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Capital Budgeting Techniques and Practice

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Discuss why it is difficult to find profitable projects. Use capital budget techniques to evaluate new projects. Discuss Capital Rationing concerns ... – PowerPoint PPT presentation

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Title: Capital Budgeting Techniques and Practice


1
Capital Budgeting Techniques and Practice
Chapter 9
2
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

3
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

4
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?

5
Capital Budgeting Decision Criteria
  • Payback Period
  • Net Present Value
  • Profitability Index (Benefit-Cost Ratio)
  • Internal Rate of Return

6
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

7
Payback Period Examples
8
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)

9
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

10
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

11
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

12
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

13
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

14
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

15
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

16
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

17
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

18
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)

19
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

20
NPV and IRR Compared
21
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22
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

23
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

24
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

25
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

26
Size Disparity Example
27
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

28
Time Disparity Example
29
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

30
Unequal Lives Ranking Problem
31
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
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