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- 1. Capital Budgeting Estimating Cash Flows & Techniques
- 2. Meaning <ul><li>Capital Budgeting is the process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year. </li></ul>
- 3. <ul><li>Specifically, CB involves: </li></ul><ul><li>Generating investment project proposals consistent with the firm’s strategic objectives; </li></ul><ul><li>Estimating after-tax incremental operating cash flows for the investment projects; </li></ul><ul><li>Evaluating project incremental cash flows; </li></ul><ul><li>Selecting projects based on a value-maximizing acceptance criterion; and </li></ul><ul><li>Continually reevaluating implemented investment projects. </li></ul>
- 4. <ul><li>Since CASH is central to all decisions of the firm, the expected benefits to be received from the project is expressed in terms of Cash Flows and not income flows. </li></ul><ul><li>Cash flows should be measured on an incremental, after-tax basis. In addition, the stress is on operating , not financing flows. </li></ul><ul><li>It is helpful to place project CFs into 3 categories based on timing: (1) the initial CF , (2) interim incremental net CFs , and (3) the terminal-year incremental net CF. </li></ul>
- 5. Capital Budgeting: The process of planning for purchases of long-term assets. <ul><li>Example: </li></ul><ul><li>Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? </li></ul><ul><li>Will the machine be profitable ? </li></ul><ul><li>Will our firm earn a high rate of return on the investment? </li></ul>
- 6. Decision-making Criteria in Capital Budgeting <ul><li>How do we decide if a capital investment project should be accepted or rejected? </li></ul>
- 7. <ul><li>The Ideal Evaluation Method should: </li></ul><ul><li>a) include all cash flows that occur during the life of the project, </li></ul><ul><li>b) consider the time value of money , </li></ul><ul><li>c) incorporate the required rate of return on the project. </li></ul>Decision-making Criteria in Capital Budgeting
- 8. Payback Period <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>
- 9. Payback Period <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
- 10. Payback Period <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>Payback period = 3.33 years . 0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
- 11. <ul><li>Is a 3.33 year payback period good? </li></ul><ul><li>Is it acceptable? </li></ul><ul><li>Firms that use this method will compare the payback calculation to some standard (maximum acceptable PB period) set by the firm. </li></ul><ul><li>If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? </li></ul><ul><li>Accept the project . </li></ul>Payback Period (Acceptance Criterion)
- 12. Drawbacks of Payback Period <ul><li>Firm cutoffs are subjective . </li></ul><ul><li>Does not consider time value of money . </li></ul><ul><li>Does not consider any required rate of return . </li></ul><ul><li>Does not consider all of the project’s cash flows . </li></ul>
- 13. Drawbacks of Payback Period <ul><li>Does not consider all of the project’s cash flows. </li></ul><ul><li>Consider this cash flow stream! </li></ul>0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 (300) 0 0
- 14. Drawbacks of Payback Period <ul><li>Does not consider all of the project’s cash flows. </li></ul><ul><li>This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! </li></ul>0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 (300) 0 0
- 15. Other Methods <ul><li>1) Net Present Value (NPV) </li></ul><ul><li>2) Profitability Index (PI) </li></ul><ul><li>3) Internal Rate of Return (IRR) </li></ul><ul><li>Each of these decision-making criteria: </li></ul><ul><li>Examines all net cash flows, </li></ul><ul><li>Considers the time value of money, and </li></ul><ul><li>Considers the required rate of return. </li></ul>
- 16. Net Present Value <ul><li>NPV = the total PV of the annual net cash flows - the initial outlay (or cash outflows). </li></ul>NPV = - ICO CF t (1 + k) t n t=1
- 17. Net Present Value <ul><li>Decision Rule: </li></ul><ul><li>If NPV is positive, accept . </li></ul><ul><li>If NPV is negative, reject . </li></ul>
- 18. <ul><li>Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15% . </li></ul>NPV Example
- 19. <ul><li>Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15% . </li></ul>NPV Example 0 1 2 3 4 5 (250,000) 100,000 100,000 100,000 100,000 100,000
