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- 1. Chapter 10 Capital- BudgetingTechniquesand Practice Copyright © 2011 Pearson Prentice Hall. All rights reserved.
- 2. Learning Objectives 1. Discuss the difficulty of finding profitable projects in competitive markets and the importance of the search. 2. Determine whether a new project should be accepted or rejected using the payback period, net present value, the profitability index, and the internal rate of return. 3. Explain how the capital-budgeting decision process changes when a dollar limit is placed on the capital budget. © 2011 Pearson Prentice Hall. All rightsreserved. 10-2
- 3. Learning Objectives 4. Discuss the problems encountered in project ranking. 5. Explain the importance of ethical considerations in capital-budgeting decisions. 6. Discuss the trends in the use of different capital- budgeting criteria. 7. Explain how foreign markets provide opportunities for finding new capital budgeting projects. © 2011 Pearson Prentice Hall. All rightsreserved. 10-3
- 4. Slide Contents Capital Budgeting Capital Budgeting Decision Criteria Capital Rationing Ranking Problems Ethics in Capital Budgeting Capital Budgeting Practices Finance and the Multinational Firm: Capital Budgeting © 2011 Pearson Prentice Hall. All rightsreserved. 10-4
- 5. 1. Capital Budgeting Meaning: The process of decision making with respect to investments in fixed assets—that is, should a proposed project be accepted or rejected. It is easier to “evaluate” profitable projects than to “find them” © 2011 Pearson Prentice Hall. All rightsreserved. 10-5
- 6. Source of Ideas for projects Within the Firm: Typically, a firm has a research & development (R&D) department that searches for ways of improving existing products or finding new projects. Other sources: Other employees, Competition, Suppliers, Customers. © 2011 Pearson Prentice Hall. All rightsreserved. 10-6
- 7. 2. Capital Budgeting Decision Criteria The Payback Period Net Present Value Profitability Index Internal Rate of Return © 2011 Pearson Prentice Hall. All rightsreserved. 10-7
- 8. 2.1 The Payback Period Meaning: Number of years needed to recover the initial cash outlay of a capital budgeting project. Decision Rule: Project feasible or desirable if the payback period is less than or equal to the firm’s maximum desired payback period. In general, shorter payback period is preferred while comparing two projects. © 2011 Pearson Prentice Hall. All rightsreserved. 10-8
- 9. Payback Period Example Example: Project with an initial cash outlay of $20,000 with following free cash flows for 5 years. YEAR CASH FLOW BALANCE 1 $ 8,000 ($ 12,000) 2 4,000 ( 8,000) 3 3,000 ( 5,000) 4 5,000 0 5 10,000 12,000 © 2011 Pearson years. Hall. All rights Payback is 4 Prenticereserved. 10-9
- 10. Trade-offs Benefits: Uses cash flows rather than accounting profits Easy to compute and understand Useful for firms that have capital constraints Drawbacks: Ignores the time value of money and Does not consider cash flows beyond the payback period. © 2011 Pearson Prentice Hall. All rights 10-reserved. 10
- 11. Discounted Payback Period The discounted payback period is similar to the traditional payback period except that it uses discounted free cash flows rather than actual undiscounted cash flows. The discounted payback period is defined as the number of years needed to recover the initial cash outlay from the discounted free cash flows. © 2011 Pearson Prentice Hall. All rights 10-reserved. 11
- 12. Table 10-2 © 2011 Pearson Prentice Hall. All rights 10-reserved. 12
- 13. Payback Period Example Table 10-2 shows the difference between traditional payback and discounted payback methods. With undiscounted free cash flows, the payback period is only 2 years while with discounted free cash flows (at 17%), the discounted payback period is 3.07 years. © 2011 Pearson Prentice Hall. All rights 10-reserved. 13
