500
1,200
800
300
Project L
$(3,000)
400
900
1,300
1,500
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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.
 Unrecov ered cost at start 
 Number of years before  


  of full - recovery year 
Payback  PB  
full recovery of
   Total cash flow during 
 original investment  


 
full - recovery year 

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Payback Period for Project S
0
Net
Cash Flow
1
2
PBS
3
4
-3,000
1,500
1,200
800
300
Cumulative
-3,000
Net CF
-1,500
-300
500
800
PaybackS = 2 + 300/800 = 2.375 years
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Payback Period for Project L
0
1
2
3 PB
L
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Net
Cash Flow - 3,000
400
900
1,300
1,500
Cumulative
- 3,000
Net CF
- 2,600
- 1,700
- 400
1,100
PaybackL = 3 + 400/1,500 = 3.3 years
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Strengths and Weaknesses
of Payback:
Strengths of Payback:
• Provides an indication of a
project’s risk and liquidity
• Easy to calculate and understand
Weaknesses of Payback:
• Ignores TVM
• Ignores CFs occurring after the
payback period
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Net Present Value: Sum of the
PVs of Inflows and Outflows
NPV = PV inflows - Cost
= Net gain in wealth.
Rule: Accept project if NPV > 0.
Choose between mutually exclusive
projects on basis of higher NPV:
Which project adds the most value?
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Calculator Solution, NPV for S :
Enter in CF for S:
-3,000 CF0
1500
CF1
1200
CF2
800
CF3
300
CF4
10%
I
NPVS = 161.33 = NPVS
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Calculator Solution, NPV for L :
Enter in CF for L:
-3,000 CF0
400
CF1
900
CF2
1,300
CF3
1,500
CF4
10%
I
NPVL = 108.67 = NPVL
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Using NPV method,
which project(s) should be
accepted?
 If Projects S and L are mutually exclusive
accept S because NPVS > NPVL
 If Projects S & L are independent
accept both since NPV > 0.
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Internal Rate of Return: IRR
0
1
2
3
CF0
CF1
CF2
CF3
Cost
Inflows
IRR is the discount rate that forces
PV inflows to equal the cost.
IRR forces NPV = 0.
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What is Project S’s IRR?
0 IRR = ? 1
(3,000)
1,500
2
3
4
1,200
800
300
Sum of
PVs
for CF1-4 = 3,000
NPVS =
0
Enter CFs in CF register, then
press IRR: IRRS = 13.1% 16
What is Project L’s IRR?
0
IRR = ?
(3,000)
1
2
3
4
400
900
1300
1500
Sum of
PVs
for CF1-4 = 3,000
NPVL =
0
Enter CFs in CF register, then
press IRR: IRRL = 11.4% 17
How is a Project’s IRR
Related to a Bond’s YTM?
They are the same thing.
A bond’s YTM is the IRR
if you invest in the bond.
0
1
2
10
90
90
1090
IRR = ?
-1134.20
IRR = 7.08% (use TVM or CF register)
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Rationale for the IRR Method:
If IRR (project’s rate of return) > the
firm’s required rate of return, k, then
some return is left over to boost
stockholders’ returns.
Example: k = 10%,
IRR = 15%. The project is profitable.
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IRR acceptance criteria:
 If IRR > k (= the firm’s required rate
of return), accept project.
 If IRR < k (= the firm’s required rate
of return), reject project.
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Decisions on 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 .
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Construct NPV Profiles
Enter CFs in your calculator and find NPVL and
NPVS at several discount rates (k):
k
0
5
10
15
20
NPVL
1,100
554
109
(259)
(566)
NPVS
800
455
161
( 91)
(309)
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NPV Profiles for Project S
NPVL
and Project L k
1,200
Project L
1,000
Crossover
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Point = 8.1%
800
600
400
200
0
5
10
20
Project S
1,100
554
109
(259)
(566)
NPVS
800
455
161
( 91)
(309)
IRRS = 13.1%
0
(200) 0
(400)
2
4
6
8
10
12
14
16
18
20
IRRL = 11.4%
(600)
(800)
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NPV and IRR always lead to the
same accept/reject decision for
independent projects:
NPV ($)
IRR > k
and NPV > 0
Accept.
IRR < k
and NPV < 0.
Reject.
k (%)
IRR
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Mutually Exclusive Projects
k< 8.1: NPVL> NPVS , IRRL < IRRS
CONFLICT
NPV
k> 8.1: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
L
S
IRRs
%
8.1
IRRL
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To Find the Crossover Rate:
1.
Find cash flow differences between the projects.
See data at beginning of the case (repeated on
next slide).
2.
Enter these differences in CF register, then press
IRR. Crossover rate = 8.11, rounded to 8.1%.
3.
Can subtract S from L or vice versa.
4.
If profiles don’t cross, one project dominates the
other.
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Net Cash Flows for
Project S and Project L
Expected After-Tax
^
Net Cash Flows, CF
t
Year (T)
0a
1
2
3
4
Project S
$(3,000)
1,500
1,200
800
300
Project L
$(3,000)
400
900
1,300
1,500
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Two Reasons
NPV Profiles Cross:
1) Size (scale) differences. Smaller project
frees up funds at t = 0 for investment. The
higher the opportunity cost, the more
valuable these funds, so high k favors small
projects.
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.
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Reinvestment Rate
Assumptions
 NPV assumes reinvest at k.
 IRR assumes reinvest at IRR.
 Reinvest at opportunity cost, k, is more
realistic, so NPV method is best. NPV should
be used to choose between mutually
exclusive projects.
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Before Next Class:
1. Review Chapter 6 materials
2. Do chapter 6 homework
3. Prepare for Quiz on Ch 6
4. Read chapter 7
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