Chapter 10 Capital Budgeting Techniques And Practice Learning

Chapter 10 Capital Budgeting Techniques And Practice

Learning Objectives 1. 2. 3. 4. Discuss the difficulty encountered in finding profitable projects in competitive markets and the importance of the search. Determine whether a new project should be accepted or rejected using the payback period, net present value, the profitability index, and the internal rate of return. Explain how the capital-budgeting decision process changes when a dollar limit is placed on the capital budget. Discuss the problems encountered when deciding among mutually exclusive projects. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -1

FINDING PROFITABLE PROJECTS Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -2

Capital Budgeting • Meaning: The process of decision making with respect to investments in fixed assets— that is, should a proposed project be accepted or rejected. • It is easier to “evaluate” profitable projects than to “find them” Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -3

Source of Ideas for Projects • R&D: Typically, a firm has a research & development (R&D) department that searches for ways of improving existing products or finding new projects. • Other sources: Employees, Competition, Suppliers, Customers. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -4

CAPITAL-BUDGETING DECISION CRITERIA Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -5

Capital-Budgeting Decision Criteria • • The Payback Period Net Present Value Profitability Index Internal

The Payback Period • Meaning: Number of years needed to recover the initial cash outlay related to an investment. • Decision Rule: Project is considered feasible or desirable if the payback period is less than or equal to the firm’s maximum desired payback period. In general, shorter payback period is preferred while comparing two projects. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -7

Payback Period Example: Project with an initial cash outlay of $20, 000 with following free cash flows for 5 years. YEAR CASH FLOW 1 Payback is 4 years. Copyright © 2014 Pearson Education, Inc. All rights reserved. $ 8, 000 BALANCE ($ 12, 000) 2 4, 000 ( 8, 000) 3 3, 000 ( 5, 000) 4 5, 000 0 5 10, 000 10 -8

Payback Period Example: Project with an initial cash outlay of $20, 000 with following free cash flows for 5 years. YEAR CASH FLOW Payback is 4. 2 years. 1 8, 000 ($ 12, 000) 2 4, 000 ( 8, 000) 3 3, 000 ( 5, 000) 4 3, 000 ( 2, 000) 5 Copyright © 2014 Pearson Education, Inc. All rights reserved. $ BALANCE 10, 000 8, 000 10 -9

Trade-Offs • Benefits: – Uses cash flows rather than accounting profits – Easy to compute and understand – Useful for firms that have capital constraints • Drawbacks: – Ignores the time value of money – Does not consider cash flows beyond the payback period Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -10

Discounted Payback Period • The discounted payback period is similar to the traditional payback period except that it uses discounted free cash flows rather than actual undiscounted cash flows. • The discounted payback period is defined as the number of years needed to recover the initial cash outlay from the discounted free cash flows. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -11

Discounted Payback Period Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -12

Table 10 -2 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -13

Payback Period Example • Table 10 -2 shows the difference between traditional payback and discounted payback methods. • With undiscounted free cash flows, the payback period is only 2 years, while with discounted free cash flows (at 17%), the discounted payback period is 3. 07 years. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -14

Net Present Value (NPV) • NPV is equal to the present value of all future free cash flows less the investment’s initial outlay. It measures the net value of a project in today’s dollars. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -15

NPV Example • Example: Project with an initial cash outlay of $60, 000 with following free cash flows for 5 years. Year FCF Initial outlay – 60, 000 1 – 25, 000 Year 3 4 FCF 13, 000 12, 000 2 5 11, 000 – 24, 000 • The firm has a 15% required rate of return. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -16

NPV Example • • PV of FCF = $60, 764 • Subtracting the initial cash outlay of $60, 000 leaves an NPV of $764. • Since NPV > 0, project is feasible. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -17

NPV in Excel • Input cash flows for initial outlay and free cash inflows in cells A 1 to A 6. • In cell A 7 type the following formula: =A 1+npv(0. 15, A 2: A 6) • Excel will give the result NPV = $764. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -18

NPV Trade-Offs • Benefits – Considers all cash flows – Recognizes time value of money • Drawbacks – Requires detailed long-term forecast of cash flows • NPV is generally considered to be the most theoretically correct criterion for evaluating capital budgeting projects. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -19

The Profitability Index (PI) (Benefit-Cost Ratio) • The profitability index (PI) is the ratio of the present value of the future free cash flows (FCF) to the initial outlay. • It yields the same accept/reject decision as NPV. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -20

