Chapter 10 PPT

1© 2008 Thomson South-Western

Chapter 10

Capital Budgeting

2

Capital Budgeting

Capital budgeting involves planning and justifying large expenditures on long-term projects

○ Projects can be classified as:• Replacement • Expansion• New venture

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Characteristics of Business Projects

Project Types and Risk○ Capital projects have increasing risk according to

whether they are replacements, expansions or new ventures

Stand-Alone and Mutually Exclusive Projects○ Stand-alone project has no competing alternatives

• The project is judged on its own viability

○ Mutually exclusive projects involve selecting one project from among two or more alternatives

• Usually different ways to do the same thing

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Characteristics of Business Characteristics of Business ProjectsProjects

Project Cash Flows○ The first and most difficult step in capital budgeting is reducing

projects to a series of cash flows

C0 $(50,000)C1 (10,000)C2 15,000C3 15,000C4 15,000C5 15,000

○ Business projects: early cash outflows and later inflows○ C0 is the Initial Outlay and is usually required to get started

The Cost of Capital○ The average rate a firm pays investors for use of its long term money

• Firms raise money from two sources: debt and equity• A project is a good investment if it is expected to generate a return that’s

greater than the rate that must be paid to finance it

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Capital Budgeting Techniques

Payback ○ How many years to recover initial cost

Net Present Value ○ Present value of inflows less outflows

Internal Rate of Return ○ Project’s return on investment

Profitability Index ○ Ratio of present value of inflows to outflows

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Capital Budgeting Techniques—Payback

Payback period is the time it takes to recover early cash outflows○ Shorter paybacks are better

Payback Decision Rules○ Stand-alone projects

• payback period < policy maximum accept• Payback period > policy maximum reject

○ Mutually Exclusive Projects• If PaybackA < PaybackB choose Project A

Weaknesses of the Payback Method○ Ignores time value of money○ Ignores cash flows after payback period

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Capital Budgeting Techniques—Payback

Consider the following cash flows

Year

0 1 2 3 4

Cash flow (Ci) ($200,000) $60,000 $60,000 $60,000 $60,000

Cumulative cash flows

($200,000) ($140,000) ($80,000) ($20,000) $40,000

Payback period occurs at 3.33 years.

Year

0 1 2 3 4

Cash flow (Ci) ($200,000) $60,000 $60,000 $60,000 $60,000

Payback period is easily visualized by the cumulative cash flows

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Capital Budgeting Techniques—Payback

Example 10.1

Q: Use the payback period technique to choose between mutually exclusive projects A and B.

Exa

mpl

e

800200C5

800200C4

350400C3

400400C2

400400C1

($1,200)($1,200)C0

Project BProject A

A: Project A’s payback is 3 years as its initial outlay is fully recovered in that time. Project B doesn’t fully recover until sometime in the 4th year. Thus, according to the payback method, Project A is better than B. But project B is clearly better because of the large inflows in the last two years

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Capital Budgeting Techniques—Payback

Why Use the Payback Method?○ It’s quick and easy to apply○ Serves as a rough screening device

The Present Value Payback Method○ Calculate payback period using the present

value of project cash flows • Not widely used

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Capital Budgeting Techniques Net Present Value (NPV)

NPV is the sum of the present values of a project’s cash flows at the cost of capital

If PV inflows > PV outflows => NPV > 0

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Capital Budgeting TechniquesNet Present Value (NPV)

NPV and Shareholder Wealth

○ A project’s NPV is the net effect that it is expected to have on the firm’s value

○ To maximize shareholder wealth, select the capital spending program with the highest NPV

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Capital Budgeting Techniques Net Present Value (NPV)

Decision Rules

○ Stand-alone Projects• NPV > 0 accept• NPV < 0 reject

○ Mutually Exclusive Projects• NPVA > NPVB choose Project A over B

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Capital Budgeting Techniques Net Present Value (NPV) Example 10.2

Q: Project Alpha has the following cash flows. If the firm considering Alpha has a cost of capital of 12%, should the project be undertaken?

Exa

mpl

e $3,000C3

$2,000C2

$1,000C1

($5,000)C0

A: The NPV is found by summing the present value of the cash flows when discounted at the firm’s cost of capital.

