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Capital Budgeting

- Net Present Value Rule
- Payback Period Rule
- Discounted Payback Period Rule
- Average Accounting Return
- Internal Rate of Return
- Profitability Index
- Practice of Capital Budgeting
- Incremental Cash Flow

Net Present Value (NPV) Rule

- Net Present Value (NPV)
- Total PV of future CFs Initial Investment
- Estimating NPV
- 1. Estimate future cash flows how much? and

when? - 2. Estimate discount rate
- 3. Estimate initial costs
- Minimum Acceptance Criteria Accept if NPV gt 0
- Ranking Criteria Choose the highest NPV

Example

- Assume you have the following information on

Project X - Initial outlay -1,100 Required return 10
- Annual cash revenues and expenses are as

follows - Year Revenues Expenses
- 1 1,000 500
- 2 2,000 1,000
- Calculate its NPV.

The Payback Period Rule

- How long does it take the project to pay back

its initial investment? - Payback Period number of years to recover

initial costs - Minimum Acceptance Criteria
- set by management
- Disadvantages
- Ignores the time value of money
- Ignores cash flows after the payback period
- Biased against long-term projects

- Initial outlay -1,000
- Year Cash flow
- 1 200
- 2 400
- 3 600
- Accumulated
- Year Cash flow
- 1
- 2
- 3
- Payback period

Discounted Payback Period Rule

- How long does it take the project to pay back

its initial investment taking the time value of

money into account? - By the time you have discounted the cash flows,

you might as well calculate the NPV.

Example

Initial outlay -1,000 R 10

PV of Year

Cash flow Cash flow 1

200 182 2 400 331 3 700 526

4 300 205 Accumulated Year

discounted cash flow 1 182

2 513 3 1,039 4 1,244 Discounted

payback period is

Average Accounting Return Rule

- Another attractive but fatally flawed approach.
- Ranking Criteria and Minimum Acceptance Criteria

set by management - Disadvantages
- Ignores the time value of money
- Uses an arbitrary benchmark cutoff rate
- Based on book values, not cash flows and market

values - Advantages
- The accounting information is usually available
- Easy to calculate

Internal Rate of Return (IRR) Rule

- IRR the discount that sets NPV to zero
- Minimum Acceptance Criteria
- Accept if the IRR exceeds the required return.
- Ranking Criteria
- Select alternative with the highest IRR
- Reinvestment assumption
- All future cash flows assumed reinvested at the

IRR.

Example

- Consider the following project

The internal rate of return for this project is

19.44

NPV Payoff Profile for The Example

If we graph NPV versus discount rate, we can see

the IRR as the x-axis intercept.

Problems with the IRR Approach

- Multiple IRRs.
- The Scale Problem.
- The Timing Problem.

Multiple IRRs

- There are two IRRs for this project

Which one should we use?

The Scale Problem

Would you rather make 100 or 50 on your

investments? What if the 100 return is on a 1

investment while the 50 return is on a 1,000

investment?

The Timing Problem (page 161)

The preferred project in this case depends on the

discount rate, not the IRR.

Mutually Exclusive vs. Independent Project

- Mutually Exclusive Projects only ONE of several

potential projects can be chosen, e.g. acquiring

an accounting system. - RANK all alternatives and select the best one.
- Independent Projects accepting or rejecting one

project does not affect the decision of the other

projects. - Must exceed a MINIMUM acceptance criteria.

Which project is good?

Net present value

Year

0 1 2 3

4 Project A 350 50 100 150 200 Project B

250 125 100 75 50

160

140

120

100

80

60

40

Crossover Point

20

0

20

40

60

80

Discount rate

100

2

0

6

10

14

18

22

26

IRR A IRR B

(No Transcript)

Decision Rule

- If required rate of return lt crossover return,

take the project with lower IRR - If required rate of return gt crossover return,

take the project with higher IRR - Dont think a project with higher IRR is always

good - Projects with higher NPV is always good

Profitability Index (PI) Rule

- Minimum Acceptance Criteria Accept if PI gt 1
- Ranking Criteria Select alternative with highest

PI - Disadvantages Problems with mutually exclusive

investments - Advantages
- May be useful when available investment funds are

limited - Easy to understand and communicate
- Correct decision when evaluating independent

projects

Practice of Capital Budgeting

- Varies by industry
- Some firms use payback, others use accounting

rate of return. - The most frequently used technique for large

corporations is IRR or NPV.

Example of Investment Rules

- Compute the IRR, NPV, PI, and payback period for

the following two projects. Assume the required

return is 10. - Year Project A Project

B - 0 -200 -150
- 1 200 50
- 2 800 100
- 3 -800 150

Incremental Cash Flows

- Cash flows matternot accounting earnings.
- Sunk costs dont matter.
- Incremental cash flows matter.
- Opportunity costs matter.
- Side effects like cannibalism and erosion matter.
- Taxes matter we want incremental after-tax cash

flows. - Inflation matters.

Cash FlowsNot Accounting Earnings

- Consider depreciation expense.
- You never write a check made out to

depreciation. - Much of the work in evaluating a project lies in

taking accounting numbers and generating cash

flows.

Incremental Cash Flows

- Sunk costs are not relevant
- Just because we have come this far does not

mean that we should continue to throw good money

after bad. - Opportunity costs do matter. Just because a

project has a positive NPV that does not mean

that it should also have automatic acceptance.

Specifically if another project with a higher NPV

would have to be passed up we should not proceed.

Incremental Cash Flows

- Side effects matter (page 180)
- Erosion
- Synergy

Estimating Cash Flows

- Cash Flows from Operations
- Recall that
- Operating Cash Flow EBIT Taxes Depreciation
- Net Capital Spending
- Dont forget salvage value (after tax, of

course). - Changes in Net Working Capital
- Recall that when the project winds down, we enjoy

a return of net working capital.

The Baldwin Company An Example(page 181)

- Costs of test marketing (already spent)

250,000. - Current market value of proposed factory site

(which we own) 150,000. - Cost of bowling ball machine 100,000

(depreciated according to ACRS 5-year life).

Salvage value of 30,000. - Increase in net working capital 10,000.

Production (in units) by year during 5-year life

of the machine 5,000, 8,000, 12,000, 10,000,

6,000. - Price during first year is 20 price increases

2 per year thereafter. - Production costs during first year are 10 per

unit and increase 10 per year thereafter. - Annual inflation rate 5
- Tax rate is 34 percent
- Working Capital initially 10,000 changes with

sales.

Key Issues

- Dis-regard sunk costs
- Consider incremental cash flow additional cash

flows - Figure out revenue, cost, depreciation, tax,

capital spending, addition to net work capital - Refer to this example when you take advanced

corporate finance to deal with capital budgeting

or meet this kind of problem in your work

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