Chapter 13 Capital Budgeting

8/20/2019 Chapter 13 Capital Budgeting

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Chapter 13Chapter 13

Capital BudgetingCapital BudgetingTechniquesTechniques

© Pearson Education Limited 2004Fundamentals of Financial Management !2"e

Created #$% &regor$ '( )uhleme$er Ph(*(

Carroll College +au,esha +-


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After studying Chapter 13, After studying Chapter 13,

you should be able to:you should be able to:

.nderstand the pa$#ac, period /PBP method of pro1ect ealuation andselection including its% /a calculation3 /# acceptance criterion3 /cadantages and disadantages3 and /d focus on liquidit$ rather thanprofita#ilit$(

.nderstand the three ma1or discounted cash flo /*CF methods of

pro1ect ealuation and selection 5 internal rate of return /-66 netpresent alue /7P8 and profita#ilit$ inde9 /P-(

E9plain the calculation acceptance criterion and adantages /oer thePBP method for each of the three ma1or *CF methods(

*efine construct and interpret a graph called an :7P8 profile(;

.nderstand h$ ran,ing pro1ect proposals on the #asis of -66 7P8 and

P- methods :ma$; lead to conflicts in ran,ing( *escri#e the situations here ran,ing pro1ects ma$ #e necessar$ and

1ustif$ hen to use either -66 7P8 or P- ran,ings(

.nderstand ho :sensitiit$ anal$sis; allos us to challenge the single<point input estimates used in traditional capital #udgeting anal$sis(

E9plain the role and process of pro1ect monitoring including :progress

reies; and :post


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Capital BudgetingCapital Budgeting

TechniquesTechniques

Pro1ect Ealuation and =election

Potential *ifficulties Capital 6ationing

Pro1ect Monitoring Post


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Project Ealuation:Project Ealuation:

Alternatie !ethods Alternatie !ethods

Pa$#ac, Period /PBP

-nternal 6ate of 6eturn /-66

7et Present 8alue /7P8

Profita#ilit$ -nde9 /P-


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Proposed Project "ataProposed Project "ata

>ulie Miller is ealuating a ne pro1ectfor her firm Bas#et $onders %B$&(

=he has determined that the after


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'ndependent Project 'ndependent Project

-ndependent-n

dependent


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Paybac# Period %PBP&Paybac# Period %PBP&

PBPPBP is the period of timerequired for the cumulatie

e9pected cash flos from aninestment pro1ect to equal

the initial cash outflo(

PBPPBP is the period of timerequired for the cumulatie

e9pected cash flos from aninestment pro1ect to equal

the initial cash outflo(

0 ! 2 4 @


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/c!0 ) 22 ) 3( ) 4A ) @4 )

Paybac# *olution %+1&Paybac# *olution %+1&

PBPPBP D a / # < c " dD /40 < A " !0D / " !0D ( ears( ears

0 ! 2 3 4 @

-. ) !0 ) !2 ) !@ ) 1. ) A )

Cumulatie

-nflos

/a

/


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Paybac# *olution %+/&Paybac# *olution %+/&

PBPPBP D / ) " !0) D ((

ears ears

7ote% Ta,e a#solute alue of lastnegatie cumulatie cash flo alue(

Cumulative

Cash Flows


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PBP Acceptance CriterionPBP Acceptance Criterion

esG The firm ill receie #ac, theinitial cash outla$ in less than (@$ears( H( ears I (@ ear Ma9(J

The management of Bas#et $ondershas set a ma9imum PBP of (@

$ears for pro1ects of this t$pe(=hould this pro1ect #e acceptedK


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PBP *trengthsPBP *trengths

and $ea#nessesand $ea#nesses

=trengths=trengths%%

Eas$ to use andunderstand

Can #e used as ameasure of liquidit$

Easier to forecast=T than LT flos

+ea,nesses+ea,nesses%%

*oes not accountfor T8M

*oes not consider

cash flos #e$ondthe PBP

Cutoff period is

su#1ectie


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'nternal 0ate of 0eturn %'00&'nternal 0ate of 0eturn %'00&

-66 is the discount rate that equates thepresent alue of the future net cash

flos from an inestment pro1ect iththe pro1ects initial cash outflo(

CF! CF2 CFn

/!-66! /!-662 /!-66n+ . . . ++-C D


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?!@000 ?!0000 ?A000

'00 *olution'00 *olution

?!0000 ?!2000

/!-66!

