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Financial Management
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Chapter 13Chapter 13
Capital Budgeting Capital Budgeting TechniquesTechniques
Capital Budgeting Capital Budgeting TechniquesTechniques
© Pearson Education Limited 2004Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI
Proposed Project DataProposed Project DataProposed Project DataProposed Project Data
Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be Tk10,000; Tk12,000; Tk15,000; Tk10,000; and Tk7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be Tk40,000.
• For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.
• IndependentIndependent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.
Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be Tk10,000; Tk12,000; Tk15,000; Tk10,000; and Tk7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be Tk40,000.
• For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.
• IndependentIndependent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.
1. Project Evaluation: 1. Project Evaluation: Alternative MethodsAlternative Methods
1. Project Evaluation: 1. Project Evaluation: Alternative MethodsAlternative Methods
– Payback Period (PBP)– Internal Rate of Return (IRR)– Net Present Value (NPV)– Profitability Index (PI)
– Payback Period (PBP)– Internal Rate of Return (IRR)– Net Present Value (NPV)– Profitability Index (PI)
Payback Period (PBP)Payback Period (PBP)Payback Period (PBP)Payback Period (PBP)
PBPPBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.
PBPPBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K10 K 22 K 37 K 47 K 54 K
Cumulative Inflows
PBPPBP = a + ( b - c ) / d = 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years3.3 Years
PBPPBP = a + ( b - c ) / d = 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years3.3 Years
(a)
(c)-b(d)
a – minimum whole year for recovery
b – initial cash outflow
c – maximum amount not crossing b
d – portion of payment necessary for payback
a – minimum whole year for recovery
b – initial cash outflow
c – maximum amount not crossing b
d – portion of payment necessary for payback
PBP Acceptance CriterionPBP Acceptance CriterionPBP Acceptance CriterionPBP Acceptance Criterion
Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.]
Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.]
The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type.
Should this project be accepted?
If maximum PBP is set for 3 years?
No! The firm will receive back the initial cash outlay in more than 3 years. [3.3 Years > 3 Year Max.]
If maximum PBP is set for 3 years?
No! The firm will receive back the initial cash outlay in more than 3 years. [3.3 Years > 3 Year Max.]
PBP Strengths PBP Strengths and Weaknessesand Weaknesses
PBP Strengths PBP Strengths and Weaknessesand Weaknesses
StrengthsStrengths::– Easy to use and understand
– Can be used as a
measure of liquidity– Easier to forecast
ST than LT flows
StrengthsStrengths::– Easy to use and understand
– Can be used as a
measure of liquidity– Easier to forecast
ST than LT flows
WeaknessesWeaknesses::– Does not account for TVM (time value of money)
– Does not consider cash flows beyond the PBP
– Cutoff period is subjective
Internal Rate of Return (IRR)Internal Rate of Return (IRR)Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash
outflow.
CF1 CF2 CFn
(1+IRR)1 (1+IRR)2 (1+IRR)n+ . . . +
+ICO = +
Tk15,000 Tk10,000 Tk7,000Tk10,000 Tk12,000
(1+IRR)1 (1+IRR)2+Tk40,000 =
(1+IRR)3 (1+IRR)4 (1+IRR)5+ + +
Find the interest rate (IRR) that causes the discounted cash flows to equal Tk40,000.
IRR Solution (Try 10% and 15%)IRR Solution (Try 10% and 15%)IRR Solution (Try 10% and 15%)IRR Solution (Try 10% and 15%)
Tk40,000Tk40,000 = Tk10,000(PVIF10%,1) + Tk12,000(PVIF10%,2) +Tk15,000(PVIF10%,3) + Tk10,000(PVIF10%,4) + Tk 7,000(PVIF10%,5)
Tk40,000Tk40,000 = Tk10,000(.909) + Tk12,000(.826) + Tk15,000(.751) + Tk10,000(.683) + Tk 7,000(.621)
Tk40,000Tk40,000 = Tk9,090 + Tk9,912 + Tk11,265 + Tk6,830 + Tk4,347
=Tk 41,444Tk 41,444 [[Rate is too low!!Rate is too low!!]]
Tk40,000Tk40,000 = Tk10,000(PVIF15%,1) + Tk12,000(PVIF15%,2) + Tk15,000(PVIF15%,3) + Tk10,000(PVIF15%,4) + Tk 7,000(PVIF15%,5)
Tk40,000Tk40,000 = Tk10,000(.870) + Tk12,000(.756) + Tk15,000(.658) + Tk10,000(.572) + Tk 7,000(.497)
Tk40,000Tk40,000 = Tk8,700 + Tk9,072 + Tk9,870 + Tk5,720 + Tk3,479 = Tk 36,841Tk 36,841 [[Rate is too high!!Rate is too high!!]]
