Chapter 6 Capital Budgeting Techniques

1. Chapter 6 Capital Budgeting Techniques

2. Net Present Value (NPV) • Net Present Value (NPV). Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.

3. Net Present Value (NPV) • Net Present Value (NPV). Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, indifferent

4. Net Present Value (NPV)

5. Net Present Value (NPV) Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 9.2

6. Net Present Value (NPV)

7. Internal Rate of Return (IRR) • The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. • The IRRis the project’s intrinsic rate of return.

8. Capital Budgeting (NPV) Advantages: • Cash flows rather than profits are analyzed • Recognizes the time value of money • Acceptance criterion is consistent with the goal of maximizing value Disadvantage: • Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance

9. Internal Rate of Return (IRR) • The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. • The IRRis the project’s intrinsic rate of return. Decision Criteria If IRR > k, accept the project If IRR < k, reject the project If IRR = k, indifferent

10. The Internal Rate of Return (IRR)

11. Capital Budgeting (IRR) Advantages: • Cash flows rather than profits are analyzed • Recognizes the time value of money • Acceptance criterion is consistent with the goal of maximizing value Disadvantages: • Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance • Difficult to solve for IRR without a financial calculator or spreadsheet

12. NPV versus IRR • When NPV>0, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project. • When IRR>k, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project. • When NPV>0, IRR>k for a project—that is, if a project is acceptable using NPV, it is also acceptable using IRR

13. Net Present Value Profiles

14. IRR and Mutually Exclusive Projects • Mutually exclusive projects • If you choose one, you can’t choose the other • Example: You can choose to attend graduate school next year at either Harvard or Stanford, but not both • Intuitively you would use the following decision rules: • NPV – choose the project with the higher NPV • IRR – choose the project with the higher IRR

15. Example With Mutually Exclusive Projects The required return for both projects is 10%. Which project should you accept and why?

16. NPV profiles

17. Conflicts Between NPV and IRR • NPV directly measures the increase in value to the firm • Whenever there is a conflict between NPV and another decision rule, you should always use NPV • IRR is unreliable in the following situations • Non-conventional cash flows • Mutually exclusive projects