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Capital budgeting
 

Capital budgeting

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    Capital budgeting Capital budgeting Presentation Transcript

    • Capital Budgeting
    • JOIN KHALID AZIZ
      • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
      • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
      • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
      • CONTACT:
      • 0322-3385752
      • 0312-2302870
      • 0300-2540827
      • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
      • The capital budgeting process involves three basic steps:
      The Capital Budgeting Decision Process
        • Generating long-term investment proposals;
        • Reviewing, analyzing, and selecting from the proposals that have been granted, and
        • Implementing and monitoring the proposals that have been selected.
        • Managers should separate investment and financing decisions.
    • Capital Budgeting Decision Techniques
        • Payback period : most commonly used
      Accounting rate of return (ARR): focuses on project’s impact on accounting profits Net present value (NPV): best technique theoretically; difficult to calculate realistically Internal rate of return (IRR): widely used with strong intuitive appeal Profitability index (PI): related to NPV
    • A Capital Budgeting Process Should: Account for the time value of money; Account for risk; Focus on cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders’ wealth.
    • Example: Global Wireless
      • Global Wireless is a worldwide provider of wireless telephony devices.
      • Global Wireless is contemplating a major expansion of its wireless network in two different regions:
        • Western Europe expansion
        • A smaller investment in Southeast U.S. to establish a toehold
    • Global Wireless $175 Year 5 inflow $160 Year 4 inflow $130 Year 3 inflow $80 Year 2 inflow $35 Year 1 inflow -$250 Initial Outlay $32 Year 5 inflow $30 Year 4 inflow $25 Year 3 inflow $22 Year 2 inflow $18 Year 1 inflow -$50 Initial Outlay
    • Accounting Rate Of Return (ARR) Can be computed from available accounting data ARR uses accounting numbers, not cash flows; no time value of money.
      • Need only profits after taxes and depreciation.
      • Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.
      Average profits after taxes Average annual operating cash inflows Average annual depreciation = –
      • The payback period is the amount of time required for the firm to recover its initial investment.
      Payback Period
        • If the project’s payback period is less than the maximum acceptable payback period, accept the project.
        • If the project’s payback period is greater than the maximum acceptable payback period, reject the project.
      Management determines maximum acceptable payback period.
      • Management’s cutoff is 2.75 years.
      • Western Europe project: initial outflow of -$250M
        • But cash inflows over first 3 years is only $245 million.
        • Global Wireless will reject the project (3>2.75).
      • Southeast U.S. project: initial outflow of -$50M
        • Cash inflows over first 2 years cumulate to $40 million.
        • Project recovers initial outflow after 2.40 years.
          • Total inflow in year 3 is $25 million. So, the project generates $10 million in year 3 in 0.40 years ($10 million  $25 million).
        • Global Wireless will accept the project (2.4<2.75).
      Payback Analysis For Global Wireless
    • Pros and Cons of the Payback Method
      • Advantages of payback method:
        • Computational simplicity
        • Easy to understand
        • Focus on cash flow
      Disadvantages of payback method:
      • Does not account properly for time value of money
        • Does not account properly for risk
        • Cutoff period is arbitrary
        • Does not lead to value-maximizing decisions
      • Discounted payback accounts for time value.
        • Apply discount rate to cash flows during payback period.
        • Still ignores cash flows after payback period.
      • Global Wireless uses an 18% discount rate.
      Discounted Payback Reject (46.3<50) Reject (166.2 < 250)
    • Net Present Value (NPV) NPV: The sum of the present values of a project’s cash inflows and outflows. Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk. Accept projects if NPV > 0.
      • A key input in NPV analysis is the discount rate.
      Net Present Value (NPV)
        • r represents the minimum return that the project must earn to satisfy investors.
        • r varies with the risk of the firm and /or the risk of the project.
      • Assuming Global Wireless uses 18% discount rate, NPVs are:
      NPV Analysis for Global Wireless Should Global Wireless invest in one project or both? Western Europe project: NPV = $75.3 million Southeast U.S. project: NPV = $25.7 million
    • The NPV Rule and Shareholder Wealth
    • Pros and Cons of NPV NPV is the “gold standard” of investment decision rules.
      • Key benefits of using NPV as decision rule:
        • Focuses on cash flows, not accounting earnings
        • Makes appropriate adjustment for time value of money
        • Can properly account for risk differences between projects
      Though best measure, NPV has some drawbacks:
        • Lacks the intuitive appeal of payback, and
        • Doesn’t capture managerial flexibility (option value) well.
    • Internal Rate of Return (IRR) IRR: the discount rate that results in a zero NPV for a project. The IRR decision rule for an investing project is :
      • If IRR is greater than the cost of capital, accept the project .
      • If IRR is less than the cost of capital, reject the project .
    • NPV Profile and Shareholder Wealth
    • IRR Analysis for Global Wireless Global Wireless will accept all projects with at least 18% IRR. Western Europe project: IRR ( r WE ) = 27.8% Southeast U.S. project: IRR (r SE ) = 36.7%
    • JOIN KHALID AZIZ
      • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
      • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
      • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
      • CONTACT:
      • 0322-3385752
      • 0312-2302870
      • 0300-2540827
      • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
    • Pros and Cons of IRR
      • Advantages of IRR:
        • Properly adjusts for time value of money
        • Uses cash flows rather than earnings
        • Accounts for all cash flows
        • Project IRR is a number with intuitive appeal
      Disadvantages of IRR:
        • “ Mathematical problems”: multiple IRRs, no real solutions
        • Scale problem
        • Timing problem
    • Multiple IRRs Which IRR do we use? When project cash flows have multiple sign changes, there can be multiple IRRs. IRR IRR
    • No Real Solution Sometimes projects do not have a real IRR solution . Modify Global Wireless’ s Western Europe project to include a large negative outflow ( -$ 355 million ) in year 6 .
      • There is no real number that will make NPV=0, so no real IRR .
      Project is a bad idea based on NPV. At r =1 8 %, project has negative NPV, so reject!
    • Conflicts Between NPV and IRR: The Scale Problem NPV and IRR do not always agree when ranking competing projects.
      • The Southeast U.S. project has a higher IRR, but doesn’t increase shareholders’ wealth as much as the Western Europe project.
      The scale problem: $25.7 mn 36.7% Southeast U.S. $75.3 mn 27.8% Western Europe NPV (18%) IRR Project
    • Conflicts Between NPV and IRR: The Scale Problem
      • Why the conflict?
      • The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project.
      • Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive.
    • Conflicts Between NPV and IRR: The Timing Problem
      • The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.
    • Conflicts Between NPV and IRR: The Timing Problem
      • Because of the differences in the timing of the two projects’ cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign.
    • Profitability Index Decision rule: Accept project with PI > 1.0, equal to NPV > 0
      • Both PI > 1.0, so both acceptable if independent.
      Calculated by dividing the PV of a project’s cash inflows by the PV of its initial cash outflows. Like IRR, PI suffers from the scale problem. 1.5 $50 million $75.7 million Southeast U.S. 1.3 $250 million $325.3 million Western Europe PI Initial Outlay PV of CF (yrs1-5) Project
      • Methods to generate, review, analyze, select, and implement long-term investment proposals:
      • Accounting rate of return
      • Payback Period
      • Discounted payback period
      • Net Present Value (NPV)
      • Internal rate of return (IRR)
      • Profitability index (PI)
      Capital Budgeting
    • JOIN KHALID AZIZ
      • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
      • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
      • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
      • CONTACT:
      • 0322-3385752
      • 0312-2302870
      • 0300-2540827
      • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.