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FINANCE 7311

This comprehensive guide to capital budgeting outlines essential investment criteria for evaluating potential projects. It highlights the differences between mutually exclusive and independent projects, along with methods such as Net Present Value (NPV) and Internal Rate of Return (IRR) to assess their viability. Understand various cash flow analysis techniques, including profitability index and decision tree analysis, while exploring relevant cash flows and the importance of focusing on incremental cash flows. This resource is vital for financial professionals aiming to make informed project investment decisions.

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FINANCE 7311

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  1. FINANCE 7311 CAPITAL BUDETING

  2. Outline • Projects • Investment Criteria • NPV v. IRR • Sources of NPV • Project Cash Flow Checklist

  3. Projects • A project is any potential real investment opportunity • Distinguish real from financial • Mutually Exclusive - can do only one • Independent - decision about one does not affect decision w/r/t the others • Replacement - special case

  4. Investment Criteria • Investment criteria are the rules by which we decide whether or not to accept a particular project; consider the following:

  5. Accounting Rate of Return • ARR = Avg. Income / Avg. Investment • Uses Income rather than Cash Flow • Ignores Time Value of Money

  6. Payback • Years needed to recover initial investment • To Find: Calculate where cumulative cash flows become positive • Project A: 2 1/6 years • Project B: 2 6/7 years

  7. Problems with Payback • Ignores Time Value of Money • Can use Discounted Payback; Why? • Ignores CF’s after payback • To see: Assume Project B’s cash flow in year 4 is 1,000,000; how does this affect payback

  8. Net Present Value • This rule is always consistent with maximizing the value of the firm • Economically, take all projects for which benefits > costs (in PV dollars) • Mathematically, sum the present values of all the cash flows

  9. Net Present Value

  10. NPV example

  11. Internal Rate of Return (IRR) • IRR - That rate which causes NPV to = 0.

  12. IRR • Independent Projects - select all projects for which IRR > Cost of Capital • Mutually Exclusive - select project with highest IRR • Use ‘well-designed’ spreadsheet

  13. Comparison of NPV & IRR • Business people are accustomed to thinking in rates of return, so does it matter which of NPV or IRR we use? • Independent - the two rules are equivalent • NPV > 0 <==> IRR > Cost of Capital

  14. Comparison of NPV & IRR • Mutually Exclusive Projects - can get different answers • NPV Profile for Example • Reinvestment Assumption

  15. NPV v. IRR Example • Project 1: (100,000) 125,000 • Project 2: 1,000 2,000 • NPVIRR • Project 1 13,636 25% • Project 2 818 100%

  16. NPV v. IRR, cont. • IRR ==> Do Project 2 • NPV ==> Do Project 1 • Problem: Reinvestment Assumption • What are you going to do with the other $99,000?

  17. Profitability Index • PV Cash Inflows / PV Cash Outflows • Independent: Choose all with PI > 1 • Mutually Exclusive: Choose highest PI • Project 1: 1.136 • Project 2: 1.818 • May be useful for capital rationing

  18. Other Real Options • Option to Expand • Option to Abandon • Strategic Options • Excluding biases NPV down • Decision Tree: Capital Budgeting should be dynamic, not static

  19. Source of NPV • Market Opportunities - ‘deviations from equilibrium’ • Economies of Scale • Cost Advantages • Product differentiation • Distribution Advantage • Regulatory Protection

  20. Relevant Cash Flows • We can always write: • EBIT • + Depreciation • - Taxes (t x EBIT) • = Operating Cash Flow • - ∆ NWC • - Capital Spending • = FCF

  21. Cash Flows • Focus on Cash Flows; not accounting #’s • Depreciation • Not a cash flow • Affects Cash Flow through depreciation • Capital spending • Capitalized for accounting purposes • Cash outflow for finance purposes

  22. Project Cash Flows • Focus on Incremental Cash Flows • “What is different if project is accepted?” • Sunk Costs - those costs which have been incurred and are not affected by project decision • Opportunity Cost - highest value use of an asset if not used in project

  23. Project CF’s, cont. • Externalities - less obvious costs/benefits which should be included in analysis • Change in NWC - often a cash outflow initially and cash inflow at end • Cash flows should be after tax • ∆Rev/Exp x (1-t) • Depreciation x t • Do not include interest as a cash flow

  24. Project CF’s, cont. • Replacement problem - should you keep an existing asset, or replace it with a new one • ∆ in Cash Flows • Net of tax proceeds from disposal of existing asset

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