- 14. 2.2 Net Present Value (NPV) Meaning: NPV is equal to the present value of all future free cash flows less the investment’s initial outlay. It measures the net value of a project in today’s dollars. © 2011 Pearson Prentice Hall. All rights 10-reserved. 14
- 15. NPV Example Example: Project with an initial cash outlay of $60,000 with following free cash flows for 5 years. Year FCF Year FCF Initial outlay –60,000 3 13,000 1 –25,000 4 12,000 2 –24,000 5 11,000 The firm has a 15% required rate of return. © 2011 Pearson Prentice Hall. All rights 10-reserved. 15
- 16. NPV Example PV of FCF = $60,764 Subtracting the initial cash outlay of $60,000 leaves an NPV of $764. Since NPV > 0, project is feasible. © 2011 Pearson Prentice Hall. All rights 10-reserved. 16
- 17. NPV in Excel® Input cash flows for initial outlay and free cash inflows in cells A1 to A6. In cell A7 type the following formula: =A1+npv(.15,a2:a6) Excel will give the NPV = $764 © 2011 Pearson Prentice Hall. All rights 10-reserved. 17
- 18. NPV Trade-offs Benefits Considers cash flows, not profits Considers all cash flows Recognizes time value of money Drawbacks Requires detailed long-term forecast of cash flows NPV is considered to be the most theoretically correct criterion for evaluating capital budgeting projects.© 2011 Pearson Prentice Hall. All rights 10-reserved. 18
- 19. 2.3 Profitability Index (PI) (Benefit-Cost ratio) Meaning: PI is the ratio of the present value of the future free cash flows (FCF) to the initial outlay. It yields the same accept/reject decision as NPV. PI = PV of FCF/Initial outlay © 2011 Pearson Prentice Hall. All rights 10-reserved. 19
- 20. Profitability Index Decision Rule: PI ≥ 1 = accept; PI < 1 = reject © 2011 Pearson Prentice Hall. All rights 10-reserved. 20
- 21. PI Example A firm with a 10% required rate of return is considering investing in a new machine with an expected life of six years. The initial cash outlay is $50,000. © 2011 Pearson Prentice Hall. All rights 10-reserved. 21
- 22. PI Example FCF PVF @ 10% PV Initial Outlay –$50,000 1.000 –$50,000 Year 1 15,000 0.909 13,636 Year 2 8,000 0.826 6,612 Year 3 10,000 0.751 7,513 Year 4 12,000 0.683 8,196 Year 5 14,000 0.621 8,693 Year 6 16,000 0.564 9,032 © 2011 Pearson Prentice Hall. All rights 10-reserved. 22
- 23. PI Example PI = ($13,636 + $6,612+$7,513 + $8,196 + $8,693+ $9,032) / $50,000 = $53,682/$50,000 = 1.0736 Project’s PI is greater than 1. Therefore, accept. © 2011 Pearson Prentice Hall. All rights 10-reserved. 23
- 24. NPV and PI When the present value of a project’s free cash inflows are greater than the initial cash outlay, the project NPV will be positive. PI will also be greater than 1. NPV and PI will always yield the same decision. © 2011 Pearson Prentice Hall. All rights 10-reserved. 24
- 25. 2.4 Internal Rate of Return (IRR) Meaning: IRR is the discount rate that equates the present value of a project’s future net cash flows with the project’s initial cash outlay. © 2011 Pearson Prentice Hall. All rights 10-reserved. 25
- 26. Internal Rate of Return Decision Rule: If IRR ≥ Required Rate of Return, accept If IRR < Required Rate of Return, reject © 2011 Pearson Prentice Hall. All rights 10-reserved. 26
- 27. Figure 10-1 © 2011 Pearson Prentice Hall. All rights 10-reserved. 27
- 28. IRR and NPV If NPV is positive, IRR will be greater than the required rate of return If NPV is negative, IRR will be less than required rate of return If NPV = 0, IRR is the required rate of return. © 2011 Pearson Prentice Hall. All rights 10-reserved. 28
- 29. IRR Example Initial Outlay: $3,817 Cash flows: Yr.1=$1,000, Yr. 2=$2,000, Yr. 3=$3,000 Discount rate NPV 15% $4,356 20% $3,958 22% $3,817 IRR is 22% because the NPV equals the initial cash outlay at that rate.© 2011 Pearson Prentice Hall. All rights 10-reserved. 29
- 30. IRR in Excel® IRR can be easily computed in Excel® In the previous example, input cash outflow and three year cash inflows in cells A1:A4 In cell A5 input “=IRR(a1:a4)” Excel® will give the IRR = 22% © 2011 Pearson Prentice Hall. All rights 10-reserved. 30
