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Capital Budgeting is the process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.
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.
Cash flows should be measured on an incremental, after-tax basis. In addition, the stress is on operating , not financing flows.
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.
5.
Capital Budgeting: The process of planning for purchases of long-term assets.
Example:
Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide?
Will the machine be profitable ?
Will our firm earn a high rate of return on the investment?
6.
Decision-making Criteria in Capital Budgeting
How do we decide if a capital investment project should be accepted or rejected?
7.
The Ideal Evaluation Method should:
a) include all cash flows that occur during the life of the project,
b) consider the time value of money ,
c) incorporate the required rate of return on the project.
Decision-making Criteria in Capital Budgeting
8.
Payback Period
How long will it take for the project to generate enough cash to pay for itself?
9.
Payback Period
How long will it take for the project to generate enough cash to pay for itself?
NPV = the total PV of the annual net cash flows - the initial outlay (or cash outflows).
NPV = - ICO CF t (1 + k) t n t=1
17.
Net Present Value
Decision Rule:
If NPV is positive, accept .
If NPV is negative, reject .
18.
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% .
NPV Example
19.
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% .
If IRR is greater than or equal to the required rate of return, accept .
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.
If IRR is less than the required rate of return, reject .
33.
IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
34.
IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
0 1 2 3 4 5 (500) 200 100 (200) 400 300
35.
IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
1 0 1 2 3 4 5 (500) 200 100 (200) 400 300
36.
IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
0 1 2 3 4 5 (500) 200 100 (200) 400 300 1 2
37.
IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
0 1 2 3 4 5 (500) 200 100 (200) 400 300 1 2 3
38.
Summary Problem
Enter the cash flows only once.
Find the IRR .
Using a discount rate of 15%, find NPV .
Add back IO and divide by IO to get PI .
0 1 2 3 4 5 (900) 300 400 400 500 600
39.
Summary Problem
IRR = 34.37%.
Using a discount rate of 15%,
NPV = $510.52.
PI = 1.57 .
0 1 2 3 4 5 (900) 300 400 400 500 600
40.
Capital Rationing
A final potential difficulty related to implementing the alternative methods of project evaluation and selection.
Refers to a situation where a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.
Constraints come when there is a policy of financing all capital expenditures.
41.
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.
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.