Download
capital budgeting n.
Skip this Video
Loading SlideShow in 5 Seconds..
Capital Budgeting PowerPoint Presentation
Download Presentation
Capital Budgeting

Capital Budgeting

366 Vues Download Presentation
Télécharger la présentation

Capital Budgeting

- - - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

  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