Capital Budgeting

1. Capital Budgeting Rules for Sensible Investment Decisions!!

2. Cost vs. Benefits • Investment typically has two components: • Outflow of cash (cost) • Inflow of cash (benefits) • TVM requires all cash flows to be compared at the same point in time • Most convenient is time 0

3. Recall Forbes Example • Tax savings: $500,000 forever • Campaign Costs: $40 million • r = 10% • PV of Benefits: .5 mill / .10 = $5 million • Cost: $40 million • Benefit - Cost = 5- 40 = -$35 million

4. Forbes example... • Obviously this is a lousy investment • What you just used in analyzing this ‘investment’ proposal is NPV rule! • It turns out the NPV rule is the most sensible rule to use for evaluating projects

5. Examples of Capital Budgeting Projects • To open a corner latte stand • To replace replace a 486 computer used in business with a Pentium computer • To decide between a coal-fired and a nuclear fuel power plant costing $1 billion • To add 5 stories to an existing office tower • To shut down an aging factory making ball bearings

6. Evaluating Investments • There are many ways to evaluate investments • Among all the investment rules we will consider, NPV rule is the only rule that always gives correct answer in all situations!! • Other rules may or may not give an answer consistent with NPV rule

7. Net Present Value • NPV = PV of Benefits - PV of Costs • Accept project if NPV > 0 • Reject project if NPV < 0

8. Another Example... 0 1 2 Revenues $2,000 Expenses 1,000 Cash flow $1,000 Initial outlay ($1,100) Revenues $1,000 Expenses 500 Cash flow $500 – $1,100.00 +454.54 +826.45 +$180.99 1 $500 x 1.10 1 $1,000 x 1.102 NPV

9. NPV Formula • ‘r’ has many names: • ‘r’ is called the discount rate or • ‘r’ is called the required return or • ‘r’ is called the cost of capital

10. Computing NPV on calculator • Use the CFj key • First entry is at time 0 • Subsequent entries are time 1, 2, 3, ... and so on • make sure the cash flows have the proper signs • Enter ‘r’ as the I/YR • Use the keysThat’s it!! NPV

11. Another Example.. NPV = $ _______ Accept / Reject Project ?

12. Another Example... • The cash flows are Year Cash flow 0 -$252 1 1431 2 -3035 3 2850 4 -1000 r = 10% NPV = _______ Accept / Reject ??

13. Example continued... • This was an example of unconventional cash flows • Conventional Cash Flows: Only one change in sign (from + to - or vice versa)e.g. - + + + + • Unconventional Cash Flows: More than one change in signe.g. - + + - + -

14. Importance of NPV • NPV is the dollar value added to the enterprise • it’s the amount by which the enterprise is richer! • For public companies, NPV is the increase in total market value of equity • Managers should not take negative NPV projects since it reduces the firm value

15. Other Rules • Alternative rules of evaluating investments are: • Internal Rate of Return (IRR) • Payback • Discounted Payback • Profitability Index • Accounting Rate of Return

16. IRR Rule • IRR: the discount rate that makes NPV = 0 • Rule: Accept if IRR > required returnReject if IRR < required return

17. IRR and Required Return • Required return also called the ‘Hurdle Rate’ • Required return is the cost of investment funds • i.e. what it costs to borrow money or raise equity capital for investments • it is the same cost of capital ‘r’ used in NPV calculations

18. IRR on Calculator • Enter the cash flows as before • Use the keys • That’s it! • Without financial calculator, IRR is computed by trial and error IRR/YR

19. IRR Example Year Cash flow 0 -200 1 50 2 100 3 150 50 100 150 0 = -200 + + + (1+IRR)1 (1+IRR)2 (1+IRR)3 IRR = ______% Hurdle rate = 9% Accept / reject?

20. Another Example 1 2 3 4 5 0 6 • What is the IRR? Ans: _____ • What is the NPV if r = 16% Ans: _____ • Do IRR and NPV give the same answer? -256 +31 +128 +194 +61 +55 +108

21. Net Present Value Profile Net present value 120 Year Cash flow 0 – $275 1 100 2 100 3 100 4 100 100 80 60 40 NPV>0 20 0 NPV < 0 – 20 Discount rate – 40 2% 6% 10% 14% 18% 22% IRR

22. IRR and Unconventional Cash Flows • The cash flows are • Year Cash flow • 0 -$252 • 1 1431 • 2 -3035 • 3 2850 • 4 -1000 • IRR = ?

23. Example continued.... • What’s the IRR? at 25.00%: NPV = _______ at 33.33%: NPV = _______ at 42.86%: NPV = _______ at 66.66%: NPV = _______ • Two questions: • 1. What’s going on here? • 2. How many IRRs can there be?

