1 / 50

Capital Budgeting Decision Methods

Capital Budgeting Decision Methods. Chapter 10. Oct 31, 2012. 1. Learning Objectives. The capital budgeting process. Calculation of Payback, NPV, IRR Capital rationing. Measurement of risk in capital budgeting and how to deal with it. 2. Overview. Time Value of Money

rossa
Download Presentation

Capital Budgeting Decision Methods

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Capital Budgeting Decision Methods Chapter 10 Oct 31, 2012 1

  2. Learning Objectives • The capital budgeting process. • Calculation of Payback, NPV, IRR • Capital rationing. • Measurement of risk in capital budgeting and how to deal with it. 2

  3. Overview • Time Value of Money • Calculating value of K – WACC • Use of K (firm’s hurdle rate) to evaluate projects – calc NPV • Now, how to calculate project IRR (return provided by the project)

  4. The Accept/Reject Decision Three methods: • Payback Period • years to recoup the initial investment • Net Present Value (NPV) • change in value of firm if project is under taken • Internal Rate of Return (IRR) • projected percent rate of return project will earn 4

  5. The Capital Budgeting Process • Capital Budgeting is the process of evaluating proposed investment projects • Managers must determine which projects are acceptable from a financial standpoint • Examples might include: • purchase of fixed assets, computers, • investments in R & D, or new businesses • Advertising; intellectual property 3

  6. Relevant cash flows • The relevant cash flows are after-taxincremental cash flows – Axiom 4 • Cash flows that will occur if the project is done, and won’t occur if the project isn’t done. • Remember the brief case example

  7. P R O J E C T Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 Capital Budgeting Methods • Consider Projects A and B that have the following expected cash flows 5

  8. P R O J E C T Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 Payback in 2.86 years 0 1 2 3 4 0 1 2 3 4 (10,000) 3,500 -6,500 3,500 -3,000 3,500 +500 3,500 Cumulative CF 8 Capital Budgeting Methods • What is the payback for Project A? (10,000) 3,500 -6,500 3,500 -3,000 3,500 +500 3,500 Cumulative CF (3,000/3,500 = 2.86)

  9. P R O J E C T Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 0 1 2 3 4 Capital Budgeting Methods • What is the payback for Project B? 9 (10,000) 500 4,600 10,000 500

  10. Payback in 3.44 years P R O J E C T Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 0 1 2 3 4 (10,000) 500 -9,500 500 -9,000 4,600 -4,400 10,000 +5,600 Cumulative CF Capital Budgeting Methods • What is the payback for Project B? 10

  11. Payback Decision Rule • Accept project if payback is less than the company’s predetermined maximum. • If company has determined that it requires payback in 3.0 years or less, then you would: • accept Project A (2.86 years) • reject Project B (3.44 years) 11

  12. Payback - Problems • Does not consider cash received after the payback period is over Example: the remainder of the $10,000 in year four is ignored in project B • Does not consider the time value of money Example: the $3,500 per year for the four years in A may have a higher present value than project B, even though B pays back more total dollars ($15,600 vs. $14,000).

  13. Capital Budgeting Methods • Present Value of all costs and benefits (measured in terms of incremental cash flows) of a project. • Concept is similar to Discounted Cash flow model for valuing securities but subtracts the cost of the project. Net Present Value 12

  14. CF1 (1+ k)1 CF2 (1+ k)2 …. CFn (1+ k)n NPV = + + – Initial Investment Capital Budgeting Methods Net Present Value • Present Value of all costs and benefits (measured in terms of incremental cash flows) of a project. • Concept is similar to Discounted Cash flow model for valuing securities but subtracts of cost of project (initial investment). NPV = PV of Inflows – Initial Investment 13

  15. k=10% P R O J E C T Time A B 0 (10,000) (10,000) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 0 1 2 3 4 (10,000) 500 500 4,600 10,000 What is the NPV for Project B? 14

  16. k=10% P R O J E C T $500 (1.10)2 455 Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 0 1 2 3 4 $4,600 (1.10)3 413 (10,000) 500 500 4,600 10,000 3,456 What is the NPV for Project B? $10,000 (1.10)4 18 6,830

  17. k=10% 455 P R O J E C T Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 413 PV Benefits > PV Costs NPV > $0 0 1 2 3 4 $11,154 > $ 10,000 $1,154 > $0 3,456 (10,000) 500 500 4,600 10,000 6,830 $11,154 What is the NPV for Project B? 21 - $10,000 = $1,154 = NPV

