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Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
Capital budgeting i
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Capital budgeting i

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  • 1. 0 Outline 1 Why Use Net Present Value? 2 The Payback Period Rule 3 The Discounted Payback Period Rule 4 The Average Accounting Return 5 The Internal Rate of Return 6 Problems with the IRR Approach 7 The Profitability Index 8 The Practice of Capital Budgeting 9 Summary and Conclusions
  • 2. 1 Why Use Net Present Value?  Accepting positive NPV projects benefits shareholders.  NPV uses cash flows  NPV uses all the cash flows of the project  NPV discounts the cash flows properly
  • 3. 2 The Net Present Value (NPV) Rule  Net Present Value (NPV) = Total PV of future CF’s - Initial Investment  Estimating NPV:  1. Estimate future cash flows: how much? and when?  2. Estimate discount rate  3. Estimate initial costs  Minimum Acceptance Criteria: Accept if NPV > 0  Ranking Criteria: Choose the highest NPV
  • 4. 3 Good Attributes of the NPV Rule  1. Uses cash flows  2. Uses ALL cash flows of the project  3. Discounts ALL cash flows properly  Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.
  • 5. 4 The Payback Period Rule  How long does it take the project to “pay back” its initial investment?  Payback Period = number of years to recover initial costs  Minimum Acceptance Criteria: set by management  Ranking Criteria: set by management
  • 6. 5 The Payback Period Rule (continued)  Disadvantages: Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria A project accepted based on the payback criteria may not have a positive NPV  Advantages: Easy to understand Biased toward liquidity
  • 7. 6 The Discounted Payback Period Rule  How long does it take the project to “pay back” its initial investment taking the time value of money into account?  By the time you have discounted the cash flows, you might as well calculate the NPV.
  • 8. 7 The Average Accounting Return Rule  Another attractive but fatally flawed approach.  Ranking Criteria and Minimum Acceptance Criteria set by management  Disadvantages:  Ignores the time value of money  Uses an arbitrary benchmark cutoff rate  Based on book values, not cash flows and market values  Advantages:  The accounting information is usually available  Easy to calculate InvestentofValueBookAverage IncomeNetAverage AAR
  • 9. 8 The Internal Rate of Return (IRR) Rule  IRR: the discount that sets NPV to zero  Minimum Acceptance Criteria:  Accept if the IRR exceeds the required return.  Ranking Criteria:  Select alternative with the highest IRR  Reinvestment assumption:  All future cash flows assumed reinvested at the IRR.  Disadvantages:  Does not distinguish between investing and borrowing.  IRR may not exist or there may be multiple IRR  Problems with mutually exclusive investments  Advantages:  Easy to understand and communicate
  • 10. 9 The Internal Rate of Return: Example Consider the following project: 0 1 2 3 $50 $100 $150 -$200 The internal rate of return for this project is 19.44% 32 )1( 150$ )1( 100$ )1( 50$ 200 IRRIRRIRR
  • 11. 10 The NPV Payoff Profile for This Example Discount Rate NPV 0% $100.00 4% $71.04 8% $47.32 12% $27.79 16% $11.65 20% ($1.74) 24% ($12.88) 28% ($22.17) 32% ($29.93) 36% ($36.43) 40% ($41.86) If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept. IRR = 19.44% ($60.00) ($40.00) ($20.00) $0.00 $20.00 $40.00 $60.00 $80.00 $100.00 $120.00 -1% 9% 19% 29% 39% Discount rate NPV
  • 12. 11 Problems with the IRR Approach  Multiple IRRs.  Are We Borrowing or Lending?  The Scale Problem  The Timing Problem
  • 13. 12 Multiple IRRs There are two IRRs for this project: 0 1 2 3 $200 $800 -$200 - $800 ($150.00) ($100.00) ($50.00) $0.00 $50.00 $100.00 -50% 0% 50% 100% 150% 200% Discount rate NPV 100% = IRR2 0% = IRR1 Which one should we use?
  • 14. 13 Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR? Yes, MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at a discount rate. Thus, MIRR assumes cash inflows are reinvested at a discount rate.
