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.

After Studying Chapter 13, you should be able to: 13. 2 1. Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability. 2. Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and profitability index (PI). 3. Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. 4. Define, construct, and interpret a graph called an “NPV profile. ” 5. Understand why ranking project proposals on the basis of IRR, NPV, and PI methods “may” lead to conflicts in rankings. 6. Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or PI rankings. 7. Understand how “sensitivity analysis” allows us to challenge the single-point input estimates used in traditional capital budgeting analysis. 8. Explain the role and process of project monitoring, including “progress reviews” and “post-completion audits. ” Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Capital Budgeting Techniques 13. 3 • Project Evaluation and Selection • Potential Difficulties • Capital Rationing • Project Monitoring • Post-Completion Audit Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Overview Of Capital Budgeting Techniques 13. 4 Capital budgeting techniques are used to assess and rank proposed projects. Preferred techniques should include: Time value considerations Risk and return considerations Valuation considerations Are used to ensure projects selected are consistent with the firm’s goal of maximising shareholder wealth. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Project Evaluation: Alternative Methods • Payback Period (PBP) • Internal Rate of Return (IRR) • Net Present Value (NPV) • Profitability Index (PI) • 13. 5 Refer to the additional Power. Point slides and the Excel spreadsheet “VW 13 E-13 b. xlsx” for computer-based solutions. 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. 6 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. 7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Period (PBP) 0 1 2 3 – 40 K 12 K 15 K 4 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. 8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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

Payback Solution (#2) 0 1 2 3 4 5 – 40 K 10 K – 30 K 12 K – 18 K 15 K – 3 K 10 K 7 K 7 K 14 K PBP Cumulative Cash Flows = 3 + ( 3 K ) / 10 K = 3. 3 Years Note: Take absolute value of last negative cumulative cash flow value. 13. 10 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 13. 12 Peng Xi is currently contemplating two projects: project A, requiring an initial investment of $42, 000; and project B, requiring an initial investment of $45, 000. The projected incremental (relevant) operating net cash inflows for the two projects are shown below: Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Period 13. 13 Project A: $42, 000 $14, 000 = 3 years Project B: $28, 000 (Year 1) + $12, 000 (Year 2) $40, 000 + $5, 000/$10, 000 (Year 3) = 3. 5 years Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

PBP Strengths and Weaknesses Strengths: 13. 14 Weaknesses: • Easy to use and understand • Does not account for TVM • Can be used as a measure of liquidity • Does not consider cash flows beyond the PBP • Easier to forecast ST than LT flows • Cutoff period is subjective 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. We equate the NPV of the investment opportunity with $0. CF 1 CF 2 CFn ICO = (1 + IRR)1 + (1 + IRR)2 +. . . + (1 + IRR)n 13. 15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Internal Rate of Return (IRR) 13. 16 Calculated by: [Equation 13. 1] Where: CF 0 = Project’s initial investment CFt = Net cash inflows for year t t = Year t Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Internal Rate of Return (IRR) 13. 17 Requires a trial and error approach, substituting different discount rates until the equation balances. Get 2 NPVs – one positive, the other negative, then interpolate. Decision criteria: Accept if IRR > Hurdle rate (Cost Of Capital) Reject if IRR < Hurdle rate (Cost Of Capital) 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. 18 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. 19 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. 20 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 Interpolation Formula Interpolate for IRR using this formula [(N 1 k 2) – (N 2 k 1)] / (N 1 – N 2) Where: N 1 = Positive NPV N 2 = Negative NPV k 1 = discount rate for positive NPV k 2 = discount rate for negative NPV 13. 24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR Interpolation Formula Interpolate for IRR [(N 1 k 2) – (N 2 k 1)] / (N 1 – N 2) [(1, 444 x 0. 15) – (- 3, 159 x. 1)]/(41, 444 – 36, 841) [(216. 6 – -315. 9)/4, 603 532. 5/4, 603 11. 57% 13. 25 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 hurdle 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 < Hurdle Rate ] 13. 26 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 • 13. 27 Less subjectivity 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. CF 1 NPV = (1+k)1 13. 28 + 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.

