Capital Budgeting by suchenfz


									Capital Budgeting

    Chapter 12
• Capital budgeting: process by which
  organization evaluates and selects long-term
  investment projects
  – Ex. Investments in capital equipment, purchase or
    lease of buildings, purchase or lease of vehicles,
• There are various techniques used to make
  capital budgeting decisions.
• Small businesses use this method because it is
• Requires calculation of number of years required
  to pay back original investment
• Payback-based decisions:
  – Between two mutually exclusive investment projects,
    choose project with shortest payback period
  – Set a predetermined standard
     • Ex. “Accept all projects with payback of less than 5 years and
       reject all others”
• Poor method on which to rely for allocation of scarce capital
  resources because:
    1.   Payback ignores time value of money
    2.   Payback ignores expected cash flows beyond payback period.
• Ex.:      PROJECT A                                PROJECT B
            Cost = $100,000                         Cost = $100,000
            Expected Future Cash Flow:        Expected Future Cash Flow:
            Year 1    $50,000                     Year 1     $100,000
            Year 2    $50,000                       Year 2    $5,000
            Year 3    $110,000                      Year 3    $5,000
            Year 4 and thereafter: None       Year 4 and thereafter: None
            Total = $210,000                        Total = $110,000
            Payback = 2 years                       Payback = 1 year
-Payback period for Project B is shorter, but Project A provides higher return
-Project A is superior to Project B.
              Net Present Value
• Difference between present value of expected
  future benefits of project to present value of
  expected cost of project
• If NPV is positive (if present value of benefits
  exceeds present value of cost), then project is
• If NPV is negative (if present value of costs exceeds
  present value of benefits), then project is rejected.
   – Where NPV = net present value
               PVB = present value of benefits
              PVC = present value of costs
                 Net Present Value
• Between two mutually exclusive projects, choose project
  with highest net present value.
• Ex.: Consider Project A and Project B and 12% discount rate

   PVBa = ($50,000)(0.893) + ($50,000)(0.797) + ($110,000)(0.712)
   PVBa = $162,820
   PVBb = ($100,000)(0.893) + ($5,000)(0.792) + ($5,000)(0.712)
   PVBb = $96,820
   PVCa = PVCb = $100,000

   NPVa = $162,000 – $100,000 = $62,800
   NPVb = $96,820 – $100,000 = ($3,180)

   – Project A is superior to Project B because PVBa > PVCa and
     PVBb < PVCb
   – Return on Project B is insufficient to justify investment
     given firm’s cost of capital.
            Net Present Value
Selection of a Discount Rate
• To find discounted present value of sum of
  money to be received in future, choose rate at
  which money in hand may be invested
  between now and future period in which
  money is to be received.
  – This rate represents individual’s “opportunity
    cost,” or cost of next-best opportunity.
           Internal Rate of Return
• Discount rate that exactly equates present value of
  expected benefits to cost (drives NPV to zero)
• Find this discount rate by trial and error
• Ex.:
   – Use discount rate of 20% as first estimate of IRR on Project
     NPVa = PVBa – PVCa
     NPVa = $40,040
   – Since NPV is too high, use higher estimate of 40%.
     NPVa = $1,240
   – Use estimate of 41% to get closer to zero.
      NPVa = $290
           Internal Rate of Return
• Investment of $100,000 at 41% annual compound rate of
  return allows withdrawal of that investment as a cash flow of
  $50,000 at end of 1 year, $50,000 at end of 2nd year, and
  $110,000 at end of 3rd year.