  • 15. 14 MIRR = 16.5% 10.0 80.060.0 0 1 2 3 10% 66.0 12.1 158.1 MIRR for Project L (k = 10%) -100.0 10% 10% TV inflows-100.0 PV outflows MIRRL = 16.5% $100 = $158.1 (1+MIRRL)3
  • 16. 15 The Scale Problem  Would you rather make 100% or 50% on your investments?  What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment?
  • 17. 16 The Timing Problem 0 1 2 3 $10,000 $1,000 $1,000 -$10,000 Project A 0 1 2 3 $1,000 $1,000 $12,000 -$10,000 Project B The preferred project in this case depends on the discount rate, not the IRR.
  • 18. 17 The Timing Problem ($4,000.00) ($3,000.00) ($2,000.00) ($1,000.00) $0.00 $1,000.00 $2,000.00 $3,000.00 $4,000.00 $5,000.00 0% 10% 20% 30% 40% Discount rate NPV Project A Project B 10.55% = crossover rate 16.04% = IRRA12.94% = IRRB
  • 19. 18 Calculating the Crossover Rate Compute the IRR for either project “A-B” or “B-A” Year Project A Project B Project A-B Project B-A 0 ($10,000) ($10,000) $0 $0 1 $10,000 $1,000 $9,000 ($9,000) 2 $1,000 $1,000 $0 $0 3 $1,000 $12,000 ($11,000) $11,000 ($3,000.00) ($2,000.00) ($1,000.00) $0.00 $1,000.00 $2,000.00 $3,000.00 0% 5% 10% 15% 20% Discount rate NPV A-B B-A 10.55% = IRR
  • 20. 19 Mutually Exclusive vs. Independent Project  Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system.  RANK all alternatives and select the best one.  Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.  Must exceed a MINIMUM acceptance criteria.
  • 21. 20 The Profitability Index (PI) Rule  Minimum Acceptance Criteria:  Accept if PI > 1  Ranking Criteria:  Select alternative with highest PI  Disadvantages:  Problems with mutually exclusive investments  Advantages:  May be useful when available investment funds are limited  Easy to understand and communicate  Correct decision when evaluating independent projects InvestentInitial FlowsCashFutureofPVTotal PI
  • 22. 21 The Practice of Capital Budgeting  Varies by industry: Some firms use payback, others use accounting rate of return.  The most frequently used technique for large corporations is IRR or NPV.
  • 23. 22 Example of Investment Rules Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%. Year Project A Project B 0 -$200 -$150 1 $200 $50 2 $800 $100 3 -$800 $150
  • 24. 23 Example of Investment Rules Project A Project B CF0 -$200.00 -$150.00 PV0 of CF1-3 $241.92 $240.80 NPV = $41.92 $90.80 IRR = 0%, 100% 36.19% PI = 1.2096 1.6053
  • 25. 24 Example of Investment Rules Payback Period: Project A Project B Time CF Cum. CF CF Cum. CF 0 -200 -200 -150 - 150 1 200 0 50 -100 2 800 800 100 0 3 -800 0 150 150 Payback period for project B = 2 years. Payback period for project A = 1 or 3 years?
  • 26. 25 Relationship Between NPV and IRR Discount rate NPV for A NPV for B -10% -87.52 234.77 0% 0.00 150.00 20% 59.26 47.92 40% 59.48 -8.60 60% 42.19 -43.07 80% 20.85 -65.64 100% 0.00 -81.25 120% -18.93-92.52
  • 27. 26 Project A Project B ($200) ($100) $0 $100 $200 $300 $400 -15% 0% 15% 30% 45% 70% 100% 130% 160% 190% Discount rates NPV IRR 1(A) IRR (B) NPV Profiles Cross-over Rate IRR 2(A)
  • 28. 27 Summary and Conclusions  This lecture evaluates the most popular alternatives to NPV: Payback period Accounting rate of return Internal rate of return Profitability index  When it is all said and done, they are not the NPV rule; for those of us in finance, it makes them decidedly second-rate.

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