  18. P/YR CF NPV IRR N I/Y PV PMT FV Financial Calculator: • Additional Keys used to enter Cash Flows and compute the Net Present Value (NPV) Key used to enter expected cash flows in order of their receipt. Note: the initial investment (CF0) must be entered as a negative number since it is an outflow. 23

  19. P/YR CF NPV IRR N I/Y PV PMT FV Financial Calculator: • Additional Keys used to enter Cash Flows and compute the Net Present Value (NPV) Key used to calculate the net present value of the cash flows that have been entered in the calculator. 24

  20. P/YR CF NPV IRR N I/Y PV PMT FV Financial Calculator: • Additional Keys used to enter Cash Flows and compute the Net Present Value (NPV) Key used to calculate the internal rate of return for the cash flows that have been entered in the calculator. 25

  21. P R O J E C T Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 Calculate the NPV for Project A. Since it is an annuity, N = 4 i/y = 10 PV = CPT PMT = 3500 FV = 0 CPT PV = 11,094.53 NPV = 11,094.53 - 10,000.00 1,094.53 26

  22. P/YR CF NPV IRR P R O J E C T N I/Y PV PMT FV Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 Calculate the NPV for Project B with calculator. 26

  23. P/YR CF NPV IRR CF 10000 +/- ENTER N I/Y PV PMT FV Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: CF0 = -10,000 27

  24. Keystrokes for TI BAII PLUS: P/YR CF NPV IRR CF 10000 +/- ENTER N I/Y PV PMT FV 500 ENTER Calculate the NPV for Project B with calculator. C01 = 500 28

  25. Keystrokes for TI BAII PLUS: P/YR CF NPV IRR CF 10000 +/- ENTER N I/Y PV PMT FV 500 ENTER 2 ENTER Calculate the NPV for Project B with calculator. F01 = 2 F stands for “frequency”. Enter 2 since there are two adjacent payments of 500 in periods 1 and 2. 29

  26. Keystrokes for TI BAII PLUS: P/YR CF NPV IRR CF 10000 +/- ENTER N I/Y PV PMT FV 500 ENTER 2 ENTER 4600 ENTER Calculate the NPV for Project B with calculator. C02 = 4600 30

  27. Keystrokes for TI BAII PLUS: P/YR CF NPV IRR CF 10000 +/- ENTER N I/Y PV PMT FV 500 ENTER 2 ENTER 4600 ENTER 1 ENTER Calculate the NPV for Project B with calculator. F02 = 1 31

  28. Keystrokes for TI BAII PLUS: P/YR CF NPV IRR CF 10000 +/- ENTER N I/Y PV PMT FV 500 ENTER 2 ENTER 4600 ENTER 1 ENTER 10000 ENTER Calculate the NPV for Project B with calculator. C03 = 10000 32

  29. Keystrokes for TI BAII PLUS: P/YR CF NPV IRR CF 10000 +/- ENTER N I/Y PV PMT FV 500 ENTER 2 ENTER 4600 ENTER 1 ENTER 10000 ENTER 1 ENTER Calculate the NPV for Project B with calculator. F03 = 1 33

  30. P/YR CF NPV IRR NPV N I/Y PV PMT FV 10 ENTER Calculate the NPV for Project B with calculator. Keystrokes for TI BAII PLUS: I = 10 k = 10% 34

  31. Keystrokes for TI BAII PLUS: P/YR CF NPV IRR NPV N I/Y PV PMT FV 10 ENTER CPT Calculate the NPV for Project B with calculator. NPV = 1,153.95 The net present value of Project B = $1,154 as we calculated previously. (Note: If you press the IRR key, and CPT, it will calculate the IRR for you.) 35

  32. Calculate the NPV for project A with calculator • CF -10,000 ENTER down arrow • CO1 3,500 ENTER down arrow • FO1 4 ENTER • Down arrow • CO2 NPV • I = 10 ENTER • NPV = CPT • NPV = $1,094.53 For IRR, punch the IRR key and then CPT

  33. NPV Decision Rule • Accept the project if the NPV is greater than or equal to 0. Example: NPVA= $1,095 NPVB= $1,154 Accept > 0 > 0 Accept • If projects are independent, accept both projects. • If projects are mutually exclusive (you can only do one of them), accept the project with the higher NPV. 36

