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Capital Budgeting Decision Criteria

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Capital Budgeting Decision Criteria

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    1. Capital Budgeting Decision Criteria

    2. Methods of Evaluating Capital Budgeting Projects Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Profitability Index (PI) Payback Period (PB)

    3. Evaluate a Project with the Following Cash Flows

    4. Net Present Value NPV is the present value of all project cash flows Discount at weighted average cost of capital (WACC) Assumes cash flows are reinvested at WACC NPV varies inversely with WACC Decision Rule: Accept if NPV $0 Reject if NPV < $0 NPV represents change in the value of operations from accepting a capital budgeting project Thus, NPV accrues to shareholders and creditors

    5. Net Present Value

    6. Internal Rate of Return IRR is the discount rate making NPV = 0 Assumes cash flows are reinvested at IRR Single IRR for a project (assuming normal cash flows) Decision Rule: Accept if IRR WACC Reject if IRR < WACC IRR represents the return on a project, while WACC represents the cost of financing a project.

    7. Internal Rate of Return

    8. NPV Profile

    9. Mutually Exclusive & Independent Projects Independent Accept ALL projects which pass the decision rule (NPV or IRR) NPV & IRR give identical accept/reject outcomes Mutually Exclusive Accept Single Best project that passes the decision rule Possible conflicts between NPV & IRR NPV Best

    10. Example

    11. Example

    12. Conflicts between NPV and IRR For mutually exclusive projects NPV and IRR may give conflicting decisions when: Project Size (initial cost) differs Timing of Cash Flows differs Use NPV over IRR: NPV represents the increase in firm value Earning a high IRR doesnt mean the firm can reinvest at that same high IRR

    13. Non-Normal Cash Flows

    14. Modified Internal Rate of Return 3 step process First: find future value of all Positive Cash Flows [compound at WACC] Second: find present value of all Negative Cash Flows [discount at WACC] Third: Find rate of return using Lump Sum formula Use IRR rule: Accept if MIRR WACC Reject if MIRR < WACC

    15. MIRR

    16. Mutually Exclusive Projects with Different Life Spans

    17. Replacement Chain

    18. Equivalent Annual Annuity

    19. Profitability Index PI is the present value of all project cash flows divided by the initial cost of the investment Discount at weighted average cost of capital (WACC) Assumes cash flows are reinvested at WACC Decision Rule: Accept if PI 1.0 Reject if PI < 1.0 PI is often preferred over NPV when a firm faces a capital rationing constraint (a limit on what it can spend on capital budgeting projects)

    20. Profitability Index

    21. Capital Rationing Example

    22. Capital Rationing Example

    23. Why Ration Capital? Managers believe market conditions temporarily adverse Shortage of needed talent / skill sets Growing faster than is sustainable Adverse to issuing new stock Adverse to altering capital structure Adverse to altering dividend payout Managerial risk aversion

    24. Payback Period Number of years to recover Initial Investment Doesnt discount Ignores cash flows past payback period date Target payback period is subjective determined Benefit Measures Liquidity of the project

    25. Drawbacks of Payback Method

    26. Average Accounting Return A company invests $200,000 in a project, depreciated straight-line over 5 years:

    27. Drawbacks of AAR Based on accounting income rather than cash flow Ignores time value of money An acceptable AAR is purely subjective

    28. Economic v Physical Life Physical Life = accounting lifespan of asset Economic Life = maximizes NPV

    29. Summary Independent Projects NPV, IRR, MIRR, PI produce same accept/reject decision Mutually Exclusive Projects NPV or MIRR to avoid conflicting decisions Capital Rationing PI Non-Normal Cash Flows MIRR & NPV give same decision

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