Capital budgeting -2

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Capital budgeting

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Capital budgeting -2

  1. 1.  1999, Prentice Hall, Inc. Ch. 9: Capital Budgeting Decision Criteria
  2. 2. <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>Capital Budgeting : the process of planning for purchases of long-term assets.
  3. 3. <ul><li>How do we decide if a capital investment project should be accepted or rejected? </li></ul>Decision-making Criteria in Capital Budgeting
  4. 4. <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
  5. 5. <ul><li>The number of years needed to recover the initial cash outlay. </li></ul><ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>Payback Period
  6. 6. <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>(500) 150 150 150 150 150 150 150 150 Payback Period 0 1 2 3 4 5 8 6 7
  7. 7. <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. Payback Period 0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
  8. 8. <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 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>
  9. 9. <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>Drawbacks of Payback Period:
  10. 10. <ul><li>Does not consider all of the project’s cash flows. </li></ul>(500) 150 150 150 150 150 (300) 0 0 Consider this cash flow stream! Drawbacks of Payback Period: 0 1 2 3 4 5 8 6 7
  11. 11. <ul><li>Does not consider all of the project’s cash flows. </li></ul>(500) 150 150 150 150 150 (300) 0 0 This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! Drawbacks of Payback Period: 0 1 2 3 4 5 8 6 7
  12. 12. <ul><li>Discounts the cash flows at the firm’s required rate of return. </li></ul><ul><li>Payback period is calculated using these discounted net cash flows. </li></ul><ul><li>Problems : </li></ul><ul><li>Cutoffs are still subjective. </li></ul><ul><li>Still does not examine all cash flows. </li></ul>Discounted Payback
  13. 13. <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 </li></ul>Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
  14. 14. <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 1 year </li></ul><ul><li> 280.70 </li></ul>Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
  15. 15. <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 1 year </li></ul><ul><li> 280.70 </li></ul><ul><li>2 250 192.38 </li></ul>Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
  16. 16. <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 1 year </li></ul><ul><li> 280.70 </li></ul><ul><li>2 250 192.38 2 years </li></ul><ul><li> 88.32 </li></ul>Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
  17. 17. <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 1 year </li></ul><ul><li> 280.70 </li></ul><ul><li>2 250 192.38 2 years </li></ul><ul><li> 88.32 </li></ul><ul><li>3 250 168.75 </li></ul>Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
  18. 18. <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 1 year </li></ul><ul><li> 280.70 </li></ul><ul><li>2 250 192.38 2 years </li></ul><ul><li> 88.32 </li></ul><ul><li>3 250 168.75 .52 years </li></ul>Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
  19. 19. <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 1 year </li></ul><ul><li> 280.70 </li></ul><ul><li>2 250 192.38 2 years </li></ul><ul><li> 88.32 </li></ul><ul><li>3 250 168.75 .52 years </li></ul>Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250 The Discounted Payback is 2.52 years
  20. 20. <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>Other Methods
  21. 21. <ul><li>NPV = the total PV of the annual net cash flows - the initial outlay. </li></ul>Net Present Value NPV = - IO ACF t (1 + k) t n t=1 
  22. 22. 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>
  23. 23. <ul><li>Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%. </li></ul>NPV Example
  24. 24. <ul><li>Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%. </li></ul>NPV Example 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000
  25. 25. <ul><li>-276,400 CFj </li></ul><ul><li>83,000 CFj </li></ul><ul><li>4 shift Nj </li></ul><ul><li>116,000 CFj </li></ul><ul><li>15 I/YR </li></ul><ul><li>shift NPV </li></ul><ul><li>You should get NPV = 18,235.71 . </li></ul>NPV with the HP10B:
  26. 26. <ul><li>Select CFLO mode. </li></ul><ul><li>FLOW(0)=? -276,400 INPUT </li></ul><ul><li>FLOW(1)=? 83,000 INPUT </li></ul><ul><li>#TIMES(1)=1 4 INPUT </li></ul><ul><li>FLOW(2)=? 116,000 INPUT </li></ul><ul><li>#TIMES(2)=1 INPUT EXIT </li></ul><ul><li>CALC 15 I% NPV </li></ul><ul><li>You should get NPV = 18,235.71 </li></ul>NPV with the HP17BII:
