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Chapter04_Capital_Budgeting.pptx
1.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. Chapter 9 Capital Budgeting Techniques
2.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-2 Learning Goals 1. Understand the role of capital budgeting techniques in the capital budgeting process. 2. Calculate, interpret, and evaluate the payback period. 3. Calculate, interpret, and evaluate the net present value (NPV).
3.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-3 Learning Goals (cont.) 4. Calculate, interpret, and evaluate the internal rate of return (IRR). 5. Use net present value profiles to compare NPV and IRR techniques. 6. Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach.
4.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 8-4 The Capital Budgeting Decision Process • Capital Budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities. • It seeks to identify investments that will enhance a firm’s competitive advantage and increase shareholder wealth. • The typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. • Poor capital budgeting decisions can ultimately result in company bankruptcy.
5.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 8-5 Table 8.1 Key Motives for Making Capital Expenditures
6.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 8-6 1. Proposal Generation 2. Review and Analysis 3. Decision Making 4. Implementation 5. Follow-up Our Focus is on Step 2 and 3 Steps in the Process
7.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 8-7 Basic Terminology: Independent versus Mutually Exclusive Projects • Independent Projects, on the other hand, do not compete with the firm’s resources. A company can select one, or the other, or both—so long as they meet minimum profitability thresholds. • Mutually Exclusive Projects are investments that compete in some way for a company’s resources—a firm can select one or another but not both.
8.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 8-8 Basic Terminology: Unlimited Funds versus Capital Rationing • If the firm has unlimited funds for making investments, then all independent projects that provide returns greater than some specified level can be accepted and implemented. • However, in most cases firms face capital rationing restrictions since they only have a given amount of funds to invest in potential investment projects at any given time.
9.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 8-9 Basic Terminology: Accept-Reject versus Ranking Approaches • The accept-reject approach involves the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criteria. • The ranking approach involves the ranking of capital expenditures on the basis of some predetermined measure, such as the rate of return.
10.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 8-10 Basic Terminology: Conventional versus Nonconventional Cash Flows Figure 8.1 Conventional Cash Flow
11.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 8-11 Basic Terminology: Conventional versus Nonconventional Cash Flows (cont.) Figure 8.2 Nonconventional Cash Flow
12.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-12 Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1. Capital Budgeting Techniques • Chapter Problem
13.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-13 Capital Budgeting Techniques (cont.) Table 9.1 Capital Expenditure Data for Bennett Company
14.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-14 Capital Budgeting Techniques (cont.) Figure 9.1 Bennett Company’s Projects A and B
15.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-15 Payback Period • The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. • The maximum acceptable payback period is determined by management. • If the payback period is less than the maximum acceptable payback period, accept the project. • If the payback period is greater than the maximum acceptable payback period, reject the project.
16.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-16 Pros and Cons of Payback Periods • The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. • It is simple, intuitive, and considers cash flows rather than accounting profits. • It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.
17.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-17 Pros and Cons of Payback Periods (cont.) • One major weakness of the payback method is that the appropriate payback period is a subjectively determined number. • It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value. • Thus, payback fails to fully consider the time value of money.
18.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-18
19.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-19 Pros and Cons of Payback Periods (cont.) Table 9.2 Relevant Cash Flows and Payback Periods for DeYarman Enterprises’ Projects
20.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-20 Pros and Cons of Payback Periods (cont.) Table 9.3 Calculation of the Payback Period for Rashid Company’s Two Alternative Investment Projects
21.
Accounting Rate of
Return • Accounting Rate of Return (ARR) is the average net income an asset is expected to generate divided by its average capital cost, expressed as an annual percentage. • The ARR is a formula used to make capital budgeting decisions. It is used in situations where companies are deciding on whether or not to invest in an asset (a project, an acquisition, etc.) based on the future net earnings expected compared to the capital cost. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-21
22.
Accounting Rate of
Return • ARR = (Average Annual Profit / Average Investment)*100 Some positive aspects to the accounting rate of return • It is simple to calculate from readily available accounting data – no complicated discount factors to calculate! • The concept of profit is easily understood by managers, and the answer is easily interpreted – does the project give the necessary accounting return or not? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-22
23.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-23 • Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. Net Present Value (NPV)
24.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-24 Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent Net Present Value (NPV) (cont.) • Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.
25.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-25 Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 9.2 Net Present Value (NPV) (cont.)
26.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-26 Net Present Value (NPV) (cont.) Figure 9.2 Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives
27.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-27 Internal Rate of Return (IRR) • The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. • The IRR is the project’s intrinsic rate of return.
28.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-28 Decision Criteria If IRR > k, accept the project If IRR < k, reject the project If IRR = k, technically indifferent Internal Rate of Return (IRR) (cont.) • The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. • The IRR is the project’s intrinsic rate of return.
29.
IRR Calculation • IRR
=𝑅𝐿 + 𝑁𝑃𝑉𝐿 𝑁𝑃𝑉𝐿− 𝑁𝑃𝑉𝐻 × (𝑅𝐻- 𝑅𝐿) • Where, • 𝑅𝐿 = Lower Discount Rate • 𝑅𝐻= Higher Discount Rate • 𝑁𝑃𝑉𝐿= NPV at lower discount rate • 𝑁𝑃𝑉𝐻 = 𝑁𝑃𝑉 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑟 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-29
30.
• Think of
a project where initial investment is 45,000BDT. Cashflows from project are 27,000 (year1) and 33,000 (year2). Cost of Capital is 10%. What is the IRR of this project? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-30
31.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-31 To prepare NPV profiles for Bennett Company’s projects A and B, the first step is to develop a number of discount rate-NPV coordinates and then graph them as shown in the following table and figure. Net Present Value Profiles • NPV Profiles are graphs that depict project NPVs for various discount rates and provide an excellent means of making comparisons between projects.
32.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-32 Net Present Value Profiles (cont.) Table 9.4 Discount Rate–NPV Coordinates for Projects A and B
33.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-33 Which Approach is Better? • On a purely theoretical basis, NPV is the better approach because: – NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, – Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR. • Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return.
34.
Copyright © 2009
Pearson Prentice Hall. All rights reserved. 9-34 Table 9.8 Summary of Key Formulas/Definitions and Decision Criteria for Capital Budgeting Techniques
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