Transcript Capital Budgeting

Big
Picture…
Capital Budgeting
Select investments which increase value of
firm
 Maximize wealth of shareholders
 Important to firm’s long-term success

 Substantial
cost
 Cash flows over long time period
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Steps in evaluating capital
assets
Determine cost of asset
 Estimate incremental cash flows

 Very
difficult but…
 Very important…
Determine decision criteria
 Apply decision criteria
 Compare actual results to projected

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Capital Budgeting Decision
Criteria

Should you sign Shaq O’ Squeal to a four-year
contract for $100 million???
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Capital Budgeting Decision
Criteria


Determine cost
Estimate incremental cash flows
 Increase
in revenue
 Increase in expenses
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Capital Budgeting Decision
Criteria


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
Payback period
NPV
Profitability index
IRR
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Payback Period

How long until we get our money back???
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Payback Period
2005
2006
2007
2008
Shaq
30 mil
40 mil
40 mil
70 mil
Hack
101 mil
0
0
0
Mac
10 mil
10 mil
70 mil
510 mil
170 mil
101 mil
600 mil
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Payback Period
Payback: length of time to get $$$
back
 Rule: accept investments that payback
before required period

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Payback Period

Advantages:
 Easy

to calculate and understand
Useful for small investments
 Favors
investments with quick returns
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Payback Period

Disadvantages:
 Future

cash flows not discounted
Since favors quick returns, not huge problem
 Ignores

cash flows after payback
Coal mine: negative cash flows at end
 Must
select cutoff period
Three or four years reasonable
 20 years, probably not

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Net Present Value
NPV: PV of cash flow – Cost of
Investment
 Rule: accept investments with a positive
NPV

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Net Present Value
Shaq
Mac
2005
$
30 $
2006
$
2007
Hack
101
$
10
40
$
10
$
40
$
70
2008
$
70
$
510
Total
$
180 $
101 $
600
Cost
$
100 $
100 $
100
Discount Rate
12%
12%
12%
PV Cash Flows
$131.63
$90.18
$390.84
NPV
$31.63
($9.82)
$290.84
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Net Present Value

Advantages:
 If
assumptions correct, increases value of firm
 Discounts future cash flows
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Net Present Value

Disadvantages:
 Determining
In an efficient
market, should
projects have
huge positive
NPVs???
proper discount rate
Should it be adjusted for riskiness of each project’s
cash flows???
 Set too high, pass up acceptable projects



Buyer with lower discount rate will pay highest price
Set too low, decrease wealth of firm
 Ignores
relative cost of investments
Project A: cost $1 million; NPV $20
 Project B: cost $50; NPV $19

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Profitability Index
PI: PV Cash Flows / Cost
 Rule: accept investments with a PI above
1.0

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Profitability Index
Shaq
Mac
2005
$
30 $
2006
$
2007
Hack
101
$
10
40
$
10
$
40
$
70
2008
$
70
$
510
Total
$
180 $
101 $
600
Cost
$
100 $
100 $
350
Discount Rate
12%
12%
12%
PV Cash Flows
$131.63
$90.18
$390.84
NPV
$31.63
($9.82)
$40.84
PI
1.32
0.90
1.12
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Profitability Index

Advantages:
 Comparing
alternative investments
 Discounts future cash flows

Disadvantages:
 Favors
lower cost investments
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Internal Rate of Return
IRR: Discount rate where NPV = 0
 Rule: accept investments with an IRR
above required return

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IRR
Shaq
Shaq
(100) $
Shaq
Cost
$
(100) $
2005
$
30
$
30
$
30
2006
$
40
$
40
$
40
2007
$
40
$
40
$
40
2008
$
70
$
70
$
70
Total
$
180 $
180
180 $
(100)
Discount Rate
12%
20%
30%
PV Cash Flows
$131.63
$109.68
$89.46
NPV
$31.63
$9.68
($10.54)
IRR
24.39%
24.39%
24.39%
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IRR

Advantages:
 Most
often used criteria in capital budgeting
 Not required to select a discount rate
 Does discount future cash flows
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IRR

Disadvantages:
 Assumes
can reinvest cash flows at IRR
NPV assumes reinvest at required rate return
 NPV assumption more logical

 Favors

short-term investments
Difficult to achieve high IRR on distant cash flows
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Calculating IRR
Spend $10,000 today and receive $17,182
in 8 years
 Spend $10,000 today and receive $1,993
at the end of the next 10 years
 Spend $10,000 today and receive $2,000
in year 1; $5,000 in year 2 and $8,000 in
year 3 (all at end of year)
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