Transcript Capital Budgeting

Capital Budgeting
Net Present Value Rule
Payback Period Rule
Discounted Payback Period Rule
Average Accounting Return
Internal Rate of Return
Profitability Index
Practice of Capital Budgeting
Incremental Cash Flow
Chapters 6 & 7 – MBA504
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Net Present Value (NPV) Rule
• Net Present Value (NPV) =
Total PV of future CF’s + Initial Investment
• Estimating NPV:
– 1. Estimate future cash flows: how much? and when?
– 2. Estimate discount rate
– 3. Estimate initial costs
• Minimum Acceptance Criteria: Accept if NPV > 0
• Ranking Criteria: Choose the highest NPV
Chapters 6 & 7 – MBA504
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Example
Assume you have the following information on Project X:
Initial outlay -$1,100
Required return = 10%
Annual cash revenues and expenses are as follows:
Year
1
2
Calculate its NPV.
Revenues
$1,000
2,000
Expenses
$500
1,000
Chapters 6 & 7 – MBA504
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The Payback Period Rule
• How long does it take the project to “pay back” its
initial investment?
• Payback Period = number of years to recover
initial costs
• Minimum Acceptance Criteria:
– set by management
• Disadvantages
– Ignores the time value of money
– Ignores cash flows after the payback period
– Biased against long-term projects
Chapters 6 & 7 – MBA504
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Initial outlay -$1,000
YearCash flow
1
2
3
$200
400
600
Accumulated
YearCash flow
1
2
3
Payback period =
Chapters 6 & 7 – MBA504
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Discounted Payback Period Rule
• How long does it take the project to “pay
back” its initial investment taking the time
value of money into account?
• By the time you have discounted the cash
flows, you might as well calculate the NPV.
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Example
Initial outlay -$1,000
R = 10%
PV of
Cash flow
Cash flow
Year
1
2
3
4
Accumulated:
Year
1
2
3
4
$ 200
400
700
300
$ 182
331
526
205
discounted cash flow
$ 182
513
1,039
1,244
Discounted payback period is
Chapters 6 & 7 – MBA504
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Average Accounting Return Rule
Average Net Income
AAR 
Average Book Value of Investent
• Another attractive but fatally flawed approach.
• Ranking Criteria and Minimum Acceptance Criteria
set by management
• Disadvantages:
– Ignores the time value of money
– Uses an arbitrary benchmark cutoff rate
– Based on book values, not cash flows and market values
• Advantages:
– The accounting information is usually available
– Easy to calculate
Chapters 6 & 7 – MBA504
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Internal Rate of Return (IRR) Rule
• IRR: the discount that sets NPV to zero
• Minimum Acceptance Criteria:
– Accept if the IRR exceeds the required return.
• Ranking Criteria:
– Select alternative with the highest IRR
• Reinvestment assumption:
– All future cash flows assumed reinvested at the IRR.
Chapters 6 & 7 – MBA504
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Example
Consider the following project:
0
-$200
$50
$100
$150
1
2
3
The internal rate of return for this project is 19.44%
$50
$100
$150
NPV  0 


2
(1  IRR ) (1  IRR ) (1  IRR )3
Chapters 6 & 7 – MBA504
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NPV Payoff Profile for The Example
If we graph NPV versus discount rate, we can see the IRR as
the x-axis intercept.
NPV
$100.00
$71.04
$47.32
$27.79
$11.65
($1.74)
($12.88)
($22.17)
($29.93)
($36.43)
($41.86)
$120.00
$100.00
$80.00
$60.00
NPV
Discount Rate
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
$40.00
IRR = 19.44%
$20.00
$0.00
-1%
($20.00)
9%
19%
39%
29%
($40.00)
($60.00)
Discount rate
Chapters 6 & 7 – MBA504
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Problems with the IRR Approach
• Multiple IRRs.
• The Scale Problem.
• The Timing Problem.
Chapters 6 & 7 – MBA504
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Multiple IRRs
There are two IRRs for this project:
$200
NPV
0
-$200
$800
1
2
3
- $800
$100.00
Which one should
we use?
100% = IRR2
$50.00
$0.00
-50%
0%
($50.00)
50%
100%
0% = IRR1
($100.00)
($150.00)
Chapters 6 & 7 – MBA504
150%
200%
Discount rate
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The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment
while the 50% return is on a $1,000
investment?