                     Project A Cash Flow Schedule
                                      1          2        3
    Beginning investment         $100,000    $91,000 $78,310
    Annual earnings at 41%          41,000     37,310 _32,107
        Subtotal                  $141,000   $128,310 $110,417
    Annual cash flow               (50,000)   (50,000) (110,417)
        Ending investment          $91,000    $78,310    $-0-
        Internal Rate of Return
• In general, any project with IRR greater than
  or equal to cost of capital should be
  accepted. Any project with IRR less than cost
  of capital should be rejected.
• In this case, Project A would be accepted.
        Internal Rate of Return
• Ex. (continued):
• IRR for Project B is approximately 8.75%.
  NPVb = $120
• 8.75% per year is less than cost of capital of
  12%. Achieved rate of return on Project B falls
  short of attainable rate of return on other
           Internal Rate of Return
IRR of an Annuity
• Project A and Project B do not provide benefits in form of
  annuity (constant annual cash flow).
• If project costing $100,000 and returning $25,000 per year for
  5 years is available, calculate appropriate annuity factor:
                  $100,000 = $25,000X
                         X = 4.0
• X represents annuity factor that will cause $25,000, 5-year
  annuity to have present value of $100,000.
• Refer to table of annuity factors in Exhibit 11.4 to find
  discount rate that has present value of annuity factor equal to
  4.00 after 5 years.
        Internal Rate of Return
Personal Computer Applications
• Most basic business-oriented electronic
  calculators, personal computers, business-
  oriented spreadsheet applications, special-
  purpose capital budgeting software packages
  can do actual calculations or be programmed
  to solve capital budgeting problems.
            Profitability Index
• Also benefit/cost ratio
• Calculated as ratio of present value of
  benefits of investment to cost of investment
           PI = NPV(benefits)/NPV(costs)
• General rule: All projects with PI > 1.0 should
  be accepted.
• Between two or more mutually exclusive
  projects having different costs, choose project
  with highest profitability index.
            Profitability Index
• Investment decisions based on profitability
  index will be same as decisions made using
  net present value.
• All projects having positive net present value
  have profitability index larger than 1.0 and
  therefore are acceptable.
          Selection of Method
• All 3 methods (net present value, internal rate
  of return, profitability index) result in same
  accept-reject decision for given investment
• There are three important circumstances
  under which methods may yield conflicting
            Selection of Method
1. Choosing from among mutually exclusive
    investment projects with similar costs, but
    radically differing time patterns of cash inflows.
   – Ex. One project provides large cash flows in early
       years and small cash flows in later years
       compared with another project providing small
       cash flows in early years but large cash flows in
       later years.
     •   Project having highest net present value and
         profitability may have lowest internal rate of return.
           Selection of Method
1. (continued)
  – Choice of method depends on which assumption
    is closest to reality.
  – Choice should be based on which reinvestment
    rate is closest to rate that firm will be able to
    earn on cash flows generated by project.
    •   If cash flows can be reinvested at cost of capital, select
        project with higher net present value.
    •   If cash inflows can be reinvested at IRR of project,
        select project with higher IRR.
           Selection of Method
1. (continued)
  – General rule: NPV method should be preferred if
    conflict arises because projects with very high
    IRRs relative to firm’s cost of capital are rare. In
    most cases, reinvestment rate will be closer to
    cost of capital than to IRR and thus, NPV method
    is normally preferred to IRR method.
           Selection of Method
2. Choosing from among mutually exclusive
   projects with widely differing costs.
  – If project with highest NPV has lowest PI and IRR,
    in general, give preference to project with
    highest NPV since this will maximize value of
  – If project with highest PI and IRR is substantially
    less expensive than competing project, former is
    selected because lower-cost project may be
    perceived as less risky than higher-cost project.
           Selection of Method
3. Capital rationing where insufficient capital is
   available to accept all projects having
   positive NPVs.
  – Rank-order projects from highest IRR to lowest
    and select projects that firm has sufficient capital
    to accept.

  •   In general, NPV method preferred over IRR and
      PI methods.
       Dealing With Uncertainty
• In practice, uncertainty is often dealt with
  through simple mechanism of assigning
  higher discount rate to riskier projects.
  – How much higher depends on management’s
    perception of degree of risk and additional
    compensation required because of that risk
                         Case Study
• Droppitt Parcel Company is considering purchasing new
  equipment to replace existing equipment that has book value
  of zero and market value of $15,000.
• New equipment costs $90,000 and is expected to provide
  production savings and increased profits of $20,000 per year
  for the next 10 years.
• New equipment has expected useful life of 10 years, after
  which its estimated salvage value would be $10,000.
• Straight-line depreciation
    Effective tax rate: 34%
    Cost of capital: 12%
• “Machinery Replacement” Problem: Should Droppitt replace
  current equipment?
                 Case Study
• See Exhibit 12.4
1. Effective cost of new equipment: $80,100
  – Droppits trades its old equipment in for new
    equipment by selling it and applying sale
    proceeds to new equipment.
                      Case Study
2. Calculate present value of expected benefits
   of new equipment.
  –  All benefits have been converted to after-tax basis before
     present values are calculated.
  – Profit increase is multiplied by 0.66 (1.00 – tax rate) to
     determine increased profit remaining after tax.
  – Calculate tax benefit resulting from effect of depreciation by
     multiplying annual depreciation deduction by effective tax
  – Reflects salvage value of new equipment at end of its expected
     useful life.
    • No tax effect here because there is no profit or loss
                 Case Study
3. NPV: $13,068
4. IRR (solved by trial and error using electronic
   calculator): 15.7%
• New machine should be purchased to
   replace old machine since NPV is positive
   and IRR exceeds cost of capital.

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