Capital budgeting ppt@ bec doms on finance
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Capital budgeting ppt@ bec doms on finance

Capital budgeting ppt@ bec doms on finance

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Capital budgeting ppt@ bec doms on finance Presentation Transcript

  • 1. 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
    2
  • 3. 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
    3
  • 4. Characteristics of Business Projects
    • Project Cash Flows
      • The first and most difficult step in capital budgeting is reducing projects to a series of cash flows
        • C 0 $(50,000)
        • C 1 (10,000)
        • C 2 15,000
        • C 3 15,000
        • C 4 15,000
        • C 5 15,000
      • Business projects: early cash outflows and later inflows
      • C 0 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
    4
  • 5. 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
    5
  • 6. 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 Payback A < Payback B  choose Project A
    • Weaknesses of the Payback Method
      • Ignores time value of money
      • Ignores cash flows after payback period
    6
  • 7. Capital Budgeting Techniques—Payback
    • Consider the following cash flows
    7 Payback period occurs at 3.33 years.
    • Payback period is easily visualized by the cumulative cash flows
    Year 0 1 2 3 4 Cash flow (C i ) ($200,000) $60,000 $60,000 $60,000 $60,000 Cumulative cash flows ($200,000) ($140,000) ($80,000) ($20,000) $40,000 Year 0 1 2 3 4 Cash flow (C i ) ($200,000) $60,000 $60,000 $60,000 $60,000
  • 8. Capital Budgeting Techniques—Payback Example 10.1 8 Q: Use the payback period technique to choose between mutually exclusive projects A and B. Example 800 200 C 5 800 200 C 4 350 400 C 3 400 400 C 2 400 400 C 1 ($1,200) ($1,200) C 0 Project B Project 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 4 th 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
  • 9. 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
    9
  • 10. 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
    10
    • If PV inflows > PV outflows => NPV > 0
  • 11. Capital Budgeting Techniques Net 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
    11
  • 12. Capital Budgeting Techniques Net Present Value (NPV)
    • Decision Rules
      • Stand-alone Projects
        • NPV > 0  accept
        • NPV < 0  reject
      • Mutually Exclusive Projects
        • NPV A > NPV B  choose Project A over B
    12
  • 13. Capital Budgeting Techniques Net Present Value (NPV) Example 10.2 13 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? Example $3,000 C 3 $2,000 C 2 $1,000 C 1 ($5,000) C 0 A: The NPV is found by summing the present value of the cash flows when discounted at the firm’s cost of capital.
  • 14. 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
    14
        • 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 0 1 2 3 -5,000 1,000 2,000 3,000
  • 15. Internal Rate of Return (IRR)
    • Defining IRR Through the NPV Equation
      • The IRR is the interest rate that makes a project’s NPV zero
    15
  • 16. 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
        • IRR A > IRR B  choose Project A over Project B
    16
  • 17. 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
    17
  • 18. Internal Rate of Return (IRR) Example 10.4 18 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%? Example $1,000 C 1 ($5,000) C 0 $2,000 C 2 $3,000 C 3
  • 19. 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
    19
  • 20. Comparing 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
    20
  • 21. NPV and IRR Solutions Using Financial Calculators 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
    21
  • 22. Comparing Projects with Unequal 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
    22
  • 23. Comparing Projects with Unequal 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
    23
  • 24. Comparing Projects with Unequal Lives - Example 24 Q: Which of the two following mutually exclusive projects should a firm purchase? Example Short-Lived Project (NPV = $432.82 at an 8% discount rate; IRR = 23.4%) $750 $750 $750 $750 $750 $750 ($2,600) - C 5 - C 4 $750 C 3 Long-Lived Project (NPV = $867.16 at an 8% discount rate; IRR = 18.3%) $750 C 1 ($1,500) C 0 $750 C 2 - C 6 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.
  • 25. Replacement Chain Method Figure 10.3 25 Thus, buying the Long-Lived Project is a better decision than buying the Short-Lived Project twice.
  • 26. A Three-Year Project Chained into Six Years Figure 10.4 26
  • 27. Capital 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
    27