Capital Budgeting Arguing for your project Arguing for

Capital Budgeting Arguing for your project

Arguing for your project 4 Capital budgeting 4 CFO receives proposals from divisions 4 Projects described by cash flows

Arguing means applying measures 4 Net present value is the right measure. 4 Many smart people use the wrong ones. 4 Alternative ways to the same end.

Uses of measures 4 Project acceptance 4 Mutually exclusive alternatives.

Capital Budgeting Techniques 4 Kim, Crick, and Kim, Management Accounting 4 Nov. 1986, p. 49 -52

Survey of use of measures by corporations

Make no mistake 4 NPV is the right measure always. 4 Others work sometimes. 4 NPV measures value to owners, their wealth.

Objectives of a good measure 4 Value cash flows. 4 Respond to the market.

NPV’s merits 4 Values cash flows as the market does. 4 Responsive because the discount rate is the current market rate. 4 Measures increase in shareholder value.

Payback period is 4 The time required for undiscounted cash flows to add up to the initial investment. 4 e. g. , build a Wendy’s if it “pays for itself” in two years or less.

Payback merits 4 Based on cash flows

Payback defects 4 No market response. When r is high, payback period should be shorter. 4 Subtracts time-t dollars from time-0 dollars, a cardinal sin. 4 Ignores cash flow after payback. 4 Ignores timing during payback.

Defects are not necessarily fatal 4 Repeated, similar investments. 4 Stable financial conditions.

The well-informed capital budgeter knows 4 When to accept payback period as a measure. 4 When it is likely to fail.

Accounting rate of return 4 Doesn’t value cash flows 4 No market response 4 Ignores market values 4 Scaling problems: melons or malls

Merits of accounting r. o. r. 4 Easily understood. 4 Sometimes okay in stable markets. 4 Smart application can overcome defects.

Internal rate of return 4 Definition: IRR is the discount rate that makes NPV = 0 That is, IRR is the r such that

Internal rate of return 4 Definition: IRR is the discount rate that makes NPV(r) = 0. 4 NPV(r) is a function. 4 RWJ Figures 6. 4 and 6. 5.

Project

Figure 6. 4: NPV(r)=0 at r=23. 37% NPV 100 NPV(. 1) = 48. 68520 IRR =23. 37 48. 685 r. 1 NPV(r)

Figure 6. 4 4 NPV (r) = 0 at r = 23. 37%

Applications of IRR measure 4 Hurdle rate = market rate 4 Project acceptance: Accept a project if IRR > hurdle rate. 4 Mutually exclusive projects: Take the one with the highest IRR (> hurdle rate)? ? ? Don’t rely on it.

Project acceptance: 4 NPV and IRR give the same conclusion when. . . 4 Cash flows have one sign change. 4 In the example: IRR = 23. 37% > hurdle = 10% for an investment project. 4 IRR = 23. 37% < hurdle rate = 30% for a financing or “borrowing from nature” project.

Merits 4 Uses cash flows. 4 Responds to the market when the hurdle rate changes

Objective 4 Learn to recognize the times when NPV and IRR are the same. 4 and also the problems with IRR

Defects of IRR -- project acceptance 4 Lending to nature or borrowing from her? 4 Multiple IRR's may occur.

Financing (borrowing from nature) 4 Seek IRR < hurdle rate 4 Same as NPV > 0

Multiple IRR's

IRR’s at r = 1 and r = 2 4 100% per decade = 7. 17735% per year. 4 200% per decade = 11. 61232% per year.

IRR’s at r=1 and r=2. NPV 100% 200% r

Descartes’ Rule 4 The number of internal rates of return is no more than the number of sign changes.

Defects of IRR -- mutually exclusive projects 4 Ignores market values. 4 Scale problems -- melons or malls.

Typical hour exam question 4 What is the scale problem in using IRR to choose between mutually exclusive projects?

Scale problem in IRR One canyon, one dam.

Sketch of answer 4 The smaller dam has the higher IRR. 4 The big dam has higher value. 4 The big dam extends consumption possibility of owners more than the little dam does. 4 It is wrong to take the higher IRR in this case.

Scale problems in IRR

More answer 4 Consider the project of replacing the little dam by the big dam. 4 Cash flows are -900, +1300. 4 IRR of the project is 4/9 =. 4444 >. 1 4 NPV is 281. 8181… 4 So replace the little dam. 4 Capital budgeting jiu jitsu.

NPV 500 100 Big dam Little dam IRR 50% r IRR 100%

Big dam, little dam NPV 500 For hurdle rates below r*, the big dam is preferred. NPV of the big dam NPV of the small dam 100 r* =. 4444. . . r r*. 5 1