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1

Capital Budgeting

Capital budgeting decisions: what fixed assets

should we buy?

Firms will frequently face broader issues like

whether or not they should launch a new product

or enter a new market.

Decisions such as these will determine the nature

of a firms operations and products for years to

come, primarily because fixed asset investments

are generally long-lived and not easily reversed

once they are made.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 2

Capital Budgeting

The most fundamental decision that a business

must make concerns its product line.

What services they will offer or what will they sell?

In what markets will they compete?

What new products will they introduce?

that the firm commit its scare and valuable capital

to certain types of assets.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 3

Good Decision Criteria

Any firm possesses a huge number of possible

investments.

Each of these possible investments is an option

available to the firm.

Some of these options are valuable and some are

not. The essence of successful financial

management, is learning to identify which are

which.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 4

Good Decision Criteria

We need to ask ourselves the following questions

when evaluating decision criteria:

Does the decision rule adjust for the time value

of money?

Does the decision rule adjust for risk?

Does the decision rule provide information on

whether we are creating value for the firm?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 5

Net Present Value

The difference between the market value of a

project and its cost is the NPV.

How much value is created from undertaking an

investment?

The first step is to estimate the expected future

cash flows

The second step is to estimate the required

return for projects of this risk level

The third step is to find the present value of the

cash flows and subtract the initial investment

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 6

Net Present Value

An investment is worth undertaking if it creates

value for its owners; that is an investment that is

worth more in the marketplace than it costs to

acquire it.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 7

Net Present Value

Example

Suppose you buy a run-down house for $95 000

and spend another $25 000 on painters, plumbers,

and so on to get it fixed up. Your total investment

is $120 000. when the work is completed, you place

the house back on the market and find that its

worth $130 000.

The net result is that you have created $10 000 in

value.

With this example, it turned out after the fact

that $10 000 in value was created. Things thus

worked out nicely.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 8

Net Present Value

Example contd

The real challenge, of course, was to somehow

identify ahead of time whether or not investing the

necessary $120 000 was a good idea in the first

place this is what capital budgeting is all about.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 9

NPV Decision Rule

In other words, NPV is a measure of how much

value is created or added today by undertaking an

investment.

Given our goal of creating value : If the NPV is

positive, accept the project

A positive NPV means that the project is expected

to add value to the firm and will therefore increase

the wealth of the owners

Since our goal is to increase owner wealth, NPV is a

direct measure of how well this project will meet

our goal.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 10

NPV Decision Rule

Investment decisions are greatly simplified when

there is a market for assets similar to the

investment we are considering.

Capital budgeting becomes much more difficult

when we can not observe the market price for at

least roughly comparable investments.

The reason is that we are then faced with the

problem of estimating the value of an investment

using indirect market information.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 11

Project Example Information

You are looking at a new project and you have

estimated the following cash flows:

Year 0: CF = -165,000

Year 1: CF = 63,120; NI = 13,620

Year 2: CF = 70,800; NI = 3,300

Year 3: CF = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk is 12%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 12

Computing NPV for the Project

Using the formula:

where

t - the time of the cash flow

i - the discount rate (the rate of return that could be

earned on an investment in the financial markets with

similar risk.); the opportunity cost of capital

Rt - the net cash flow (the amount of cash, inflow minus

outflow) at time t.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 13

Computing NPV for the Project

Using the formuls:

91,080/(1.12)3 165,000 = $12,627.42

Do we accept or reject the project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 14

Decision Criteria Test NPV

Does the NPV rule account for the time value of

money?

Does the NPV rule account for the risk of the cash

flows?

Does the NPV rule provide an indication about the

increase in value?

Should we consider the NPV rule for our primary

decision criteria?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 15

Payback Period

Payback is the length of time it takes to recover our

initial investment or get our money back.

Computation

Estimate the cash flows

Subtract the future cash flows from the initial

cost until the initial investment has been

recovered

Decision Rule Accept if the payback period is

less than some preset limit

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 16

Project Example Information

You are looking at a new project and you have

estimated the following cash flows:

Year 0: CF = -165,000

Year 1: CF = 63,120; NI = 13,620

Year 2: CF = 70,800; NI = 3,300

Year 3: CF = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk is 12%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 17

Computing Payback for the Project

Assume we will accept the project if it pays back within

two years

Year 1: 165,000 63,120 = $101,880 still to recover

Year 2: 101,880 70,800 = $31,080 still to recover

Year 3: 31,080 91,080 = -$60,000 project pays back in

year 3

Do we accept or reject the project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 18

Decision Criteria Test

Payback

Does the payback rule account for the time value of

money?