Chapters 6 & 7 – MBA504
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The Timing Problem (page 161)
$10,000
$1,000
$1,000
Project A
0
1
2
3
-$10,000
$1,000
$1,000
$12,000
Project B
0
1
2
3
-$10,000
The preferred project in this case depends on the discount
rate, not the IRR.
Chapters 6 & 7 – MBA504
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Mutually Exclusive vs. Independent Project
• Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring an
accounting system.
– RANK all alternatives and select the best one.
• Independent Projects: accepting or rejecting one
project does not affect the decision of the other
projects.
– Must exceed a MINIMUM acceptance criteria.
Chapters 6 & 7 – MBA504
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Which project is good?
Net present value
Year
0
160
140
120
100
80
60
40
20
0
1
2
3
4
Project A:
– $350
50
100
150
200
Project B:
– $250
125
100
75
50
Crossover Point
– 20
– 40
– 60
– 80
– 100
Discount rate
0
2%
6%
10%
14%
IRR A
18%
22%
26%
IRR B
Chapters 6 & 7 – MBA504
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HOW TO FIND CROSS POINT
PROJECT A
PROJECT B
A-B
-350
50
100
150
200
-250
125
100
75
50
-100
-75
0
75
150
12.91%
IRR(A3: A7)
17.80%
IRR(B3: B7)
8.07%
IRR(C3: C7)
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Decision Rule
• If required rate of return < crossover return,
take the project with lower IRR
• If required rate of return > crossover return,
take the project with higher IRR
• Don’t think a project with higher IRR is
always good
• Projects with higher NPV is always good
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Profitability Index (PI) Rule
•
•
•
•
Total PV of Future Cash Flows
PI 
Initial Investent
Minimum Acceptance Criteria: Accept if PI > 1
Ranking Criteria: Select alternative with highest PI
Disadvantages: Problems with mutually exclusive investments
Advantages:
– May be useful when available investment funds are
limited
– Easy to understand and communicate
– Correct decision when evaluating independent projects
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Practice of Capital Budgeting
• Varies by industry:
– Some firms use payback, others use accounting
rate of return.
• The most frequently used technique for
large corporations is IRR or NPV.
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Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for
the following two projects. Assume the required
return is 10%.
Year
0
1
2
3
Project A
-$200
$200
$800
-$800
Chapters 6 & 7 – MBA504
Project B
-$150
$50
$100
$150
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Incremental Cash Flows
•
•
•
•
•
•
•
Cash flows matter—not accounting earnings.
Sunk costs don’t matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like cannibalism and erosion matter.
Taxes matter: we want incremental after-tax cash flows.
Inflation matters.
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Cash Flows—Not Accounting Earnings
• Consider depreciation expense.
• You never write a check made out to
“depreciation”.
• Much of the work in evaluating a
project lies in taking accounting
numbers and generating cash flows.
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Incremental Cash Flows
• Sunk costs are not relevant
– Just because “we have come this far” does not mean that
we should continue to throw good money after bad.
• Opportunity costs do matter. Just because a project
has a positive NPV that does not mean that it should
also have automatic acceptance. Specifically if
another project with a higher NPV would have to be
passed up we should not proceed.
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Incremental Cash Flows
• Side effects matter (page 180)
– Erosion
– Synergy
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Estimating Cash Flows
• Cash Flows from Operations
– Recall that:
Operating Cash Flow = EBIT – Taxes + Depreciation
• Net Capital Spending
– Don’t forget salvage value (after tax, of course).
• Changes in Net Working Capital
– Recall that when the project winds down, we enjoy a
return of net working capital.
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The Baldwin Company: An Example
(page 181)
Costs of test marketing (already spent): $250,000.
Current market value of proposed factory site (which we own): $150,000.
Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5year life). Salvage value of 30,000.
Increase in net working capital: $10,000. Production (in units) by year during
5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000.
Price during first year is $20; price increases 2% per year thereafter.
Production costs during first year are $10 per unit and increase 10% per year
thereafter.
Annual inflation rate: 5%
Tax rate is 34 percent
Working Capital: initially $10,000 changes with sales.
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Key Issues
• Dis-regard sunk costs
• Consider incremental cash flow – additional cash
flows
• Figure out revenue, cost, depreciation, tax, capital
spending, addition to net work capital
• Refer to this example when you take advanced
corporate finance to deal with capital budgeting or
meet this kind of problem in your work
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