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3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
3 capital budgeting
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3 capital budgeting

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  • 1. 3-1 Capital BudgetingCapital Budgeting TechniquesTechniques © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI
  • 2. 3-2 After studying Chapter 13,After studying Chapter 13, you should be able to:you should be able to: Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability. Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and profitability index (PI). Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. Define, construct, and interpret a graph called an “NPV profile.” Understand why ranking project proposals on the basis of IRR, NPV, and PI methods “may” lead to conflicts in ranking. Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or PI rankings. Understand how “sensitivity analysis” allows us to challenge the single- point input estimates used in traditional capital budgeting analysis. Explain the role and process of project monitoring, including “progress reviews” and “post-completion audits.”
  • 3. 3-3 CAPITAL BUDGETING PROCESSCAPITAL BUDGETING PROCESS NEWINVEST IMROVEMENT EVALUATION PROCEEDURE PROPOSALS PLANNING PHASE PROPOSALS EVALUATION PHASE PROJECTS IMPLEMENTATION PHASE CONTROL PHASE PROJECT TERMINATION AUDITING PHASE ONLINE PROJECTS SELECTION PHASE ACCEPTED PROJECTS REJECTED OPPORTUNITIES REJECTED PROPOSALS REJECTED PROJECTS
  • 4. 3-4 EVALUATION CRITERIA DISCOUNTING CRITERIA NON DISCOUNTING CRITERIA NET PRESENT VALUE INTERNAL RATE OF RETURN DISC. PAYBACK PERIOD PR’ABLTY INDEX (PI) ACC. RATE OF RETURN PAYBACK PERIOD
  • 5. 3-5 Capital BudgetingCapital Budgeting TechniquesTechniques Project Evaluation and Selection Potential Difficulties Capital Rationing Project Monitoring Post-Completion Audit
  • 6. 3-6 Proposed Project DataProposed Project Data Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.
  • 7. 3-7 Independent ProjectIndependent Project IndependentIndependent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.
  • 8. 3-8 Payback Period (PBP)Payback Period (PBP) PBPPBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. PBPPBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K
  • 9. 3-9 (c)10 K 22 K 37 K 47 K 54 K Payback Solution (#1)Payback Solution (#1) PBPPBP = a + ( b - c ) / d = 3 + (40 - 37) / 10 = 3 + (3) / 10 = 3.3 Years3.3 Years 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K Cumulative Inflows (a) (-b) (d)
  • 10. 3-10 Payback Solution (#2)Payback Solution (#2) PBPPBP = 3 + ( 3K ) / 10K = 3.3 Years3.3 Years Note: Take absolute value of last negative cumulative cash flow value. Cumulative Cash Flows -40 K 10 K 12 K 15 K 10 K 7 K 0 1 2 3 4 5 -40 K -30 K -18 K -3 K 7 K 14 K
  • 11. 3-11 PBP Acceptance CriterionPBP Acceptance Criterion Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.] The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type. Should this project be accepted?
  • 12. 3-12 PBP StrengthsPBP Strengths and Weaknessesand Weaknesses StrengthsStrengths:: Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows WeaknessesWeaknesses:: Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective
  • 13. 3-13 Internal Rate of Return (IRR)Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. CF1 CF2 CFn (1+IRR)1 (1+IRR)2 (1+IRR)n + . . . ++ICO =
  • 14. 3-14 $15,000 $10,000 $7,000 IRR SolutionIRR Solution $10,000 $12,000 (1+IRR)1 (1+IRR)2 Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000. + + ++$40,000 = (1+IRR)3 (1+IRR)4 (1+IRR)5
  • 15. 3-15 IRR Solution (Try 10%)IRR Solution (Try 10%) $40,000$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5) $40,000$40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) + $ 7,000(.621) $40,000$40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 = $41,444$41,444 [[Rate is too low!!Rate is too low!!]]
  • 16. 3-16 IRR Solution (Try 15%)IRR Solution (Try 15%) $40,000$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5) $40,000$40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) + $10,000(.572) + $ 7,000(.497) $40,000$40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 = $36,841$36,841 [[Rate is too high!!Rate is too high!!]]
  • 17. 3-17 .10 $41,444 .05 IRR $40,000 $4,603 .15 $36,841 X $1,444 .05 $4,603 IRR Solution (Interpolate)IRR Solution (Interpolate) $1,444X =
  • 18. 3-18 .10 $41,444 .05 IRR $40,000 $4,603 .15 $36,841 X $1,444 .05 $4,603 IRR Solution (Interpolate)IRR Solution (Interpolate) $1,444X =
  • 19. 3-19 .10 $41,444 .05 IRR $40,000 $4,603 .15 $36,841 ($1,444)(0.05) $4,603 IRR Solution (Interpolate)IRR Solution (Interpolate) $1,444X X = X = .0157 IRR = .10 + .0157 = .1157 or 11.57%
  • 20. 3-20 IRR Acceptance CriterionIRR Acceptance Criterion No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR < Hurdle Rate ] The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted?
