Chapter 13 Capital Budgeting Techniques 13 1 Van

Chapter 13 Capital Budgeting Techniques 13. 1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Project Evaluation: Alternative Methods Simple Method • Payback Period (PBP) Discounted Cash Flow (DCF) Method • Internal Rate of Return (IRR) • Net Present Value (NPV) • Profitability Index (PI) 13. 4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Proposed Project Data Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10, 000; $12, 000; $15, 000; $10, 000; and $7, 000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40, 000. 13. 5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Period (PBP) 0 – 40 K 1 2 3 4 10 K 12 K 15 K 10 K 5 7 K PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. 13. 6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Period Year 0 1 2 3 4 5 13. 7 Cash Flows Cumulative Inflows (40, 000) -------10, 000 12, 000 22, 000 15, 000 37, 000 10, 000 47, 000 54, 000 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Period Solution(#1) u 1) 40, 000 – 37, 000 = 3, 000 u 2) 3, 000 / 10, 000 = 0. 3 u 3) 0. 3 x 12 = 3. 6 u 4) 0. 6 x 30 = 18 u. The payback period is 3 years and 3 monthes and 18 days 13. 8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Solution (#2) Another Method 0 – 40 K (-b) Cumulative Inflows 13. 9 1 2 10 K 12 K 22 K PBP 3 (a) 15 K 37 K(c) 4 10 K(d) 47 K 5 7 K 54 K =a+(b–c)/d = 3 + (40 – 37) / 10 = 3 + (3) / 10 = 3. 3 Years Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Solution (#3) 0 1 2 – 40 K 10 K – 30 K 12 K – 18 K PBP Cumulative Cash Flows 13. 10 3 15 K – 3 K 4 5 10 K 7 K 7 K 14 K = 3 + ( 3 K ) / 10 K = 3. 3 Years Note: Take absolute value of last negative cumulative cash flow value. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

PBP Acceptance Criterion The management of Basket Wonders has set a maximum PBP of 3. 5 years for projects of this type. Should this project be accepted? Yes! The firm will receive back the initial cash outlay in less than 3. 5 years. [3. 3 Years < 3. 5 Year Max. ] 13. 11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Period (Equal Cash Inflow) u. If we assume for the same example the cash outflow is $40, 000 and the inflow will be $15, 000 each year, what is the payback period? 13. 12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Period (PBP)(Solution) u. Payback period = Cash outflow/ Annual Cash inflow u$40, 000 / 15, 000 = 2. 67 u 0. 67 x 12 = 8. 04 u 0. 04 x 30 = 1. 2 u. The 13. 13 (PBP) is 2 years and 8 month Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