Does the payback rule account for the risk of the cash

flows?

Does the payback rule provide an indication about the

increase in value?

Should we consider the payback rule for our primary

decision criteria?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 19

Advantages and Disadvantages of

Payback

Advantages

Easy to understand

Adjusts for uncertainty of later cash flows

Biased towards liquidity (it is biased toward

liquidity) . Favor investments that frees up cash

for other uses more quickly.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 20

Advantages and Disadvantages of

Payback

Disadvantages

Ignores the time value of money (no discounting

involved)

Requires an arbitrary cutoff point. We dont have

a objective basis for choosing a particular

number.

Ignores cash flows beyond the cutoff date

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 21

Advantages and Disadvantages of

Payback

Disadvantages

Biased against long-term projects, such as

research and development, and new projects

(The NPV of the shorter term investment is

actually negative, meaning that it diminishes the

value of the shareholders equity and the opposite

is true for longer term investment).

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 22

Accounting Rate of Return (ARR)

There are many different definitions for average

accounting return

The one we will use is:

Average net income/average book value

Note that the average book value depends on

how the asset is depreciated.

Need to have a target cutoff rate

Decision Rule: Accept the project if the AAR is

greater than a preset rate

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 23

Project Example Information

You are looking at a new project and you have

estimated the following cash flows:

Year 0: CF = -165,000

Year 1: CF = 63,120; NI = 13,620

Year 2: CF = 70,800; NI = 3,300

Year 3: CF = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk is 12%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 24

Computing ARR for the Project

Assume we require an average accounting return of

25%

Average Net Income:

(13,620 + 3,300 + 29,100) / 3 = $15,340

AAR = 15,340 / 72,000 = .213 = 21.3%

Do we accept or reject the project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 25

Decision Criteria Test ARR

Does the AAR rule account for the time value of

money?

Does the AAR rule account for the risk of the cash

flows?

Does the AAR rule provide an indication about the

increase in value?

Should we consider the AAR rule for our primary

decision criteria?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 26

Advantages and Disadvantages of ARR

Advantages

Easy to calculate

Needed information will usually be available

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 27

Advantages and Disadvantages of ARR

Disadvantages

Not a true rate of return; time value of money is

ignored. When we average figures that occur at

different times, we are treating the near future

and the more distant future the same way.

Uses an arbitrary benchmark cutoff rate. There

is no agreed upon way to specify the target ARR.

Based on accounting net income and book

values, not cash flows and market values. As a

result it does not tell us what the effect on share

price will be from taking an investment.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 28

Internal Rate of Return (IRR)

This is the most important alternative to NPV

It is often used in practice and is intuitively

appealing

It is based entirely on the estimated cash flows and

is independent of interest rates found elsewhere

Definition: IRR is the discount rate that makes the

NPV of an investment zero.

Decision Rule: Accept the project if the IRR is

greater than the required return

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 29

Project Example Information

You are looking at a new project and you have

estimated the following cash flows:

Year 0: CF = -165,000

Year 1: CF = 63,120; NI = 13,620

Year 2: CF = 70,800; NI = 3,300

Year 3: CF = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk is 12%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 30

Computing IRR for the Project

If you do not have a financial calculator, then this

becomes a trial and error process (interpolation)

. making NPV = 0)

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 31

Computing IRR for the Project

If you do not have a financial calculator, then this

becomes a trial and error process (interpolation)

=Initial Cost (thereby

making NPV = 0)

NPV = 63,120/(1.15)+70,800/(1.15)2 + 91,080/(1.15)3 =168308.51

Try 16% as a 2nd pass at the cost of debt

NPV = 63,120/(1.16)+70,800/(1.16)2 + 91,080/(1.16)3 =165380.83

Try 17% as a 3rd pass at the cost of debt

NPV = 63,120/(1.17)+70,800/(1.17)2 + 91,080/(1.17)3 =162536.75

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 32

Computing IRR for the Project

So we take the interpolation between 16% and 17%

as:

Difference of lower discount rate value and initial

cost 165380.83 165 000 = 380.83

Difference of lower and higher discount rate value

165380.83 162536.75= 2844.08

Take ratio of difference 380.83/2844.08 = 0.13

Lower rate ratio 16% +0.13 = 16.13%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 33

Computing IRR for the Project

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 34

Decision Criteria Test IRR

Does the IRR rule account for the time value of

money?

