Capital budgeting techniques

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  • See Chapter 14.(weaknesses)
  • Capital budgeting techniques

    1. 1. Capital BudgetingCapital BudgetingTechniquesTechniques
    2. 2. CAPITAL BUDGETINGCAPITAL BUDGETING The process of identifying, analyzing andThe process of identifying, analyzing andselecting investment projects whoseselecting investment projects whosereturns (cash flows) are expected to extendreturns (cash flows) are expected to extendbeyond one year.beyond one year.
    3. 3. Capital Budgeting TechniquesCapital Budgeting Techniques Project Evaluation and SelectionProject Evaluation and Selection Potential DifficultiesPotential Difficulties Capital RationingCapital Rationing Project MonitoringProject Monitoring Post-Completion AuditPost-Completion Audit
    4. 4. 1.1. New product or ExpansionNew product or Expansion2.2. ReplacementReplacement3.3. Research and DevelopmentResearch and Development4.4. ExplorationExploration5.5. Other purposes ( Advertisement, safety orOther purposes ( Advertisement, safety orpollution related )pollution related )Key Motives for Making CapitalKey Motives for Making CapitalExpendituresExpenditures
    5. 5. Project Evaluation: AlternativeProject Evaluation: AlternativeMethodsMethods Payback Period (PBP)Payback Period (PBP) Internal Rate of Return (IRR)Internal Rate of Return (IRR) Net Present Value (NPV)Net Present Value (NPV) Profitability Index (PI)Profitability Index (PI)
    6. 6. Project RelationshipsProject Relationships Mutually ExclusiveMutually Exclusive -- A project whose-- A project whoseacceptance precludes the acceptance ofacceptance precludes the acceptance ofone or more alternative projects.one or more alternative projects.• IndependentIndependent -- A project whoseacceptance (or rejection) does notprevent the acceptance of other projectsunder consideration.• DependentDependent -- A project whoseacceptance depends on the acceptanceof one or more other projects.
    7. 7. Payback Period (PBP)Payback Period (PBP)PBPPBP is the period of time required for theis the period of time required for thecumulative expected cash flows from ancumulative expected cash flows from aninvestment project to equal the initialinvestment project to equal the initialcash outflow.cash outflow.
    8. 8. Proposed Project DataProposed Project DataJulie Miller is evaluating a new project for her firmJulie Miller is evaluating a new project for her firmBasket Wonders (BW)Basket Wonders (BW). She has determined that. She has determined thatthe after-tax cash flows for the project will bethe after-tax cash flows for the project will be$10,000, $12,000, $15,000, $10,000, and $7,000$10,000, $12,000, $15,000, $10,000, and $7,000respectively for each of therespectively for each of the Years 1 through 5Years 1 through 5..The initial cash outlay will beThe initial cash outlay will be $40,000$40,000..
    9. 9. (c)10 K 22 K 37 K 47 K 54 KPayback SolutionPayback SolutionPBPPBP == aa + (+ ( bb -- cc ) /) / dd== 33 + (+ (4040 -- 3737) /) / 1010 == 33 + (+ (33) /) / 1010== 3.3 Years3.3 Years0 1 2 3 4 5-40 K 10 K 12 K 15 K 10 K 7 KCumulativeInflows(a)(-b) (d)
    10. 10. PBP Acceptance CriterionPBP Acceptance CriterionThe management ofThe management of Basket WondersBasket Wonders has set ahas set amaximum PBP ofmaximum PBP of 3.5 Years3.5 Years for projects offor projects ofthis type.this type.Should this project be accepted?Should this project be accepted?Yes!Yes! The firm will receive back the initial cashThe firm will receive back the initial cashoutlay in less than 3.5 Years. [outlay in less than 3.5 Years. [3.3 Years3.3 Years << 3.53.5Year MaxYear Max..]]
