Capital Budgeting by mu80rArl

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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

                  Chapters 6 & 7 – MBA504   1
      Net Present Value (NPV) Rule
• Net Present Value (NPV) =
   Total PV of future CF’s + 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 > 0
• Ranking Criteria: Choose the highest NPV
                     Chapters 6 & 7 – MBA504              2
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.




                           Chapters 6 & 7 – MBA504                           3
      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

                      Chapters 6 & 7 – MBA504       4
Initial outlay -$1,000
    Year Cash flow
         1         $200
         2         400
         3         600

                 Accumulated
    Year Cash flow
         1
         2
         3

Payback period =




                         Chapters 6 & 7 – MBA504   5
      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.



                 Chapters 6 & 7 – MBA504     6
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



                     Chapters 6 & 7 – MBA504      7
Average Accounting Return Rule
                    Average Net Income
      AAR 
             Average Book Value of Investent
• 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
                   Chapters 6 & 7 – MBA504             8
      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.




                     Chapters 6 & 7 – MBA504                9
                     Example
Consider the following project:
               $50                  $100       $150



   0            1                    2          3
 -$200

The internal rate of return for this project is 19.44%
                $50        $100       $150
   NPV  0                        
             (1  IRR ) (1  IRR ) (1  IRR )3
                                  2


                     Chapters 6 & 7 – MBA504          10
  NPV Payoff Profile for The Example
If we graph NPV versus discount rate, we can see the IRR as
the x-axis intercept.
Discount Rate      NPV           $120.00
     0%         $100.00          $100.00
     4%          $71.04           $80.00
     8%          $47.32
                                  $60.00
    12%          $27.79
                                  $40.00
                           NPV
    16%          $11.65
    20%          ($1.74)
                                                                            IRR = 19.44%
                                  $20.00
    24%         ($12.88)           $0.00
    28%         ($22.17)
    32%         ($29.93)
                                        -1%
                                 ($20.00)            9%         19%         29%        39%
    36%         ($36.43)         ($40.00)
    40%         ($41.86)         ($60.00)
                                                            Discount rate


                                  Chapters 6 & 7 – MBA504                         11
   Problems with the IRR Approach
• Multiple IRRs.
• The Scale Problem.
• The Timing Problem.




                   Chapters 6 & 7 – MBA504   12
                      Multiple IRRs
There are two IRRs for this project:
                  $200       $800                       Which one should
                                                                we use?
    0             1               2            3
  -$200                                    - $800
NPV




      $100.00
                                                    100% = IRR2
       $50.00

         $0.00
  -50%        0%          50%         100%          150%      200%
     ($50.00)
                         0% = IRR1                     Discount rate
      ($100.00)

      ($150.00)           Chapters 6 & 7 – MBA504                      13
       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?




              Chapters 6 & 7 – MBA504     14
The Timing Problem (page 161)
                              $10,000         $1,000   $1,000
   Project A
                      0             1             2       3
                    -$10,000
                             $1,000           $1,000    $12,000
   Project B
                      0             1             2       3
                    -$10,000
The preferred project in this case depends on the discount
rate, not the IRR.
                    Chapters 6 & 7 – MBA504                     15
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.



                       Chapters 6 & 7 – MBA504         16
Which project is good?
 Net present value                                                   Year
   160                                              0       1         2     3         4
   140                           Project A:      – $350         50   100    150       200
   120
   100                           Project B:      – $250     125      100    75        50
    80
    60
    40
               Crossover Point
    20
     0
   – 20
   – 40
   – 60
   – 80
  – 100                                                                               Discount rate
          0   2%        6%       10%          14%         18%        22%        26%


                                         IRR A          IRR B




                                  Chapters 6 & 7 – MBA504                                             17
HOW TO FIND CROSS POINT

  PROJECT A          PROJECT B            A-B

     -350                -250             -100
      50                 125               -75
      100                100                0
      150                 75                75
      200                 50               150

    12.91%             17.80%          8.07%
  IRR(A3: A7)        IRR(B3: B7)     IRR(C3: C7)




                Chapters 6 & 7 – MBA504            18
           Decision Rule
• If required rate of return < crossover return,
  take the project with lower IRR
• If required rate of return > crossover return,
  take the project with higher IRR
• Don’t think a project with higher IRR is
  always good
• Projects with higher NPV is always good



                 Chapters 6 & 7 – MBA504           19
         Profitability Index (PI) Rule
             Total PV of Future Cash Flows
        PI 
                      Initial Investent
•   Minimum Acceptance Criteria: Accept if PI > 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

                       Chapters 6 & 7 – MBA504                20
  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.




                 Chapters 6 & 7 – MBA504        21
   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

                  Chapters 6 & 7 – MBA504               22
    Incremental Cash Flows
•   Cash flows matter—not accounting earnings.
•   Sunk costs don’t 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.

                      Chapters 6 & 7 – MBA504         23
Cash Flows—Not 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.

              Chapters 6 & 7 – MBA504   24
       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.


                     Chapters 6 & 7 – MBA504              25
     Incremental Cash Flows
• Side effects matter (page 180)
  – Erosion
  – Synergy




               Chapters 6 & 7 – MBA504   26
        Estimating Cash Flows
• Cash Flows from Operations
  – Recall that:
  Operating Cash Flow = EBIT – Taxes + Depreciation
• Net Capital Spending
  – Don’t 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.



                      Chapters 6 & 7 – MBA504             27
    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.


                            Chapters 6 & 7 – MBA504                       28
                  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


                    Chapters 6 & 7 – MBA504          29

								
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