Capital Budgeting Techniques 2007 ThomsonSouthWestern 1 Essentials of

Capital Budgeting Techniques © 2007 Thomson/South-Western 1

Essentials of How do firms make decisions about whether to invest in costly, long-lived assets? How does a firm make a choice between two acceptable investments when only one can be purchased? How are different capital budgeting techniques related? Which capital budgeting methods do firms actually use? 2

What is Capital Budgeting? The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year Analysis of potential additions to fixed assets Long-term decisions; involve large expenditures Very important to firm’s future 3

Generating Ideas for Capital Projects A firm’s growth and its ability to remain competitive depend on a constant flow of ideas for new products, ways to make existing products better, and ways to produce output at a lower cost. Procedures must be established for evaluating the worth of such projects. 4

Project Classifications Replacement Decisions: whether to purchase capital assets to take the place of existing assets to maintain or improve existing operations Expansion Decisions: whether to purchase capital projects and add them to existing assets to increase existing operations Independent Projects: Projects whose cash flows are not affected by decisions made about other projects Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted 5

Similarities between Capital Budgeting and Asset Valuation Determine the cost, or purchase price, of the asset. Estimate the cash flows expected from the project. Assess the riskiness of cash flows. Compute the present value of the expected cash flows to obtain as estimate of the asset’s value to the firm. Compare the present value of the future expected cash flows with the initial investment. 6

Net Cash Flows for Project S and Project L Expected After-Tax ^ Net Cash Flows, CF t Year (T) 0 1 2 3 4 Project S $(3, 000) 1, 500 1, 200 800 300 Project L $(3, 000) 400 900 1, 300 1, 500 7

What is the Payback Period? The length of time before the original cost of an investment is recovered from the expected cash flows or. . . How long it takes to get our money back. 8

Payback Period for Project S 0 1 2 PBS 3 4 Net Cash Flow -3, 000 1, 500 1, 200 800 300 Cumulative Net CF -3, 000 -1, 500 -300 500 800 Payback. S = 2 + 300/800 = 2. 375 years 9

Payback Period for Project L 0 1 2 3 PB L 4 Net Cash Flow - 3, 000 400 900 1, 300 1, 500 Cumulative Net CF - 3, 000 - 2, 600 - 1, 700 - 400 1, 100 Payback. L = 3 + 400/1, 500 = 3. 3 years 10

Strengths and Weaknesses of Payback: Strengths of Payback: • Provides an indication of a project’s risk and liquidity • Easy to calculate and understand Weaknesses of Payback: • Ignores TVM • Ignores CFs occurring after the payback period 11

Net Present Value: Sum of the PVs of Inflows and Outflows ^ Cost is CF 0 and is generally negative. ^ ^ 12

What is Project S’s NPV? 0 r = 10% 1 (3, 000) 1, 500 2 3 4 1, 200 800 300 1, 363. 64 991. 74 601. 05 204. 90 NPVS = 161. 33 13

What is Project L’s NPV? 0 r = 10% (3, 000) 1 2 3 400 900 1300 4 1500 363. 64 743. 80 976. 71 1024. 52 NPVL = 108. 67 14

Calculator Solution, NPV for L Enter in CF for L: -3, 000 CF 0 400 CF 1 900 CF 2 1, 300 CF 3 1, 500 CF 4 10% I NPVL = 108. 67 = NPVL 15

Rationale for the NPV method: NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Which adds most value? 16

Using NPV method, which project(s) should be accepted? If Projects S and L are mutually exclusive, accept S because NPVS > NPVL. If S & L are independent, accept both; NPV > 0. 17

Internal Rate of Return: IRR 0 1 2 3 CF 0 CF 1 CF 2 CF 3 Cost Inflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. 18

Calculating IRR NPV: Enter r, solve for NPV. IRR: Enter NPV = 0, solve for IRR. 19

What is Project S’s IRR? 0 IRR = ? 1 (3, 000) 1, 500 2 3 4 1, 200 800 300 Sum of PVs for CF 1 -4 = 3, 000 NPVS = 0 Enter CFs in CF register, then press IRR: IRRS = 13. 1% 20

What is Project L’s IRR? 0 IRR = ? (3, 000) 1 2 3 4 400 900 1300 1500 Sum of PVs for CF 1 -4 = 3, 000 NPVL = 0 Enter CFs in CF register, then press IRR: IRRL = 11. 4% 21

How is a Project’s IRR Related to a Bond’s YTM? They are the same thing. A bond’s YTM is the IRR if you invest in the bond. 0 1 2 10 90 90 1090 IRR = ? -1134. 20 IRR = 7. 08% (use TVM or CF register) 22

Rationale for the IRR Method If IRR (project’s rate of return) > the firm’s required rate of return, r, then some return is left over to boost stockholders’ returns. Example: r = 10%, IRR = 15%. Profitable. 23

IRR Acceptance Criteria If IRR > r, accept project. If IRR < r, reject project. 24

Decisions on Projects S and L per IRR If S and L are independent, accept both. IRRs > r = 10%. If S and L are mutually exclusive, accept S because IRRS > IRRL. 25

Construct NPV Profiles Enter CFs in your calculator and find NPVL and NPVS at several discount rates (r): r 0 5 10 15 20 NPVL 1, 100 554 109 (259) (566) NPVS 800 455 161 ( 91) (309) 26

NPV Profiles for Project S and Project L Crossover Point = 8. 1% Project S k 0 5 10 15 20 NPVL 1, 100 554 109 (259) (566) NPVS 800 455 161 ( 91) (309) IRRS = 13. 1% IRRL = 11. 4% 27

NPV and IRR always lead to the same accept/reject decision for independent projects NPV ($) IRR > r and NPV > 0 Accept. IRR < r and NPV < 0. Reject. IRR r (%) 28

Mutually Exclusive Projects r < 8. 1: NPVL> NPVS , IRRL < IRRS CONFLICT NPV L r > 8. 1: NPVS> NPVL , IRRS > IRRL NO CONFLICT S IRRs % 8. 1 IRRL 29

To Find the Crossover Rate: 1. Find cash flow differences between the projects. See data at beginning of the case. 2. Enter these differences in CF register, then press IRR. Crossover rate = 8. 11, rounded to 8. 1%. 3. Can subtract S from L or vice versa. 4. If profiles don’t cross, one project dominates the other. 30

Two Reasons NPV Profiles Cross: 1) Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects. 2) Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPVS> NPVL. 31

Reinvestment Rate Assumptions NPV assumes reinvest at r. IRR assumes reinvest at IRR. Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects. 32

Modified Internal Rate of Return A better indicator of relative profitability Better for use in capital budgeting 33