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Capital Budgeting

Capital Budgeting

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Capital Budgeting

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  1. Capital Budgeting Net Present Value Rule Payback Period Rule Discounted Payback Period Rule Average Accounting Return Internal Rate of Return Profitability Index Practice of Capital Budgeting Incremental Cash Flow Chapters 6 & 7 – MBA504

  2. Net Present Value (NPV) Rule • Net Present Value (NPV) = Total PV of future CF’s + Initial Investment • Estimating NPV: • 1. Estimate future cash flows: how much? and when? • 2. Estimate discount rate • 3. Estimate initial costs • Minimum Acceptance Criteria: Accept if NPV > 0 • Ranking Criteria: Choose the highest NPV Chapters 6 & 7 – MBA504

  3. Example Assume you have the following information on Project X: Initial outlay -$1,100 Required return = 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1,000 $500 2 2,000 1,000 Calculate its NPV. Chapters 6 & 7 – MBA504

  4. The Payback Period Rule • How long does it take the project to “pay back” its initial investment? • Payback Period = number of years to recover initial costs • Minimum Acceptance Criteria: • set by management • Disadvantages • Ignores the time value of money • Ignores cash flows after the payback period • Biased against long-term projects Chapters 6 & 7 – MBA504

  5. Initial outlay -$1,000 Year Cash flow 1 $200 2 400 3 600 Accumulated Year Cash flow 1 2 3 Payback period = Chapters 6 & 7 – MBA504

  6. Discounted Payback Period Rule • How long does it take the project to “pay back” its initial investment taking the time value of money into account? • By the time you have discounted the cash flows, you might as well calculate the NPV. Chapters 6 & 7 – MBA504

  7. Example Initial outlay -$1,000 R = 10% PV of Year Cash flow Cash flow 1 $ 200 $ 182 2 400 331 3 700 526 4 300 205 Accumulated: Year discounted cash flow 1 $ 182 2 513 3 1,039 4 1,244 Discounted payback period is Chapters 6 & 7 – MBA504

  8. Average Accounting Return Rule • Another attractive but fatally flawed approach. • Ranking Criteria and Minimum Acceptance Criteria set by management • Disadvantages: • Ignores the time value of money • Uses an arbitrary benchmark cutoff rate • Based on book values, not cash flows and market values • Advantages: • The accounting information is usually available • Easy to calculate Chapters 6 & 7 – MBA504

  9. Internal Rate of Return (IRR) Rule • IRR: the discount that sets NPV to zero • Minimum Acceptance Criteria: • Accept if the IRR exceeds the required return. • Ranking Criteria: • Select alternative with the highest IRR • Reinvestment assumption: • All future cash flows assumed reinvested at the IRR. Chapters 6 & 7 – MBA504

  10. $50 $100 $150 0 1 2 3 -$200 Example Consider the following project: The internal rate of return for this project is 19.44% Chapters 6 & 7 – MBA504

  11. IRR = 19.44% NPV Payoff Profile for The Example If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept. Chapters 6 & 7 – MBA504

  12. Problems with the IRR Approach • Multiple IRRs. • The Scale Problem. • The Timing Problem. Chapters 6 & 7 – MBA504

  13. $200 $800 0 1 2 3 100% = IRR2 - $800 -$200 0% = IRR1 Multiple IRRs Which one should we use? There are two IRRs for this project: Chapters 6 & 7 – MBA504

  14. The Scale Problem Would you rather make 100% or 50% on your investments? What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment? Chapters 6 & 7 – MBA504

  15. $10,000 $1,000 $1,000 Project A 0 1 2 3 -$10,000 $1,000 $1,000 $12,000 Project B 0 1 2 3 -$10,000 The Timing Problem (page 161) The preferred project in this case depends on the discount rate, not the IRR. Chapters 6 & 7 – MBA504

  16. Mutually Exclusive vs. Independent Project • Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system. • RANK all alternatives and select the best one. • Independent Projects: accepting or rejecting one project does not affect the decision of the other projects. • Must exceed a MINIMUM acceptance criteria. Chapters 6 & 7 – MBA504

  17. Which project is good? Net present value Year 0 1 2 3 4 Project A: – $350 50 100 150 200 Project B: – $250 125 100 75 50 160 140 120 100 80 60 40 Crossover Point 20 0 – 20 – 40 – 60 – 80 Discount rate – 100 0 2% 14% 18% 22% 10% 6% 26% IRRA IRRB Chapters 6 & 7 – MBA504

  18. Chapters 6 & 7 – MBA504

  19. Decision Rule • If required rate of return < crossover return, take the project with lower IRR • If required rate of return > crossover return, take the project with higher IRR • Don’t think a project with higher IRR is always good • Projects with higher NPV is always good Chapters 6 & 7 – MBA504

  20. Profitability Index (PI) Rule • Minimum Acceptance Criteria: Accept if PI > 1 • Ranking Criteria: Select alternative with highest PI • Disadvantages: Problems with mutually exclusive investments • Advantages: • May be useful when available investment funds are limited • Easy to understand and communicate • Correct decision when evaluating independent projects Chapters 6 & 7 – MBA504

  21. Practice of Capital Budgeting • Varies by industry: • Some firms use payback, others use accounting rate of return. • The most frequently used technique for large corporations is IRR or NPV. Chapters 6 & 7 – MBA504

  22. Example of Investment Rules Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%. Year Project A Project B 0 -$200 -$150 1 $200 $50 2 $800 $100 3 -$800 $150 Chapters 6 & 7 – MBA504

  23. Incremental Cash Flows • Cash flows matter—not accounting earnings. • Sunk costs don’t matter. • Incremental cash flows matter. • Opportunity costs matter. • Side effects like cannibalism and erosion matter. • Taxes matter: we want incremental after-tax cash flows. • Inflation matters. Chapters 6 & 7 – MBA504

  24. Cash Flows—Not Accounting Earnings • Consider depreciation expense. • You never write a check made out to “depreciation”. • Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows. Chapters 6 & 7 – MBA504

  25. Incremental Cash Flows • Sunk costs are not relevant • Just because “we have come this far” does not mean that we should continue to throw good money after bad. • Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed. Chapters 6 & 7 – MBA504

  26. Incremental Cash Flows • Side effects matter (page 180) • Erosion • Synergy Chapters 6 & 7 – MBA504

  27. Estimating Cash Flows • Cash Flows from Operations • Recall that: Operating Cash Flow = EBIT – Taxes + Depreciation • Net Capital Spending • Don’t forget salvage value (after tax, of course). • Changes in Net Working Capital • Recall that when the project winds down, we enjoy a return of net working capital. Chapters 6 & 7 – MBA504

  28. The Baldwin Company: An Example(page 181) Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $150,000. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Salvage value of 30,000. Increase in net working capital: $10,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $10 per unit and increase 10% per year thereafter. Annual inflation rate: 5% Tax rate is 34 percent Working Capital: initially $10,000 changes with sales. Chapters 6 & 7 – MBA504

  29. Key Issues • Dis-regard sunk costs • Consider incremental cash flow – additional cash flows • Figure out revenue, cost, depreciation, tax, capital spending, addition to net work capital • Refer to this example when you take advanced corporate finance to deal with capital budgeting or meet this kind of problem in your work Chapters 6 & 7 – MBA504