Net Present Value (NPV) Decision criteria: Accept if NPV > $0 Reject if NPV < $0 If the NPV is greater than $0, the firm will earn a return greater than its hurdle rate (cost of capital). 13. 29 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 Period CF 13. 32 PVIF 13%, 5 (alternative layout) PV 0 -40, 000 1. 000 -40, 000 1 10, 000 0. 885 8, 850 2 12, 000 0. 783 9, 396 3 15, 000 0. 693 10, 395 4 10, 000 0. 613 6, 130 5 7, 000 0. 543 3, 801 Net present value - 1, 428 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: • • • 13. 34 Cash flows assumed to be reinvested at the hurdle rate. Weaknesses: May not include managerial options embedded in the project. See Chapter 14. (We do Accounts for TVM. not cover this topic in Considers all this course) cash flows. • Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Ranking & Conflicting Rankings 13. 35 Ranking is necessary when: Projects are mutually exclusive Capital rationing is necessary Conflicting rankings arise due to differences in cash flow: Timing Magnitude Which are a result of differences in the underlying assumptions concerning the reinvestment of intermediate net cash flows. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Ranking & Conflicting Rankings 13. 36 NPV assumes minimum opportunity cost – the opportunity cost of the current project would be the return on a hypothetical alternative project that just covers the cost of capital. IRR assumes maximum opportunity cost – the maximum cost of capital a project could sustain and still be acceptable or the opportunity cost on a hypothetical alternative project offering a return equal to the IRR. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Which Is Better – NPV Or IRR? 13. 37 On a theoretical basis NPV is preferred as: it assumes intermediate flows are reinvested at the firm’s cost of capital. avoids possibility of time consuming multiple IRR’s. it directly reflects the actual project return. On a practical basis, many financial managers prefer IRR because: it works with rates of return not dollars. NPV does not measure benefits relative to the amount invested Most organisations use both. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Net Present Value Profile Net Present Value $000 s 15 Plot NPV for each discount rate. Thre e of 10 thes e po ints 5 IRR are easy NPV@13% now ! 0 -4 13. 38 Sum of CF’s 0 3 6 9 12 Discount Rate (%) 15 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 + CF 2 (1+k)2 +. . . + CFn (1+k)n ICO << OR >> Method #2: 13. 39 PI = 1 + [ NPV / 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, 572 / $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. 40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

PI Strengths and Weaknesses Strengths: 13. 41 Weaknesses: • Same as NPV • Allows comparison of different scale projects • Provides only relative profitability • Potential Ranking Problems 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. 42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Project Evaluation: Remember Chapter 12 ‘New Asset’ project? We will start with the cash flows of the project and also calculate the cumulative cash flow values. We can use Excel functions / approaches to calculate each of the following methods from the above cash flows. 13. 43 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. • 13. 44 Mutually Exclusive – A project whose acceptance precludes the acceptance of one or more alternative projects. 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. 45 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. 46 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? Project 13. 47 IRR NPV S 100% $ L 25% 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. 48 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. 49 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. 50 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. 51 600 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 ($) -200 0 200 400 600 Fisher’s Rate of Intersection 0 13. 52 At k<10%, I is best! Fisher’s Rate of Intersection At k>10%, D is best! 5 10 15 20 Discount Rate ($) 25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Remember to refer to Excel spreadsheet ‘VW 13 E-13 b. xlsx’ and the ‘Pattern’ tab. B. Cash Flow Pattern Refer to VW 13 E-13 b. xlsx on the ‘Pattern’ tab. 13. 53 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. 54 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. 55 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.