  27. 27. <ul><li>Select CF mode. </li></ul>NPV with the TI BAII Plus:
  28. 28. <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -276,400 ENTER </li></ul>NPV with the TI BAII Plus:
  29. 29. <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -276,400 ENTER </li></ul><ul><li>C01=? 83,000 ENTER </li></ul>NPV with the TI BAII Plus:
  30. 30. <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -276,400 ENTER </li></ul><ul><li>C01=? 83,000 ENTER </li></ul><ul><li>F01= 1 4 ENTER </li></ul>NPV with the TI BAII Plus:
  31. 31. <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -276,400 ENTER </li></ul><ul><li>C01=? 83,000 ENTER </li></ul><ul><li>F01= 1 4 ENTER </li></ul><ul><li>C02=? 116,000 ENTER </li></ul>NPV with the TI BAII Plus:
  32. 32. <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -276,400 ENTER </li></ul><ul><li>C01=? 83,000 ENTER </li></ul><ul><li>F01= 1 4 ENTER </li></ul><ul><li>C02=? 116,000 ENTER </li></ul><ul><li>F02= 1 ENTER </li></ul>NPV with the TI BAII Plus:
  33. 33. <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -276,400 ENTER </li></ul><ul><li>C01=? 83,000 ENTER </li></ul><ul><li>F01= 1 4 ENTER </li></ul><ul><li>C02=? 116,000 ENTER </li></ul><ul><li>F02= 1 ENTER </li></ul><ul><li>NPV I= 15 ENTER CPT </li></ul>NPV with the TI BAII Plus:
  34. 34. <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -276,400 ENTER </li></ul><ul><li>C01=? 83,000 ENTER </li></ul><ul><li>F01= 1 4 ENTER </li></ul><ul><li>C02=? 116,000 ENTER </li></ul><ul><li>F02= 1 ENTER </li></ul><ul><li>NPV I= 15 ENTER CPT </li></ul><ul><li>You should get NPV = 18,235.71 </li></ul>NPV with the TI BAII Plus:
  35. 35. Profitability Index NPV = - IO ACF t (1 + k) t n t=1 
  36. 36. t Profitability Index NPV = - IO ACF t (1 + k) t n t=1  PI = IO ACF t (1 + k) n t=1 
  37. 37. Profitability Index <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>
  38. 38. <ul><li>-276,400 CFj </li></ul><ul><li>83,000 CFj </li></ul><ul><li>4 shift Nj </li></ul><ul><li>116,000 CFj </li></ul><ul><li>15 I/YR </li></ul><ul><li>shift NPV </li></ul><ul><li>You should get NPV = 18,235.71 . </li></ul><ul><li>Add back IO: + 276,400 </li></ul><ul><li>Divide by IO: / 276,400 = </li></ul><ul><li>You should get PI = 1.066 </li></ul>PI with the HP10B:
  39. 39. <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>Internal Rate of Return (IRR)
  40. 40. Internal Rate of Return (IRR) NPV = - IO ACF t (1 + k) t n t=1 
  41. 41. n t=1  Internal Rate of Return (IRR) IRR: = IO ACF t (1 + IRR) t NPV = - IO ACF t (1 + k) t n t=1 
  42. 42. <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>Internal Rate of Return (IRR) n t=1  IRR: = IO ACF t (1 + IRR) t
  43. 43. <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>Calculating IRR 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000
  44. 44. <ul><li>This is what we are actually doing: </li></ul><ul><li>83,000 (PVIFA 4, IRR ) + 116,000 (PVIF 5, IRR ) </li></ul><ul><li>= 276,400 </li></ul>0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000
  45. 45. <ul><li>This is what we are actually doing: </li></ul><ul><li>83,000 (PVIFA 4, IRR ) + 116,000 (PVIF 5, IRR ) </li></ul><ul><li>= 276,400 </li></ul><ul><li>This way, we have to solve for IRR by trial and error. </li></ul>0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000
  46. 46. <ul><li>IRR is easy to find with your financial calculator. </li></ul><ul><li>Just enter the cash flows as you did with the NPV problem and solve for IRR. </li></ul><ul><li>You should get IRR = 17.63%! </li></ul>IRR with your Calculator
  47. 47. IRR <ul><li>Decision Rule : </li></ul><ul><li>If IRR is greater than or equal to the required rate of return, ACCEPT . </li></ul><ul><li>If IRR is less than the required rate of return, REJECT . </li></ul>
  48. 48. <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>
  49. 49. <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>(500) 200 100 (200) 400 300 0 1 2 3 4 5
  50. 50. <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>(500) 200 100 (200) 400 300 0 1 2 3 4 5
  51. 51. <ul><li>Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) </li></ul><ul><li>We could find 3 different IRRs! </li></ul>(500) 200 100 (200) 400 300 0 1 2 3 4 5 1 2 3
  52. 52. <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>Summary Problem: 0 1 2 3 4 5 (900) 300 400 400 500 600
  53. 53. <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>Summary Problem: 0 1 2 3 4 5 (900) 300 400 400 500 600

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