1 Chapter 10 Capital Budgeting Introduction and Techniques
1 Chapter 10: Capital Budgeting: Introduction and Techniques Part III Foundations of Corporate Finance Copyright © 1999 Addison Wesley Longman
CHAPTER 10 Capital Budgeting: Introduction and Techniques Copyright © 1999 Addison Wesley Longman
3 Chapter 10: Capital Budgeting: Introduction and Techniques Objectives 1. Learn to use TVM in investment analysis 2. Develop project evaluation models Copyright © 1999 Addison Wesley Longman
4 Chapter 10: Capital Budgeting: Introduction and Techniques The Capital Budgeting Process The Process for analyzing potential investments Copyright © 1999 Addison Wesley Longman
5 Chapter 10: Capital Budgeting: Introduction and Techniques Define the projects – – – 1. 2. 3. 4. 5. • • • replace worn-equipment replace outdated equipment increase current capacity expand product offerings miscellaneous a. b. c. safety environmental cosmetics Copyright © 1999 Addison Wesley Longman
6 Chapter 10: Capital Budgeting: Introduction and Techniques Cash Flow Estimations – 1. cash flow time lines – 2. cash flow riskiness Copyright © 1999 Addison Wesley Longman
7 Chapter 10: Capital Budgeting: Introduction and Techniques Determine Project Feasibility 1. independent projects – The decision to implement the project is determined independently of all other projects. – a. accept if increase firm wealth – b. reject if reduces firm wealth Copyright © 1999 Addison Wesley Longman
8 Chapter 10: Capital Budgeting: Introduction and Techniques 2. mutually exclusive projects The decision to implement a project depends upon its feasibility as compared to other projects - a. accept project that increases firm wealth the most - b. reject all projects that reduce firm wealth Copyright © 1999 Addison Wesley Longman
9 Chapter 10: Capital Budgeting: Introduction and Techniques DECISION CRITERIA – – – 1. 2. 3. 4. 5. net present value (NPV) payback rule discounted payback rule internal rate of return (IRR) modified internal rate of return (MIRR) – 6. profitability index Copyright © 1999 Addison Wesley Longman
10 Chapter 10: Capital Budgeting: Introduction and Techniques Net Present Value (NPV) The sum of the present value of all positive and negative cash flows. – – – Year 0 1 2 3 4 $85 CF’s Dscting. DCF’s -$200/1. 100 = -$200 $70 /1. 101 = $64 $90 /1. 102 = $74 $100/1. 103 = $75 $125 /1. 104 = Copyright © 1999 Addison Wesley Longman
11 Chapter 10: Capital Budgeting: Introduction and Techniques Using the calculator - HP 10 B – 1. clear the memory: [�] [CLEAR ALL] – 2. for CF 0, enter [200] [+/-] [CFj] – 3. for CF 1, enter [70] [CFj] – 4. repeat step 3 until all cash flows are entered – 5. for the discount rate, enter [10] [I/YR] – 6. to calculate NPV, enter [�] [NPV] Copyright © 1999 Addison Wesley Longman
12 Chapter 10: Capital Budgeting: Introduction and Techniques TI BA II PLUS – 1. clear the memory: [CF] [2 nd] [CLR Work] – 2. CF 0: [CF] [200] [+/-] [ENTER] [ ] – 3. CF 1: [70] [ENTER] [ ] [1] [ENTER] [ ] – 4. repeat step 3 until all cash flows are entered – 5. to enter discount rate: [NPV] [10] [ENTER] [ ] Copyright © 1999 Addison Wesley Longman
13 Chapter 10: Capital Budgeting: Introduction and Techniques Decision Criteria a. independent: accept if NPV > 0 b. mutually exclusive: accept highest (+) NPV Copyright © 1999 Addison Wesley Longman
14 Chapter 10: Capital Budgeting: Introduction and Techniques FIGURE 10. 1 NPV Profile Copyright © 1999 Addison Wesley Longman
15 Chapter 10: Capital Budgeting: Introduction and Techniques FIGURE 10. 2 IRR Ranking Problem Copyright © 1999 Addison Wesley Longman
16 Chapter 10: Capital Budgeting: Introduction and Techniques Payback Rule – The expected number of years until recovery of original investment. Copyright © 1999 Addison Wesley Longman
17 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation Project Cash Flows Year CF’s Cumulative 0 -$200 1 $70 -$130 2 $90 -$40 3 $100 $60 4 $125 $185 (balance at beginning of next year) Payback = 2 + ($40 / $100) (year before full recovery) (cash flow during next Copyright © 1999 Addison Wesley Longman
18 Chapter 10: Capital Budgeting: Introduction and Techniques problems with payback – a. ignores the time value of money – b. ignores cash flows received after payback period benefits of payback – a. measures projects liquidity – (high PB => low liquidity) Copyright © 1999 Addison Wesley Longman
19 Chapter 10: Capital Budgeting: Introduction and Techniques Discounted Payback Rule The expected number of years until the discounted cash flows equals the initial investment. Copyright © 1999 Addison Wesley Longman
20 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation Project Cash Flows, assume discount rate of 10% Year CF’s DCF’s 0 -$200 1 $70 2 $90 3 $100 4 $125 Dscting. DCF’s Cum. /1. 100= -$200 /1. 101= $64 -$136 /1. 102= $74 -$62 /1. 103= $75 $13 /1. 104= $85 $98 (balance at beginning of next year) Payback = 2 + ($62 / $75) (year before full recovery) (DCF during next year) Copyright © 1999 Addison Wesley Longman
21 Chapter 10: Capital Budgeting: Introduction and Techniques Problems with discounted payback – a. may reject positive NPV investments – b. ignores cash flows received after payback period Copyright © 1999 Addison Wesley Longman