/!-662

Find the interest rate /'00 that causes thediscounted cash flos to equal ?40000(

?40000 D

/!-66 /!-664 /!-66@


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'00 *olution %Try 1.&'00 *olution %Try 1.&

?40000?40000 D ?!0000/P8-F!0N! ?!2000/P8-F!0N2

?!@000/P8-F!0N ?!0000/P8-F!0N4 ?

A000/P8-F!0N@?40000?40000 D ?!0000/(O0O ?!2000/(2

?!@000/(A@! ?!0000/( ? A000/(2!

?40000?40000 D ?O0O0 ?OO!2 ?!!2@ ?0 ?44A D ?4!444?4!444 HH0ate is too lo2 0ate is too lo2 JJ


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'00 *olution %Try 14&'00 *olution %Try 14&

?40000?40000 D ?!0000/P8-F!@N! ?!2000/P8-F!@N2

?!@000/P8-F!@NC ?!0000/P8-F!@N4

? A000/P8-F!@N@?40000?40000 D ?!0000/(A0 ?!2000/(A@

?!@000/(@ ?!0000/(@A2 ? A000/(4OA

?40000?40000 D ?A00 ?O0A2 ?OA0 ?@A20 ?4AO

D ?4!?4! HH0ate is too high 0ate is too high JJ


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(!0 ?4!444

(0@ -66 ?40000 ?40

(!@ ?4!

Q ?!444(0@ ?40

'00 *olution %'nterpolate&'00 *olution %'nterpolate&

?!444Q

D


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(!0 ?4!444

(0@ -66 ?40000 ?40

(!@ ?4!

Q ?!444(0@ ?40


?!444Q

D


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(!0 ?4!444

(0@ -66 ?40000 ?40

(!@ ?4!

/?!444/0(0@ ?40


?!444Q

Q D Q D (0!@A

-66 D (!0 (0!@A D (!!@A or !!(@AN


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'00 Acceptance Criterion'00 Acceptance Criterion

7oG The firm ill receie !!(@AN foreach dollar inested in this pro1ect ata cost of !N( H -66 I Rurdle 6ate J

The management of Bas#et $ondershas determined that the hurdle rate

is !N for pro1ects of this t$pe( =hould this pro1ect #e acceptedK


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'00s on the Calculator '00s on the Calculator

+e ill use thecash flo registr$to sole the -66for this pro#lem

quic,l$ and

accuratel$G


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Actual '00 *olution 5sing Actual '00 *olution 5sing

6our 7inancial Calculator 6our 7inancial Calculator

=teps in the Process=tep !% Press CF ,e$

=tep 2% Press 2nd CL6 +or, ,e$s

=tep % For C7. Press


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Actual '00 *olution 5sing Actual '00 *olution 5sing


=teps in the Process /Part --=tep !0%For C.- Press !0000 Enter ,e$s

=tep !!%For 7.- Press ! Enter ,e$s

=tep !2%For C.4 Press A000 Enter ,e$s

=tep !%For 7.4 Press ! Enter ,e$s

=tep !4% Press ,e$s

=tep !@% Press -66 ,e$=tep !% Press CPT ,e$

6esult% -nternal 6ate of 6eturn D !!(4AN


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'00 *trengths'00 *trengths



'ccounts forT8M

Considers all

cash flos Lesssu#1ectiit$


'ssumes all cashflos reinested atthe -66

*ifficulties ithpro1ect ran,ings andMultiple -66s


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8et Present 9alue %8P9&8et Present 9alue %8P9&

8P9 is the present alue of aninestment pro1ects net cash

flos minus the pro1ects initialcash outflo(

CF! CF2 CFn

/!,! /!,2 /!,n+ . . . ++


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Bas#et $onders has determined that theappropriate discount rate /, for this

pro1ect is !N(

?!0000 ?A000

8P9 *olution8P9 *olution

?!0000 ?!2000 ?!@000

/!(!! /!(!2 /!(!

