Fm10e ch09

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Fm10e ch09

  1. 1. Chapter 9 - Capital Budgeting Decision Criteria  2005, Pearson Prentice Hall
  2. 2. Capital Budgeting : The process of planning for purchases of long-term assets. <ul><li>For example : 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>
  3. 3. Decision-making Criteria in Capital Budgeting <ul><li>How do we decide if a capital investment project should be accepted or rejected? </li></ul>
  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 , and </li></ul><ul><li>c) incorporate the required rate of return on the project. </li></ul>Decision-making Criteria in Capital Budgeting
  5. 5. Payback Period <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>
  6. 6. Payback Period <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
  7. 7. Payback Period <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 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>Payback Period
  9. 9. Drawbacks of Payback Period <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>
  10. 10. Drawbacks of Payback Period <ul><li>Does not consider all of the project’s cash flows. </li></ul><ul><li>Consider this cash flow stream! </li></ul>0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
  11. 11. Drawbacks of Payback Period <ul><li>Does not consider all of the project’s cash flows. </li></ul><ul><li>This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! </li></ul>0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
  12. 12. Discounted Payback <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>
  13. 13. Discounted Payback <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>0 1 2 3 4 5 (500) 250 250 250 250 250
  14. 14. Discounted Payback <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>0 1 2 3 4 5 (500) 250 250 250 250 250
  15. 15. Discounted Payback <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>2 250 192.37 </li></ul>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>2 250 192.37 2 years </li></ul><ul><li> 88.33 </li></ul>Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
  17. 17. Discounted Payback <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>2 250 192.37 2 years </li></ul><ul><li> 88.33 </li></ul><ul><li>3 250 168.74 </li></ul>0 1 2 3 4 5 (500) 250 250 250 250 250
  18. 18. Discounted Payback <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>2 250 192.37 2 years </li></ul><ul><li> 88.33 </li></ul><ul><li>3 250 168.74 .52 years </li></ul>0 1 2 3 4 5 (500) 250 250 250 250 250
  19. 19. Discounted Payback <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>2 250 192.37 2 years </li></ul><ul><li> 88.33 </li></ul><ul><li>3 250 168.74 .52 years </li></ul>0 1 2 3 4 5 (500) 250 250 250 250 250 The Discounted Payback is 2.52 years
  20. 20. Other Methods <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>Consider each of these decision-making criteria: </li></ul><ul><li>All net cash flows. </li></ul><ul><li>The time value of money. </li></ul><ul><li>The required rate of return. </li></ul>
  21. 21. Net Present Value <ul><li>NPV = the total PV of the annual net cash flows - the initial outlay. </li></ul>NPV = - IO FCF 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 $250,000 and provides annual net cash flows of $100,000 for five years. 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 $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15% . </li></ul>NPV Example 0 1 2 3 4 5 (250,000) 100,000 100,000 100,000 100,000 100,000
  25. 25. Net Present Value <ul><li>NPV is just the PV of the annual cash flows minus the initial outflow. </li></ul><ul><li>Using TVM: </li></ul><ul><li>P/Y = 1 N = 5 I = 15 </li></ul><ul><li>PMT = 100,000 </li></ul><ul><li>PV of cash flows = $335,216 </li></ul><ul><li>- Initial outflow: ($250,000) </li></ul><ul><li>= Net PV $85,216 </li></ul>
  26. 26. NPV with the HP10B: <ul><li>-250,000 CFj </li></ul><ul><li>100,000 CFj </li></ul><ul><li>5 shift Nj </li></ul><ul><li>15 I/YR </li></ul><ul><li>shift NPV </li></ul><ul><li>You should get NPV = 85,215.51 . </li></ul>
  27. 27. NPV with the HP17BII: <ul><li>Select CFLO mode. </li></ul><ul><li>FLOW(0)=? -250,000 INPUT </li></ul><ul><li>FLOW(1)=? 100,000 INPUT </li></ul><ul><li>#TIMES(1)=1 5 INPUT EXIT </li></ul><ul><li>CALC 15 I% NPV </li></ul><ul><li>You should get NPV = 85,215.51 </li></ul>
  28. 28. NPV with the TI BAII Plus: <ul><li>Select CF mode. </li></ul>
  29. 29. NPV with the TI BAII Plus: <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -250,000 ENTER </li></ul>
  30. 30. NPV with the TI BAII Plus: <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -250,000 ENTER </li></ul><ul><li>C01=? 100,000 ENTER </li></ul>
