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CHAPTER 10 The Basics of Capital Budgeting

CHAPTER 10 The Basics of Capital Budgeting. Should we build this plant?(investment decision involving FA). OUTLINE. What is Capital Budgeting? 3 Methods of Evaluating Investment Proposals Accept/Reject Decision Net Present Value Profile Determining Whether to Purchase a Machine

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CHAPTER 10 The Basics of Capital Budgeting

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  1. CHAPTER 10The Basics of Capital Budgeting Should we build this plant?(investment decision involving FA)

  2. OUTLINE • What is Capital Budgeting? • 3 Methods of Evaluating Investment Proposals • Accept/Reject Decision • Net Present Value Profile • Determining Whether to Purchase a Machine • Capital Rationing

  3. What is capital budgeting? • analysis of potential additions to fixed assets. • represents a long-term investment decision • involves the planning of expenditures for a project with a life of many years • usually requires a large initial cash outflow with the expectation of future cash inflows • uses present value analysis • emphasizes cash flows rather than income

  4. Steps to capital budgeting • Determine the Cost of the project (Cash outflows) • Estimate the expected cash inflows • Assess riskiness of CFs. • Determine the appropriate cost of capital. • Find NPV and/or IRR. • Accept if NPV > 0 and/or IRR > WACC.

  5. 3 Methods of Evaluating Investment Proposals • There are 3 widely used methods of evaluating investment proposals: • Payback Method (PB) • Regular Payback period • Discounted Payback period • Internal Rate of Return (IRR) • Net Present Value (NPV) • PI (Profitibility index)

  6. Regular Payback Period Method (PB) • The number of years required to recover a project’s cost, or “How long does it take to get our money back?” • Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive • a cutoff period is established Advantages: – easy to use (“quick and dirty” approach) – emphasizes liquidity Disadvantages: – ignores inflows after the cutoff period and fails to consider the time value of money – is inferior to the other 2 methods (NPV & IRR)

  7. Pay Back Period - Example • The cost of new machinery for a given investment project A will be RM100,000. The investment will yield the following set of annual cash flows after tax.:- YearExpected after-tax Net CFsCumulative • 1 RM40,000 RM40,000 • 2 RM40,000 RM80,000 • 3 RM60,000 RM140,000 • What is the payback period for this project and if acceptable projects must recover the initial investment in 2.5 years, should this project be accepted or rejected?

  8. Pay Back Period – Example..cont... • Formula: • Payback = 2 years + RM20,000 RM60,000 = 2.33 years < 2.5 years Therefore, accept the project.

  9. 2.33 3 0 1 2 Proj. A 60 CFt-100 40 40 100 Cumulative -100 -60 0 50 -20 20 60 Payback = 2 + / = 2.33 years Using a timeline to solve the problem. The shorter the payback period, the better.

  10. Discounted payback Period • Similar to the regular payback except that the expected CFs are discounted by the project’s CoC. • Thus, the discounted payback period is defined as the number of years required to recover the investment from the discounted net cash flows. • This method consider capital cost-it shows the breakeven years after covering debt and equity cost. • Example: use the same example as before. Assume the project’s cost of capital is 10%

  11. Discounted payback period..cont YearExpected after-tax Discounted NCFsCumulative Net CFs(at 10%) • 1 RM40,000 RM36,364 RM36,364 • 2 RM40,000 RM33,058 RM69,422 • 3 RM60,000 RM45,079 RM114,501 • Discounted Pay back Period = 2 years + RM30,578 RM45,079 = 2.68 years.

  12. Net Present Value (NPV) How to implement this approach:- Find the present value of each cash flow, including both inflows and outflows and discounted at the project’s CoC. Sum these discounted CFs; this sum is defined as the project’s NPV. If the NPV is +ve, the project should be accepted, while if the NPV is –ve, it should be rejected. Formula: where IO =initial cash outlay (investment’s cost)

  13. NPV - example • Use the same example. Year CFs PVIF, 10% PV 1 40,000 0.909 RM36,360 2 40,000 0.826 33,040 3 60,000 0.751 45,060 Present Value of CFs 114,460 Initial Outlay - 100,000 Net Present Value RM14,460 NPV is +ve so can accept the project.

