Ch 9 Learning Goals

1. Ch 9 Learning Goals 1.Calculate, interpret, and evaluate: payback period. net present value (NPV). internal rate of return (IRR). 2. Ranking conflicts.

2. Ch 9 Learning Goals 3. The importance of risk in capital budgeting. 4. Methods of evaluating project risk. 5. Determination and use of risk-adjusted discount rates (RADRs). 6. Capital rationing.

3. CB Evaluation Techniques Techniques used to evaluate capital outlays include: Payback Net present value (___________) Internal rate of return (___________)

4. CB Evaluation Techniques • Not all evaluation techniques are equally valid. The best rely on: • Cash Flows (rather than accounting values) • Time value of money • Techniques that do these two things are _________ _________________________________________ (DCF) methods (called “sophisticated” in your text).

5. Payback Period • The payback method measures how many years it takes to recover the initial investment. • The maximum acceptable payback period is determined by management. • Decision rule: accept if the payback period is _______ ___________________________ the maximum acceptable payback period.

6. Pros and Cons of Payback Periods • Payback is simple, intuitive, and considers cash flows rather than accounting profits. • Payback is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. • It is also used to supplement other methods such as NPV and IRR.

7. Pros and Cons of Payback Periods • Weaknesses of Payback: • Does not consider all CFs • Does not consider TVOM • The appropriate payback period is __________________________ determined • It is not a ___________________ method (it is unsophisticated)

8. Pros and Cons of Payback Periods

9. Net Present Value (NPV) • Net Present Value (NPV). Net Present Value is found by subtracting the initial investment from the present value of the after-tax inflows. Decision Criteria If NPV > 0, _______________ the project If NPV < 0, _______________ the project If NPV = 0, indifferent

10. Internal Rate of Return (IRR) • The Internal Rate of Return (IRR) is defined as the discount rate that causes NPV to _____________ ________________. • The IRRmeasures the annual percentage return on funds invested in the project.

11. Internal Rate of Return (IRR) • To interpret IRR, we compare it to “k,” the required return, or “cost of capital” for the project. Decision Criteria If IRR > k, __________________ the project If IRR < k, __________________ the project If IRR = k, indifferent

12. Capital Budgeting Techniques • NPV and IRR are both _____________ (sophisticated) methods of evaluating capital budgeting projects. They are not interchangeable, however.

13. Conflicting Rankings • A ranking conflictexists if: • Project A has higher NPV than Project B • but: • Project B has higher IRR than A • Mutually exclusive projects should be ranked by __________ (not IRR) when a ranking conflict occurs.

14. Which Approach is Best? • On a theoretical basis, NPV is better than IRR: • NPV assumes that cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, • A project with non-conventional cash flows might have zero or multiple IRRs. • Despite that, more firms use the IRR because of management preference for rates of return.

15. Risk in Capital Budgeting • Different projects have different levels of risk. Analysis of the project must consider that risk (acceptance of the project affects the firm’s future ____________________).

16. Approaches for Dealing with Risk • Techniques for evaluating risk of a capital budgeting project include: • Scenario analysis • Sensitivity analysis • Simulation • Decision trees

17. Approaches for Dealing with Risk • Each of the techniques considered gives insight into project risk, but none of them provide a _________________. • Ultimately, the decision is based on a combination of analysis and judgment.

18. Assessing Project Risk: Scenario Analysis • Scenario analysis involves identifying 3 or more possible outcomes. Normally, the probability of each outcome is also estimated.

19. Approaches for Dealing with Risk • Once the risk level is determined, it is incorporated into the analysis by either: • Adjusting cash flows, or • Adjusting the required return to get the risk adjusted discount rate (______________) _______________ is more often used in practice.

20. Risk-Adjusted Discount Rates • The risk-adjusted discount rate is the rate of return that must be earned on a project to compensate for the additional risk. • The higher the risk of a project, the ______________ the RADR – and thus the __________________ a project’s NPV.

21. CAPM could be used to determine a project’s RADR. However, most firms use project characteristics to classify projects as low, average, or high risk. Approaches for Dealing with Risk

22. Risk Adjusted Discount Rates • Examples of Project Classification • Low risk: replacement existing assets without adding capacity or changing technology • Average risk: expanding capacity without changing products or technology • High risk: changing product line or technology

23. Capital Rationing • Capital rationingexists if a firm lacks sufficient financing to undertake all acceptable projects. • The firm should adopt the set of projects that provides highest ___________________________.