  34. Capital Budgeting Methods • IRR (Internal Rate of Return) • IRR is the discount rate that forces the NPV to equal zero. • It is the rate of return on the project given its initial investment and future cash flows. • The IRR is the rate earned only if all CF’s are reinvested at the IRR rate. 37

  35. P/YR CF NPV IRR P R O J E C T N I/Y PV PMT FV Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 Calculate the IRR for Project B with calculator. (Project B not an annuity) 39

  36. P/YR CF NPV IRR P R O J E C T N I/Y PV PMT FV Time A B 0 (10,000.) (10,000.) 1 3,500 500 2 3,500 500 3 3,500 4,600 4 3,500 10,000 IRR CPT Calculate the IRR for Project B with calculator. IRR = 13.5% Enter CF’s as for NPV 40

  37. IRR Decision Rule • Accept the project if the IRR is greater than or equal to the required rate ofreturn (k). • Reject the project if the IRR is less than the required rate of return (k). Example: k = 10% IRRA= 14.96% IRRB= 13.50% > 10% > 10% Accept 41 Accept

  38. Calculate NPV and IRR for Project A • NPV = $1,094.53 • IRR = 14.96% • Which project(s) should the firm accept?NPV IRR • A $1,095 14.96% • B $1,154 13.5% 48

  39. NPV/IRR Decision Rules • If projects A & B are independent, and you have enough money, accept both projects • If projects A & B are mutually exclusive, meaning you can only pick one or the other, or you don’t have enough money to do both, • Always choose the project with the highest NPV ($). 49

  40. Risk in Capital Budgeting • Project risk needs to be considered in comparing projects with different levels of risk. • The discount rate can be adjusted for risk when NPV is used to evaluate projects. • The hurdle rate can be adjusted when IRR is used to evaluate projects. 51

  41. Risk in Capital Budgeting • Example: Normal risk, k = WACC • Medium risk – new product K = WACC + 2 to 3 % • High risk – new industry K = WACC + 5 to 10% • (Axiom 1 – risk/reward trade off)

  42. What is capital rationing? • Capital rationing is the practice of placing a dollar limit on the total size of the capital budget.. • Choose between projects by selecting the combination of projects that yields the highest total NPV without exceeding the capital budget limit. 54

  43. Capital Rationing Example • ProjectCash OutlayNPV • A $20,000 $8,000 • B $50,000 $7,200 • C $40,000 $6,500 • D $60,000 $5,100 • E $50,000 $4,200 • F $30,000 $3,800 • G $30,000 $2,000 $280,000 If cash outlay spending limit is $200,000, which combination of projects should be chosen to maximize NPV?

  44. Capital Rationing example • ProjectCash OutlayNPV A,B,C,D $170,000 $26,800 A,B,C,D,F $200,000 $30,600 A,B,C,D,G $200,000 $28,800 B,C,D,E $200,000 $23,000 B,C,E,F,G $200,000 $23,700 A,C,D,E,F $200,000 $27,600 A,C,D,E,G $200,000 $25,500

  45. Mutually Exclusive Projects With Unequal Lives • Mutually exclusive projects with unequal project lives can be compared by using two methods: • Replacement Chain • Equivalent Annual Annuity (ignore) 68

  46. Replacement Chain Approach • Assumes each project can be replicated until a common period of time has passed, allowing the projects to be compared. • Example • Project Cheap Talk has a 3-year life, with an NPV of $4,424. • Project Rolles Voice has a 12-year life, with an NPV of $12,500. 69

  47. Replacement Chain Approach • Project Cheap Talk could be repeated four times during the life of Project Rolles Voice. • The NPVs of Project Cheap Talk, in years t3, t6, and t9,are discounted back to year t0. 70

  48. k=10% 0 3 6 9 4,424 4,424 4,424 4,424 Replacement Chain Approach • The NPVs of Project Cheap Talk, in years t3, t6, and t9,are discounted back to year t0, which results in an NPV of $12,121. 3,324 2,497 71 1,876 12,121 vs 12,500 in Rolls Voice

  49. Disparate sizes • Suppose capital budget is $10,000 • Project A: $2,000 with NPV of $1,000 • Project B: $10,000 with NPV of $3,000 • Which should you choose? Say you only have $10,000 and can’t do both.

  50. Disparate Sizes • Ans: depends on what you can earn on the extra $8,000 if you choose Project A. If the combined NPV’s for project A plus what you earned on the other $8,000 exceeds the NPV of project B, then do project A plus others. • Otherwise, choose project B • Always choose the option with the highest NPV!

More Related