  14. Rationale for the NPV method NPV = PV of inflows – Cost = Net gain in wealth • IF NPV=0, the project’s CF are exactly sufficient to repay the invested capital. • If projects are independent, accept if the project NPV > 0. • If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. Mutual Exclusive Project – a set of project where only one can be accepted Independent Project- project whose CF are not affected by the acceptance or no acceptance of anther projects

  15. Internal Rate of Return (IRR)  represents a yield on an investment or an interest rate • The IRR is defined as the discount rate that equates the PV of the project’s expected cash flows (inflow) to the PV of the project’s costs. • PV(Inflows) = PV (Investment costs)  is the interest rate where the cash outflows equal the cash inflows (or NPV = 0)

  16. IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:  Thus, the IRR is unknown, and we need to solve for IRR. Solve IRR by using trial and error basis. (try some discount rate and see if the equation solve to zero, if it does not, try different discount rate until force the equation equal to zero).

  17. IRR – Example (refer the same example) Year CFs try PVIF, 12% PV 1 40,000 0.893 RM35720 2 40,000 0.797 31880 3 60,000 0.712 42720 Present Value of CFs 110320 Initial Outlay - 100000 Net Present Value RM10320

  18. Year CFs try PVIF, 20% PV 1 40,000 0.833 RM33320 2 40,000 0.694 27760 3 60,000 0.579 34740 Present Value of CFs 95820 Initial Outlay - 100000 Net Present Value -RM4180

  19. Year CFs try PVIF, 16% PV 1 40,000 0.862 RM34480 2 40,000 0.743 29720 3 60,000 0.641 38460 Present Value of CFs 102660 Initial Outlay - 100000 Net Present Value RM2660

  20. Year CFs try PVIF, 18% PV 1 40,000 0.847 RM33880 2 40,000 0.718 28720 3 60,000 0.609 36540 Present Value of CFs 99140 Initial Outlay - 100000 Net Present Value -RM860

  21. Year CFs try PVIF, 17% PV 1 40,000 0.855 RM34200 2 40,000 0.731 29240 3 60,000 0.624 37440 Present Value of CFs 100880 Initial Outlay - 100000 Net Present Value RM880 • Therefore the range of IRR is as follows; • 17%<IRR<18% • Or use interpolation to find the exact IRR.

  22. How to apply interpolation method? IRR = 17% + 880/1740 = 17.51% 100880-10000 = 880 100,000 18% 17% 99140 100880 100880-99140 =1740

  23. IRR Acceptance Criteria • If IRR > k, accept project. • If IRR < k, reject project. • If projects are independent, more than one project can be accepted as long the IRR > k • If projects are mutually exclusive, accept only one project which gives greater IRR

  24. Rationale for the IRR method • If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns.

  25. Accept/Reject Decision LT 12-7 Payback Method (PB): –if PB period < cutoff period, accept the project – if PB period > cutoff period, reject the project Internal Rate of Return (IRR): – if IRR > cost of capital, accept the project – if IRR < cost of capital, reject the project Net Present Value (NPV): – if NPV > 0, accept the project – if NPV < 0, reject the project

  26. What is the difference between independent and mutually exclusive projects? • Independent projects – if the cash flows of one are unaffected by the acceptance of the other. • Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.

  27. Net Present Value Profile LT 12-9 a graph of the NPV of a project at 3 different discount rates: • a zero discount rate • the normal discount rate (or cost of capital) • the IRR for the investment  allows an easy way to visualize whether or not an investment should be undertaken

  28. NPV Profiles • A graphical representation of project NPVs at various different costs of capital. • NPV ranking depend on the CoC k NPVLNPVS 0 $50 $40 5 33 29 10 19 20 15 7 12 20 (4) 5

  29. Drawing NPV profiles-both project decrease as the COC increase NPV ($) 60 . Project L- has the higher NPV at a low CoC - greeter sensitivity (steeper slope) 50 . 40 . Crossover Point = 8.7% . 30 . . IRRL = 18.1% 20 . . S . IRRS = 23.6% 10 L . . Discount Rate (%) 0 5 15 20 23.6 10 -10 Project S has the higher NPV at a high CoC

  30. Comparing the NPV and IRR methods • If projects are independent, the two methods always lead to the same accept/reject decisions. (IRR>CoC or NPV +ve) • If projects are mutually exclusive … • If k > crossover point (8.7), the two methods (IRRS exceed IRRL & NPVs is larger than NPVL) lead to the same decision (pro.S)and there is no conflict. • If k < crossover point, the two methods lead to different accept/reject decisions.(NPV method rank pro. L higher, but IRR method indicate pro.s is better)

  31. Reasons why NPV profiles cross (conflict between NPV and IRR) • Size (scale) differences – the cost of one project is larger that of the other. • if one pro. cost more than the other then firm will have more money at t = 0 to invest elsewhere if it select smaller project. • The higher the opportunity cost, the more valuable these funds, so high k favors small projects. • Timing differences – most of the CF from one pro. come in early years, while the other come in later years. • the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good.