- 20. Net Present Value (NPV) <ul><li>NPV is just the PV of the annual cash flows minus the initial outflow. </li></ul><ul><li>PV of cash flows = $335,216 </li></ul><ul><li>- Initial outflow: ($250,000) </li></ul><ul><li>= Net PV $85,216 </li></ul>
- 21. Profitability Index
- 22. Profitability Index NPV = - ICO CF t (1 + k) t n t=1
- 23. Profitability Index PI = ICO CF t (1 + k) n t=1 t NPV = - ICO CF t (1 + k) t n t=1
- 24. <ul><li>Decision Rule : </li></ul><ul><li>If PI is greater than or equal to 1, accept . </li></ul><ul><li>If PI is less than 1, reject . </li></ul>Profitability Index
- 25. PI Example <ul><li>We know that from the previous example PV of cash flows is $335,216 and the Initial cash outflow is $250,000. </li></ul><ul><li>Therefore, PI = 335,216 / 250,000 = 1.34 </li></ul><ul><li>You should accept as PI = 1.34 , which is more than 1. </li></ul>
- 26. Internal Rate of Return (IRR) <ul><li>IRR: The return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects. </li></ul>
- 27. Internal Rate of Return (IRR)
- 28. Internal Rate of Return (IRR) NPV = - ICO CF t (1 + k) t n t=1
- 29. Internal Rate of Return (IRR) NPV = - ICO CF t (1 + k) t n t=1 n t=1 IRR: = ICO CF t (1 + IRR) t
- 30. Internal Rate of Return (IRR) <ul><li>IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay . </li></ul><ul><li>This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond. </li></ul>n t=1 IRR: = ICO CF t (1 + IRR) t
- 31. Calculating IRR <ul><li>Looking again at our problem: </li></ul><ul><li>The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay. </li></ul>0 1 2 3 4 5 (250,000) 100,000 100,000 100,000 100,000 100,000
- 32. IRR Decision Rule <ul><li>If IRR is greater than or equal to the required rate of return, accept . </li></ul><ul><li>The acceptance criterion related to the IRR method is to compare it to the required r.o.r., known as the cutoff or hurdle rate . Hurdle rate is the rate at which a project is acceptable. </li></ul><ul><li>If IRR is less than the required rate of return, reject . </li></ul>
- 33. <ul><li>IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +) </li></ul><ul><li>Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) </li></ul>
- 34. <ul><li>IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +) </li></ul><ul><li>Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) </li></ul>0 1 2 3 4 5 (500) 200 100 (200) 400 300
- 35. <ul><li>IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +) </li></ul><ul><li>Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) </li></ul>1 0 1 2 3 4 5 (500) 200 100 (200) 400 300
- 36. <ul><li>IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +) </li></ul><ul><li>Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) </li></ul>0 1 2 3 4 5 (500) 200 100 (200) 400 300 1 2
- 37. <ul><li>IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +) </li></ul><ul><li>Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) </li></ul>0 1 2 3 4 5 (500) 200 100 (200) 400 300 1 2 3
- 38. Summary Problem <ul><li>Enter the cash flows only once. </li></ul><ul><li>Find the IRR . </li></ul><ul><li>Using a discount rate of 15%, find NPV . </li></ul><ul><li>Add back IO and divide by IO to get PI . </li></ul>0 1 2 3 4 5 (900) 300 400 400 500 600
- 39. Summary Problem <ul><li>IRR = 34.37%. </li></ul><ul><li>Using a discount rate of 15%, </li></ul><ul><li>NPV = $510.52. </li></ul><ul><li>PI = 1.57 . </li></ul>0 1 2 3 4 5 (900) 300 400 400 500 600
- 40. Capital Rationing <ul><li>A final potential difficulty related to implementing the alternative methods of project evaluation and selection. </li></ul><ul><li>Refers to a situation where a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period. </li></ul><ul><li>Constraints come when there is a policy of financing all capital expenditures. </li></ul>
- 41. <ul><li>CR also occurs when a division of a large company is allowed to make capital expenditure only upto a specified budget ceiling, over which the division usually has no control. </li></ul><ul><li>With such a constraint, the firm attempts to select the combination of investment proposals that will provide the greatest increase in the value of the firm subject to not exceeding the budget ceiling constraint. </li></ul>

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