    11. 11. PBP Strengths and WeaknessesPBP Strengths and WeaknessesStrengthsStrengths:: Easy to use andEasy to use andunderstandunderstand Can be used as aCan be used as ameasure of liquiditymeasure of liquidityWeaknesses:•Does not account forTVM•Does not considercash flows beyond thePBP• Cutoff period issubjective
    12. 12. Net Present Value (NPV)Net Present Value (NPV)NPVNPV is the present value of an investmentis the present value of an investmentproject’s net cash flows minus the project’sproject’s net cash flows minus the project’sinitial cash outflow.initial cash outflow.CF1 CF2 CFn(1+k)1(1+k)2(1+k)n+ . . . ++ - ICOICONPV =
    13. 13. Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent
    14. 14. Basket WondersBasket Wonders has determined that the appropriatehas determined that the appropriatediscount rate (k) for this project is 13%.discount rate (k) for this project is 13%.$10,000 $7,000NPV SolutionNPV Solution$10,000 $12,000 $15,000(1.13)1(1.13)2(1.13)3+ ++ - $40,000$40,000(1.13)4(1.13)5NPVNPV = +
    15. 15. NPV SolutionNPV SolutionNPVNPV == $10,000$10,000(PVIF(PVIF13%13%,,11) +) + $12,000$12,000(PVIF(PVIF13%13%,,22) +) +$15,000$15,000(PVIF(PVIF13%13%,,33) +) + $10,000$10,000(PVIF(PVIF13%13%,,44) +) +$ 7,000$ 7,000(PVIF(PVIF13%13%,,55) -) - $40,000$40,000NPVNPV == $10,000$10,000(.885) +(.885) + $12,000$12,000(.783) +(.783) +$15,000$15,000(.693) +(.693) + $10,000$10,000(.613) +(.613) +$ 7,000$ 7,000(.543) -(.543) -$40,000$40,000NPVNPV == $8,850 + $9,396 + $10,395 +$8,850 + $9,396 + $10,395 +$6,130 + $3,801 -$6,130 + $3,801 - $40,000$40,000== - $1,428- $1,428
    16. 16. NPV Acceptance CriterionNPV Acceptance CriterionNo!No! TheThe NPVNPV isis negativenegative. This means that the. This means that theproject is reducing shareholder wealth. [project is reducing shareholder wealth. [RejectReject asasNPVNPV << 00 ]]The management ofThe management of Basket WondersBasket Wonders hashasdetermined that the required rate is 13% fordetermined that the required rate is 13% forprojects of this type.projects of this type.Should this project be accepted?Should this project be accepted?
    17. 17. NPV Strengths and WeaknessesNPV Strengths and WeaknessesStrengthsStrengths:: Cash flowsCash flowsassumed to beassumed to bereinvested at thereinvested at thehurdle rate.hurdle rate. Accounts for TVM.Accounts for TVM. Considers allConsiders allcash flows.cash flows.WeaknessesWeaknesses:: May not includeMay not includemanagerial optionsmanagerial optionsembeddedembedded in thein theproject.project.
    18. 18. Profitability Index (PI)Profitability Index (PI)PI is the ratio of the present value of a project’sPI is the ratio of the present value of a project’sfuture net cash flows to the project’s initial cashfuture net cash flows to the project’s initial cashoutflow.outflow.CF1 CF2 CFn(1+k)1(1+k)2(1+k)n+ . . . ++ ICOICOPI =PI = 1 + [ NPVNPV / ICOICO ]<< OR >>
    19. 19. PI Acceptance CriterionPI Acceptance CriterionNo!No! TheThe PIPI isis less than 1.00less than 1.00. This. This meansmeansthat the project is not profitable. [that the project is not profitable. [RejectReject asas PIPI <<1.001.00 ]]PIPI = $38,572 / $40,000= $38,572 / $40,000= .9643= .9643Should this project be accepted?Should this project be accepted?
