Ch 9 Learning Goals 1.Calculate, interpret, and evaluate: payback period. net present value (NPV). internal rate of return (IRR). 2. Ranking conflicts.
Feb 25, 2016
Ch 9 Learning Goals
1.Calculate, interpret, and evaluate:
payback period.
net present value (NPV).
internal rate of return (IRR).
2. Ranking conflicts.
Ch 9 Learning Goals3. The importance of risk in capital budgeting.
4. Methods of evaluating project risk.
5. Determination and use of risk-adjusted
discount rates (RADRs).
6. Capital rationing.
CB Evaluation TechniquesTechniques used to evaluate capital outlays
include:
Payback
Net present value (___________)
Internal rate of return (___________)
CB Evaluation Techniques • Not all evaluation techniques are equally valid. The
best rely on:
– Cash Flows (rather than accounting values)
– Time value of money
• Techniques that do these two things are _________
_________________________________________
(DCF) methods (called “sophisticated” in your text).
Payback Period• The payback method measures how many years it
takes to recover the initial investment.
• The maximum acceptable payback period is
determined by management.
• Decision rule: accept if the payback period is _______
___________________________ the maximum
acceptable payback period.
Pros and Cons of Payback Periods• Payback is simple, intuitive, and considers cash flows
rather than accounting profits.
• Payback is widely used by large firms to evaluate
small projects and by small firms to evaluate most
projects.
• It is also used to supplement other methods such as
NPV and IRR.
Pros and Cons of Payback Periods• Weaknesses of Payback:
– Does not consider all CFs
– Does not consider TVOM
– The appropriate payback period is
__________________________ determined
It is not a ___________________ method (it is
unsophisticated)
Pros and Cons of Payback Periods
Net Present Value (NPV)
• Net Present Value (NPV). Net Present Value is found by subtracting the initial investment from the present value of the after-tax inflows.
Decision Criteria
If NPV > 0, _______________ the project
If NPV < 0, _______________ the project
If NPV = 0, indifferent
• The Internal Rate of Return (IRR) is defined as the discount rate that causes NPV to _____________ ________________.
• The IRR measures the annual percentage return on funds invested in the project.
Internal Rate of Return (IRR)
• To interpret IRR, we compare it to “k,” the required return, or “cost of capital” for the project.
Decision Criteria
If IRR > k, __________________ the project
If IRR < k, __________________ the project
If IRR = k, indifferent
Internal Rate of Return (IRR)
Capital Budgeting Techniques
• NPV and IRR are both _____________ (sophisticated) methods of evaluating capital budgeting projects. They are not interchangeable, however.
Conflicting Rankings
• A ranking conflict exists if:– Project A has higher NPV than Project B
but:
– Project B has higher IRR than A
• Mutually exclusive projects should be ranked by __________ (not IRR) when a ranking conflict occurs.
Which Approach is Best?• On a theoretical basis, NPV is better than IRR:
– NPV assumes that cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR,
– A project with non-conventional cash flows might have zero or multiple IRRs.
• Despite that, more firms use the IRR because of management preference for rates of return.
Risk in Capital Budgeting
• Different projects have different levels of risk.
Analysis of the project must consider that risk
(acceptance of the project affects the firm’s
future ____________________).
Approaches for Dealing with Risk
• Techniques for evaluating risk of a capital budgeting project include:– Scenario analysis– Sensitivity analysis– Simulation– Decision trees
Approaches for Dealing with Risk
• Each of the techniques considered gives insight into project risk, but none of them provide a _________________.
• Ultimately, the decision is based on a combination of analysis and judgment.
Assessing Project Risk: Scenario Analysis
• Scenario analysis involves identifying 3 or more possible outcomes. Normally, the probability of each outcome is also estimated.
Approaches for Dealing with Risk
• Once the risk level is determined, it is incorporated into the analysis by either:– Adjusting cash flows, or– Adjusting the required return to get the risk
adjusted discount rate (______________)
_______________ is more often used in practice.
Risk-Adjusted Discount Rates• The risk-adjusted discount rate is the rate of return
that must be earned on a project to compensate for the additional risk.
• The higher the risk of a project, the ______________ the RADR – and thus the __________________ a project’s NPV.
Approaches for Dealing with Risk
• CAPM could be used to determine a project’s RADR. However, most firms use project characteristics to classify projects as low, average, or high risk.
Risk Adjusted Discount Rates
• Examples of Project Classification– Low risk: replacement existing assets without
adding capacity or changing technology– Average risk: expanding capacity without changing
products or technology– High risk: changing product line or technology
Capital Rationing• Capital rationing exists if a firm lacks sufficient
financing to undertake all acceptable projects.
• The firm should adopt the set of projects that provides
highest ___________________________.