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Internal Rate of Return (IRR)

A project’s IRR is the return it generates on the investment of its cash outflows○ For example, if a project has the following cash

flows

0 1 2 3

-5,000 1,000 2,000 3,000

• The IRR is the interest rate at which the present value of the three inflows just equals the $5,000 outflow

The “price” of receiving the inflows

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Internal Rate of Return (IRR)

Defining IRR Through the NPV Equation○ The IRR is the interest rate that makes a

project’s NPV zero

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Internal Rate of Return (IRR)

Decision Rules

○ Stand-alone Projects• If IRR > cost of capital (k) accept• If IRR < cost of capital (k) reject

○ Mutually Exclusive Projects• IRRA > IRRB choose Project A over Project B

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Internal Rate of Return (IRR)

Calculating IRRs○ Finding IRRs usually requires an iterative,

trial-and-error technique• Guess at the project’s IRR• Calculate the project’s NPV using this interest

rate– If NPV = zero, the guessed interest rate is the

project’s IRR– If NPV > 0, try a higher interest rate– If NPV < 0, try a lower interest rate

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Internal Rate of Return (IRR) Example 10.4

Q: Find the IRR for the following series of cash flows:

If the firm’s cost of capital is 8%, is the project a good idea? What if the cost of capital is 10%?

Exa

mpl

e

$1,000

C1

($5,000)

C0

$2,000

C2

$3,000

C3

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Techniques Internal Rate of Return (IRR)

Technical Problems with IRR○ Multiple Solutions

• Unusual projects can have more than one IRR• The number of positive IRRs to a project depends on the

number of sign reversals to the project’s cash flows– Normal pattern involves only one sign change

○ The Reinvestment Assumption• IRR method implicitly assumes cash inflows will be

reinvested at the project’s IRR– For projects with extremely high IRRs, this is unlikely

○ These are rarely of practical concern

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Comparing IRR and NPVComparing IRR and NPV

NPV and IRR do not always select the same project in mutually exclusive decisions

A conflict can arise if NPV profiles cross in the first quadrant

In the event of a conflict The selection of the NPV method is preferred

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NPV and IRR Solutions Using Financial NPV and IRR Solutions Using Financial Calculators and SpreadsheetsCalculators and Spreadsheets

Financial calculators and spreadsheets make calculating NPV and IRR easy

Input a project’s cash flows, the calculator or spreadsheet calculates NPV and IRR○ An interest rate is needed to calculate NPV

The calculator procedure is tricky Cash Flow (CF) mode

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Comparing Projects with Comparing Projects with Unequal LivesUnequal Lives

If a significant difference exists between mutually exclusive projects’ lives, a direct comparison is meaningless

The problem arises due to the NPV method○ Longer lived projects almost always have

higher NPVs

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Comparing Projects with Comparing Projects with Unequal LivesUnequal Lives

Two solutions exist

○ Replacement Chain Method• Extends projects until a common time horizon is reached

– If mutually exclusive Projects A (with a life of 3 years) and B (with a life of 5 years) are compared, both projects will be replicated so that they last 15 years

○ Equivalent Annual Annuity (EAA) Method• Replaces each project with an equivalent perpetuity that

equates to the project’s original NPV

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Comparing Projects with Unequal Lives - Example

Q: Which of the two following mutually exclusive projects should a firm purchase?

Exa

mpl

e

Short-Lived Project (NPV = $432.82 at an 8% discount rate; IRR = 23.4%)

$750$750$750$750$750$750($2,600)

-

C5

-

C4

$750

C3

Long-Lived Project (NPV = $867.16 at an 8% discount rate; IRR = 18.3%)

$750

C1

($1,500)

C0

$750

C2

-

C6

A: The IRR method argues for undertaking the Short-Lived Project while the NPV method argues for the Long-Lived Project. We’ll correct for the unequal life problem by using both the Replacement Chain Method and the EAA Method. Both methods will lead to the same decision.

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Replacement Chain Method Figure

10.3

Thus, buying the Long-Lived Project is a better decision than buying the Short-Lived Project twice.

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A Three-Year Project Chainedinto Six Years Figure 10.4

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Capital RationingCapital Rationing

Used when capital funds for new projects are limited

Generally rank projects in descending order of IRR and cut off at the cost of capital

However this doesn’t always make the best use of capital so a complex mathematical process called constrained maximization can be used