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CHAPTER 9

CHAPTER 9. TECHNIQUES IN CAPITAL BUDGETING. The Basics of Capital Budgeting. Should we build this plant?. What is capital budgeting?. The process of planning for purchases of long-term assets. Analysis of potential additions to fixed assets.

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CHAPTER 9

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  1. CHAPTER 9 TECHNIQUES IN CAPITAL BUDGETING

  2. The Basics of Capital Budgeting Should we build this plant? SITI AISHAH BINTI KASSIM (FM2)

  3. What is capital budgeting? • The process of planning for purchases of long-term assets. • Analysis of potential additions to fixed assets. • Long-term decisions; involve large expenditures, therefore irreversible once made. • Very important to firm’s future. SITI AISHAH BINTI KASSIM (FM2)

  4. Capital Budgeting • For example: Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? • Will the machine be profitable? • Will our firm earn a high rate of return on the investment? SITI AISHAH BINTI KASSIM (FM2)

  5. Decision-making Criteria in Capital Budgeting How do we decide if a capital investment project should be accepted or rejected? SITI AISHAH BINTI KASSIM (FM2)

  6. Decision-making Criteria in Capital Budgeting • The ideal evaluation method should: a) include all cash flows that occur during the life of the project, b) consider the time value of money, and c) incorporate the required rate of return on the project. SITI AISHAH BINTI KASSIM (FM2)

  7. Steps to Capital Budgeting • Estimate CFs (inflows & outflows). • Assess riskiness of CFs. • Determine the appropriate cost of capital. • Find NPV and/or IRR. • Accept if NPV > 0 and/or IRR > WACC. SITI AISHAH BINTI KASSIM (FM2)

  8. What is the difference between independent and mutually exclusive projects? • Independent projects – if the cash flows of one project are unaffected by the acceptance of the other projects. • Mutually exclusive projects – if the cash flows of one project can be adversely impacted by the acceptance of the other project. These are a set of projects that perform essentially the same task, so that acceptance of one will necessarily mean rejection of the others. SITI AISHAH BINTI KASSIM (FM2)

  9. What is the difference between normal and non-normal cash flow streams? • Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. (- + + + + +) CF($) (500) 150 150 150 150 150 Year 0 1 2 3 4 5 • Non-normal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. .(- + + - + +). Examples: Nuclear power plant, strip mine, etc. CF ($) (500) 200 100 (200) 400 300 Year 0 1 2 3 4 5 SITI AISHAH BINTI KASSIM (FM2)

  10. Payback Period How long will it take for the project to generate enough cash to pay for itself? (500) 150 150 150 150 150 150 150 150 8 7 0 1 2 3 4 5 6 Payback period = 3.33 years (50/150 =0.33) SITI AISHAH BINTI KASSIM (FM2)

  11. Payback Period • Is a 3.33 year payback period good? • Is it acceptable? • Firms that use this method will compare the payback calculation to some standard set by the firm. • If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? • Accept the project. SITI AISHAH BINTI KASSIM (FM2)

  12. Further Example:Calculating payback 2.4 3 0 1 2 Project L 80 CFt-100 10 60 100 Cumulative -100 -90 -30 0 50 PaybackL = 2 + / = 2.375 years 30 80 1.6 3 0 1 2 Project S CFt-100 70 100 20 50 Cumulative -100 0 20 40 -30 30 50 PaybackS = 1 + / = 1.6 years SITI AISHAH BINTI KASSIM (FM2)

  13. Strengths of Payback Period • Provides an indication of a project’s risk and liquidity. • Easy to calculate and understand. SITI AISHAH BINTI KASSIM (FM2)

  14. Drawbacks of Payback Period • Firm cut-offs are subjective. • Does not consider time value of money. • Does not consider any required rate of return. • Ignores cash flows occurring after the payback period. SITI AISHAH BINTI KASSIM (FM2)

  15. Drawbacks of Payback Period • Does not consider all of the project’s cash flows. Consider this cash flow stream! (500) 150 150 150 150 150 150 150 150 8 7 0 1 2 3 4 5 6 SITI AISHAH BINTI KASSIM (FM2)

  16. Drawbacks of Payback Period • Does not consider all of the project’s cash flows. This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! (500) 150 150 150 150 150 150 150 150 8 7 0 1 2 3 4 5 6 SITI AISHAH BINTI KASSIM (FM2)

  17. Discounted Payback • Uses discounted cash flows rather than raw cash flows. • Discounts the cash flows at the firm’s required rate of return. • Payback period is calculated using these discounted net cash flows. Problems: • Cut-offs are still subjective. • Still does not examine all cash flows. SITI AISHAH BINTI KASSIM (FM2)

  18. Discounted Payback (500) 250 250 250 250 250 1 2 3 4 5 0 Discounted YearCash FlowCF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.37 2 years 88.33 3 250 168.74 SITI AISHAH BINTI KASSIM (FM2)