PBP Strengths and Weaknesses Strengths: • Easy to use and understand • Can be used as a measure of liquidity Weaknesses: • Does not account for TVM • Does not consider cash flows beyond the PBP • Easier to forecast • Cutoff period is ST than LT flows subjective 13. 14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow (ICO). CF 1 ICO = (1 + IRR)1 13. 15 + CF 2 (1 + IRR)2 +. . . + CFn (1 + IRR)n Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Solution $10, 000 $12, 000 $40, 000 = + + (1+IRR)1 (1+IRR)2 $15, 000 $10, 000 $7, 000 + + (1+IRR)3 (1+IRR)4 (1+IRR)5 Find the interest rate (IRR) that causes the discounted cash flows to equal $40, 000. 13. 16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Solution (Try 10%) $40, 000 = $10, 000(PVIF 10%, 1) + $12, 000(PVIF 10%, 2) + $15, 000(PVIF 10%, 3) + $10, 000(PVIF 10%, 4) + $ 7, 000(PVIF 10%, 5) $40, 000 = $10, 000(0. 909) + $12, 000(0. 826) + $15, 000(0. 751) + $10, 000(0. 683) + $ 7, 000(0. 621) $40, 000 = $9, 090 + $9, 912 + $11, 265 + $6, 830 + $4, 347 = $41, 444 [Rate is too low!!] 13. 17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Solution (Try 10% ) 13. 18 Year Net Cash Flows PVIF 10% Present Value 1 2 10, 000 12, 000 0. 909 0. 826 9, 090 9, 912 3 4 5 Total Present Value 15, 000 10, 000 7, 000 0. 751 0. 683 0. 621 11, 265 6, 830 4, 347 41, 444 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Solution (Try 15%) $40, 000 = $10, 000(PVIF 15%, 1) + $12, 000(PVIF 15%, 2) + $15, 000(PVIF 15%, 3) + $10, 000(PVIF 15%, 4) + $ 7, 000(PVIF 15%, 5) $40, 000 = $10, 000(0. 870) + $12, 000(0. 756) + $15, 000(0. 658) + $10, 000(0. 572) + $ 7, 000(0. 497) $40, 000 = $8, 700 + $9, 072 + $9, 870 + $5, 720 + $3, 479 = $36, 841 [Rate is too high!!] 13. 19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Solution (Try 15%) 13. 20 Year Net Cash Flows PVIF 15% Present Value 1 2 10, 000 12, 000 0. 870 0. 756 8, 700 9, 072 3 4 5 Total Present Value 15, 000 10, 000 7, 000 0. 658 0. 572 0. 497 9, 870 5, 720 3, 479 36, 841 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Solution (Interpolate) 0. 05 X 0. 10 $41, 444 IRR $40, 000 $1, 444 $4, 603 0. 15 $36, 841 X 0. 05 13. 21 = $1, 444 $4, 603 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Solution (Interpolate) 0. 05 X 0. 10 $41, 444 IRR $40, 000 $1, 444 $4, 603 0. 15 $36, 841 X 0. 05 13. 22 = $1, 444 $4, 603 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Solution (Interpolate) 0. 05 X 0. 10 $41, 444 IRR $40, 000 $1, 444 $4, 603 0. 15 $36, 841 X = ($1, 444)(0. 05) $4, 603 X = 0. 0157 IRR = 0. 10 + 0. 0157 = 0. 1157 or 11. 57% 13. 23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Acceptance Criterion The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted? No! The firm will receive 11. 57% for each dollar invested in this project at a cost of 13%. [ IRR < required Rate ] 13. 24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Strengths and Weaknesses Strengths: • Accounts for TVM • Considers all cash flows • Less subjectivity 13. 28 Weaknesses: • Assumes all cash flows reinvested at the IRR • Difficulties with project rankings and Multiple IRRs Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow (ICO). CF 1 NPV = (1+k)1 13. 29 + CF 2 (1+k)2 CFn - ICO +. . . + n (1+k) Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

NPV Solution Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. NPV = $10, 000 +$12, 000 +$15, 000 + (1. 13)1 (1. 13)2 (1. 13)3 $10, 000 $7, 000 + $40, 000 4 5 (1. 13) 13. 30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

NPV Solution NPV = $10, 000(PVIF 13%, 1) + $12, 000(PVIF 13%, 2) + $15, 000(PVIF 13%, 3) + $10, 000(PVIF 13%, 4) + $ 7, 000(PVIF 13%, 5) – $40, 000 NPV = $10, 000(0. 885) + $12, 000(0. 783) + $15, 000(0. 693) + $10, 000(0. 613) + $ 7, 000(0. 543) – $40, 000 NPV = $8, 850 + $9, 396 + $10, 395 + $6, 130 + $3, 801 – $40, 000 = - $1, 428 13. 31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

NPV Solution (Another Method) 13. 32 Year Cash Flows PVIF 13% Present Value 1 2 3 4 5 Total PV Cash outflow Net PV 10, 000 12, 000 15, 000 10, 000 7, 000 0. 885 0. 783 0. 693 0. 613 0. 543 8, 850 9, 396 10, 396 6, 130 3, 801 38, 573 40, 000 (1, 427) Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

NPV Acceptance Criterion The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted? No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ] 13. 33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

NPV Strengths and Weaknesses Strengths: Weaknesses: • Cash flows • assumed to be reinvested at the required rate. May not include managerial options embedded in the project. See • Accounts for TVM. Chapter 14. 13. 37 • Considers all cash flows. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. Method #1: CF 1 PI = (1+k)1 13. 40 + CF 2 CFn +. . . + 2 (1+k)n ICO Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

PI Acceptance Criterion PI = $38, 573 / $40, 000 =. 9643 (Method #1, previous slide) Should this project be accepted? No! The PI is less than 1. 00. This means that the project is not profitable. [Reject as PI < 1. 00 ] 13. 41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

PI Strengths and Weaknesses Strengths: • Same as NPV Weaknesses: • Same as NPV • Allows • Provides only comparison of relative profitability different scale • Potential Ranking projects Problems 13. 42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Evaluation Summary Basket Wonders Independent Project 13. 43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Independent Project • For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake. • Independent – A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. 13. 45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Other Project Relationships • Dependent – A project whose acceptance depends on the acceptance of one or more other projects. • Mutually Exclusive – A project whose acceptance precludes the acceptance of one or more alternative projects. 13. 46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Potential Problems Under Mutual Exclusivity Ranking of project proposals may create contradictory results. A. Scale of Investment B. Cash-flow Pattern C. Project Life 13. 47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