  • 21. 3-21 IRRs on the CalculatorIRRs on the Calculator We will use the cash flow registry to solve the IRR for this problem quickly and accurately!
  • 22. 3-22 Actual IRR Solution UsingActual IRR Solution Using Your Financial CalculatorYour Financial Calculator Steps in the Process Step 1: Press CF key Step 2: Press 2nd CLR Work keys Step 3: For CF0 Press -40000 Enter ↓ keys Step 4: For C01 Press 10000 Enter ↓ keys Step 5: For F01 Press 1 Enter ↓ keys Step 6: For C02 Press 12000 Enter ↓ keys Step 7: For F02 Press 1 Enter ↓ keys Step 8: For C03 Press 15000 Enter ↓ keys Step 9: For F03 Press 1 Enter ↓ keys
  • 23. 3-23 Actual IRR Solution UsingActual IRR Solution Using Your Financial CalculatorYour Financial Calculator Steps in the Process (Part II) Step 10:For C04 Press 10000 Enter ↓ keys Step 11:For F04 Press 1 Enter ↓ keys Step 12:For C05 Press 7000 Enter ↓ keys Step 13:For F05 Press 1 Enter ↓ keys Step 14: Press ↓ ↓ keys Step 15: Press IRR key Step 16: Press CPT key Result: Internal Rate of Return = 11.47%
  • 24. 3-24 IRR StrengthsIRR Strengths and Weaknessesand Weaknesses StrengthsStrengths:: Accounts for TVM Considers all cash flows Less subjectivity WeaknessesWeaknesses:: Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs
  • 25. 3-25 Net Present Value (NPV)Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n + . . . ++ - ICOICONPV =
  • 26. 3-26 Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. $10,000 $7,000 NPV SolutionNPV Solution $10,000 $12,000 $15,000 (1.13)1 (1.13)2 (1.13)3 + + + - $40,000$40,000(1.13)4 (1.13)5 NPVNPV = +
  • 27. 3-27 NPV SolutionNPV Solution NPVNPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $ 7,000(PVIF13%,5) - $40,000$40,000 NPVNPV = $10,000(.885) + $12,000(.783) + $15,000(.693) + $10,000(.613) + $ 7,000(.543) - $40,000$40,000 NPVNPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000$40,000 = - $1,428$1,428
  • 28. 3-28 NPV Acceptance CriterionNPV Acceptance Criterion No! The NPV is negative. This means that the project is reducing shareholder wealth. [RejectReject as NPVNPV < 00 ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted?
  • 29. 3-29 NPV on the CalculatorNPV on the Calculator We will use the cash flow registry to solve the NPV for this problem quickly and accurately! Hint: If you have not cleared the cash flows from your calculator, then you may skip to Step 15.
  • 30. 3-30 Actual NPV Solution UsingActual NPV Solution Using Your Financial CalculatorYour Financial Calculator Steps in the Process Step 1: Press CF key Step 2: Press 2nd CLR Work keys Step 3: For CF0 Press -40000 Enter ↓ keys Step 4: For C01 Press 10000 Enter ↓ keys Step 5: For F01 Press 1 Enter ↓ keys Step 6: For C02 Press 12000 Enter ↓ keys Step 7: For F02 Press 1 Enter ↓ keys Step 8: For C03 Press 15000 Enter ↓ keys Step 9: For F03 Press 1 Enter ↓ keys
  • 31. 3-31 Steps in the Process (Part II) Step 10:For C04 Press 10000 Enter ↓ keys Step 11:For F04 Press 1 Enter ↓ keys Step 12:For C05 Press 7000 Enter ↓ keys Step 13:For F05 Press 1 Enter ↓ keys Step 14: Press ↓ ↓ keys Step 15: Press NPV key Step 16: For I=, Enter 13 Enter ↓ keys Step 17: Press CPT key Result: Net Present Value = -$1,424.42 Actual NPV Solution UsingActual NPV Solution Using Your Financial CalculatorYour Financial Calculator
  • 32. 3-32 NPV StrengthsNPV Strengths and Weaknessesand Weaknesses StrengthsStrengths:: Cash flows assumed to be reinvested at the hurdle rate. Accounts for TVM. Considers all cash flows. WeaknessesWeaknesses:: May not include managerial options embedded in the project. See Chapter 14.
