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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