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Capital Budgeting Decision Methods October 27, 2008 1 Learning Objectives • The capital budgeting process. • Calculation of: Payback Net Present Value (NPV) $ Internal Rate of Return (IRR) % for proposed projects, for decision making. • Capital rationing, when funds are limited. 2 The Capital Budgeting Process • Capital Budgeting is the process of evaluating proposed investment projects for a firm. • Managers must determine which projects are acceptable from a financial standpoint • Examples might include: – purchase of fixed assets, – investments in R & D, or new businesses – Advertising; intellectual property 3 Relevant cash flows • The relevant cash flows are after-tax incremental cash flows – Axiom 4 • Cash flows that will occur if the project is done, and won’t occur if the project isn’t done. • Remember the brief case example The Accept/Reject Decision Three methods: • Payback Period – Time expressed in years to recoup the initial investment • Net Present Value (NPV) – change in value of the firm in $ if the project is accepted and completed • Internal Rate of Return (IRR) = K – projected rate of return (%) the 4 project will earn Capital Budgeting Methods - Payback • Consider Projects A and B that have the following expected cash flows: P R O J E C T Time A B 0 (10,000) (10,000) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 How long will it take for the firm to recover it’s investment? 5 Capital Budgeting Methods • What is the payback for Project A? P R O J E C T Time A B 0 (10,000) (10,000) 1 3,500 500 2 3,500 500 3 3,500 4,600 Payback in 4 3,500 10,000 *2.86 years 0 1 2 3 4 (10,000) 3,500 3,500 3,500 3,500 Cumulative CF -6,500 -3,000 +500 +4,000 8 *(Yr 1 + Yr 2 + 3000/3500 or 86% of Yr 3) (or 10,000/3,500 = 2.86) Capital Budgeting Methods • What is the payback for Project B? P R O J E C T Time A B 0 (10,000) (10,000) 1 3,500 500 2 3,500 500 3 3,500 4,600 Payback in 4 3,500 10,000 *3.44 years 0 1 2 3 4 (10,000) 500 500 4,600 10,000 Cumulative CF -9,500 -9,000 -4,400 +5,600 10 *(Yr 1 + Yr 2 + Yr 3 + 4,400/10,000 or 44% of Yr 4) Payback Decision Rule • Accept project if payback is less than the company’s predetermined maximum. • If company has determined that it requires payback in three years or less, then you would: – accept Project A (2.86 years) – reject Project B (3.44 years) 11 Payback - Problems • Does not consider cash received after the payback period is over Example: the remainder of the $10,000 in year four is ignored in project B • Does not consider the time value of money Example, the $3,500 per year for the four years in A may have a higher present value than project B, even though B pays back more total dollars ($15,600 vs. $14,000). Capital Budgeting Methods Net Present Value • Present Value of all costs and benefits (measured in terms of after-tax incremental cash flows) of a project. • It is the dollar amount of the change in the value of a firm as a result of undertaking the project. • A positive NPV increases firm value +$ • A negative NPV decreases the firm’s value -$ 12 Financial Calculator: • Additional Keys used to enter Cash Flows and compute the Net Present Value (NPV) P/YR CF NPV IRR N I/Y PV PMT FV Key used to enter expected cash flows in order of their receipt. Note: the initial investment (CF0) must be entered as a negative number since it is an 23 outflow. Financial Calculator: • Additional Keys used to enter Cash Flows and compute the Net Present Value (NPV) P/YR CF NPV IRR N I/Y PV PMT FV Key used to calculate the net present value of the cash flows ($) to be received by the company that have been entered in the calculator. 24 Financial Calculator: • Additional Keys used to enter Cash Flows and compute the Net Present Value (NPV) P/YR and Internal CF NPV IRR Rate of Return (IRR) N I/Y PV PMT FV Key used to calculate the internal rate of return (%) for the cash flows that have been entered in the calculator. 25 Calculate the NPV for Project B with calculator. P R O J E C T Time A B 0 (10,000) (10,000) 1 3,500 500 P/YR 2 3,500 500 CF NPV IRR 3 3,500 4,600 4 3,500 10,000 N I/Y PV PMT FV Note: First step is to press the CF button. Then press 2nd and CE/C to clear all prior data 26 Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: CF0 = -10,000 CF 10000 +/- ENTER P/YR CF NPV IRR N I/Y PV PMT FV 27 Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: C01 = 500 CF 10000 +/- ENTER P/YR 500 ENTER CF NPV IRR N I/Y PV PMT FV 28 Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: F01 = 2 CF 10000 +/- ENTER P/YR 500 ENTER CF NPV IRR 2 ENTER N I/Y PV PMT FV F stands for “frequency”. Enter 2 since there are two adjacent payments of 500 in periods 1 and 2. 