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## Capital Budgeting

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**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)