A. Scale Differences Compare a small (S) and a large (L) project. END OF YEAR 13. 48 NET CASH FLOWS Project L 0 -$100, 000 1 0 0 2 $400 $156, 250 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

A. Scale Differences Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why? 13. 49 Project IRR S 100% L 25% NPV $ PI 231 3. 31 $29, 132 1. 29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Remember to refer to Excel spreadsheet ‘VW 13 E-13 b. xlsx’ and the ‘Scale’ tab. A. Scale Differences Refer to VW 13 E-13 b. xlsx on the ‘Scale’ tab. 13. 50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

B. Cash Flow Pattern Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project. END OF YEAR 0 1 2 3 13. 51 NET CASH FLOWS Project D Project I -$1, 200 1, 000 100 500 600 1, 080 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cash Flow Pattern Calculate the IRR, NPV@10%, and PI@10%. Which project is preferred? Project 13. 52 IRR NPV PI D 23% $198 1. 17 I 17% $198 1. 17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

13. 53 600 Plot NPV for each project at various discount rates. 400 Project I 200 NPV@10% IRR Project D 0 -200 Net Present Value ($) Examine NPV Profiles 0 5 10 15 20 Discount Rate (%) 25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Net Present Value ($) -200 0 200 400 600 Fisher’s Rate of Intersection 0 13. 54 At k<10%, I is best! Fisher’s Rate of Intersection At k>10%, D is best! 5 10 15 20 Discount Rate ($) 25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

C. Project Life Differences Let us compare a long life (X) project and a short life (Y) project. END OF YEAR 0 1 2 3 13. 56 NET CASH FLOWS Project X Project Y -$1, 000 0 2, 000 0 0 3, 375 0 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Project Life Differences Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why? 13. 57 Project IRR NPV PI X 50% $1, 536 2. 54 Y 100% $ 818 1. 82 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period. Example: Julie Miller must determine what investment opportunities to undertake for Basket Wonders (BW). She is limited to a maximum expenditure of $32, 500 only for this capital budgeting period. 13. 62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Available Projects for BW Project A B C D E F G H 13. 63 $ ICO 500 5, 000 7, 500 12, 500 15, 000 17, 500 25, 000 IRR 18% 25 37 20 26 28 19 15 $ NPV PI 50 6, 500 5, 000 500 21, 000 7, 500 6, 000 1. 10 2. 30 2. 10 1. 67 1. 04 2. 40 1. 43 1. 24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Choosing by IRRs for BW Project C F E B ICO IRR NPV PI $ 5, 000 12, 500 5, 000 37% 28 26 25 $ 5, 500 21, 000 500 6, 500 2. 10 2. 40 1. 04 2. 30 Projects C, F, and E have three largest IRRs. The resulting increase in shareholder wealth is $27, 000 with a $32, 500 outlay. 13. 64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Choosing by NPVs for BW Project F G B ICO $15, 000 17, 500 5, 000 IRR NPV PI 28% 19 25 $21, 000 7, 500 6, 500 2. 40 1. 43 2. 30 Projects F and G have the two largest NPVs. The resulting increase in shareholder wealth is $28, 500 with a $32, 500 outlay. 13. 65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Choosing by PIs for BW Project F B C D G ICO IRR NPV PI $15, 000 7, 500 17, 500 28% 25 37 20 19 $21, 000 6, 500 5, 000 7, 500 2. 40 2. 30 2. 10 1. 67 1. 43 Projects F, B, C, and D have the four largest PIs. The resulting increase in shareholder wealth is $38, 000 with a $32, 500 outlay. 13. 66 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Summary of Comparison Method Projects Accepted Value Added PI F, B, C, and D $38, 000 NPV F and G $28, 500 IRR C, F, and E $27, 000 PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period. 13. 67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Single-Point Estimate and Sensitivity Analysis: Analysis A type of “what-if” uncertainty analysis in which variables or assumptions are changed from a base case in order to determine their impact on a project’s measured results (such as NPV or IRR). • Allows us to change from “single-point” (i. e. , revenue, installation cost, salvage, etc. ) estimates to a “what if” analysis • Utilize a “base-case” to compare the impact of individual variable changes • E. g. , Change forecasted sales units to see impact on the project’s NPV 13. 68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Post-Completion Audit Post-completion Audit A formal comparison of the actual costs and benefits of a project with original estimates. • Identify any project weaknesses • Develop a possible set of corrective actions • Provide appropriate feedback Result: Making better future decisions! 13. 69 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.