.10 Tk41,444
.05 IRR Tk40,000 Tk4,603
.15 Tk36,841
X Tk1,444
IRR Solution (Interpolate)IRR Solution (Interpolate)IRR Solution (Interpolate)IRR Solution (Interpolate)
Tk1,444X
=.05 Tk4,603
.10 Tk41,444
.05 IRR Tk40,000 Tk4,603
.15 Tk36,841
X Tk1,444
IRR Solution IRR Solution (Interpolate [Trial and Error])(Interpolate [Trial and Error])
IRR Solution IRR Solution (Interpolate [Trial and Error])(Interpolate [Trial and Error])
Tk1,444X
=.05 Tk4,603
.10 Tk41,444
.05 IRR Tk40,000 Tk4,603
.15 Tk36,841
(Tk1,444)(0.05)
IRR Solution (Interpolate)IRR Solution (Interpolate)IRR Solution (Interpolate)IRR Solution (Interpolate)
Tk1,444X
X = X = .0157
IRR = .10 + .0157 = .1157 or 11.57%
Tk4,603
IRR Acceptance CriterionIRR Acceptance CriterionIRR Acceptance CriterionIRR Acceptance Criterion
No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%.
[ IRR < Hurdle Rate ]
No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%.
[ IRR < Hurdle Rate ]
The management of Basket Wonders has determined that the Hurdle (cutoff) rate is 13% for projects of this type.
Should this project be accepted?
IRR Strengths IRR Strengths and Weaknessesand Weaknesses
IRR Strengths IRR Strengths and Weaknessesand Weaknesses
StrengthsStrengths: : – Accounts for
TVM– Considers all
cash flows– Less
subjectivity
StrengthsStrengths: : – Accounts for
TVM– Considers all
cash flows– Less
subjectivity
WeaknessesWeaknesses: : – Assumes all cash
flows reinvested at the IRR– Difficulties with project rankings and Multiple IRRs
Net Present Value (NPV)Net Present Value (NPV)Net Present Value (NPV)Net Present Value (NPV)
NPV is the present value of an investment project’s net cash flows minus the project’s
initial cash outflow.
CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n
+ . . . ++ - ICOICONPV =
Basket Wonders has determined that the appropriate discount rate (k) for this project is
13%.
Tk10,000 Tk7,000
NPV SolutionNPV Solution NPV SolutionNPV Solution
Tk10,000 Tk12,000 Tk15,000 (1.13)1 (1.13)2 (1.13)3
+ +
+ - Tk40,000Tk40,000(1.13)4 (1.13)5
NPVNPV = +
NPV SolutionNPV SolutionNPV SolutionNPV Solution
NPVNPV = Tk10,000(PVIF13%,1) + Tk12,000(PVIF13%,2) + Tk15,000(PVIF13%,3) + Tk10,000(PVIF13%,4) + Tk 7,000(PVIF13%,5) - Tk40,000Tk40,000
NPVNPV = Tk10,000(.885) + Tk12,000(.783) + Tk15,000(.693) + Tk10,000(.613) + Tk 7,000(.543) - Tk40,000Tk40,000
NPVNPV = Tk8,850 + Tk9,396 + Tk10,395 + Tk6,130 + Tk3,801 - Tk40,000Tk40,000
= - Tk1,428Tk1,428
NPV Acceptance CriterionNPV Acceptance CriterionNPV Acceptance CriterionNPV Acceptance Criterion
No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject Reject
as NPVNPV < 00 ]
No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject Reject
as NPVNPV < 00 ]
The management of Basket Wonders has determined that the required rate is 13% for projects of this
type.
Should this project be accepted?
NPV Strengths NPV Strengths and Weaknessesand Weaknesses
NPV Strengths NPV Strengths and Weaknessesand Weaknesses
StrengthsStrengths::– Cash flows
assumed to be reinvested at the hurdle rate.
– Accounts for TVM.– Considers all
cash flows.
StrengthsStrengths::– Cash flows
assumed to be reinvested at the hurdle rate.
– Accounts for TVM.– Considers all
cash flows.
WeaknessesWeaknesses::– May not include managerial options embedded in the project. See Chapter 14.
Profitability Index (PI)Profitability Index (PI)Profitability Index (PI)Profitability Index (PI)
PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash
outflow.
CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n
+ . . . ++ ICOICOPI =
PI = 1 + [ NPVNPV / ICOICO ]
<< OR >>
Method #2:
Method #1:
PI Acceptance CriterionPI Acceptance Criterion PI Acceptance CriterionPI Acceptance Criterion
No! The PIPI is less than 1.00. This means that the project is not profitable. [Reject Reject as PIPI <
1.001.00 ]
No! The PIPI is less than 1.00. This means that the project is not profitable. [Reject Reject as PIPI <
1.001.00 ]
PIPI = Tk38,572 / Tk40,000= .9643 (Method #1, 13-34)
Should this project be accepted?
PI Strengths PI Strengths and Weaknessesand Weaknesses
PI Strengths PI Strengths and Weaknessesand Weaknesses
StrengthsStrengths::– Same as NPV– Allows comparison of different scale projects
StrengthsStrengths::– Same as NPV– Allows comparison of different scale projects
WeaknessesWeaknesses::– Same as NPV– Provides only relative profitability– Potential Ranking
Problems
Evaluation SummaryEvaluation Summary
Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
Basket Wonders Independent Project
Other Project Other Project RelationshipsRelationships
• Mutually ExclusiveMutually Exclusive -- A project whose acceptance precludes the acceptance of one or more alternative projects.
DependentDependent -- A project whose acceptance depends on the acceptance of one or more other projects.
Potential Problems Potential Problems Under Mutual ExclusivityUnder Mutual Exclusivity
Potential Problems Potential Problems Under Mutual ExclusivityUnder Mutual Exclusivity
A. Scale of InvestmentA. Scale of Investment
B. Cash-flow PatternB. Cash-flow Pattern
C. Project LifeC. Project Life
A. Scale of InvestmentA. Scale of Investment
B. Cash-flow PatternB. Cash-flow Pattern
C. Project LifeC. Project Life
Ranking of project proposals may create contradictory results.
A. Scale DifferencesA. Scale DifferencesA. Scale DifferencesA. Scale Differences
Compare a small (S) and a large (L) project.
NET CASH FLOWSProject S Project LEND OF YEAR
0 -Tk100 -Tk100,000
1 0 0
2 Tk400 Tk156,250
Scale DifferencesScale DifferencesScale DifferencesScale Differences
Calculate the PBP, IRR, NPV@10%, and PI@10%.
Which project is preferred? Why? Project IRR NPV PI
S 100% Tk 231 3.31
L 25% Tk29,132 1.29
S 100% Tk 231 3.31
L 25% Tk29,132 1.29
B. Cash Flow PatternB. Cash Flow PatternB. Cash Flow PatternB. Cash Flow Pattern
Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project.
NET CASH FLOWSProject D Project IEND OF YEAR
0 -Tk1,200 -Tk1,200 1 1,000 100
2 500 600
3 100 1,080
D 23% Tk198 1.17Tk198 1.17
I 17% Tk198 1.17Tk198 1.17
D 23% Tk198 1.17Tk198 1.17
I 17% Tk198 1.17Tk198 1.17
Cash Flow PatternCash Flow PatternCash Flow PatternCash Flow Pattern
Calculate the IRR, NPV@10%, and PI@10%.
Which project is preferred?
Project IRR NPV PI
Examine NPV ProfilesExamine NPV ProfilesExamine NPV ProfilesExamine NPV Profiles
Discount Rate (%)0 5 10 15 20 25-2
00
0
200
400
600
IRR
NPV@10%
Plot NPV for eachproject at various
discount rates.
Net
Pre
sen
t V
alu
e (T
k)
Project IProject I
Project DProject D
Fisher’s Rate of IntersectionFisher’s Rate of IntersectionFisher’s Rate of IntersectionFisher’s Rate of Intersection
Discount Rate (Tk)0 5 10 15 20 25-2
00
0
200
400
600
Net
Pre
sen
t V
alu
e (T
k)
At k<10%, I is best!At k<10%, I is best! Fisher’s Fisher’s RateRate of ofIntersectionIntersection
At k>10%, D is best!At k>10%, D is best!
C. Project Life DifferencesC. Project Life DifferencesC. Project Life DifferencesC. Project Life Differences
Let us compare a long life (X) project and a short life (Y) project.
NET CASH FLOWSProject X Project YEND OF YEAR
0 -Tk1,000 -Tk1,000 1 0 2,000
2 0 0
3 3,375 0
X 50% Tk1,536 2.54
Y 100% Tk 818 1.82
X 50% Tk1,536 2.54
Y 100% Tk 818 1.82
Project Life DifferencesProject Life DifferencesProject Life DifferencesProject Life Differences
Calculate the PBP, IRR, NPV@10%, and PI@10%.
Which project is preferred? Why?
Project IRR NPV PI