  31. 31. NPV with the TI BAII Plus: <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -250,000 ENTER </li></ul><ul><li>C01=? 100,000 ENTER </li></ul><ul><li>F01= 1 5 ENTER </li></ul>
  32. 32. NPV with the TI BAII Plus: <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -250,000 ENTER </li></ul><ul><li>C01=? 100,000 ENTER </li></ul><ul><li>F01= 1 5 ENTER </li></ul><ul><li>NPV I= 15 ENTER </li></ul>
  33. 33. NPV with the TI BAII Plus: <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -250,000 ENTER </li></ul><ul><li>C01=? 100,000 ENTER </li></ul><ul><li>F01= 1 5 ENTER </li></ul><ul><li>NPV I= 15 ENTER CPT </li></ul>
  34. 34. NPV with the TI BAII Plus: <ul><li>Select CF mode. </li></ul><ul><li>CFo=? -250,000 ENTER </li></ul><ul><li>C01=? 100,000 ENTER </li></ul><ul><li>F01= 1 5 ENTER </li></ul><ul><li>NPV I= 15 ENTER CPT </li></ul><ul><li>You should get NPV = 85,215.51 </li></ul>
  35. 35. Profitability Index
  36. 36. Profitability Index NPV = - IO FCF t (1 + k) t n t=1 
  37. 37. Profitability Index PI = IO FCF t (1 + k) n t=1  t NPV = - IO FCF t (1 + k) t n t=1 
  38. 38. <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>Profitability Index
  39. 39. PI with the HP10B: <ul><li>-250,000 CFj </li></ul><ul><li>100,000 CFj </li></ul><ul><li>5 shift Nj </li></ul><ul><li>15 I/YR </li></ul><ul><li>shift NPV </li></ul><ul><li>Add back IO: + 250,000 </li></ul><ul><li>Divide by IO: / 250,000 = </li></ul><ul><li>You should get PI = 1.34 </li></ul>
  40. 40. Internal Rate of Return (IRR) <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>
  41. 41. Internal Rate of Return (IRR)
  42. 42. Internal Rate of Return (IRR) NPV = - IO FCF t (1 + k) t n t=1 
  43. 43. Internal Rate of Return (IRR) NPV = - IO FCF t (1 + k) t n t=1  n t=1  IRR: = IO FCF t (1 + IRR) t
  44. 44. Internal Rate of Return (IRR) <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>n t=1  IRR: = IO FCF t (1 + IRR) t
  45. 45. Calculating IRR <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>0 1 2 3 4 5 (250,000) 100,000 100,000 100,000 100,000 100,000
  46. 46. IRR with your Calculator <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 = 28.65%! </li></ul>
  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>0 1 2 3 4 5 (500) 200 100 (200) 400 300
  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>1 0 1 2 3 4 5 (500) 200 100 (200) 400 300
  51. 51. <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>0 1 2 3 4 5 (500) 200 100 (200) 400 300 1 2
  52. 52. <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>0 1 2 3 4 5 (500) 200 100 (200) 400 300 1 2 3
  53. 53. Summary Problem <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>0 1 2 3 4 5 (900) 300 400 400 500 600
  54. 54. Summary Problem <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>0 1 2 3 4 5 (900) 300 400 400 500 600
  55. 55. Modified Internal Rate of Return (MIRR) <ul><li>IRR assumes that all cash flows are reinvested at the IRR . </li></ul><ul><li>MIRR provides a rate of return measure that assumes cash flows are reinvested at the required rate of return . </li></ul>
  56. 56. MIRR Steps: <ul><li>Calculate the PV of the cash outflows. </li></ul><ul><ul><li>Using the required rate of return. </li></ul></ul><ul><li>Calculate the FV of the cash inflows at the last year of the project’s time line. This is called the terminal value (TV). </li></ul><ul><ul><li>Using the required rate of return. </li></ul></ul><ul><li>MIRR: the discount rate that equates the PV of the cash outflows with the PV of the terminal value, ie, that makes: </li></ul><ul><li>PV outflows = PV inflows </li></ul>
  57. 57. MIRR <ul><li>Using our time line and a 15% rate: </li></ul><ul><li>PV outflows = (900). </li></ul><ul><li>FV inflows (at the end of year 5) = 2,837. </li></ul><ul><li>MIRR: FV = 2837, PV = (900), N = 5. </li></ul><ul><li>Solve: I = 25.81%. </li></ul>0 1 2 3 4 5 (900) 300 400 400 500 600
  58. 58. <ul><li>Using our time line and a 15% rate: </li></ul><ul><li>PV outflows = (900). </li></ul><ul><li>FV inflows (at the end of year 5) = 2,837. </li></ul><ul><li>MIRR: FV = 2837, PV = (900), N = 5. </li></ul><ul><li>Solve: I = 25.81%. </li></ul><ul><li>Conclusion : The project’s IRR of 34.37% assumes that cash flows are reinvested at 34.37%. </li></ul>MIRR
  59. 59. <ul><li>Using our time line and a 15% rate: </li></ul><ul><li>PV outflows = (900). </li></ul><ul><li>FV inflows (at the end of year 5) = 2,837. </li></ul><ul><li>MIRR: FV = 2837, PV = (900), N = 5. </li></ul><ul><li>Solve: I = 25.81%. </li></ul><ul><li>Conclusion : The project’s IRR of 34.37% assumes that cash flows are reinvested at 34.37%. </li></ul><ul><li>Assuming a reinvestment rate of 15%, the project’s MIRR is 25.81%. </li></ul>MIRR

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