Capital-Budgeting Decision Criteria

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Foundations of FinanceArthur J. Keown John D.
MartinJ. William Petty David F. Scott, Jr.

• Chapter 9
• Capital-Budgeting Decision Criteria

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Principles Used in this Chapter

• Principle 2 The Time Value of Money A Dollar
  Received Today is Worth More Than a Dollar
  Received in the Future.
• Principle 5 The Curse of Competitive Markets
  Why Its Hard to Find Exceptionally Profitable
  Projects.

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Capital Budgeting

• Investments in fixed assets
• An approach to source and evaluate profitable
  projects
• Evaluating the profitability of projects
• Often choosing between one or more projects

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R D

• Typically, a firm has a research development
  department that searches for ways of improving
  existing products or finding new projects.

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Capital Budgeting

• Payback Period
• Net Present Value
• Profitability Index
• Internal Rate of Return
• Capital Rationing

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Payback Period

• Number of years needed to recover the initial
  cash outlay of a capital budgeting project
• Deals with cash flows
• Ignores the time value of money and does not
  discount these free cash flows back to the
  present.

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Payback Period

• Example
• Project with an initial cash outlay of 10,000
  with following free cash flows for 5 years.

YEAR CASH FLOW BALANCE
1 2,000 ( 8,000)
2 4,000 ( 4,000)
3 3,000 ( 1,000)
4 3,000 2,000
5 10,000 12,000
Payback is 3 1/3 years
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Payback Period

• Ignores the time value of money and does not
  discount these free cash flows back to the
  present.

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Net Present Value or NPV

• Present value of the free cash flows less the
  initial outlay
• Gives a measurement of the net value of a project
  in todays dollars
• If NPV gt 0, accept
• If NPV lt 0, reject

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Net Present Value or NPV

• Example Project with an initial cash outlay of
  40,000 with following free cash flows for 5
  years.
• Yr FCF Yr FCF
• Initial outlay -40,000 3 13,000
• 1 14,000 4 12,000
• 2 13,000 5 11,000
• The firm has a 12 required rate of return and
  the present value of the FCFs is 47,678.
  Subtracting the initial cash outlay of 40,000
  leaves an NPV of 7,678. NPVgt0, therefore we
  accept.

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NPV

• Examines cash flows, not profits
• Recognizes time value of money
• By accepting only positive NPV projects,
  increases value of the firm

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Profitability Index

• Benefit-cost ratio
• Ratio of the present value of the future free
  cash flows to the initial outlay
• Generates same results as NPV
• PI PV FCF/ Initial outlay
• PI gt 1 accept PI lt 1 reject

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Profitability Index

• 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.

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Profitability Index
FCF PVF _at_ 10 PV
Initial Outlay -50,000 1.000 -50,000
Year 1 15,000 0.909 13,635
Year 2 8,000 0.826 6,608
Year 3 10,000 0.751 7,510
Year 4 12,000 0.683 8,196
Year 5 14,000 0.621 8,694
Year 6 16,000 0.564 9,024
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Profitability Index

• PI (13,635 6,6087,510 8,196 8,694
  9,024) / 50,000
• 53,667/50,000
• 1.0733
• Project PI gt 1
• Therefore, accept.

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NPV and PI

• When the present value of a projects cash flows
  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

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Internal Rate of Return or IRR

• Discount rate that equates the present value of a
  projects future net cash flows with the
  projects initial cash outlay
• If IRR gt Required rate of return, accept
• IF IRR lt Required rate of return, reject

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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.

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IRR

• Purchase 3,817
• Cash flows Yr.11,000, Yr. 22,000, Yr.
  33,000
• Discount rate PV
• 15 4,356
• 20 3,958
• 22 3,817
• IRR is between 22 because the NPV equals the
  initial cash outlay

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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
• MIRRgt required rate of return Accept
• MIRRlt required rate of return Reject

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Capital Rationing

• Limit on the dollar size of the capital budget
• Often a firm may select a set of projects with
  the highest NPV subject to the capital
  constraint
• May preclude accepting the highest ranked project
  in terms of PI or IRR

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Ranking Problems

• Size Disparity
• Time Disparity
• Unequal Life

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Ethics in Capital Budgeting

• Ethics do play a role in capital budgeting
• Any actions that violate ethical standards can
  cause a loss of trust which can have a negative
  and long lasting effect on the firm

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Popularity of Capital Budgeting Techniques

• Percent of Firms Using Each
• Method used Primary Secondary Total
• Method Method Firms
• 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.
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The Multinational Firm Capital Budgeting

• The key to success in capital budgeting is
  finding good projects
• Often these projects are overseas in todays
  global environment
• Joint ventures and strategic alliances are
  current trends
• Some companies have gt 50 of their revenues from
  sales abroad

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How Do Financial Managers Use this Material?

• If you dont take on new projects, a company
  couldnt continue to exist
• Finding new projects and correctly evaluating
  them are key
• Whatever decision made results in an investment
  in fixed assets
• Process often called strategic planning but
  involves the Capital Budgeting Process