    20. 20. PI Strengths and WeaknessesPI Strengths and WeaknessesStrengthsStrengths:: Same as NPVSame as NPV AllowsAllowscomparison ofcomparison ofdifferent scaledifferent scale projectsprojectsWeaknessesWeaknesses:: Same as NPVSame as NPV Provides only relativeProvides only relativeprofitabilityprofitability Potential RankingPotential RankingProblemsProblems
    21. 21. Internal Rate of Return (IRR)Internal Rate of Return (IRR)IRR is the discount rate that equates the presentIRR is the discount rate that equates the presentvalue of the future net cash flows from anvalue of the future net cash flows from aninvestment project with the project’s initial cashinvestment project with the project’s initial cashoutflow.outflow.CF1 CF2 CFn(1+IRR)1(1+IRR)2(1+IRR)n+ . . . ++ICO =
    22. 22. $15,000 $10,000 $7,000IRR SolutionIRR Solution$10,000 $12,000(1+IRR)1(1+IRR)2Find the interest rate (Find the interest rate (IRRIRR) that causes the discounted cash) that causes the discounted cashflows to equalflows to equal $40,000$40,000..+ +++$40,000 =(1+IRR)3 (1+IRR)4 (1+IRR)5
    23. 23. IRR Solution (Try 10%)IRR Solution (Try 10%)$40,000$40,000 == $10,000(PVIF$10,000(PVIF10%10%,,11) + $12,000(PVIF) + $12,000(PVIF10%10%,,22))+ $15,000(PVIF+ $15,000(PVIF10%10%,,33) + $10,000(PVIF) + $10,000(PVIF10%10%,,44) +) +$ 7,000(PVIF$ 7,000(PVIF10%10%,,55))$40,000$40,000 == $10,000(.909) + $12,000(.826) +$10,000(.909) + $12,000(.826) +$15,000(.751) + $10,000(.683) +$15,000(.751) + $10,000(.683) +$ 7,000(.621)$ 7,000(.621)$40,000$40,000 == $9,090 + $9,912 + $11,265 +$9,090 + $9,912 + $11,265 +$6,830 + $4,347$6,830 + $4,347== $41,444$41,444 [[Rate is too low!!Rate is too low!!]]
    24. 24. IRR Solution (Try 15%)IRR Solution (Try 15%)$40,000$40,000 == $10,000(PVIF$10,000(PVIF15%15%,,11) + $12,000(PVIF) + $12,000(PVIF15%15%,,22) +) +$15,000(PVIF$15,000(PVIF15%15%,,33) + $10,000(PVIF) + $10,000(PVIF15%15%,,44) +) +$7,000(PVIF$7,000(PVIF15%15%,,55))$40,000$40,000 == $10,000(.870) + $12,000(.756) +$10,000(.870) + $12,000(.756) + $15,000(.658) +$15,000(.658) +$10,000(.572) + $ 7,000(.497)$10,000(.572) + $ 7,000(.497)$40,000$40,000 == $8,700 + $9,072 + $9,870 + $5,720 + $3,479$8,700 + $9,072 + $9,870 + $5,720 + $3,479
    25. 25. IRR Solution (Interpolate)IRR Solution (Interpolate)IRRIRR = .10 += .10 + .0157.0157 == .1157.1157 oror 11.57%11.57%
    26. 26. Decision Criteria If IRR > cost of capital, accept the project If IRR < cost of capital, reject the project If IRR = cost of capital, technicallyindifferent
    27. 27. IRR Acceptance CriterionIRR Acceptance CriterionNo!No! The firm will receiveThe firm will receive 11.57%11.57% for eachfor eachdollar invested in this project at a cost ofdollar invested in this project at a cost of 13%13%..[[ IRRIRR << Hurdle RateHurdle Rate ]]The management ofThe management of Basket WondersBasket Wonders hashasdetermined that thedetermined that the hurdle ratehurdle rate isis 13%13% forforprojects of this type.projects of this type.Should this project be accepted?Should this project be accepted?