  19. Discounted Payback (500) 250 250 250 250 250 1 2 3 4 5 0 Discounted YearCash FlowCF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.37 2 years 88.33 (88.33/168.74)= 3 250 168.74 .52 years SITI AISHAH BINTI KASSIM (FM2)

  20. Further Example:Discounted Payback Period 2.7 3 0 1 2 CFt -100 10 60 80 PV of CFt -100 9.09 49.59 60.11 Cumulative -100 -90.91 18.79 -41.32 Disc PaybackL = 2 + / = 2.7 years 41.32 60.11 SITI AISHAH BINTI KASSIM (FM2)

  21. Other Methods(Discounted Cash Flow Methods) 1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Consider each of these decision-making criteria: • All net cash flows. • The time value of money. • The required rate of return. SITI AISHAH BINTI KASSIM (FM2)

  22. Net Present Value NPV = the total PV of the annual net cash flows - the initial outlay. n t=1 S FCFt (1 + k) NPV = - IO t SITI AISHAH BINTI KASSIM (FM2)

  23. Net Present Value Decision Rule: • If NPV is positive, accept. • If NPV is negative, reject. SITI AISHAH BINTI KASSIM (FM2)

  24. NPV Example Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15%. SITI AISHAH BINTI KASSIM (FM2)

  25. NPV Example Suppose we are considering a capital investment that costs$250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15%. (250,000) 100,000 100,000 100,000 100,000 100,000 0 1 2 3 4 5 SITI AISHAH BINTI KASSIM (FM2)

  26. Net Present Value NPV is just the PV of the annual cash flows minus the initial outflow. Mathematical Solution: PV of cash flows = $100,000(PVIFA15%,5) = $100,000(3.352) PV of cash flows = $335,216 - Initial outflow ($250,000) = Net PV $85,216 SITI AISHAH BINTI KASSIM (FM2)

  27. Example:What is Project S’s and L’s NPVs? Year CFs PVs CFLPV L 0 -100 -100 -$100.00 1 70 10 9.09 2 50 60 49.59 3 20 80 60.11 NPVs = $19.98 NPVL= $ 18.79 (k = 10%) SITI AISHAH BINTI KASSIM (FM2)

  28. Rationale for the NPV method NPV = PV of inflows – Cost = Net gain in wealth • 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. • In this example, we would accept S if the 2 projects are mutually exclusive (NPVs > NPVL), and would accept both if they are independent projects. SITI AISHAH BINTI KASSIM (FM2)

  29. Profitability Index n t=1 S FCFt (1 + k) NPV = - IO t n t=1 S FCFt (1 + k) PI = IO t SITI AISHAH BINTI KASSIM (FM2)

  30. Profitability Index Decision Rule: • If PI is greater than or equal to 1, accept. • If PI is less than 1, reject. SITI AISHAH BINTI KASSIM (FM2)

  31. Internal Rate of Return (IRR) The return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects. n t=1 FCFt (1 + IRR) S IRR: = IO t SITI AISHAH BINTI KASSIM (FM2)

  32. Internal Rate of Return (IRR) • IRR is the rate of return that makes thePV of the cash flowsequal to the initial outlay. • This looks very similar to our Yield to Maturity formula for bonds. In fact, YTMisthe IRR of a bond. SITI AISHAH BINTI KASSIM (FM2)

  33. Calculating IRR • Looking again at our problem: The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay. (250,000) 100,000 100,000 100,000 100,000 100,000 0 1 2 3 4 5 SITI AISHAH BINTI KASSIM (FM2)

  34. Internal Rate of Return (IRR) Decision Rule: • If IRR is greater than or equal to the required rate of return, accept. • If IRR is less than the required rate of return, reject. SITI AISHAH BINTI KASSIM (FM2)

  35. IRR Acceptance Criteria • If IRR > k, accept project. • If IRR < k, reject project. • If projects are independent, accept both projects, if both projects’ IRR > k. • If projects are mutually exclusive, accept the project with the higher IRR. SITI AISHAH BINTI KASSIM (FM2)

  36. IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) 1 2 3 (500) 200 100 (200) 400 300 0 1 2 3 4 5 SITI AISHAH BINTI KASSIM (FM2)

  37. 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. SITI AISHAH BINTI KASSIM (FM2)

  38. Comparing the NPV and IRR methods • If projects are independent, the two methods always lead to the same accept/reject decisions. • If projects are mutually exclusive … • If k > crossover point, the two methods lead to the same decision and there is no conflict. • If k < crossover point, the two methods lead to different accept/reject decisions. SITI AISHAH BINTI KASSIM (FM2)

  39. 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. SITI AISHAH BINTI KASSIM (FM2)

  40. Since managers prefer the IRR to the NPV method, is there a better IRR measure? • Yes, Modified Internal Rate of Return (MIRR). • IRR assumes that all cash flows are reinvested at the IRR. • MIRR provides a rate of return measure that assumes cash flows are reinvested at the required rate of return (or WACC). • 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. SITI AISHAH BINTI KASSIM (FM2)

  41. THE END SITI AISHAH BINTI KASSIM (FM2)

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