< ?40000?40000/!(!4 /!(!@

7P87P8 D


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8P9 *olution8P9 *olution

7P87P8 D ?!0000/P8-F!CN! ?!2000/P8-F!CN2

?!@000/P8-F!CNC ?!0000/P8-F!CN4

? A000/P8-F!CN@ < ?40000?40000

7P87P8 D ?!0000/(@ ?!2000/(A ?!@000/(O ?!0000/(! ? A000/(@4 < ?40000?40000

7P87P8 D ?@0 ?OO ?!0O@ ?!0 ?0! < ?40000?40000

D < ?!42?!42


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8P9 Acceptance Criterion8P9 Acceptance Criterion

7oG The 7P8 is negatie( This meansthat the pro1ect is reducing shareholderealth( H0eject0eject as 8P9 8P9 I . . J

The management of Bas#et $ondershas determined that the required

rate is !N for pro1ects of this t$pe(=hould this pro1ect #e acceptedK


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8P9 on the Calculator 8P9 on the Calculator

+e ill use the cashflo registr$ to sole

the 7P8 for thispro#lem quic,l$ and

accuratel$G

Rint% -f $ou hae not cleared the cash flosfrom $our calculator then$ou ma$ s,ip to =tep !@(


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Actual 8P9 *olution 5sing Actual 8P9 *olution 5sing


=teps in the Process=tep !% Press CF ,e$

=tep 2% Press 2nd CL6 +or, ,e$s

=tep % For C7. Press


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=teps in the Process /Part --=tep !0%For C.- Press !0000 Enter ,e$s

=tep !!%For 7.- Press ! Enter ,e$s

=tep !2%For C.4 Press A000 Enter ,e$s

=tep !%For 7.4 Press ! Enter ,e$s

=tep !4% Press ,e$s

=tep !@% Press 7P8 ,e$=tep !% For -D Enter ! Enter ,e$s

=tep !A% Press CPT ,e$

6esult% 7et Present 8alue D


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8P9 *trengths8P9 *trengths



Cash flosassumed to #ereinested at thehurdle rate(

'ccounts for T8M(

Considers all

cash flos(


Ma$ not includemanagerialoptions em#eddedin the pro1ect( =ee

Chapter !4(


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8et Present 9alue Profile8et Present 9alue Profile

*iscount 6ate /N

0 O !2 !@

-667P8S!N

=um of CFs Plot 7P8 for eachdiscount rate(T h r e e o

f t h e s e p o i n t s a r e e a s $ n o 4 G

7 e

t P r e s e n t 8

a l u e

?000s

!@

!0

@

0


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Creating 8P9 ProfilesCreating 8P9 Profiles

5sing the Calculator 5sing the Calculator

Rint% 's long as $oudo not :clear; the

cash flos from theregistr$ simpl$ startat =tep !@ and entera different discount

rate( Each resulting7P8 ill proide a:point; for $our 8P9

ProfileG


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Profitability 'nde %P'&Profitability 'nde %P'&

P- is the ratio of the present alue ofa pro1ects future net cash flos to

the pro1ects initial cash outflo(

CF! CF2 CFn

/!,! /!,2 /!,n+ . . . ++ -C-CP- D

P- D ! H 7P87P8 " -C-C J

II 6

Method U2%

Method U!%


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P' Acceptance CriterionP' Acceptance Criterion

7oG The P-P- is less than !(00( Thismeans that the pro1ect is not profita#le(H0eject0eject as P' P' I 1;.. 1;.. J

P-P- D ?@A2 " ?40000

D (O4 %!ethod +1, 133-&

=hould this pro1ect #e acceptedK


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P' *trengthsP' *trengths



=ame as 7P8

'lloscomparison of

different scalepro1ects


=ame as 7P8

Proides onl$relatie profita#ilit$

Potential 6an,ingPro#lems


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Ealuation *u


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=ther Project=ther Project

0elationships0elationships

!utually Eclusie!utual ly Eclusie


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Potential Proble


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A; *cale "ifferences A; *cale "ifferences

