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Capital Budgeting

Capital Budgeting. Professor Trainor. Capital Budgeting Decision Techniques. Payback period : most commonly used Discounted Payback, not as common. Net present value (NPV): best technique theoretically; difficult to calculate realistically.

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Capital Budgeting

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  1. Capital Budgeting Professor Trainor

  2. Capital Budgeting Decision Techniques • Payback period: most commonly used • Discounted Payback, not as common Net present value(NPV):best technique theoretically; difficult to calculate realistically Internal rate of return(IRR): widely used with strong intuitive appeal. Modified IRR can be used if several neg. cash flows Profitability index(PI):related to NPV

  3. A Capital Budgeting Process Should: Account for the time value of money; Account for risk; Focus on cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders’ wealth.

  4. The payback period is the amount of time required for the firm to recover its initial investment. • If the project’s payback period is less than the maximum acceptable payback period, accept the project. • If the project’s payback period is greater than the maximum acceptable payback period, reject the project. Payback Period Management determines maximum acceptable payback period.

  5. Initial outlay Initial outlay -$50 -$250 Year 1 inflow Year 1 inflow $35 $18 Year 2 inflow Year 2 inflow $80 $22 Year 3 inflow Year 3 inflow $130 $25 Year 4 inflow Year 4 inflow $160 $30 Year 5 inflow Year 5 inflow $175 $32 Global Wireless • Global Wireless is a worldwide provider of wireless telephony devices. • Global Wireless evaluating major expansion of its wireless network in two different regions: • Western Europe expansion • A smaller investment in Southeast U.S. to establish a toehold Western Europe ($ millions) Southeast U.S. ($ millions)

  6. Calculating Payback Periods for Global Wireless Projects • Management selects a 2.75 years payback period. • Western Europe project has initial outflow of -$250 million, • But cash inflows over first 3 years only $245 million. • Global Wireless would reject Western Europe project. • Southeast U.S. project: initial outflow of -$50 million • Cash inflows over first 2 years cumulate to $40 million. • Project recovers initial outflow after 2.40 years. • Total inflow in year 3 is $25 million. We estimate that the projects generates $10 million in year 3 in 0.40 years ($10 million  $25 million). • Global Wireless would accept the project.

  7. Advantages of payback method: • Computational simplicity • Easy to understand • Focus on cash flow Disadvantages of payback method: • Does not account properly for time value of money • Does not account properly for risk • Cutoff period is arbitrary • Does not lead to value-maximizing decisions Pros and Cons of Payback Method

  8. Item PV Factors (18%) Western Europe project ($million) Southeast U.S. project ($million) PV Year 1 inflow 0.8475 $29.7 $15.2 PV Year 2 inflow 0.7182 $57.4 $15.8 PV Year 3 inflow 0.6086 $79.1 $15.2 Cumulative PV -- $166.2 $46.2 Accept / reject -- Reject Reject Discounted Payback Period • Discounted payback accounts for time value. • Apply discount rate to cash flows during payback period. • Still ignores cash flows after payback period • Global Wireless uses an 18% discount rate.

  9. Accept projects if NPV > 0. Net Present Value The present value of a project’s cash inflows and outflows Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk.

  10. A key input in NPV analysis is the discount rate. • r represents the minimum return that the project must earn to satisfy investors. • r varies with the risk of the firm and/or the risk of the project. Net Present Value

  11. Calculating NPVs for Global Wireless Projects • Assuming Global Wireless uses 18% discount rate, NPVs are: Western Europe project: NPV = $75.3 million Southeast U.S. project: NPV = $25.7 million Should Global Wireless invest in one project or both?

  12. Key benefits of using NPV as decision rule: • Focuses on cash flows, not accounting earnings • Makes appropriate adjustment for time value of money • Can properly account for risk differences between projects Though best measure, NPV has some drawbacks: • Lacks the intuitive appeal of payback, and • Doesn’t capture managerial flexibility (option value) well. Pros and Cons of Using NPV as Decision Rule NPV is the “gold standard” of investment decision rules.

  13. Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project: • IRR found by computer/calculator or manually by trial and error. The IRR decision rule is: • If IRR is greater thanthe cost of capital, acceptthe project. • If IRR is less thanthe cost of capital, rejectthe project. Internal Rate of Return

  14. Western Europe project: IRR (rWE) = 27.8% Southeast U.S. project: IRR (rSE) = 36.7% Calculating IRRs for Global Wireless Projects Global Wireless will accept all projects with at least 18% IRR.

  15. Advantages of IRR: • Properly adjusts for time value of money • Uses cash flows rather than earnings • Accounts for all cash flows • Project IRR is a number with intuitiveappeal Disadvantages of IRR • “Mathematical problems”: multiple IRRs, no real solutions • Scale problem • Timing problem Advantages and Disadvantages of IRR

  16. Multiple IRRs NPV ($) NPV>0 IRR NPV>0 Discount rate NPV<0 NPV<0 IRR When project cash flows have multiple sign changes, there can be multiple IRRs. With multiple IRRs, which do we compare with the cost of capital to accept/reject the project?

  17. Modify Global Wireless’s Western Europe project to include a large negative outflow (-$355 million) in year 6. • There is no real number thatwill make NPV=0, so noreal IRR. However, can use something called modified IRR. No Real Solution Sometimes projects do not have a real IRR solution. Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!

  18. Project IRR NPV (18%) The scale problem: Western Europe 27.8% $75.3 mn Southeast U.S. 36.7% $25.7 mn • Southeast U.S. project has higher IRR, but doesn’t increase shareholders’ wealth as much as Western Europe project. Conflicts Between NPV and IRR NPV and IRR do not always agreewhen ranking competing projects.

  19. The Timing Problem Long-term project IRR = 15% NPV Short-term project IRR = 17% Discount rate 13% 15% 17% • The NPV of the long-term project is more sensitive to the discount rate than the NPV of the short-term project is. • Long-term project has higher NPV if the cost of capital is less than 13%. Short-term project has higher NPV if the cost of capital is greater than 13%.

  20. Decision rule: Accept project with PI > 1.0, equal to NPV > 0 Project PV of CF (yrs1-5) Initial Outlay PI Western Europe $325.3 million $250 million 1.3 Southeast U.S. $75.7 million $50 million 1.5 • Both projects’ PI > 1.0, so both acceptable if independent. Profitability Index Calculated by dividing the PV of a project’s cash inflows by the PV of its outflows: Like IRR, PI suffers from the scale problem.

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