- 31. Multiple IRRs A normal cash flow pattern for project is negative initial outlay followed by positive cash flows (–, +, +, + …) However, if the cash flow pattern is not normal (such as –, +, –) there can be more than one IRRs. Figure 10-2 is based on cash flows of: –1,600; +10,000; –10,000 in years 0,1, 2 © 2011 Pearson Prentice Hall. All rights 10-reserved. 31
- 32. Figure 10-2 © 2011 Pearson Prentice Hall. All rights 10-reserved. 32
- 33. Modified IRR Primary drawback of the IRR relative to the net present value is the reinvestment rate assumption made by the internal rate of return. Modified IRR allows the decision maker to directly specify the appropriate reinvestment rate. © 2011 Pearson Prentice Hall. All rights 10-reserved. 33
- 34. Modified IRR Accept if MIRR ≥ required rate of return Reject if MIRR < required rate of return © 2011 Pearson Prentice Hall. All rights 10-reserved. 34
- 35. MIRR Example Project having a 3 year life and a required rate of return of 10% with the following cash flows: FCF’s FCF’s Initial –$6,000 Year 2 $3,000 Outlay Year 1 2,000 Year 3 4,000 © 2011 Pearson Prentice Hall. All rights 10-reserved. 35
- 36. MIRR Example Step 1: Determine the PV of the project’s cash outflows. $6,000 is already at present. Step 2: Determine the terminal value of the project’s free cash flows. To do this use the project’s required rate of return to calculate the FV of the project’s three cash flows of the project’s cash outflows. They turn out to be $2,420 + $3,300 + $4,000 = $9,720 for the terminal value © 2011 Pearson Prentice Hall. All rights 10-reserved. 36
- 37. MIRR Example Step 3: Determine the discount rate that equates to the PV of the terminal value and the PV of the project’s cash outflows. MIRR = 17.446%. It is greater than required rate of return so Accept. © 2011 Pearson Prentice Hall. All rights 10-reserved. 37
- 38. MIRR in Excel® = MIRR (values, finance rate, reinvestment rate) where values is simply the range of cells where the cash flows are stored, and k is entered for both the finance rate and the reinvestment rate. © 2011 Pearson Prentice Hall. All rights 10-reserved. 38
- 39. 3. Capital Rationing Meaning: Capital rationing refers to situation where there is a limit on the dollar size of the capital budget. This may be due to: (a) temporarily adverse conditions in the market; (b) shortage of qualified personnel to direct new projects; and/or (c) other factors such as not willing to take on excess debt to finance new projects. © 2011 Pearson Prentice Hall. All rights 10-reserved. 39
- 40. Capital Rationing How to select? Select a set of projects with the highest NPV—subject to the capital constraint. Using NPV may preclude accepting the highest ranked project in terms of PI or IRR. © 2011 Pearson Prentice Hall. All rights 10-reserved. 40
- 41. Figure 10-4 © 2011 Pearson Prentice Hall. All rights 10-reserved. 41
- 42. Table 10-7 © 2011 Pearson Prentice Hall. All rights 10-reserved. 42
- 43. 4. Ranking Mutually Exclusive Projects Size Disparity Time Disparity Unequal Life © 2011 Pearson Prentice Hall. All rights 10-reserved. 43
- 44. 4.1 Size Disparity This occurs when we examine mutually exclusive projects of unequal size. Example: Consider the following cash flows for one-year Project A and B, with required rates of return of 10%. Initial Outlay: A = $200; B = $1,500 Inflow: A = $300; B = $1,900 © 2011 Pearson Prentice Hall. All rights 10-reserved. 44
- 45. Table 10-8 © 2011 Pearson Prentice Hall. All rights 10-reserved. 45
- 46. Size-Disparity Ranking Problem Project A Project B NPV 72.73 227.28 PI 1.36 1.15 IRR 50% 27% Ranking Conflict: Using NPV, Project B is better; Using PI and IRR, Project A is better. © 2011 Pearson Prentice Hall. All rights 10-reserved. 46
- 47. Size-Disparity Ranking Problem Which technique to use to select the project? Use NPV whenever there is size disparity. If there is no capital rationing, project with the largest NPV will be selected. When capital rationing exists, select set of projects with the largest NPV. © 2011 Pearson Prentice Hall. All rights 10-reserved. 47
