The Basics of Capital Investment Decisions

7/26/2019 The Basics of Capital Investment Decisions

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The Basics of Capital InvestmentDecisions: Evaluating Cash Flows

What is capital budgeting?• Plan and manage capital expenditures for long-lived

assets.

• Analysis of potential projects.

• Long-term decisions.

• Involve large commitments.

• ery important to firm!s future.

"teps in #apital $udgeting• %stimate cash flo&s 'inflo&s ( outflo&s).

• Assess ris* of cash flo&s.

• +etermine r , WA## for project.

• %valuate cash flo&s.

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Independent versus utually %xclusive Projects

Projects are / independent0 if the cash flo&s of one are unaffected by

the acceptance of the other. Projects stand on their o&n. / mutually exclusive0 if the cash flo&s of one can be

adversely impacted by the acceptance of the other. Allother alternatives are automatically deleted once aproject is chosen.

1P "um of the Ps of all cash flo&s

NPV =∑t =0

n

CF t

(1+r )t

#ost is often CF 0 and is negative.

NPV =∑t =1

nCF

t

(1+r )t −CF

0

%xample 23iven the follo&ing data and the opportunity cost ofcapital is 245.6ear Project 7 Project 64 -8244 -82442 24 94: ;4 <4= >4 :4

ind the 1P of project 7 and of project 6.

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@ationale for the 1P ethod• 1P , P inflo&s / #ost

• his is net gain in &ealth in dollar terms '8)0 soaccept project only if 1P B 4.

• #hoose bet&een mutually exclusive projects onbasis of higher 1P. Adds most value.

• 1P B 4 implies %A B 4 and A B 4.

Csing 1P method0 &hich project's) should be accepted?• If Project 7 and Project 6 are mutually exclusive0

accept 7 because 1Px B 1Py .

• If 7 ( 6 are independent0 accept both because 1PB 4.

Internal @ate of @eturn I@@• I@@ is the discount rate that forces P inflo&s , cost.

• his is the same as forcing 1P , 4

1P %nter r0 solve for 1P.

∑t =0

nCF

t

(1+r )t = NPV

I@@ %nter 1P , 40 solve for I@@.∑t =0

n CF t

(1+ IRR)t =0

%xample :

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ind the I@@s of project 7 and of project 6.

%xample = ind I@@ if #s are constant3iven the follo&ing data6ear #ash flo&s4 -8244

2 D4: D4= D4

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@ationale for the I@@ ethod• If I@@ B WA##0 then the project!s rate of return is

greater than its cost adding extra values tostoc*holders. Accept the project.

• I@@ is internal to the project and does not depend onthe mar*et interest rate.

• 3iven in 50 I@@ provides an easy measure ofprofitability.

+ecisions on Project 7 and Project 6 using I@@• If 7 and 6 are independent0 accept both I@@x B

WA## and I@@y B WA##

• If 7 and 6 are mutually exclusive0 accept 7 becauseI@@x B I@@y given I@@x B WA## . Ether&ise0 rejectboth. #ost must be justified.

#onstruct 1P Profiles and cross over rate• %nter #s in the calculator and find 1Px and 1Py

at different discount rates o ind the #rossover

@ate• ind cash flo& differences bet&een the projects from

each corresponding year starting from t , 4 to t , n.

• %nter these differences in cash flo& register0 thenpress I@@.

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%xample D@efer to example 2 data0 if r , 45F <5F 2450 2<5F:45F ind the 1Px and 1Py respectively. "*etch the

1P profile and find the crossover rate.

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&o @easons 1P Profiles #ross• "iGe 'scale) differences. "maller project frees up

funds at t , 4 for investment. he higher the

opportunity cost0 the more valuable these funds0 sohigh r favours small projects.

• iming differences. Project &ith faster paybac*

provides more # in early years for reinvestment. If r

is high0 early # especially good0 1Px B 1Py

@einvestment @ate Assumptions• 1P assumes reinvest at r 'opportunity cost of

capital0 WA##).

• I@@ assumes reinvest at I@@.

• @einvest at opportunity cost0 r0 is more realistic0 so

1P method is best. 1P should be used to choose

bet&een mutually exclusive projects if a conflictexists.

1ormal vs. 1onnormal #ash lo&s• 1ormal #ash lo& Project

o #ost 'negative #) follo&ed by a series of

positive cash inflo&s.

o Ene change of signs.

• 1onnormal #ash lo& Projecto &o or more changes of signs.

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Why use I@@ versus I@@?• I@@ also avoids the problem of multiple I@@s.

• I@@ correctly assumes reinvestment at opportunity

cost , WA##.

• anagers li*e using rates of return for comparisons0

and I@@ is better for this than I@@.

odified Internal @ate of @eturn 'I@@)• I@@ is the discount rate &hich causes the P of a

project!s terminal value ') to eHual the P of costs.

• is found by compounding inflo&s at WA##.

• I@@ assumes cash inflo&s are reinvested at WA##

&hich is reasonable.

• I@@ is uniHue.

• Accept the project if I@@ B WA##.

• irst0 find P and at given WA##.

• "econd0 find discount rate that eHuates P and

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%xample <@efer to example 20 find the I@@ of project 7 and

project 6.

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Profitability Index• he profitability index 'PI) is the present value of

future cash flo&s divided by the initial cost.

PI = PV future CF

InitialCost

• PI is the scale-version of 1P.

•

o accept a project0 PI B 2.

• PI B 2 is eHuivalent to 1P B 4.

%xample ;@efer to example 20 &hat is the PI of 7 and of 6?

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Paybac* ethods• Paybac* period is the number of years reHuired to

recover a project!s cost0 or ho& long it ta*es to get

the business!s money bac*.

• irms establish a benchmar* paybac* periodF

projects &hose paybac* exceeds this benchmar* arerejected.

• "trengthso Provides an indication of a project!s ris* and

liHuidity.

o %asy to calculate and understand.

• Wea*nesseso Ignores the time value of money.

o Ignores #s occurring after the paybac* period.

%xample 9@efer to example 20 find the paybac* period for project 7 andproject 6.

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+iscounted Paybac*• Cses discounted rather than ra& #s.

%xample >@efer to example 20 find the discounted paybac* period ofproject 7 and project 6.

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#apital $udgeting Process @emar*s• uantitative methods provide valuable information0

but they should not be used as the sole criteria for

acceptJreject decisions in capital budgeting process.

• 1P is the single most important method sho&ing

the absolute profitability.

• I@@ is ran*ed second of importance.

• Paybac* is still used significantly among small

businesses.

utually %xclusive Projects &ith uneHual lives %Huivalent Annual Annuity Approach '%AA)

• #onvert the P into a stream of annuity payments

&ith the same P.

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%xample KWhich project should be adopted given they are mutuallyexclusive and the opportunity cost of capital is2<5?6ear Project

#

Project +

irst #ost'year 4)

-8D40444 -8;<0444

Annual cost

'from year2)

-8240444 -82:0444

"alvagealue

82:0444 8:<0444

Life0 6ears = ;

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Eptimal #apital $udget

• inance theory says to accept all positive 1P

projects.

• &o problems can occur &hen there is not enough

internally generated cash to fund all positive 1Pprojectso An increasing marginal cost of capital.

o #apital rationing.

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The Basics of Capital Investment Decisions