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## CHAPTER 11 Capital Budgeting Decision Criteria

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**CHAPTER 11Capital Budgeting Decision Criteria** 2005, Pearson Prentice Hall**CHAPTER 11The Basics of Capital Budgeting**Should we build this plant?**What is capital budgeting?**• The process of planning for purchases of long-term assets. • Analysis of potential additions to fixed assets. • Long-term decisions; involve large expenditures, therefore irreversible once made. • Very important to firm’s future.**Capital Budgeting**• For example: Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? • Will the machine be profitable? • Will our firm earn a high rate of return on the investment?**Decision-making Criteria in Capital Budgeting**How do we decide if a capital investment project should be accepted or rejected?**Decision-making Criteria in Capital Budgeting**• The ideal evaluation method should: a) include all cash flows that occur during the life of the project, b) consider the time value of money, and c) incorporate the required rate of return on the project.**Steps to capital budgeting**• Estimate CFs (inflows & outflows). • Assess riskiness of CFs. • Determine the appropriate cost of capital. • Find NPV and/or IRR. • Accept if NPV > 0 and/or IRR > WACC.**What is the difference between independent and mutually**exclusive projects? • Independent projects – if the cash flows of one project are unaffected by the acceptance of the other projects. • Mutually exclusive projects – if the cash flows of one project can be adversely impacted by the acceptance of the other project. These are a set of projects that perform essentially the same task, so that acceptance of one will necessarily mean rejection of the others.**What is the difference between normal and nonnormal cash**flow streams? • Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. (- + + + + +) CF($) (500) 150 150 150 150 150 Year 0 1 2 3 4 5 • Non-normal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. .(- + + - + +). Examples: Nuclear power plant, strip mine, etc. CF ($) (500) 200 100 (200) 400 300 Year 0 1 2 3 4 5**(500) 150 150 150 150 150 150 150 150**8 7 0 1 2 3 4 5 6 Payback Period • How long will it take for the project to generate enough cash to pay for itself?**(500) 150 150 150 150 150 150 150 150**8 7 0 1 2 3 4 5 6 Payback Period • How long will it take for the project to generate enough cash to pay for itself? Payback period = 3.33 years (50/150 =0.33)**Payback Period**• Is a 3.33 year payback period good? • Is it acceptable? • Firms that use this method will compare the payback calculation to some standard set by the firm. • If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? • Accept the project.**2.4**3 0 1 2 Project L 80 CFt-100 10 60 100 Cumulative -100 -90 0 50 -30 30 80 PaybackL = 2 + / = 2.375 years = 1.6 3 0 1 2 Project S CFt-100 70 100 20 50 Cumulative -100 0 20 40 -30 30 50 PaybackS = 1 + / = 1.6 years = Further Example:Calculating payback**Strengths of payback**• Provides an indication of a project’s risk and liquidity. • Easy to calculate and understand.**Drawbacks of Payback Period**• Firm cutoffs are subjective. • Does not consider time value of money. • Does not consider any required rate of return. • Ignores cash flows occurring after the payback period.**(500) 150 150 150 150 150 150 150 150**8 7 0 1 2 3 4 5 6 Drawbacks of Payback Period • Does not consider all of the project’s cash flows. • Consider this cash flow stream!**(500) 150 150 150 150 150 150 150 150**8 7 0 1 2 3 4 5 6 Drawbacks of Payback Period • Does not consider all of the project’s cash flows. • This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!**Discounted Payback**• Uses discounted cash flows rather than raw cash flows. • Discounts the cash flows at the firm’s required rate of return. • Payback period is calculated using these discounted net cash flows. Problems: • Cutoffs are still subjective. • Still does not examine all cash flows.**(500) 250 250 250 250 250**1 2 3 4 5 0 Discounted Payback Discounted YearCash FlowCF (14%) 0 -500 -500.00 1 250 219.301 year 280.70 2 250 192.372 years 88.33 3 250 168.74**(500) 250 250 250 250 250**1 2 3 4 5 0 Discounted Payback Discounted YearCash FlowCF (14%) 0 -500 -500.00 1 250 219.301 year 280.70 2 250 192.372 years 88.33 (88.33/168.74)= 3 250 168.74 .52 years**(500) 250 250 250 250 250**1 2 3 4 5 0 The Discounted Payback is 2.52 years Discounted Payback Discounted YearCash FlowCF (14%) 0 -500 -500.00 1 250 219.301 year 280.70 2 250 192.372 years 88.33 3 250 168.74 .52 years**2.7**3 0 1 2 10% CFt -100 10 60 80 PV of CFt -100 9.09 49.59 60.11 Cumulative -100 -90.91 18.79 -41.32 Disc PaybackL = 2 + / = 2.7 years = 41.32 60.11 Further Example:Discounted payback period**Other Methods(Discounted Cash Flow Methods)**1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Consider each of these decision-making criteria: • All net cash flows. • The time value of money. • The required rate of return.