- 48. 4.2 Time Disparity Problem Time Disparity problem arises because of differing reinvestment assumptions made by the NPV and IRR decision criteria. How are Cash flows reinvested? According to NPV: Required rate of return According to IRR: IRR © 2011 Pearson Prentice Hall. All rights 10-reserved. 48
- 49. 4.2 Time Disparity Problem Example: Consider two projects, A and B, with initial outlay of $1,000, cost of capital of 10%, and following cash flows in years 1, 2, and 3: A: $100 $200 $2,000 B: $650 $650 $650 © 2011 Pearson Prentice Hall. All rights 10-reserved. 49
- 50. Table 10-9 © 2011 Pearson Prentice Hall. All rights 10-reserved. 50
- 51. Time Disparity Problem Project A Project B NPV 758.83 616.45 PI 1.759 1.616 IRR 35% 43% Ranking Conflict: Using NPV or PI, A is better Using IRR, B is better Which technique to use to select the superior project? Use NPV © 2011 Pearson Prentice Hall. All rights 10-reserved. 51
- 52. 4.3 Unequal Lives Problem This occurs when we are comparing two mutually exclusive projects with different life spans. To compare projects, we compute the Equivalent Annual Annuity (EAA) © 2011 Pearson Prentice Hall. All rights 10-reserved. 52
- 53. Unequal Lives Problem Example: If you have two projects, A and B, with equal investment of $1,000, required rate of return of 10%, and following cash flows in years 1-3 (for project A) and 1-6 (for project B) Project A = $500 each in years 1-3 Project B = $300 each in years 1-6 © 2011 Pearson Prentice Hall. All rights 10-reserved. 53
- 54. Computing EAA Calculate the project’s NPV: A = $243.43 and B = $306.58 Calculate EAA = NPV/annual annuity factor A = $97.89 B = $70.39 Project A is better © 2011 Pearson Prentice Hall. All rights 10-reserved. 54
- 55. 5. Ethics in Capital Budgeting Ethics play a role in capital budgeting Any actions that violate ethical standards can have a negative impact on the image of the firm and consequently, future cash flows. © 2011 Pearson Prentice Hall. All rights 10-reserved. 55
- 56. 6. Actual Capital Budgeting Practices Popularity of Capital Budgeting Techniques Percent of Firms Using Each Method Primary Secondary Total used Method Method IRR 88% 11% 99% NPV 63% 22% 85% Payback 24% 59% 83% PI 15% 18% 33% Source: Harold Bierman, Jr.,”Capital Budgeting in 1992: A Survey,” Financial Management (Autumn 1993):24. © 2011 Pearson Prentice Hall. All rights 10-reserved. 56
- 57. 7. Finance and The Multinational Firm: Capital Budgeting The key to success in capital budgeting is finding good projects. Finding new projects and correctly evaluating them are key to continued success of firms. For many companies, finding new projects involves going overseas through joint ventures or strategic alliances or establishing subsidiary abroad. Some companies have more than 50% of their revenues from sales abroad.© 2011 Pearson Prentice Hall. All rights 10-reserved. 57
- 58. Figure 10-3 © 2011 Pearson Prentice Hall. All rights 10-reserved. 58
- 59. Figure 10-5 © 2011 Pearson Prentice Hall. All rights 10-reserved. 59
- 60. Figure 10-6 © 2011 Pearson Prentice Hall. All rights 10-reserved. 60
- 61. Table 10-1 © 2011 Pearson Prentice Hall. All rights 10-reserved. 61
- 62. Table 10-3 © 2011 Pearson Prentice Hall. All rights 10-reserved. 62
- 63. Table 10-4 © 2011 Pearson Prentice Hall. All rights 10-reserved. 63
- 64. Table 10-5 © 2011 Pearson Prentice Hall. All rights 10-reserved. 64
- 65. Table 10-6 © 2011 Pearson Prentice Hall. All rights 10-reserved. 65
- 66. Key Terms Capital budgeting Capital rationing Discounted payback Equivalent annual annuity (EAA) Internal rate of return (IRR) Mutually exclusive projects Net present value (NPV) Payback period Profitability index (PI) © 2011 Pearson Prentice Hall. All rights 10-reserved. 66

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