  • 33. 3-33 Net Present Value ProfileNet Present Value Profile Discount Rate (%) 0 3 6 9 12 15 IRR NPV@13% Sum of CF’s Plot NPV for each discount rate.Three of these points are easy now! NetPresentValue $000s 15 10 5 0 -4
  • 34. 3-34 Creating NPV ProfilesCreating NPV Profiles Using the CalculatorUsing the Calculator Hint: As long as you do not “clear” the cash flows from the registry, simply start at Step 15 and enter a different discount rate. Each resulting NPV will provide a “point” for your NPV Profile!
  • 35. 3-35 Profitability Index (PI)Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n + . . . ++ ICOICOPI = PI = 1 + [ NPVNPV / ICOICO ] << OR >> Method #2: Method #1:
  • 36. 3-36 PI Acceptance CriterionPI Acceptance Criterion No! The PIPI is less than 1.00. This means that the project is not profitable. [RejectReject as PIPI < 1.001.00 ] PIPI = $38,572 / $40,000 = .9643 (Method #1, 13-34) Should this project be accepted?
  • 37. 3-37 PI StrengthsPI Strengths and Weaknessesand Weaknesses StrengthsStrengths:: Same as NPV Allows comparison of different scale projects WeaknessesWeaknesses:: Same as NPV Provides only relative profitability Potential Ranking Problems
  • 38. 3-38 Evaluation SummaryEvaluation Summary Method Project Comparison Decision PBP 3.3 3.5 Accept IRR 11.47% 13% Reject NPV -$1,424 $0 Reject PI .96 1.00 Reject Basket Wonders Independent Project
  • 39. 3-39 Other ProjectOther Project RelationshipsRelationships Mutually ExclusiveMutually Exclusive -- A project whose acceptance precludes the acceptance of one or more alternative projects. DependentDependent -- A project whose acceptance depends on the acceptance of one or more other projects.
  • 40. 3-40 Potential ProblemsPotential Problems Under Mutual ExclusivityUnder Mutual Exclusivity A. Scale of InvestmentA. Scale of Investment B. Cash-flow PatternB. Cash-flow Pattern C. Project LifeC. Project Life Ranking of project proposals may create contradictory results.
  • 41. 3-41 A. Scale DifferencesA. Scale Differences Compare a small (S) and a large (L) project. NET CASH FLOWS Project S Project LEND OF YEAR 0 -$100 -$100,000 1 0 0 2 $400 $156,250
  • 42. 3-42 Scale DifferencesScale Differences Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why? Project IRR NPV PI S 100% $ 231 3.31 L 25% $29,132 1.29
  • 43. 3-43 B. Cash Flow PatternB. Cash Flow Pattern Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project. NET CASH FLOWS Project D Project IEND OF YEAR 0 -$1,200 -$1,200 1 1,000 100 2 500 600 3 100 1,080
  • 44. 3-44 D 23% $198 1.17$198 1.17 I 17% $198 1.17$198 1.17 Cash Flow PatternCash Flow Pattern Calculate the IRR, NPV@10%, and PI@10%. Which project is preferred? Project IRR NPV PI
  • 45. 3-45 Examine NPV ProfilesExamine NPV Profiles Discount Rate (%) 0 5 10 15 20 25 -2000200400600 IRR NPV@10% Plot NPV for each project at various discount rates. NetPresentValue($) Project IProject I Project DProject D
  • 46. 3-46 Fisher’s Rate of IntersectionFisher’s Rate of Intersection Discount Rate ($) 0 5 10 15 20 25 -2000200400600 NetPresentValue($) At k<10%, I is best!At k<10%, I is best! Fisher’sFisher’s RateRate ofof IntersectionIntersection At k>10%, D is best!At k>10%, D is best!
  • 47. 3-47 C. Project Life DifferencesC. Project Life Differences Let us compare a long life (X) project and a short life (Y) project. NET CASH FLOWS Project X Project YEND OF YEAR 0 -$1,000 -$1,000 1 0 2,000 2 0 0 3 3,375 0
  • 48. 3-48 X 50% $1,536 2.54 Y 100% $ 818 1.82 Project Life DifferencesProject Life Differences Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why? Project IRR NPV PI
  • 49. 3-49 Another Way toAnother Way to Look at ThingsLook at Things 1. Adjust cash flows to a common terminal year if project “Y” will NOTNOT be replaced. Compound Project Y, Year 1 @10% for 2 years. Year 0 1 2 3 CF -$1,000 $0 $0 $2,420 Results: IRR* = 34.26% NPV = $818 *Lower IRR from adjusted cash-flow stream. X is still Best.