  32. Reinvestment rate assumptions • NPV method assumes CFs are reinvested at k, the opportunity cost of capital. • IRR method assumes CFs are reinvested at IRR. • Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best.(NPV method should be used to choose between mutually exclusive projects.) • Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.

  33. Since managers prefer the IRR to the NPV method, is there a better IRR measure? • Yes, modified the IRR and it is better indicator of relative profitability • Modified Internal Rate of Return (MIRR) is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. PV(cost) = PV (Terminal value)

  34. Since managers prefer the IRR to the NPV method, is there a better IRR measure? PV(cost) = PV (Terminal value) • MIRR assumes cash flows are reinvested at the WACC. Compounded value of inflow =TV * COF- cash outflow CIF –cash inflow PV investment outlay discounted at CoC

  35. 0 1 2 3 10% -100.0 40.0 40.0 60.0 10% 44.0 48.4 10% MIRR = 15.075% 152.4 $152.4 (1 + MIRR)3 -100.0 TV inflows $100 = PV outflows MIRR = 15.075% Calculating MIRR – use same example

  36. Why use MIRR versus IRR? • MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs (the situation where a project has two or more IRRs). • Managers like rate of return comparisons, and MIRR is better for this than IRR.

  37. NPV Profile NPV IRR2 = 400% 450 0 k 100 400 IRR1 = 25% -800 Multiple IRRs

  38. Why are there multiple IRRs? • At very low discount rates, the PV of CF2 is large & negative, so NPV < 0. • At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0. • In between, the discount rate hits CF2 harder than CF1, so NPV > 0. • Result: 2 IRRs.

  39. Capital Rationing • A limit or constraint on the amount of funds that can be invested • Firm must rank investments based on their NPVs • Those with positive NPVs are accepted until all funds are exhausted

  40. Dealing with Capital Rationing • Because of capitol rationing constraint, the capital budgeting techniques (NPV and IRR) may prove inadequate since they are constructed based on the premise that all good project will be accepted. • Good project = project with positive NPV and projects with an IRR greater than cost of capital (CoC) • Another simplest approach to dealing with capital rationing is the PROFITABILITY INDEX(PI) PI = NPV per dollar of initial investment PI = NPV/ Initial Investment • TNPV that a firm get for each dollar of initial investment

  41. Dealing with Capital Rationing • The step involved in using the PI: • The amount of fund available for capital investment are clearly identified (how much money available) • Calculate the NPV for each project and estimate the initial investment required for each project • Compute the PI for all available project • The project are ranked in order to PI • The project should be chosen starting from highest PI and moving down while tracking the cumulative initial investment and comparing it to the fund available for investment. • When the cumulative initial investment in the project reaches the capital funding constraints, investment are stopped and no further project are taken

  42. For Example : Capital Rationing – assume the capital is only RM100,000.

  43. For Example : Capital Rationing

  44. Dealing with Capital Rationing • Based on profitability index Project B, C and G should be accepted • The acceptance of these project would exhaust the capital budget of RM100 million while maximizing the NPV of the project accepted.

  45. Estimating Project Cash Flow • The most important and also most difficult step in capital budgeting • Many variables are involved and many individual are participate in the process such as to forecast unit sales, sales price, Variable cost and etc. • It is difficult to forecast accurately thus the forecast error can quite large.

  46. Identify the relevant Cash Flow • It is starting point in any capital budgeting. • It defines as the specific set of cash flows that should consider in decision at hand • The project CF is different from accounting income , thus to avoid an error during estimating the CF, these are the 2 rules that should be follow: • Capital budgeting decision must based on project CF (free cash flow) • Only incremental CF are relevant –not included the sunk cost

  47. Identifying the relevant risk project • A project is assumed to produce a set of CF, then we analyze the CF whether to accept or reject the project. • However the CF is not known with certain, thus the firm must determine the project risk and then decide whether its profit potential is worth the risk • The 3 types of project risk are • Stand-alone risk • Corporate risk • Market risk

  48. What is stand-alone risk? • The project’s total risk, if it were operated independently. • Usually measured by standard deviation (or coefficient of variation). • However, it ignores the firm’s diversification among projects and investor’s diversification among firms.

  49. What is corporate risk? • The project’s risk when considering the firm’s other projects, i.e., diversification within the firm. • Corporate risk is a function of the project’s NPV and standard deviation and its correlation with the returns on other projects in the firm.

  50. What is market risk? • The project’s risk to a well-diversified investor. • Theoretically, it is measured by the project’s beta and it considers both corporate and stockholder diversification.

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