Profitability Index • Decision Rule: PI 1 = accept; PI < 1 = reject

Profitability Index Example • A firm with a 10% required rate of return is considering investing in a new machine with an expected life of six years. The initial cash outlay is $50, 000. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -22

Profitability Index Example FCF PVF @ 10% PV Initial Outlay –$50, 000 1. 000 –$50, 000 Year 1 15, 000 0. 909 13, 636 Year 2 8, 000 0. 826 6, 612 Year 3 10, 000 0. 751 7, 513 Year 4 12, 000 0. 683 8, 196 Year 5 14, 000 0. 621 8, 693 Year 6 16, 000 0. 564 9, 032 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -23

Profitability Index Example PI = ($13, 636 + $6, 612 + $7, 513 + $8, 196 + $8, 693 + $9, 032) / $50, 000 = $53, 682/$50, 000 = 1. 0736 Project’s PI is greater than 1. Therefore, accept. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -24

NPV and PI • When the present value of a project’s free cash inflows are greater than the initial cash outlay, the project NPV will be positive. PI will also be greater than 1. • NPV and PI will always yield the same decision. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -25

Internal Rate of Return (IRR) • IRR is the discount rate that equates the present value of a project’s future net cash flows with the project’s initial cash outlay (IO). • Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -26

Internal Rate of Return • Decision Rule: – If IRR Required Rate of Return,

Figure 10 -1 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -28

IRR and NPV • If NPV is positive, IRR will be greater than the required rate of return • If NPV is negative, IRR will be less than required rate of return • If NPV = 0, IRR is the required rate of return. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -29

IRR Example • Initial Outlay: $3, 817 • Cash flows: Yr. 1 = $1, 000, Yr. 2 = $2, 000, Yr. 3 = $3, 000 Discount rate NPV 15% $4, 356 20% $3, 958 22% $3, 817 • IRR is 22% because the NPV equals the initial cash outlay at that rate. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -30

IRR in Excel • IRR can be easily computed in Excel. • In the previous example, input cash outflow and three yearly cash inflows in cells A 1: A 4. • In cell A 5 input =IRR(A 1: A 4) • Excel will give the result IRR = 22%. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -31

Multiple IRRs • A normal cash flow pattern for project is negative initial outlay followed by positive cash flows (–, +, +, + …) • However, if the cash flow pattern is not normal (such as –, +, –) there can be more than one IRR. • Figure 10 -2 is based on cash flows of – 1, 600, +10, 000, – 10, 000 in years 0, 1, 2. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -32

Multiple IRRs (Figure 10 -2) Copyright © 2014 Pearson Education, Inc. All rights reserved.

Modified IRR (MIRR) • Primary drawback of the IRR relative to the net present value is the reinvestment rate assumption made by the internal rate of return. Modified IRR allows the decision maker to directly specify the appropriate reinvestment rate. • Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -34

Modified IRR • Accept if MIRR required rate of return • Reject if MIRR

MIRR Example • Project having a 3 -year life and a required rate of return of 10% with the following free cash flows: FCFs Initial Outlay Year 1 –$6, 000 FCFs Year 2 $2, 00 Year 3 0 Copyright © 2014 Pearson Education, Inc. All rights reserved. $3, 000 $4, 000 10 -36

MIRR Example • Step 1: Determine the PV of the project’s free cash outflows. $6, 000 is already at the present. • Step 2: Determine the terminal value of the project’s free cash inflows. To do this use the project’s required rate of return to calculate the FV of the project’s three cash inflows. They turn out to be $2, 420 + $3, 300 + $4, 000 = $9, 720 for the terminal value. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -37

MIRR Example • Step 3: Determine the discount rate that equates the PV of the terminal value and the PV of the project’s cash outflows. MIRR = 17. 446%. • Decision: MIRR is greater than required rate of return, so accept. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -38

Example of Calculating the IRR Timeline Net cash flow 0 -$560 1 $240 2 3 $240 year Ford’s initial investment is $560 Cost of capital = 12% IRR = ? Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -39

Steps taken: 1. Calculate the NPV at 12%: NPV + NCF 1 + NCF 2 + … + NCFn (1+IRR)² (1+IRR)ⁿ NPV 12% = -$560 + $240 = $16. 45 1. 12 (1. 12)² (1. 12)³ 2. = NCF 0 Recall that the result that we are looking for is zero. The discount rate of 12% is too low, and we must try a higher rate. Lets try 13% NPV 13% = -$560 + $240 1. 13 Copyright © 2014 Pearson Education, Inc. All rights reserved. (1. 13)² + $240 = $6. 68 (1. 13)³ 10 -40