**n**t=1 S FCFt (1 + k) NPV = - IO t Net Present Value • NPV = the total PV of the annual net cash flows - the initial outlay.**Net Present Value**Decision Rule: • If NPV is positive, accept. • If NPV is negative, reject.**NPV Example**• Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15%.**(250,000) 100,000 100,000 100,000 100,000**100,000 0 1 2 3 4 5 NPV Example • Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15%.**Net Present Value**NPV is just the PV of the annual cash flows minus the initial outflow. Mathematical Solution: PV of cash flows = $100,000(PVIFA15%,5) = $100,000(3.352) PV of cash flows =$335,216 - Initial outflow($250,000) = Net PV$85,216**EXAMPLE:What is Project S’s and L’s NPVs?**Year CFs PVs CFLPV L 0 -100 -100 -$100.00 1 70 10 9.09 2 50 60 49.59 3 20 80 60.11 NPVs = $19.98 NPVL= $ 18.79 (k = 10%)**Rationale for the NPV method**NPV = PV of inflows – Cost = Net gain in wealth • If projects are independent, accept if the project NPV > 0. • If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. • In this example, we would accept S if the 2 projects are mutually exclusive (NPVs > NPVL), and would accept both if they are independent projects.**n**t=1 S FCFt (1 + k) NPV = - IO t Profitability Index**n**t=1 S FCFt (1 + k) NPV = - IO t n t=1 S FCFt (1 + k) PI = IO t Profitability Index**Profitability Index**• Decision Rule: • If PI is greater than or equal to 1, accept. • If PI is less than 1, reject.**n**t=1 S FCFt (1 + k) PI = IO t Mathematical Solution PI = $335,216/$250,000 = 1.34**Internal Rate of Return (IRR)**• IRR: The return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.**n**t=1 S FCFt (1 + k) NPV = - IO t Internal Rate of Return (IRR)**n**t=1 S FCFt (1 + k) NPV = - IO t n t=1 FCFt (1 + IRR) S IRR: = IO t Internal Rate of Return (IRR)**n**t=1 FCFt (1 + IRR) S IRR: = IO t Internal Rate of Return (IRR) • IRR is the rate of return that makes thePV of the cash flowsequal to the initial outlay. • This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.**(250,000) 100,000 100,000 100,000 100,000**100,000 0 1 2 3 4 5 Calculating IRR • Looking again at our problem: • The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.**IRR with your Calculator**• IRR is easy to find with your financial calculator. • Just enter the cash flows as you did with the NPV problem and solve for IRR. • You should get IRR = 28.65%!**IRR**Decision Rule: • If IRR is greater than or equal to the required rate of return, accept. • If IRR is less than the required rate of return, reject.**IRR Acceptance Criteria**• If IRR > k, accept project. • If IRR < k, reject project. • If projects are independent, accept both projects, if both projects’ IRR > k. • If projects are mutually exclusive, accept the project with the higher IRR.**1 2 3**(500) 200 100 (200) 400 300 0 1 2 3 4 5 • IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)**Rationale for the IRR method**• If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns.**(900) 300 400 400 500 600**0 1 2 3 4 5 Summary Problem • Enter the cash flows only once. • Find the IRR. • Using a discount rate of 15%, find NPV. • Add back IO and divide by IO to get PI.**(900) 300 400 400 500 600**0 1 2 3 4 5 Summary Problem • IRR = 34.37%. • Using a discount rate of 15%, NPV = $510.52. • PI = 1.57.**NPV Profiles**• A graphical representation of project NPVs at various different costs of capital. k NPVLNPVS 0 $50 $40 5 33 29 10 19 20 15 7 12 20 (4) 5**Drawing NPV profiles**NPV ($) 60 . 50 . 40 . Crossover Point = 8.7% . 30 . . IRRL = 18.1% 20 . . S . IRRS = 23.6% 10 L . . Discount Rate (%) 0 5 15 20 23.6 10 -10**Comparing the NPV and IRR methods**• If projects are independent, the two methods always lead to the same accept/reject decisions. • If projects are mutually exclusive … • If k > crossover point, the two methods lead to the same decision and there is no conflict. • If k < crossover point, the two methods lead to different accept/reject decisions.**Findingthe crossover point(using financial calculator)**• Find cash flow differences between the projects for each year. • Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%. • Can subtract S from L or vice versa, but better to have first CF negative. • If profiles don’t cross, one project dominates the other.