Capital Budgeting Arguing for your project
Arguing for your project • Capital budgeting • CFO receives proposals from divisions • Projects described by cash flows
Arguing means applying measures • Net present value is the right measure. • Many smart people use the wrong ones. • Alternative ways to the same end.
Uses of measures • Project acceptance • Mutually exclusive alternatives.
Capital Budgeting Techniques • Kim, Crick, and Kim, Management Accounting • Nov. 1986, p. 49-52
Make no mistake • NPV is the right measure always. • Others work sometimes. • NPV measures value to owners, their wealth.
Objectives of a good measure • Value cash flows. • Respond to the market.
NPV’s merits • Values cash flows as the market does. • Responsive because the discount rate is the current market rate. • Measures increase in shareholder value.
Payback period is • The time required for undiscounted cash flows to add up to the initial investment. • e.g., build a Wendy’s if it “pays for itself” in two years or less.
Payback merits • Based on cash flows
Payback defects • No market response.When r is high, payback period should be shorter. • Subtracts time-t dollars from time-0 dollars, a cardinal sin. • Ignores cash flow after payback. • Ignores timing during payback.
Defects are not necessarily fatal • Repeated, similar investments. • Stable financial conditions.
The well-informed capital budgeter knows • When to accept payback period as a measure. • When it is likely to fail.
Accounting rate of return • Doesn’t value cash flows • No market response • Ignores market values • Scaling problems: melons or malls
Merits of accounting r.o.r. • Easily understood. • Sometimes okay in stable markets. • Smart application can overcome defects.
Internal rate of return • Definition: IRR is the discount rate that makes NPV = 0 That is, IRR is the r such that
Internal rate of return • Definition: IRR is the discount rate that makes NPV(r) = 0. • NPV(r) is a function. • RWJ Figures 6.4 and 6.5.
IRR =23.37 48.685 .1 NPV(r) Figure 6.4: NPV(r)=0 at r=23.37% NPV NPV(.1) = 48.68520 100 r
Figure 6.4 • NPV (r) = 0 at r = 23.37%
Applications of IRR measure • Hurdle rate = market rate • Project acceptance: Accept a project if IRR > hurdle rate. • Mutually exclusive projects: Take the one with the highest IRR (> hurdle rate)????? Don’t rely on it.
Project acceptance: • NPV and IRR give the same conclusion when ... • Cash flows have one sign change. • In the example: IRR = 23.37% > hurdle = 10% for an investment project. • IRR = 23.37% < hurdle rate = 30% for a financing or “borrowing from nature” project.
Merits • Uses cash flows. • Responds to the market when the hurdle rate changes
Objective • Learn to recognize the times when NPV and IRR are the same. • and also the problems with IRR
Defects of IRR -- project acceptance • Lending to nature or borrowing from her? • Multiple IRR's may occur.
Financing (borrowing from nature) • Seek IRR < hurdle rate • Same as NPV > 0
IRR’s at r = 1 and r = 2 • 100% per decade = 7.17735% per year. • 200% per decade = 11.61232% per year.
IRR’s at r=1 and r=2. NPV 100% 200% r
Descartes’ Rule • The number of internal rates of return is no more than the number of sign changes.
Defects of IRR -- mutually exclusive projects • Ignores market values. • Scale problems -- melons or malls.
Typical hour exam question • What is the scale problem in using IRR to choose between mutually exclusive projects?
Scale problem in IRR One canyon, one dam.
Sketch of answer • The smaller dam has the higher IRR. • The big dam has higher value. • The big dam extends consumption possibility of owners more than the little dam does. • It is wrong to take the higher IRR in this case.
More answer • Consider the project of replacing the little dam by the big dam. • Cash flows are -900, +1300. • IRR of the project is 4/9 = .4444 > .1 • NPV is 281.8181… • So replace the little dam. • Capital budgeting jiu jitsu.
NPV 500 Big dam 100 Little dam r IRR IRR 50% 100%
Big dam, little dam For hurdle rates below r*, the big dam is preferred. NPV NPV of the big dam 500 NPV of the small dam 100 r 1 r* .5 r* = .4444...