We are very close; lets try 14% NPV 14% = -$560 + $240 1. 14 (1. 14)² + $240 (1. 14)³ = - $2. 81 Because our result is now a negative number, we know the correct rate is between 13% and 14%. So looking at this answer, it is closer to 14%. Lets try 13. 7%. NPV 13. 7% = -$560 + $240 + 1. 137 Copyright © 2014 Pearson Education, Inc. All rights reserved. $240 (1. 137)² + $240 = 0 (1. 137)³ 10 -41

Conclusion: • This means that the NPV of the firm’s capital project is zero at a discount rate of 13. 7%. • Ford’s required rate of return is the cost of capital which is 12%. • Since the project’s IRR of 13. 7% > Ford’s cost of capital 12%, therefore accept the project. • The project’s NPV is a positive $16, 440, which also indicates that Ford should go ahead with the project. NPV = $576. 44 - $ 560. 00 = $16. 44 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -42

MIRR in Excel = MIRR(values, finance rate, reinvestment rate) where values is the range of cells where the cash flows are stored, and k is entered for both the finance rate and the reinvestment rate. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -43

CAPITAL RATIONING Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -44

Capital Rationing • Capital rationing refers to situation where there is a limit on the dollar size of the capital budget. This may be due to: a) temporary adverse conditions in the market; b) shortage of qualified personnel to direct new projects; and/or c) other factors such as not being willing to take on excess debt to finance new projects. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -45

Capital Rationing • How to select? Select a set of projects with the highest NPV—subject to the capital constraint. • Note, using NPV may preclude accepting the highest ranked project in terms of PI or IRR. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -46

Figure 10 -4 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -47

Table 10 -7 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -48

RANKING MUTUALLY EXCLUSIVE PROJECTS Copyright © 2014 Pearson Education, Inc. All rights reserved. 10

Ranking Mutually Exclusive Projects • Size Disparity • Time Disparity • Unequal Life Copyright

Size Disparity • This occurs when we examine mutually exclusive projects of unequal size. • Example: Consider the following cash flows for one-year Project A and B, with required rates of return of 10%. – Initial Outlay: A = $200; B = $1, 500 – Inflow: A = $300; B = $1, 900 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -51

Table 10 -8 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -52

Size-Disparity Ranking Problem NPV Project A 72. 73 Project B 227. 28 PI IRR 1. 36 50% 1. 15 27% Ranking Conflict: – Using NPV, Project B is better; – Using PI and IRR, Project A is better. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -53

Size-Disparity Ranking Problem • Which technique to use to select the project? • Use NPV whenever there is size disparity. If there is no capital rationing, project with the largest NPV will be selected. When capital rationing exists, rank and select set of projects based on NPV. Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -54

The Time-Disparity Problem • Time-disparity problem arises because of differing reinvestment assumptions made by the NPV and IRR decision criteria. • How are cash flows reinvested? – According to NPV: Required rate of return – According to IRR: IRR Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -55

The Time-Disparity Problem • Example: Consider two projects, A and B, with initial outlay of $1, 000, cost of capital of 10%, and following cash flows in years 1, 2, and 3: • A: $100 $2, 000 • B: $650 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -56

The Time-Disparity Problem Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -57

The Time-Disparity Problem NPV Project A 758. 83 Project B 616. 45 PI IRR 1. 759 35% 1. 616 43% • Ranking Conflict: – Using NPV or PI, A is better – Using IRR, B is better • Which technique to use to select the superior project? – Use NPV Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -58

Unequal-Lives Problem • This occurs when we are comparing two mutually exclusive projects with different life spans. • To compare projects, we compute the Equivalent Annual Annuity (EAA). Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -59

Unequal-Lives Problem • Example: If you have two projects, A and B, with equal investment of $1, 000, required rate of return of 10%, and following cash flows in years 1 -3 (for project A) and 1 -6 (for project B) • Project A = $500 each in years 1 -3 • Project B = $300 each in years 1 -6 Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -60

Computing EAA • Calculate the project’s NPV: A = $243. 43 and B = $306. 58 • Calculate EAA = NPV/annual annuity factor A = $97. 89 B = $70. 39 • Project A is better Copyright © 2014 Pearson Education, Inc. All rights reserved. 10 -61