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Capital Budgeting

Capital Budgeting. Typical Capital Budgeting System. Illustration of Sustainable Growth. Calculating Accounting Rate of Return. Calculating Payback Period. Calculating Discounted Payback Period. Calculating NPV. Calculating NPV…. Use Nominal or Real WACC?.

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Capital Budgeting

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  1. Capital Budgeting

  2. Typical Capital Budgeting System FIN 591: Financial Fundamentals/Valuation

  3. Illustration of Sustainable Growth FIN 591: Financial Fundamentals/Valuation

  4. Calculating Accounting Rate of Return FIN 591: Financial Fundamentals/Valuation

  5. Calculating Payback Period FIN 591: Financial Fundamentals/Valuation

  6. Calculating Discounted Payback Period FIN 591: Financial Fundamentals/Valuation

  7. Calculating NPV FIN 591: Financial Fundamentals/Valuation

  8. Calculating NPV… FIN 591: Financial Fundamentals/Valuation

  9. 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

  10. 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

  11. Calculating IRR FIN 591: Financial Fundamentals/Valuation

  12. Illustration for Calculating IRR FIN 591: Financial Fundamentals/Valuation

  13. 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

  14. Size Problem FIN 591: Financial Fundamentals/Valuation

  15. Cash Flow Pattern Problems FIN 591: Financial Fundamentals/Valuation

  16. Multiple IRR Solutions FIN 591: Financial Fundamentals/Valuation

  17. Undervaluation of Later Cash Flows FIN 591: Financial Fundamentals/Valuation

  18. Calculating the Profitability Index FIN 591: Financial Fundamentals/Valuation

  19. 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

  20. Sunk Costs FIN 591: Financial Fundamentals/Valuation

  21. Salvage Value Comparisons FIN 591: Financial Fundamentals/Valuation

  22. Calculating Initial Investment FIN 591: Financial Fundamentals/Valuation

  23. Calculating Annual Operating Cash Flows FIN 591: Financial Fundamentals/Valuation

  24. Alternatively, Calculating Annual Operating Cash Flows… FIN 591: Financial Fundamentals/Valuation

  25. Calculating Terminal Cash Flows FIN 591: Financial Fundamentals/Valuation

  26. Salvage Value: Present vs. Future FIN 591: Financial Fundamentals/Valuation

  27. 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

  28. 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

  29. 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

  30. -$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

  31. 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

  32. 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

  33. Another Example:Calculating EAA FIN 591: Financial Fundamentals/Valuation

  34. 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

  35. The End FIN 591: Financial Fundamentals/Valuation

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