Remember to refer to Excel spreadsheet ‘VW 13 E-13 b. xlsx’ and the ‘Life’ tab. C. Project Life Differences 13. 56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Comparing Projects With Unequal Lives 13. 57 Often a financial manager will need to select a project from a group of unequal life project options. When unequal life projects are mutually exclusive, the impact of differing lives must be considered as the projects will not provide benefits over comparable time periods. This is especially important when continuing service is needed from the project under consideration. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Annualised Net Present Value (ANPV) Approach Converts the net present value of unequal life projects into an equivalent annual amount (in NPV terms). Calculated by: Decision Select 13. 58 criteria: the project with the highest ANPV Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Annualised Net Present Value Approach 13. 59 Xi Chen Limited is evaluating two projects, X and Y. The relevant cash flows for each project are given in the table below. The applicable cost of capital for use in evaluating these equally risky projects is 10%. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Annualised Net Present Value Approach 13. 60 Table use The NPV of each project at a 10% cost of capital is calculated by finding the present value of each net cash inflow, summing these values and subtracting the initial investment from the sum of the present values. NPVX = [$28, 000 × (0. 909)] + [$33, 000 × (0. 826)] + [$38, 000 × (0. 751)] – $70, 000 = ($25, 452 + $27, 258 + $28, 538) – $70, 000 = $11, 248 NPVY = [$35, 000 × (0. 909)] + [$30, 000 × (0. 826)] + [$25, 000 × (0. 751)] + [$20, 000 × (0. 683)] + [$15, 000 × (0. 621)] + [$10, 000 × (0. 564)] – $85 000 = ($31, 815 + $24, 780 + $18, 775 + $13, 660 + $9, 315 + $5, 640) – $85, 000 = $18 985 The NPV for project X is $11, 248; that for project Y is $18, 985. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Annualised Net Present Value Approach Ignoring the differences in project lives, we can see that both projects are acceptable (NPVs greater than zero) and that project Y is preferred to project X. If the projects are independent and only one could be accepted, project Y, with the larger NPV, would be preferred. However, if the projects are mutually exclusive, their differing lives must be considered, as project Y provides three more years of service than project X. 13. 61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Annualised Net Present Value Approach Calculate the ANPV for each project. ANPVx = $11, 248/PVIFA 10%, 3 yrs = $11, 248/2. 487 = $4, 523 ANPVY = $18, 985/PVIFA 10%, 6 yrs = $18, 985/4. 355 = $4, 359 13. 62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Annualised Net Present Value Approach Reviewing the ANPVs calculated above, we can see that project X would be preferred to project Y. Given that projects X and Y are mutually exclusive, project X would be the recommended project because it provides the higher ANPV. 13. 63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Another Way to Look at Things 1. Adjust cash flows to a common terminal year if project “Y” will NOT be replaced. Compound Project Y, Year 1 @10% for 2 years. Year CF 0 1 2 –$1, 000 $0 $0 Results: IRR* = 34. 26% 3 $2, 420 NPV = $818 *Lower IRR from adjusted cash-flow stream. X is still Best. 13. 64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Replacing Projects with Identical Projects 2. Use Replacement Chain Approach (Appendix B) when project “Y” will be replaced. 0 1 –$1, 000 $2, 000 – 1, 000 –$1, 000 Results: IRR = 100% 2 3 $2, 000 – 1, 000 $2, 000 $1, 000 $2, 000 NPV* = $2, 238. 17 *Higher NPV, but the same IRR. Y is Best 13. 65 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 ‘Life 2’ tab. C. Project Life Differences 13. 66 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. 67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Available Projects for BW Project ICO IRR NPV PI A $ 500 18% $ 50 1. 10 B 5, 000 25 6, 500 2. 30 C 5, 000 37 5, 500 2. 10 D 7, 500 20 5, 000 1. 67 E 12, 500 26 500 1. 04 F 15, 000 28 21, 000 2. 40 G 17, 500 19 7, 500 1. 43 H 25, 000 15 6, 000 1. 24 13. 68 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 ICO C $ 5, 000 15, 000 28 12, 500 26 5, 000 25 IRR NPV 37% PI $ 5, 500 2. 10 21, 000 2. 40 E 500 1. 04 B 6, 500 2. 30 F Projects C, F, and E have three largest IRRs. The resulting increase in shareholder wealth is $27, 000 with a $32, 500 outlay. 13. 69 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 ICO F $15, 000 G 17, 500 5, 000 25 IRR 28% 19 NPV PI $21, 000 2. 40 7, 500 1. 43 6, 500 2. 30 B Projects F and G have the two largest NPVs. The resulting increase in shareholder wealth is $28, 500 with a $32, 500 outlay. 13. 70 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 $15, 000 7, 500 17, 500 IRR 28% 25 37 20 19 NPV $21, 000 6, 500 5, 000 7, 500 PI 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. 71 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 PI F, B, C, and D Value Added $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. 72 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). • • 13. 73 Allows us to change from “single-point” (i. e. , revenue, installation cost, salvage, etc. ) estimates to a “what if” analysis Utilise 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 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. 74 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Multiple IRR Problem* Let us assume the following cash flow pattern for a project for Years 0 to 4: –$100 +$900 –$1, 000 How many potential IRRs could this project have? Two!! There as many potential IRRs as there are sign changes. * Refer to Appendix A 13. 75 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

NPV Profile – Multiple IRRs Net Present Value ($000 s) 75 50 25 0 – 100 13. 76 Multiple IRRs at k = 12. 95% and 191. 15% 0 40 80 120 160 Discount Rate (%) 200 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

NPV Profile – Multiple IRRs Hint: Your calculator will only find ONE IRR – even if there are multiple IRRs. It will give you the lowest IRR. In this case, 12. 95%. 13. 77 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.