Capital-Budgeting in Finance

7/30/2019 Capital-Budgeting in Finance

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THE CAPITAL BUDGETING DECISION(CHAPTER 12)

Capital Budgeting: An Overview

Estimating Incremental Cash Flows

Payback Period

Net Present Value

Internal Rate of Return

Ranking Problems

Capital Rationing

Risk Adjustment


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CAPITAL BUDGETING: AN OVERVIEW

Search for investment opportunities. This processwill obviously vary among firms and industries.

Estimate all cash flows for each project.

Evaluate the cash flows. a) Payback period. b) NetPresent Value. c) Internal Rate of Return. d)Modified Internal rate of Return.

Make the accept/reject decision.

Independent projects: Accept/reject decision for aproject is not affected by the accept/reject decisions ofother projects.

Mutually exclusive projects: Selection of onealternative precludes another alternative.

Periodically reevaluate past investment decisions.


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ESTIMATING INCREMENTAL CASHFLOWS

Only changes in after-tax cash flows thatwould occur if the project is accepted

versus what they would be if the project isrejected are relevant.

Initial Outlay: Includes purchase price of theasset, shipping and installation, after-tax sale ofasset to be replaced if applicable, additionalrequired investments in net working capital (e.g.,increases in accounts receivable and inventoryless any spontaneous increases in accountspayable and accruals), plus any other cash flowsnecessary to put the asset in working order.


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Differential Cash Flows

Over the Projects Life:

Change in revenue- Change in operating expenses

= Change in operating income beforetaxes

- Change in taxes

= Change in operating income aftertaxes

+ Change in depreciation= Differential cash flow


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Note: Interest expenses are excluded whencalculating differential cash flow. Instead,they are accounted for in the discount rateused to evaluate projects.

Terminal Cash Flow: Includes after-tax salvagevalue of the asset, recapture of nonexpenseoutlays that occurred at the assets initiation(e.g., net working capital investments), plus

any other cash flows associated with projecttermination.


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PAYBACK PERIODThe number of years required to recoup the initial

outlay. What is (n) such that:

CF CF t

t

n

0

1

(n) = payback period (PP)

CF = initial outlayCF after - tax cash flow in period (t)

0

t


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PAYBACK PERIOD (CONTINUED)

Decision Rules:PP = payback period

MDPP = maximum desired payback periodIndependent Projects:PP MDPP - Accept

PP > MDPP - Reject

Mutually Exclusive Projects:Select the project with the fastest payback, assuming

PP MDPP.

Problems: (1) Ignores timing of the cash flows, and

(2) Ignores cash flows beyond the paybackperiod.


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NET PRESENT VALUE (NPV)

The present value of all future after-tax cash flowsminus the initial outlay

return)(requiredcapitalofcost=k:where

)1(...

)1()1(=

)1(

0221

1

0

CFk

CF

k

CF

k

CF

CFk

CFNPV

nn

n

t

t

t


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NPV (CONTINUED)Decision Rules:

Independent Projects: NPV 0 - Accept

NPV < 0 - Reject

Mutually Exclusive Projects: Select the project with the highest NPV, assuming NPV 0.


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INTERNAL RATE OF RETURN (IRR)

Rate of return on the investment. That rate ofdiscount which equates the present value of allfuture after-tax cash flows with the initial outlay.

What is the IRR such that:

When only one interest factor is required, you cansolve for the IRR algebraically. Otherwise, trialand error is necessary.

)1(10

n

t

t

tCF

IRR

CF


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IRR (CONTINUED)

If you are not using a financial calculator:1. Guess a rate.

2. Calculate:

3. If the calculation = CF0 you guessed rightIf the calculation > CF0 try a higher rate

If the calculation < CF0 try a lower rate

Note: Financial calculators do the trial and

error calculations much faster than wecan!

CF

IRR

t

tt

n

( )11


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IRR (CONTINUED)

Decision Rules (No Capital Rationing):

Independent Projects: IRR k - Accept

IRR < k - Reject

Mutually Exclusive Projects: Select the project with the highest IRR, assuming IRR k.

Multiple IRRs:

There can be as many IRRs as there are sign

reversals in the cash flow stream. When multiple IRRs

exist, the normal interpretation of the IRR loses its

meaning.


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RANKING PROBLEMS

When NPV = 0, IRR = k

When NPV > 0, IRR > k

When NPV < 0. IRR < kTherefore, given no capital rationing and

independent projects, the NPV and IRR methodswill always result in the same accept/rejectdecisions.

However, the methods may rank projects differently.As a result, decisions could differ if projects aremutually exclusive, or capital rationing isimposed. Ranking problems can occur when (1)initial investments differ, or (2) the timing of


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RANKING PROBLEMS (CONTINUED)

Ranking Conflicts: Due to reinvestment rateassumptions, the NPV method is generally moreconservative, and is considered to be the

preferred method.

NPV - Assumes reinvestment of future cash flows atthe cost of capital.

IRR - Assumes reinvestment of future cash flows atthe projects IRR.

In addition, the NPV method maximizes the value ofthe firm.


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CAPITAL RATIONINGNote:

Capital rationing exists when an artificial constraint is placed on the amount offunds that can be invested. In this case, a firm may be confronted with more

desirable projects than it is willing to finance. A wealth maximizing firm would

not engage in capital rationing.


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CAPITAL RATIONING: AN EXAMPLE(FIRMS COST OF CAPITAL = 12%)

Independent projects ranked according totheir IRRs:

Project Project Size IRR

E $20,000 21.0%

B 25,000 19.0

G 25,000 18.0

H 10,000 17.5

D 25,000 16.5

A 15,000 14.0

F 15,000 11.0

C 30,000 10.0


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CAPITAL RATIONING EXAMPLE(CONTINUED)

No Capital Rationing - Only projects F and Cwould be rejected. The firms capital budget

would be $120,000.

Capital Rationing - Suppose the capital budget isconstrained to be $80,000. Using the IRRcriterion, only projects E, B, G, and H, would

be accepted, even though projects D and Awould also add value to the firm. Also note,however, that a theoretical optimum could bereached only be evaluating all possible

combinations of projects in order to determinethe ortfolio of ro ects with the hi hest NPV.


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REQUIRED RETURNS FOR INDIVIDUALPROJECTS THAT VARY IN RISK LEVELS

Higher hurdle rates should be used forprojects that are riskier than the

existing firm, and lower hurdle ratesshould be used for lower risk projects.

Measuring risk and specifying the tradeoffbetween required return and risk,however, are indeed difficult endeavors.

Interested students should read Chapter13 entitled Risk and Capital Budgeting.


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RISK ADJUSTED REQUIRED RETURNS

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6

Required Return

Firms Risk Level

Risk

ka

Risk-ReturnTradeoff

ka= Cost ofCapital for theexisting firm.

Capital-Budgeting in Finance

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