22 Chapter 10: Capital Budgeting: Introduction and Techniques Internal Rate of Return u The discount rate that provides an NPV of zero. u PV of inflows = PV of outflows Copyright © 1999 Addison Wesley Longman
23 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation Year 0 1 2 3 4 CF’s Dscting. -$200 /1. ? 0= $70 /1. ? 1= $90 /1. ? 2= $100 /1. ? 3= $125 /1. ? 4= DCF’s -$200 $? NPV = $0 Calculation done by trial and error without calculator. Copyright © 1999 Addison Wesley Longman
24 Chapter 10: Capital Budgeting: Introduction and Techniques Using the calculator HP 10 B – 1. clear the memory: [�] [CLEAR ALL] – 2. for CF 0, enter [200] [+/-] [CFj] – 3. for CF 1, enter [70] [CFj] – 4. repeat step 3 until all cash flows are entered – 5. to calculate IRR, enter [�] [IRR/YR] Copyright © 1999 Addison Wesley Longman
25 Chapter 10: Capital Budgeting: Introduction and Techniques TI BA II PLUS – 1. clear the memory: [CF] [2 nd] [CLR Work] – 2. CF 0: [CF] [200] [+/-] [ENTER] [ ] – 3. CF 1: [70] [ENTER] [ ] [1] [ENTER] [ ] – 4. repeat step 3 until all cash flows are entered – 5. to calculate IRR: [IRR] [CPT] – 6. answer = 29% Copyright © 1999 Addison Wesley Longman
26 Chapter 10: Capital Budgeting: Introduction and Techniques Decision criteria – a. independent: • 1. NPV • 2. provides same result as accept if IRR > RRR (cost of capital) – b. mutually exclusive: • 1. may provide different results from NPV • 2. use NPV results Copyright © 1999 Addison Wesley Longman
27 Chapter 10: Capital Budgeting: Introduction and Techniques Problems with IRR a. provides multiple IRRs when CF signs change more than once b. assumes reinvestment rate equals IRR c. may provide incorrect results for mutually exclusive Copyright © 1999 Addison Wesley Longman
28 Chapter 10: Capital Budgeting: Introduction and Techniques FIGURE 10. 3 Multiple IRRs Copyright © 1999 Addison Wesley Longman
29 Chapter 10: Capital Budgeting: Introduction and Techniques Benefits of IRR a. easy to understand b. generally provides results consistent with NPV c. business executives prefer 3 to 1 over NPV Copyright © 1999 Addison Wesley Longman
30 Chapter 10: Capital Budgeting: Introduction and Techniques Modified Internal Rate of Return (MIRR) u u u The discount rate that makes the future value of cash inflows equal the present value of cash outflows. PV of cash outflows = FV of cash inflows The future value of cash inflows and present value of cash outflows is found using the RRR (cost of capital). Copyright © 1999 Addison Wesley Longman
31 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation step 1: obtain present value of cash outflows and future value of cash inflows using cost of capital Copyright © 1999 Addison Wesley Longman
32 Chapter 10: Capital Budgeting: Introduction and Techniques Year CF’s Outflow PV’s Inflow FV’s 0 -$200/1. 100= -$200 1 $70*1. 103= $93 2 $90*1. 102= $109 3 $100 *1. 101= $110 4 $125 *1. 100= $125 Total =-$200 $437 Copyright © 1999 Addison Wesley Longman
33 Chapter 10: Capital Budgeting: Introduction and Techniques step 2: use calculator to determine rate which equates present value of cash outflows to future value of cash inflows N = 4 I/YR = ? = 21. 58% PV = -$200 PMT = $0 FV = $437 Copyright © 1999 Addison Wesley Longman
34 Chapter 10: Capital Budgeting: Introduction and Techniques Benefits a. assumes cash flows from project are reinvested at the cost of capital b. eliminates multiple IRR problem c. provides results consistent with NPV Copyright © 1999 Addison Wesley Longman
35 Chapter 10: Capital Budgeting: Introduction and Techniques F. Profitability Index u (a. k. a. : benefit cost ratio) u Measures the projects profitability per dollar of investment. Copyright © 1999 Addison Wesley Longman
36 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation PI = PV of benefits / PV of costs assuming a 10% discount rate Year CF’s Outflow PV’s Inflow PV’s 0 -$200 1 $70 $64 2 $90 $74 3 $100 $75 4 $125 $85 Totals $200 $298 PI = $298 / $200 = 1. 49 Copyright © 1999 Addison Wesley Longman
37 Chapter 10: Capital Budgeting: Introduction and Techniques Decision criteria a. independent: accept if PI > 1 b. mutually exclusive: accept highest PI Copyright © 1999 Addison Wesley Longman
38 Chapter 10: Capital Budgeting: Introduction and Techniques Compared to NPV and IRR a. provides same results for independent projects b. can have conflicting results for mutually exclusive projects with significantly different sized cash flows Copyright © 1999 Addison Wesley Longman
39 Chapter 10: Capital Budgeting: Introduction and Techniques SYNTHESIZING THE PROCEDURES Copyright © 1999 Addison Wesley Longman
40 Chapter 10: Capital Budgeting: Introduction and Techniques Each method provides information u 1. NPV provides a direct measure of the increase in shareholder wealth u 2. Payback methods provide measures of liquidity u 3. IRR methods provide measures of safety margins in easy to understand terms u 4. Profitability indexes provide safety margin measures and the profitability per dollar of investment Copyright © 1999 Addison Wesley Longman
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