29 Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: C02 = 4600 CF 10000 +/- ENTER P/YR 500 ENTER CF NPV IRR 2 ENTER N I/Y PV PMT FV 4600 ENTER 30 Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: F02 = 1 CF 10000 +/- ENTER P/YR 500 ENTER CF NPV IRR 2 ENTER N I/Y PV PMT FV 4600 ENTER 1 ENTER 31 Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: C03 = 10000 CF 10000 +/- ENTER P/YR 500 ENTER CF NPV IRR 2 ENTER N I/Y PV PMT FV 4600 ENTER 1 ENTER 10000 ENTER 32 Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: F03 = 1 CF 10000 +/- ENTER P/YR 500 ENTER CF NPV IRR 2 ENTER N I/Y PV PMT FV 4600 ENTER 1 ENTER 10000 ENTER 1 ENTER 33 Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: I = 10 NPV 10 ENTER P/YR CF NPV IRR k = 10% N I/Y PV PMT FV 34 Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: NPV = 1,153.95 NPV 10 ENTER P/YR CPT CF NPV IRR N I/Y PV PMT FV The net present value of Project B = $1,154 as we calculated previously. Note: If you press the IRR key, and 35 CPT, it will calculate the IRR for you, i.e. 13.5% Calculate the NPV for project A with calculator • CF -10,000 ENTER down arrow • CO1 3,500 ENTER down arrow • FO1 4 ENTER • Down arrow • CO2 NPV • I= 10 ENTER • NPV = CPT • NPV = $1,094.53 For IRR, punch the IRR key and then CPT NPV Decision Rule • Accept the project if the NPV is greater than or equal to 0. Example: NPVA = $1,095 >0 Accept NPVB = $1,154 >0 Accept •If projects are independent, accept both projects. •If projects are mutually exclusive, or you don’t have enough money to do both, accept the project 36 with the higher NPV, in this case project B. Capital Budgeting Methods • IRR (Internal Rate of Return) = K – IRR is the discount rate (K) that forces the NPV to equal zero. – It is the rate of return on the project given its initial investment and future cash flows. • We use the same equation as for NPV, except that NPV = zero, and we solve for k • Using the table method, and you have unequal amounts of cash flow, it can only be done by trial and error. For example, substitute values for k until the NPV comes out to zero. Ugh! So don’t even try. 37 • Use your financial calculator! Calculate the IRR for project A using the financial calculator – an annuity • If the payments are $3,500 each for four periods, and the present value is $10,000, the initial outlay, then • IRR = $3,500(PVIFA k, 4), solving for k • N=4 • PMT = 3,500 • PV = -10,000 • FV = 0 • CPT I/Y = 14.96% • You can also use Cash Flow method Calculate the IRR for Project B with calculator. Not an Annuity P R O J E C T Time A B 0 (10,000) (10,000) 1 3,500 500 P/YR 2 3,500 500 CF NPV IRR 3 3,500 4,600 4 3,500 10,000 N I/Y PV PMT FV See slides 17 – 23 for entering the unequal amounts in project B 39 Calculate the IRR for Project B with calculator. P R O J E C T IRR = 13.5% Time A B 0 (10,000) (10,000) 1 3,500 500 P/YR 2 3,500 500 CF NPV IRR 3 3,500 4,600 4 3,500 10,000 N I/Y PV PMT FV Enter Cash Flows as for NPV IRR CPT Calculate IRR for project A with calculator. = 14.96% 40 IRR Decision Rule • Accept the project if the IRR is greater than or equal to the required rate of return (k). • Reject the project if the IRR is less than the required rate of return (k). Example: If k = 10% IRRA = 14.96% > 10% Accept IRRB = 13.50% > 10% Accept 41 What if NPV and IRR give different results? • Which project(s) should the firm accept? NPV IRR • A $1,095 14.96% • B $1,154 13.5% 48 NPV/IRR Decision Rules •If projects A & B are independent, and you have enough money, accept both projects •If projects A & B are mutually exclusive, meaning you can only pick one or the other, or you don’t have enough money to do both, •Always choose the project with the highest NPV. See page 257 (280), mid-page 49 What is capital rationing? • Capital rationing is the practice of placing a dollar limit on the total size of the capital budget. • This practice may not be consistent with maximizing shareholder value but may be necessary for other reasons, like lack of cash. • Choose between projects by selecting the combination of projects that yields the highest total NPV without exceeding the capital budget cash outlay limit. 54 Capital Rationing example p. 261 (284) • Project Cash Outlay NPV –A $20,000 $8,000 –B $50,000 $7,200 –C $40,000 $6,500 –D $60,000 $5,100 –E $50,000 $4,200 –F $30,000 $3,800 –G $30,000 $2,000 $280,000 If cash outlay spending limit is $200,000, which combination of projects should be chosen to maximize NPV? Capital Rationing example p. 261 (284) • Project Cash Outlay NPV A,B,C,D $170,000 $26,800 A,B,C,D,F $200,000 $30,600 A,B,C,D,G $200,000 $28,800 B,C,D,E $200,000 $23,000 B,C,E,F,G $200,000 $23,700 A,C,D,E,F $200,000 $27,600 A,C,D,E,G $200,000 $25,500 Mutually Exclusive Projects With Unequal Lives • Mutually exclusive projects with unequal project lives can be compared by using the Replacement Chain method 68 Replacement Chain Approach • Assumes each project can be replicated until a common period of time has passed, allowing the projects to be compared. • Example – Project Cheap Talk has a 3-year life, with an NPV of $4,424. – Project Rolles Voice has a 12-year life, with an NPV of $12,000. 69 Replacement Chain Approach • Project Cheap Talk could be repeated four times during the life of Project Rolles Voice. (4 x $4,424 = $17,696?) • The NPVs of Project Cheap Talk, in years t3, t6, and t9, need to be discounted back to year t0. 70 Replacement Chain Approach • The NPVs of Project Cheap Talk, in years t3, t6, and t9, are discounted back to year t0, which results in an NPV of $12,121. So choose project Cheap Talk k=10% 0 3 6 9 4,424 4,424 4,424 4,424 3,324 2,497 1,876 71 12,121 Disparate sizes • Suppose capital budget is $10,000 • Project A: $2,000 with NPV of $1,000 • Project B: $10,000 with NPV of $3,000 • Which should you choose? Say you only have $10,000 and can’t do both. Disparate Sizes • Ans: depends on what you can earn on the extra $8,000 if you choose Project A. If the combined NPV’s for project A plus what you earned on the other $8,000 exceeds the NPV of project B, then do project A plus others. • Otherwise, choose project B • Always choose the option with the highest NPV!

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posted: | 6/26/2011 |

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