24. NPV Profile - Multiple IRR Problem NPV $0.06 $0.04 IRR = 25% $0.02 $0.00 ($0.02) IRR = 66.6% IRR = 33.3% IRR = 42.8% ($0.04) ($0.06) ($0.08) 0.2 0.28 0.36 0.44 0.52 0.6 0.68 Discount rate

25. Problem 1 with IRR Rule • IRR Rule does not always give a clear answer with unconventional cash flows • In the above example, there are multiple IRRs • The accept/reject decision in the example depends on required rate of return

26. Another Problem with IRR Year 0 1 2 3 4 Project A: – $350 50 100 150 200 Project B: – $250 125 100 75 50 If the projects are mutually exclusive (i.e. can take one or the other, but not both), which project to take?

27. Example Continued...

28. Decision with mutually exclusive projects • IRR Rule does not always give a correct answer with mutually exclusive projects • In the above example, it seems we would prefer Project ________ (higher IRR)

29. Mutually Exclusive… (contd.) • But always take the project with higher NPV!! • If r = 5%, then accept project A • If r = 14%, then accept project B

30. IRR, NPV, and Mutually Exclusive Projects Net present value $ 160 Project A 140 120 100 80 Project B 60 40 NPV A >NPV B 20 0 – 20 – 40 – 60 NPV B >NPV A – 80 Discount rate % – 100 0 2% 16% 20% 24% 10% 6% IRR A < IRR B Crossover rate

31. Cross-over Rate • the discount rate that makes NPV of two projects equal • the interest rate at which you are indifferent between two mutually exclusive projects

32. Finding Crossover Rate • Take difference between cash flows of two projects and find IRR (of these incremental cash flows) Year 0 1 2 3 4 Project A: – $350 150 120 150 200 Project B: – $250 125 100 75 165 Difference: –$100 25 20 75 35 IRR (difference) = _______ %

33. Another example • Find the crossover rate of these two projects • Answer: _________

34. IRR - Criticisms • Not a measure of dollar value added • Does not consider the scale of the project • Interim cash flows are assumed to be reinvested at the IRR which is unrealistic • Does not give correct answer when • you have mutually exclusive project • unconventional cash flows

35. Payback Rule • Measure of the length of time until the sum of future cash flows equals the initial investment • Time it takes to get you money back • Accept: if payback period is less than some pre-specified benchmark

36. Payback Example • The cash flows are • Year Proj. A Proj. B • 0 -$100 -$100 • 1 90 15 • 2 15 90 • 3 10 10 • 4 10 20 Payback = 2 yrs

37. Problem with Payback Year Proj. A Proj. B 0 -$100 -$100 1 90 15 2 15 90 3 10 100 4 10 2000 Payback rule ignores these cash flows Although both projects have the same payback, Proj. B is clearly superior

38. Payback Rule - Criticisms • It does not take into account time value of money (i.e. no discounting of cash flows) • Payback rule ignores all the cash flows that occur after the payback period • Required payback benchmark is arbitrary

39. Discounted Payback • Length of time until present value of future cash flows equals the intial investment • avoids the time value criticism of simple payback rule • Accept if discounted payback less than pre-specified benchmark • Does not avoid other criticisms of payback rule

40. Disc. Payback Example • The cash flows are • Year Proj. A PV (r=10%) • 0 -$100 -$100 • 1 90 81.82 • 2 15 12.40 • 3 10 7.51 • 4 10 6.83 discounted payback = 3 years

41. Discounted Payback - criticism • Incorporates time value in decision in contrast with simple payback, • It still ignores all cash flows occuring after the required payback period • Benchmark is still arbitrary BUT

42. Profitability Index • Ratio of PV of benefits to PV of costs • “Bang for the buck” • Rule: Accept Project if PI > 1Reject project if PI < 1

43. P. I. Example • P. I. = ______ =________ 200 • Interpretation: NPV of $0.204 is added for each $1 of investiment.

44. Problems with P. I. • As with IRR, it does not consider the scale of the project. • Not a measure of total $ value added to firm • With mutually exclusive projects, P. I. can give wrong rankings

45. Another Example • Although Proj. A has higher P. I., Proj. B should be accepted because NPV is higher

46. Average Accounting Return • Measure of avg. accounting profit divided by avg. accounting value of investment:A. A. R. = avg. net income avg. book value of invest. • Accept if AAR > benchmark returnReject if AAR < benchmark return

47. A. A. R. Example • Average net income: • Year • 1 2 3 • Sales $440 $240 $160 • Costs 220 120 80 • Gross profit 220 120 80 • Depreciation 80 80 80 • Earnings before taxes 140 40 0 • Taxes (25%) 35 10 0 • Net income $105 $30 $0 • Average net income = (105 + 30 + 0)/3 = $45

48. Example continued • Average book value: • Initial investment = $240 • Average investment = ($240 + 160 + 80 + 0)/4 = $120 • (or) = $240/2 = $120 • Average accounting return (AAR): • Average net income $45 • AAR = = = 37.5% • Average book value $120

49. Problems with AAR • Does not use cash flows • Ignores timing of income • Pre-specified benchmark is arbitrary

50. Summary • Of all the rules considered, NPV consistently gives the correct answers • Other rules may or may not give the same answer as NPV • Decisions based on NPV rule are always correct!