# 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
– 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
– Ignores the time value of money
– Uses an arbitrary benchmark cutoff rate
– Based on book values, not cash flows and market values
– 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
– 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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