  • 50. 3-50 Replacing ProjectsReplacing Projects with Identical Projectswith Identical Projects 2. Use Replacement Chain Approach (Appendix B) when project “Y” will be replaced. 0 1 2 3 -$1,000 $2,000-$1,000 $2,000 -1,000 $2,000-1,000 $2,000 -1,000 $2,000-1,000 $2,000 -$1,000 $1,000 $1,000 $2,000-$1,000 $1,000 $1,000 $2,000 Results: IRR = 100% NPV*NPV* = $2,238.17$2,238.17 *Higher NPV, but the same IRR. Y is BestY is Best.
  • 51. 3-51 Capital RationingCapital Rationing Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period. Example: Julie Miller must determine what investment opportunities to undertake for Basket Wonders (BW). She is limited to a maximum expenditure of $32,500 only for this capital budgeting period.
  • 52. 3-52 Available Projects for BWAvailable Projects for BW Project ICO IRR NPV PI A $ 500 18% $ 50 1.10 B 5,000 25 6,500 2.30 C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 E 12,500 26 500 1.04 F 15,000 28 21,000 2.40 G 17,500 19 7,500 1.43 H 25,000 15 6,000 1.24
  • 53. 3-53 Choosing by IRRs for BWChoosing by IRRs for BW Project ICO IRR NPV PI C $ 5,000 37% $ 5,500 2.10 F 15,000 28 21,000 2.40 E 12,500 26 500 1.04 B 5,000 25 6,500 2.30 Projects C, F, and E have the three largest IRRs. The resulting increase in shareholder wealth is $27,000 with a $32,500 outlay.
  • 54. 3-54 Choosing by NPVs for BWChoosing by NPVs for BW Project ICO IRR NPV PI F $15,000 28% $21,000 2.40 G 17,500 19 7,500 1.43 B 5,000 25 6,500 2.30 Projects F and G have the two largest NPVs. The resulting increase in shareholder wealth is $28,500 with a $32,500 outlay.
  • 55. 3-55 Choosing by PIs for BWChoosing by PIs for BW Project ICO IRR NPV PI F $15,000 28% $21,000 2.40 B 5,000 25 6,500 2.30 C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 G 17,500 19 7,500 1.43 Projects F, B, C, and D have the four largest PIs. The resulting increase in shareholder wealth is $38,000 with a $32,500 outlay.
  • 56. 3-56 Summary of ComparisonSummary of Comparison Method Projects Accepted Value Added PI F, B, C, and D $38,000 NPV F and G $28,500 IRR C, F, and E $27,000 PIPI generates the greatestgreatest increaseincrease in shareholder wealthshareholder wealth when a limited capital budget exists for a single period.
  • 57. 3-57 Single-Point EstimateSingle-Point Estimate and Sensitivity Analysisand Sensitivity Analysis Allows us to change from “single-point” (i.e., revenue, installation cost, salvage, etc.) estimates to a “what if” analysis Utilize a “base-case” to compare the impact of individual variable changes E.g., Change forecasted sales units to see impact on the project’s NPV Sensitivity AnalysisSensitivity Analysis: A type of “what-if” uncertainty analysis in which variables or assumptions are changed from a base case in order to determine their impact on a project’s measured results (such as NPV or IRR).
  • 58. 3-58 Post-Completion AuditPost-Completion Audit Post-completion Audit A formal comparison of the actual costs and benefits of a project with original estimates. Identify any project weaknesses Develop a possible set of corrective actions Provide appropriate feedback Result: Making better future decisions!
  • 59. 3-59 Multiple IRR Problem*Multiple IRR Problem* Two!!Two!! There are as many potential IRRs as there are sign changes. Let us assume the following cash flow pattern for a project for Years 0 to 4: -$100 +$100 +$900 -$1,000 How manyHow many potentialpotential IRRs could thisIRRs could this project have?project have? * Refer to Appendix A
  • 60. 3-60 NPV Profile -- Multiple IRRsNPV Profile -- Multiple IRRs Discount Rate (%) 0 40 80 120 160 200 NetPresentValue ($000s) Multiple IRRs at kk = 12.95%12.95% and 191.15%191.15% 75 50 25 0 -100
  • 61. 3-61 NPV Profile -- Multiple IRRsNPV Profile -- Multiple IRRs Hint: Your calculator will only find ONE IRR – even if there are multiple IRRs. It will give you the lowest IRR. In this case, 12.95%.

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