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## Capital Budgeting

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**Typical Capital Budgeting System**FIN 591: Financial Fundamentals/Valuation**Illustration of Sustainable Growth**FIN 591: Financial Fundamentals/Valuation**Calculating Accounting Rate of Return**FIN 591: Financial Fundamentals/Valuation**Calculating Payback Period**FIN 591: Financial Fundamentals/Valuation**Calculating Discounted Payback Period**FIN 591: Financial Fundamentals/Valuation**Calculating NPV**FIN 591: Financial Fundamentals/Valuation**Calculating NPV…**FIN 591: Financial Fundamentals/Valuation**Use Nominal or Real WACC?**• Nominal return reflects the actual dollar return; real return measures the increase in purchasing power gained by holding a certain investment • Common in capital budgeting is the use of market rates of return at the time of the analysis • Market interest rates have embedded an assumption about inflation • Use nominal cash flows to reflect the same inflation rate as that embedded in discount rate. FIN 591: Financial Fundamentals/Valuation**Risk-Return Tradeoff for Projects**• Projects plotting above the security market line (SML) have rates of return in excess of their required market rates • Positive NPVs • Projects plotting below the SML have rates of return less than their required market rates • Negative NPVs • Projects plotting on the SML earn their market rates • Zero NPVs. FIN 591: Financial Fundamentals/Valuation**Calculating IRR**FIN 591: Financial Fundamentals/Valuation**Illustration for Calculating IRR**FIN 591: Financial Fundamentals/Valuation**IRR & Required Risk-Adjusted Rate**• Appropriate rates for comparing project returns are those falling on the upward sloping market risk-return trade-off curve • Not the firm’s horizontal cost of capital line, WACC • WACC is only appropriate for evaluating projects with risk comparable to the level of risk of the firm • “Carbon copy” projects. FIN 591: Financial Fundamentals/Valuation**Size Problem**FIN 591: Financial Fundamentals/Valuation**Cash Flow Pattern Problems**FIN 591: Financial Fundamentals/Valuation**Multiple IRR Solutions**FIN 591: Financial Fundamentals/Valuation**Undervaluation of Later Cash Flows**FIN 591: Financial Fundamentals/Valuation**Calculating the Profitability Index**FIN 591: Financial Fundamentals/Valuation**Comparison of Project Rankings**• Project B is better than project A • Project B continues to earn cash flows longer • Project D is more desirable than project C • Although both projects generate the same amount of cash flows, project D does it earlier • Unanswered question: • Is Project D better than project B? FIN 591: Financial Fundamentals/Valuation**Sunk Costs**FIN 591: Financial Fundamentals/Valuation**Salvage Value Comparisons**FIN 591: Financial Fundamentals/Valuation**Calculating Initial Investment**FIN 591: Financial Fundamentals/Valuation**Calculating Annual Operating Cash Flows**FIN 591: Financial Fundamentals/Valuation**Alternatively, Calculating Annual Operating Cash Flows…**FIN 591: Financial Fundamentals/Valuation**Calculating Terminal Cash Flows**FIN 591: Financial Fundamentals/Valuation**Salvage Value: Present vs. Future**FIN 591: Financial Fundamentals/Valuation**Another Topic:Competing Projects**• Assume projects • Mutually exclusive • On-going • Different economic lives • How do you select the correct project? FIN 591: Financial Fundamentals/Valuation**Example**• There are times when application of the NPV rule can lead to the wrong decision • Consider a factory which must have an air cleaner • The equipment is mandated by law, so there is no “doing without” • There are two choices: • The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100 and lasts for 10 years • The “cheaper cleaner” costs $1,000 today, has annual operating costs of $500 and lasts for 5 years • Which one should we choose? FIN 591: Financial Fundamentals/Valuation**Example …**• At first glance, the cheap cleaner has the “better” NPV (r = 10%): • Overlooks the fact that the Cadillac cleaner lasts twice as long • When we incorporate project life, the Cadillac cleaner is actually cheaper. FIN 591: Financial Fundamentals/Valuation**-$4,000 –100 -100 -100 -100 -100 -100 -100**-100 -100 -100 0 1 2 3 4 5 6 7 8 9 10 -$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500 0 1 2 3 4 5 6 7 8 9 10 Example … • The Cadillac cleaner time line of cash flows: • The “cheaper cleaner” time line of cash flows over ten years: FIN 591: Financial Fundamentals/Valuation**Investments of Unequal Lives**• Replacement Chain • Repeat the projects forever, find the PV of that perpetuity • Assumption: Both projects can and will be repeated • Matching Cycle • Repeat projects until they begin and end at the same time—like we just did with the air cleaners • Compute NPV for the “repeated projects” • The Equivalent Annual Annuity (EAA) Method. FIN 591: Financial Fundamentals/Valuation**Equivalent Annual Cost Method**• Equivalent Annual Annuity Method • Provides the value of the level payment annuity that has the same PV as the original set of cash flows • NPV = EAA × ArT • For example, the EAA for the Cadillac air cleaner is $750.98 Annuity Table 10%, 10 years = 6.1446 The EAA for the cheaper air cleaner is $763.80, which confirms our earlier decision to reject it. FIN 591: Financial Fundamentals/Valuation**Another Example:Calculating EAA**FIN 591: Financial Fundamentals/Valuation**Human Face of Capital Budgeting**• NPV of a project based on assumptions • Managers must be aware of optimistic bias in these assumptions made by supporters of the project • Companies need control measures to remove bias • Analysis done by a group independent of individual or group proposing the project • Analysts must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential • Another side of determining which projects receive funding – storytelling • Best analysts not only provide numbers to highlight a good investment, but also can explain why this investment makes sense. FIN 591: Financial Fundamentals/Valuation**The End**FIN 591: Financial Fundamentals/Valuation