Capital Budgeting Chapter 8
The Capital Budgeting Decision Process The capital budgeting process involves three basic steps: • Generating long-term investment proposals; • Reviewing, analyzing, and selecting from the proposals that have been granted, and • Implementing and monitoring the proposals that have been selected. • Managers should separate investment and financing decisions.
Capital Budgeting Decision Techniques Accounting rate of return (ARR):focuses on project’s impact on accounting profits • Payback period: most commonly used Net present value(NPV):best technique theoretically; difficult to calculate realistically Internal rate of return(IRR): widely used with strong intuitive appeal Profitability index(PI):related to NPV
A Capital Budgeting Process Should: Account for the time value of money; Account for risk; Focus on cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders’ wealth.
Example: Global Wireless • Global Wireless is a worldwide provider of wireless telephony devices. • Global Wireless is contemplating a major expansion of its wireless network in two different regions: • Western Europe expansion • A smaller investment in Southeast U.S. to establish a toehold
Average annual depreciation Average annual operating cash inflows = Average profits after taxes – Accounting Rate Of Return (ARR) Can be computed from available accounting data • Need only profits after taxes and depreciation. • Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows. ARR uses accounting numbers, not cash flows; no time value of money.
Payback Period The payback period is the amount of time required for the firm to recover its initial investment. • If the project’s payback period is less than the maximum acceptable payback period, accept the project. • If the project’s payback period is greater than the maximum acceptable payback period, reject the project. Management determines maximum acceptable payback period.
Payback Analysis For Global Wireless • Management’s cutoff is 2.75 years. • Western Europe project: initial outflow of -$250M • But cash inflows over first 3 years is only $245 million. • Global Wireless will reject the project (3>2.75). • Southeast U.S. project: initial outflow of -$50M • Cash inflows over first 2 years cumulate to $40 million. • Project recovers initial outflow after 2.40 years. • Total inflow in year 3 is $25 million. So, the project generates $10 million in year 3 in 0.40 years ($10 million $25 million). • Global Wireless will accept the project (2.4<2.75).
Advantages of payback method: • Computational simplicity • Easy to understand • Focus on cash flow Disadvantages of payback method: • Does not account properly for time value of money • Does not account properly for risk • Cutoff period is arbitrary • Does not lead to value-maximizing decisions Pros and Cons of the Payback Method
Reject (166.2 < 250) Reject (46.3<50) Discounted Payback • Discounted payback accounts for time value. • Apply discount rate to cash flows during payback period. • Still ignores cash flows after payback period. • Global Wireless uses an 18% discount rate.
Net Present Value (NPV) NPV: The sum of the present values of a project’s cash inflows and outflows. Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk. Accept projects if NPV > 0.
Net Present Value (NPV) A key input in NPV analysis is the discount rate. • r represents the minimum return that the project must earn to satisfy investors. • r varies with the risk of the firm and /or the risk of the project.
Western Europe project: NPV = $75.3 million Southeast U.S. project: NPV = $25.7 million NPV Analysis for Global Wireless • Assuming Global Wireless uses 18% discount rate, NPVs are: Should Global Wireless invest in one project or both?
Key benefits of using NPV as decision rule: • Focuses on cash flows, not accounting earnings • Makes appropriate adjustment for time value of money • Can properly account for risk differences between projects Though best measure, NPV has some drawbacks: • Lacks the intuitive appeal of payback, and • Doesn’t capture managerial flexibility (option value) well. Pros and Cons of NPV NPV is the “gold standard” of investment decision rules.
Internal Rate of Return (IRR) IRR: the discount rate that results in a zero NPV for a project. The IRR decision rule for an investing project is: • If IRR is greater thanthe cost of capital, acceptthe project. • If IRR is less thanthe cost of capital, rejectthe project.
Western Europe project: IRR (rWE) = 27.8% Southeast U.S. project: IRR (rSE) = 36.7% IRR Analysis for Global Wireless Global Wireless will accept all projects with at least 18% IRR.
Advantages of IRR: • Properly adjusts for time value of money • Uses cash flows rather than earnings • Accounts for all cash flows • Project IRR is a number with intuitiveappeal Disadvantages of IRR: • “Mathematical problems”: multiple IRRs, no real solutions • Scale problem • Timing problem Pros and Cons of IRR
IRR IRR Multiple IRRs When project cash flows have multiple sign changes, there can be multiple IRRs. Which IRR do we use?
No Real Solution Sometimes projects do not have a real IRR solution. Modify Global Wireless’s Western Europe project to include a large negative outflow (-$355 million) in year 6. • There is no real number thatwill make NPV=0, so noreal IRR. Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!
Project IRR NPV (18%) Western Europe 27.8% $75.3 mn Southeast U.S. 36.7% $25.7 mn Conflicts Between NPV and IRR:The Scale Problem NPV and IRR do not always agreewhen ranking competing projects. The scale problem: • The Southeast U.S. project has a higher IRR, but doesn’t increase shareholders’ wealth as much as the Western Europe project.
Conflicts Between NPV and IRR:The Scale Problem Why the conflict? • The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project. • Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive.
Conflicts Between NPV and IRR:The Timing Problem • The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.
Conflicts Between NPV and IRR:The Timing Problem Because of the differences in the timing of the two projects’ cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign.
Project PV of CF (yrs1-5) Initial Outlay PI Western Europe $325.3 million $250 million 1.3 Southeast U.S. $75.7 million $50 million 1.5 Profitability Index Calculated by dividing the PV of a project’s cash inflows by the PV of its initial cash outflows. Decision rule: Accept project with PI > 1.0, equal to NPV > 0 • Both PI > 1.0, so both acceptable if independent. Like IRR, PI suffers from the scale problem.
Capital Budgeting Methods to generate, review, analyze, select, and implement long-term investment proposals: • Accounting rate of return • Payback Period • Discounted payback period • Net Present Value (NPV) • Internal rate of return (IRR) • Profitability index (PI)