    28. 28. IRR Strengths and WeaknessesIRR Strengths and WeaknessesStrengthsStrengths:: Accounts forAccounts forTVMTVM Considers allConsiders allcash flowscash flows LessLessSubjectivitySubjectivityWeaknessesWeaknesses:: Assumes all cashAssumes all cashflows reinvested atflows reinvested at the IRRthe IRR Difficulties withDifficulties withproject rankings andproject rankings and MultipleMultipleIRRsIRRs
    29. 29. Evaluation SummaryEvaluation SummaryMethod Project Comparison DecisionPBP 3.3 3.5 AcceptIRR 11.57% 13% RejectNPV -$1,428 $0 RejectPI .96 1.00 RejectBasket Wonders Independent Project
    30. 30. 9-30Which Approach is Better?Which Approach is Better? On a purely theoretical basis, NPV is the better approachOn a purely theoretical basis, NPV is the better approachbecause:because: NPV assumes that intermediate cash flows are reinvested at theNPV assumes that intermediate cash flows are reinvested at thecost of capital whereas IRR assumes they are reinvested at thecost of capital whereas IRR assumes they are reinvested at theIRR,IRR, Certain mathematical properties may cause a project with non-Certain mathematical properties may cause a project with non-conventional cash flows to have more than one real IRR.conventional cash flows to have more than one real IRR. Despite its theoretical superiority, however, financialDespite its theoretical superiority, however, financialmanagers prefer to use the IRR because of the preferencemanagers prefer to use the IRR because of the preferencefor rates of return.for rates of return.
    31. 31. Potential Ranking Problems UnderPotential Ranking Problems UnderMutual ExclusivityMutual ExclusivityA. Scale of InvestmentA. Scale of InvestmentB. Cash-flow PatternB. Cash-flow PatternC. Project LifeC. Project LifeRanking of project proposalsRanking of project proposals maymay create contradictorycreate contradictoryresults.results.
    32. 32. A. Scale DifferencesA. Scale DifferencesCompare a small (S) and a large (L) project.Compare a small (S) and a large (L) project.NET CASH FLOWSProject S Project LEND OF YEAR0 -$100 -$100,0001 0 02 $400 $156,250
    33. 33. SS .50 Yrs 100%.50 Yrs 100% $231$231 3.313.31L 1.28 Yrs 25%L 1.28 Yrs 25% $29,132$29,132 1.291.29Scale DifferencesScale DifferencesCalculate the PBP, IRR, NPV@10%, andCalculate the PBP, IRR, NPV@10%, andPI@10%.PI@10%.Which project is preferred? Why?Which project is preferred? Why?ProjectProject PBPPBP IRRIRR NPVNPV PIPI
    34. 34. B. Cash Flow PatternB. Cash Flow PatternLet us compare aLet us compare a decreasingdecreasing cash-flow (D) project and ancash-flow (D) project and anincreasingincreasing cash-flow (I) project.cash-flow (I) project.NET CASH FLOWSProject D Project IEND OF YEAR0 -$1,200 -$1,2001 1,000 1002 500 6003 100 1,080
    35. 35. DD 23%23% $198 1.17$198 1.17II 17%17% $198 1.17$198 1.17Cash Flow PatternCash Flow PatternCalculate the IRR, NPV@10%, and PI@10%.Calculate the IRR, NPV@10%, and PI@10%.Which project is preferred?Which project is preferred?ProjectProject IRRIRR NPVNPV PIPI
    36. 36. Examine NPV ProfilesExamine NPV ProfilesDiscount Rate (%)0 5 10 15 20 25-2000200400600IRRNPV@10%Plot NPV for eachproject at variousdiscount rates.NetPresentValue($)
    37. 37. Fisher’s Rate of IntersectionFisher’s Rate of IntersectionDiscount Rate ($)0 5 10 15 20 25-2000200400600NetPresentValue($)At k<10%, I is best!At k<10%, I is best! Fisher’sFisher’s RateRate ofofIntersectionIntersectionAt k>10%, D is best!At k>10%, D is best!
    38. 38. Let us compare aLet us compare a longlong life (X) project and alife (X) project and ashortshort life (Y) project.life (Y) project.NET CASH FLOWSProject X Project YEND OF YEAR0 -$1,000 -$1,0001 0 2,0002 0 03 3,375 0C. Project Life DifferencesC. Project Life Differences
    39. 39. Project Life DifferencesProject Life DifferencesX 50%X 50% $1,536 2.54$1,536 2.54YY 100%100% $ 818 1.82$ 818 1.82Calculate the PBP, IRR, NPV@10%, andCalculate the PBP, IRR, NPV@10%, andPI@10%.PI@10%.Which project is preferred? Why?Which project is preferred? Why?ProjectProject IRRIRR NPVNPV PIPI
    40. 40. Capital RationingCapital RationingCapital RationingCapital Rationing occurs when a constraint (oroccurs when a constraint (orbudget ceiling) is placed on the total size ofbudget ceiling) is placed on the total size ofcapital expenditures during a particular period.capital expenditures during a particular period.ExampleExampleJulie Miller must determine what investmentJulie Miller must determine what investmentopportunities to undertake foropportunities to undertake for Basket WondersBasket Wonders(BW)(BW). She is limited to a. She is limited to a maximum expendituremaximum expenditureof $32,500of $32,500 onlyonly for 199X.for 199X.
