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Capital Budgeting Techniques

© 2007 Thomson/South-Western

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What is Capital Budgeting?

The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one yearAnalysis of potential additions to fixed assets

Long-term decisions; 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 ClassificationsReplacement 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 others cannot be accepted

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Determine the cost, or purchase price, of the asset.

Estimate the cash flows expected from the project.

Assess the riskiness of cash flows.

Compute the present value of the expected cash flows to obtain as estimate of the asset’s value to the firm.

Compare the present value of the future expected cash flows with the initial investment.

Similarities between Capital Budgeting and Asset Valuation

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1,5001,200

800300

400900

1,3001,500

^Net Cash Flows, CFt

r e dp AEx cte fte -Tax

Year (T) Project S Project L0 $(3,000) $(3,000)1234

Net Cash Flows for Project S and Project L

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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.

yearrecovery -full

during flowcash Totalyearrecovery -full of

startat cost dUnrecovere

investment original

ofrecovery full

before years of Number

PBPayback

What is the Payback Period?

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Payback Period for Project S

=PaybackS 2 + 300/800 = 2.375 years

Net Cash Flow

Cumulative Net CF

1,500

-1,500

800

500

1,200

-300

-3,000

-3,000

300

800

PBS0 1 2 3 4

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=PaybackL 3 + 400/1,500 = 3.3 years

Net Cash Flow

Cumulative Net CF

400

- 2,600

1,300

- 400

900

- 1,700

- 3,000

- 3,000

1,500

1,100

PBL0 1 2 3 4

Payback Period for Project L

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Strengths of Payback:Strengths of Payback:• Provides an indication of a

project’s risk and liquidity• Easy to calculate and understand

Weaknesses of Payback:Weaknesses of Payback: • Ignores TVM• Ignores CFs occurring after the

payback period

Strengths and Weaknesses of Payback:

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Cost is CF0 and is generally negative.

NPV t0

n

CFt

1 r t CF0 .^

^

Net Present Value: Sum of the PVs of Inflows and Outflows

^

NPV =CFt

(1+r)tt=0

n

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What is Project S’s NPV?r = 10%

1,500 8001,200(3,000)

1,363.64

991.74

601.05

204.90

161.33

300

0 1 2 3 4

NPVS =

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What is Project L’s NPV?r = 10%

400 1300900(3,000)

363.64

743.80

976.71

1024.52

108.67

1500

0 1 2 3 4

NPVL =

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Rationale for the NPV method:

NPV = PV inflows - Cost = Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually exclusive projects on basis of higher NPV. Which adds most value?

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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 S & L are independent, accept both; NPV > 0.

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0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

Internal Rate of Return: IRR

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.NPV

r1

CFt

tn

0t

0

IRR1

CFt

tn

0t

NPV: Enter r, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

Calculating IRR

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Enter CFs in CF register, thenpress IRR:NPVS = IRRS = 13.1%0

(3,000)

IRR = ?0 1 2 3 4

Sum of PVs for CF1-4 = 3,000

1,500 8001,200 300

What is Project S’s IRR?

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NPVL =Enter CFs in CF register, thenpress IRR: IRRL = 11.4%0

IRR = ?

400 1300900 1500

0 1 2 3 4

Sum of PVs for CF1-4 = 3,000

(3,000)

What is Project L’s IRR?

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They are the same thing.A bond’s YTM is the IRRif you invest in the bond.

90 109090

0 1 2 10IRR = ?

-1134.20

IRR = 7.08% (use TVM or CF register)

How is a Project’s IRRRelated to a Bond’s YTM?

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If IRR (project’s rate of return) > the firm’s required rate of return, r, then some return is left over to boost stockholders’ returns.

Example: r = 10%,IRR = 15%. Profitable.

Rationale for the IRR Method

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IRR Acceptance Criteria

If IRR > r, accept project.

If IRR < r, reject project.

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Decisions on Projects S and L per IRR

If S and L are independent, accept both. IRRs > r = 10%.

If S and L are mutually exclusive, accept S because IRRS > IRRL .

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Enter CFs in your calculator and find NPVL andNPVS at several discount rates (r):

r

0

5

10

15

20

NPVL

1,100

554

109

(259)

(566)

NPVS

800

455

161

( 91)

(309)

Construct NPV Profiles

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k

0

5

10

15

20

NPVL

1,100

554

109

(259)

(566)

NPVS

800

455

161

( 91)

(309)

(800)

(600)

(400)

(200)

0

200

400

600

800

1,000

1,200

0 2 4 6 8 10 12 14 16 18 20

IRRL = 11.4%

IRRS = 13.1%

Crossover Point = 8.1%

Project L

Project S

NPV Profiles for Project S and Project L

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IRR < rand NPV < 0.

Reject.

NPV ($)

r (%)IRR

IRR > rand NPV > 0

Accept.

NPV and IRR always lead to the same accept/reject decision for independent projects

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Mutually Exclusive Projectsr < 8.1: NPVL> NPVS , IRRL < IRRS

CONFLICT

r > 8.1: NPVS> NPVL , IRRS > IRRL

NO CONFLICT

8.1

NPV

%

IRRs

IRRL

S

L

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1. Find cash flow differences between the projects. See data at beginning of the case.

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.

To Find the Crossover Rate:

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Two Reasons NPV Profiles Cross:

1) Size (scale) differences.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 r favors small projects.

2) Timing differences.2) Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPVS> NPVL.

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Reinvestment Rate Assumptions

NPV assumes reinvest at r.

IRR assumes reinvest at IRR.

Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

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Modified Internal Rate of ReturnA better indicator of relative profitability

Better for use in capital budgeting

PV of cash outflows = TV

(1+MIRR)n

n

n

0t

tntn

0tt

t

)MIRR1(

)r1(CIF

r)(1

COF

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The End