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Capital Budgeting Techniques and Practice

Chapter 9

Chapter Objectives

- Discuss why it is difficult to find profitable

projects - Use capital budget techniques to evaluate new

projects - Discuss Capital Rationing concerns
- Work through issues in Project rankings

Capital Budgeting

- Capital Budgeting is the process of decision

making with respect to investment in fixed assets

(long term projects) - Evaluation of the profitability of projects
- 4 methods (decision criteria) to evaluate

projects - Decide whether to accept or reject a project
- Projects are evaluated based on Free Cash Flows

Finding Profitable Projects

- Remember It is much easier to evaluate projects

than it is to find them - The curse of Competitive markets
- Finding profitable projects is essential for the

survival of the firm - How does a company find profitable projects?
- Typically, a firm has a research development

department that searches for ways of improving

existing products or finding new projects - Other sources?

Capital Budgeting Decision Criteria

- Payback Period
- Net Present Value
- Profitability Index (Benefit-Cost Ratio)
- Internal Rate of Return

Payback Period

- Number of years needed to recover the initial

cash outlay of a project - This criteria measures how quickly the project

will return its original investment - It is based on free cash flows, not accounting

profits - Emphasizes the early cash flows, which are less

uncertain than later cash flows

Payback Period Examples

Payback Period

- Strengths
- Simple to use, easy to understand
- Focuses on free cash flows, not accounting

profits - Useful as a control for risk (since it emphasizes

early cash flows) - Drawbacks
- Ignores Time Value of Money
- Ignores Cash Flows beyond payback period,

decision may be inconsistent with goal of the

firm - No objective decision rule (accept / reject)

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 - Decision Criteria
- If NPV 0, Accept the project
- If NPV lt 0, Reject the project

Discount Rate

- Cost of Capital (more in Chapter 11)
- Rate of Return necessary to justify raising funds

to finance the project - Required Rate of Return
- Rate of Return necessary to maintain the firms

current market price per share - Only NPV positive projects increase share prices

in the long run

NPV Example

- Project Initial Outlay 10,000
- Cash flows is 2,500 a year for 6 years
- Required rate of return 10
- PV of 2,500, 6 years, 10 is 10,888
- NPV of the project 10,888 - 10,000
- 888
- Decision Since 888 gt 0, Accept

Net Present Value

- Advantages
- Examines cash flows, not profits
- Recognizes time value of money
- By accepting only positive NPV projects, decision

criteria leads to increases value of the firm,

consistent with objective of firm - Disadvantages
- Need for detailed, long term forecasts

Profitability Index

- Also know as the Benefit-Cost ratio
- Ratio of the present value of the future free

cash flows to the initial outlay - Generates same results as NPV
- Under no capital rationing constraints
- Decision Criteria
- PI 1 Accept the project
- PI lt 1 Reject the project

Profitability Index Example

- Project Initial Outlay 10,000
- Cash flows 2,500 for 6 years
- Required rate of return 10
- PV of the cash flows 10,888
- PI 10,888/10,000 1.088
- Decision Since 1.088 gt 1 , Accept

NPV and PI Compared

- When the present value of a projects cash flows

are greater than the initial cash outlay - The Project NPV will be positive.
- The Project PI will be greater than 1.
- NPV and PI will always yield the same decision,

but does not necessarily rank acceptable projects

in the same order - Important distinction when there is capital

rationing or projects are mutually exclusive - PI has same advantages/disadvantages as NPV

Internal Rate of Return or IRR

- Defined as the discount rate that equates the

present value of a projects cash flows with the

projects Initial cash outlay - Answers the question What Rate of Return does

this project earn? - Decision Criteria
- If IRR gt Required rate of return, Accept
- IF IRR lt Required rate of return, Reject

IRR Example

- Project Initial Outlay 10,000
- Cash flows 2,500 for 6 years
- Required Rate of Return 10
- CFo -10,000
- C01 2,500
- F01 6
- IRR CPT
- True IRR 12.978 via financial calculator
- Decision Since IRR gt Required ROR, Accept

Internal Rate of Return

- Advantages
- Examines cash flows, not profits
- Recognizes time value of money
- Consistent with Goal of the Firm
- Rates are comparable across projects of different

sizes - Disadvantages
- Need for detailed, long term forecasts
- IRR may not exist for certain project that have

unconventional cash flows (more than one sign

change)

IRR and NPV Compared

- 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
- NPV and IRR will yield the same decision, but

does not necessarily rank acceptable projects in

the same order - Important distinction when there is capital

rationing or when projects are mutually exclusive

NPV and IRR Compared

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Capital Rationing

- Firm may place a limit on the dollar size of the

capital budget - Have to choose among the pool of accepted

projects - Potential Reasons
- Management may think market conditions are

temporarily adverse (Recessions) - Shortage of qualified managers
- Intangible considerations
- Risk aversion to debt
- Rejecting projects because of capital rationing

is contrary to the goal of the firm

Project Selection under Capital Rationing

- Selection Criteria Select the set of projects

with the highest NPV subject to the capital

constraint - Using this criteria, the result is that projects

that increase shareholder wealth the most will be

selected, since NPV is the amount of wealth that

is created when a project is selected

Capital Rationing Example

- Consider a 1 million dollar budget constraint
- Select projects A and C
- (Total outlay 200,000 800,000 1 million)
- These projects maximizes the firms NPV subject

to the capital constraint

Mutually Exclusive Projects

- Occur when two or more projects perform

essentially the same task - Different alternatives are available, but only

one can be used accomplish the task - Acceptance of one project will necessarily mean

rejection of the other project(s) - Example
- Installation of computer system
- Need to rank projects in order to select one

project, then Ranking Problems become important - The problem is how to choose from the pool of

accepted projects

Size Disparity Example

Ranking Problems Size Disparity

- Mutually Exclusive projects of unequal sizes are

examined - Initial cash outlay are different between the

alternative projects - Without Capital Rationing
- Choose the project with the largest NPV
- With Capital Rationing
- Select the project with the largest NPV that will

fit under the capital constraint

Time Disparity Example

Ranking Problems Time Disparity

- Future CF timing differences result in time

disparity - Time disparity of cash flows produce conflicting

rankings between NPV and IRR methods that result

from the differing reinvestment assumptions made

by the NPV and the IRR - NPV criterion assumes cash flows are reinvested

at the required rate of return - IRR criterion assumes cash flows are reinvested

at the IRR - NPV criterion preferred since it is more

conservative assumption, since the required rate

of return is the lowest possible reinvestment rate

Unequal Lives Ranking Problem

Ranking Problems Unequal Lives

- Mutually Exclusive Projects with different life

spans - Decision is difficult since the projects are not

comparable - Two methods to deal with the problem
- Replacement Chains
- Equivalent Annual Annuity