    41. 41. Available Projects for BWAvailable Projects for BWProject ICO IRR NPV PIProject ICO IRR NPV PIA $ 500 18%A $ 500 18% $ 50 1.10$ 50 1.10BB 5,0005,000 2525 6,500 2.306,500 2.30CC 5,0005,000 3737 5,500 2.105,500 2.10DD 7,5007,500 2020 5,000 1.675,000 1.67EE 12,50012,500 2626 500 1.04500 1.04FF 15,00015,000 2828 21,000 2.4021,000 2.40GG 17,50017,500 1919 7,500 1.437,500 1.43HH 25,00025,000 1515 6,000 1.246,000 1.24
    42. 42. Choosing by IRRs for BWChoosing by IRRs for BWProject ICO IRR NPV PIProject ICO IRR NPV PIC $ 5,000C $ 5,000 37%37% $ 5,500 2.10$ 5,500 2.10FF 15,00015,000 2828 21,000 2.4021,000 2.40EE 12,50012,500 2626 500 1.04500 1.04BB 5,0005,000 2525 6,500 2.36,500 2.3Projects C, F, and E have the threeProjects C, F, and E have the three largest IRRslargest IRRs..The resultingThe resulting increaseincrease inin shareholder wealthshareholder wealth isis $27,000$27,000with awith a $32,500 outlay$32,500 outlay..
    43. 43. Choosing by NPVs for BWChoosing by NPVs for BWProject ICO IRR NPV PIProject ICO IRR NPV PIF $15,000F $15,000 28%28% $21,000$21,000 2.402.40G 17,500G 17,500 1919 7,5007,500 1.431.43B 5,000B 5,000 2525 6,500 2.306,500 2.30Projects F and G have the twoProjects F and G have the two largest NPVslargest NPVs..The resultingThe resulting increaseincrease inin shareholder wealthshareholder wealth isis $28,500$28,500with awith a $32,500 outlay$32,500 outlay..
    44. 44. Choosing by PIs for BWChoosing by PIs for BWProject ICO IRR NPV PIProject ICO IRR NPV PIFF $15,000$15,000 28%28% $21,000$21,000 2.402.40BB 5,0005,000 2525 6,5006,500 2.302.30CC 5,0005,000 3737 5,5005,500 2.102.10DD 7,5007,500 2020 5,0005,000 1.671.67GG 17,50017,500 1919 7,500 1.437,500 1.43Projects F, B, C and D have the fourProjects F, B, C and D have the four largest PIslargest PIs..The resultingThe resulting increaseincrease inin shareholder wealthshareholder wealth isis $38,000$38,000with awith a $32,500 outlay$32,500 outlay..
    45. 45. Summary of ComparisonSummary of ComparisonMethodMethod Projects AcceptedProjects Accepted Value AddedValue AddedPIPI F, B, C, and D $38,000F, B, C, and D $38,000NPVNPV F and G $28,500F and G $28,500IRRIRR C, F and E $27,000C, F and E $27,000PIPI generates thegenerates the greatestgreatest increaseincrease inin shareholder wealthshareholder wealth whenwhena limited capital budget exists for aa limited capital budget exists for a single periodsingle period..
    46. 46. Post-Completion AuditPost-Completion AuditPost-completion AuditPost-completion AuditA formal comparison of the actual costs and benefits of aA formal comparison of the actual costs and benefits of aproject with original estimates.project with original estimates. Identify any project weaknessesIdentify any project weaknesses Develop a possible set of corrective actionsDevelop a possible set of corrective actions Provide appropriate feedbackProvide appropriate feedbackResult:Result: Making better future decisions!Making better future decisions!

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