Compare a small /= and alarge /L pro1ect(

7ET C'=R FL+=

Pro1ect = Pro1ect LE7* F E'6

0


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*cale "ifferences*cale "ifferences

Calculate the PBP -66 7P8S!0Nand P-S!0N(

+hich pro1ect is preferredK +h$K

Pro1ect -66 7P8 P-

= !00N ? 2! (!

L 2@N ?2O!2 !(2O


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B; Cash 7lo2 PatternB; Cash 7lo2 Pattern

Let us compare a decreasing cash


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* 2N ?!O !(!A?!O !(!A

- !AN ?!O !(!A?!O !(!A

Cash 7lo2 PatternCash 7lo2 Pattern

Calculate the -66 7P8S!0N andP-S!0N(

+hich pro1ect is preferredK

Pro1ect -66 7P8 P-


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Ea


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7isher>s 0ate of 'ntersection7isher>s 0ate of 'ntersection

*iscount 6ate /?

0 @ !0 !@ 20 2@


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C; Project ?ife "ifferencesC; Project ?ife "ifferences

Let us compare a long life /Q pro1ectand a short life / pro1ect(

7ET C'=R FL+=Pro1ect Q Pro1ect E7* F E'6

0


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Q @0N ?!@ 2(@4

!00N ? ! !(2

Project ?ife "ifferencesProject ?ife "ifferences

Calculate the PBP -66 7P8S!0Nand P-S!0N(

+hich pro1ect is preferredK +h$K

Pro1ect -66 7P8 P-

A h $A th $ t


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Another $ay to Another $ay to

?oo# at Things?oo# at Things

!( 'd1ust cash flos to a common terminal$ear if pro1ect :; ill 8=T 8=T #e replaced(

Compound Pro1ect ear ! S!0N for 2 $ears(

ear 0 ! 2

CF


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0eplacing Projects0eplacing Projects

2ith 'dentical Projects2ith 'dentical Projects

2( .se 0eplace


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Aailable Projects for B$ Aailable Projects for B$

Pro1ect -C -66 7P8 P-

' ? @00 !N ? @0 !(!0

B @000 2@ @00 2(0C @000 A @@00 2(!0* A@00 20 @000 !(AE !2@00 2 @00 !(04F !@000 2 2!000 2(40& !A@00 !O A@00 !(4R 2@000 !@ 000 !(24


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Choosing by '00s for B$ Choosing by '00s for B$


C ? @000 AN ? @@00 2(!0

F !@000 2 2!000 2(40E !2@00 2 @00 !(04B @000 2@ @00 2(0

Pro1ects C F and E hae thethree largest '00s(

The resulting increase in shareholder ealth is ?2A000 ith a ?2@00 outla$(


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Choosing by 8P9s for B$ Choosing by 8P9s for B$


F ?!@000 2N ?2!000 2(40

& !A@00 !O A@00 !(4B @000 2@ @00 2(0

Pro1ects F and & hae the

to largest 8P9s(The resulting increase in shareholder ealth

is ?2@00 ith a ?2@00 outla$(


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*u


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*inglePoint Esti


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PostCo


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!ultiple '00 Proble


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8P9 Profile !ultiple '00s8P9 Profile !ultiple '00s

*iscount 6ate /N

0 40 0 !20 !0 200

7 e

t P r e s e n t 8 a l u e

/ ? 0 0 0 s

Multiple -66s at

,, D !2(O@N!2(O@N and !O!(!@N!O!(!@N

A@

@0

2@

0


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8P9 Profile !ultiple '00s8P9 Profile !ultiple '00s

Rint% our calculatorill onl$ find 7E

-66 5 een if thereare multiple -66s( -t

ill gie $ou theloest -66( -n this

case !2(O@N(

Chapter 13 Capital Budgeting

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