Additional File-Capital Budgeting 3.ppt

13 - 1
Copyright © 2002 Harcourt, Inc. All rights reserved.
Should we
build this
plant?
The Basics of Capital Budgeting:
Evaluating Cash Flows

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What is capital budgeting?
Analysis of potential additions to
fixed assets.
Long-term decisions; involve large
expenditures.
Very important to firm’s future.
Investment is made in present times

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 Evaluate expenditure decisions
benefit of which may accrue for more
than one year
Irreversible
Effect for longer period
Lot of funds are required

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What is the difference between
independent and mutually exclusive
projects?
Projects are:
independent
mutually exclusive

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An Example of Mutually Exclusive
Projects
BRIDGE vs. BOAT to get
products across a river.

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Normal Cash Flow Project:
Cost (negative CF) followed by a
series of positive cash inflows.
One change of signs.
Nonnormal Cash Flow Project:
Two or more changes of signs.
Most common: Cost (negative
CF), then string of positive CFs,
then again negative CF
.

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Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN

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What is the payback period?
The number of years required to
recover a project’s cost,
or how long does it take to get the
business’s money back?

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Payback for Project L
(Long: Most CFs in out years)
10 80
60
0 1 2 3
-100
=
CFt
Cumulative -100 -90 -30 50
PaybackL 2 + 30/80 = 2.375 years
0
100
2.4

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Project S (Short: CFs come quickly)
70 20
50
0 1 2 3
-100
CFt
Cumulative -100 -30 20 40
PaybackS 1 + 30/50 = 1.6 years
100
0
1.6
=

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Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.
Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.

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10 80
60
0 1 2 3
CFt
Cumulative 9.09 58.68 118.79
Discounted
payback 2 + 41.32/60.11 = 2.7 yrs
Discounted Payback: Uses discounted
rather than raw CFs.
PVCFt -100
-100
10%
9.09 49.59 60.11
=

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Average rate of Return
ARR=
Average annual profits after taxes and depreciation
__________________________________________
Average Investment
Note: Average Investment=
( Original Investment + Salvage Value)/2

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NPV
Cost often is CF0
 
.
1
0
1
CF
k
CF
NPV t
t
n
t


 


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What’s Project L’s NPV?
10 80
60
0 1 2 3
10%
Project L:
-100.00
9.09
49.59
60.11
18.79 = NPVL

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Rationale for the NPV Method
NPV = PV inflows - Cost
= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually
exclusive projects on basis of
higher NPV. Adds most value.

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Using NPV method, which project(s)
should be accepted?
If Projects S and L are mutually
exclusive, accept S because
NPVs > NPVL .
If S & L are independent,
accept ; NPV > 0.

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Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3
Cost Inflows
IRR is the discount rate that forces
PV inflows = cost or PV of Cash
Outflows
This is the same as forcing NPV = 0.

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 
t
n
t
t
CF
k
NPV




0 1
.
 
t
n
t
t
CF
IRR




0 1
0.
NPV: Enter k, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.

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IRR Acceptance Criteria
If IRR > k, accept project.
If IRR < k, reject project.

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Profitability Index or Benefit Cost Ratio
 PI=
Present Value of Cash Inflows
___________________________
Present Value of Cash Outflows
PI>1------Accept
PI<1------Reject

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NOTE
Pay Back/IRR/NPV/PI
= Cash Flow After Tax Before Dep
ARR= Cash Flow after tax and after
Depreciation

Additional File-Capital Budgeting 3.ppt

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