Chap 9 – Capital Budgeting

1. Chap 9 – Capital Budgeting Key Sections: • Explain Payback period, NPV and IRR • Evaluate advantages, disadvantages of each and determine project acceptability • Compute payback, NPV and IRR (with projects with irregular cash flows) • Understand capital rationing and disparities

2. Budgeting Criteria • Capital Budgeting – decision process relative to investing in fixed assets or other long-term investments in a new product or line of business. • Focuses on after-tax cash flows resulting from a project. Should it be undertaken? • Compare returns relative to costs • Criteria: NPV, IRR and payback period

3. Payback Period • How many years to recover the initial outlay? Does it meet the minimum period? • Main weakness – ignores TVM • But we could PV each cash flow to show TVM • Problems: period is arbitrary and ignores later cash flows • Advantages: understandable, early cash flows more certain

4. Net Present Value • NPV’s of inflows less NPV’s of outflows • Measures net value in today’s dollars • Criteria: If NPV > 0.0 accept but • If NPV less than zero, reject • Rationale: Discount rate used at least equals cost of capital; if you can’t cover costs, you are destroying shareholder value

5. NPV Illustration @ 10%YearCF PVIFPV 1 12,000 .909 10,908 2 13,000 .826 10,738 3 14,000 .751 10,574 4 15,000 .683 10,245 PV of inflows 42,465 Initial out -35,000 1.000 -35,000 NPV + 7,465

6. More on NPV • Depends on accuracy of cash flow projected • Advantages: deals with CF and timing; costs and benefits logically compared • Disadvantages: need detailed, long-term cash forecasts • Theoretically correct – measures project’s impact; authors prefer.

7. Internal Rate of Return • What rate of return does the project earn? How does it compare to our cost of capital? • Definition: IRR is the discount rate that produces an NPV of zero • What rate does the project earn on the IO? • (Use calculators, not tables) • Criteria: if over the required rate, accept

8. NPV and IRR

9. Problems with IRR • Can’t handle later cash outflows • NPV assumes all cash flows reinvested at discount rate (required rate of return) • IRR assumes cash flows are reinvested at IRR (perhaps unrealistically) • Authors believe NPV is better (but industry doesn’t agree)

10. NPV Profile – Page 271 Discount RateProject’s NPV 5% $24,367 10 8,207 13 0 15 -4,952 20 -15,798

11. Summary TechniqueMeasureAccept if Payback period Time Sooner than Maximum NPV Dollars > 0 IRR Disc rate > C of C

12. Capital Rationing • Dollar limit placed on capital spending • Management sees it can’t profitably do all even if NPV positive and IRR>RR • Why: adverse market conditions, lack of qualified managers and intangibles • Related to economy, interest rates, stock prices, credit availability • Effect negative but depends on severity

13. Example: $1,000 Limit ProjectCostNPV A $200 $280 B 200 260 C 800 560 D 300 90 Projects A and C have highest total NPV within the $1,000 spending limit

14. Capital Rationing

15. Project Rankings • Mutually exclusive projects perform same task • Accepting one requires rejection of other • Conflicting rankings may occur • One is caused by size disparity • Not responsible for time disparity

16. Size Disparity • On your land, you can make a parking lot ($10,000 cost, earns $10,000/yr forever) OR • Build building (costs $20 mil sold year later for $24 mil) IRR NPV @15% Parking lot 100% $66,666 Building 20% $869,565 • IRR independent of size, NPV better here

17. Methods Used by Companies • As shown in Table 9-11, more use IRR (on either primary or secondary basis) than use NPV. • Why? With computers, no more difficult to calculate. A rate may be easier to put in perspective than a dollar NPV

18. Capital Budgeting Practices T9-11

19. Major Points • Payback emphasizes risk and liquidity • NPV shows profitability and dollar benefits • IRR indicates safety margin measured by returns • Quantitative measures useful but not a substitute for sound judgment • Why are returns so high? What will comp do?