Does the IRR rule account for the risk of the cash

flows?

Does the IRR rule provide an indication about the

increase in value?

Should we consider the IRR rule for our primary

decision criteria?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 35

Advantages of IRR

Knowing a return is intuitively appealing

It is a simple way to communicate the value of a

project to someone who doesnt know all the

estimation details

If the IRR is high enough, you may not need to

estimate a required return, which is often a

difficult task

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 36

NPV vs IRR

NPV and IRR will generally give us the same

decision

Exceptions

Non-conventional cash flows

Mutually exclusive projects

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 37

Non-conventional cash flows

Non-conventional cash flows - A series of inward

and outward cash flows over time in which there is

more than one change in the cash flow direction.

This contrasts with a conventional cash flow,

where there is only one change in cash flow

direction. In terms of mathematical notation an

unconventional cash flow would appear as -, +, +,

+, -, + or alternatively +, -, -, +, -.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 38

Non-conventional cash flows

An unconventional cash flow is more difficult to

handle in DCF analysis than conventional cash flow

since it may have multiple internal rates of return

(IRR), depending on the number of changes in cash

flow direction.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 39

Mutually exclusive projects

Mutually exclusive projects - Group of capital

budget projects that compete with one another

in such a way that the acceptance of one

automatically excludes all others from further

consideration.

Analysis of competing projects using the Net

Present Value (NPV) and Internal Rate Of

Return (IRR) methods may give decision results

contradictory to each other. From a practical

standpoint, the NPV method generally gives

correct ranking to mutually exclusive projects.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 40

IRR and Mutually Exclusive

Projects

Mutually exclusive projects

If you choose one, you cant choose the other

Example: You can choose to attend graduate

school next year at either Harvard or Stanford,

but not both

Intuitively you would use the following decision

rules:

NPV choose the project with the higher NPV

IRR choose the project with the higher IRR

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 41

Example Nonconventional Cash Flow

Suppose an investment will cost $90,000 initially

and will generate the following cash flows:

Year 1: 132,000

Year 2: 100,000

Year 3: -150,000

The required return is 15%

Do we accept or reject the project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 42

Summary of Decision Rules

The NPV is positive at a required return of 15%, so

you should Accept

If you use the financial calculator, you would get

an IRR of 10.11% which would tell you to Reject

You need to recognize that there are non-

conventional cash flows and look at the NPV

profile

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 43

Conflicts Between NPV and IRR

NPV directly measures the increase in value to the

firm

Whenever there is a conflict between NPV and

another decision rule, you should always use NPV

IRR is unreliable in the following situations

Non-conventional cash flows

Mutually exclusive projects

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 44

Profitability Index

This is another tool used to evaluate projects and

is also known as benefit-cost ratio.

This index is defined as the present value of the

future cash flows divided by the initial

investments.

So if a project costs $200 and the present value of

the future cash flows is $220, the profitability

index value would be $220/$200 = 1.1

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 45

Profitability Index

A profitability index of 1.1 implies that for every $1

of investment, $1.10 is the value or we create an

additional $0.10 in value (NPV).

This measure can be very useful in situations

where we have limited capital, as we can allocate it

to those projects with the highest Profitability

index.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 46

Profitability Index

Profitability index is very similar to NPV. However,

consider an investment that costs $5 and has a $10

present value and an investment that costs $100

with a $150 present value.

The first of these investment has a NPV of $5 and a

PI of 2

The second has a NPV of $50 and a PI of 1.5

Such there seems to be little reason to rely on the

PI instead of NPV.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 47

Advantages and Disadvantages of

Profitability Index

Advantages

Closely related to NPV, generally leading to

identical decisions

Easy to understand and communicate

May be useful when available investment

funds are limited

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 48

Advantages and Disadvantages of

Profitability Index

Disadvantages

May lead to incorrect decisions in comparisons

of mutually exclusive investments

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 49

Capital Budgeting in Practice

We should consider several investment criteria

when making decisions

NPV and IRR are the most commonly used

primary investment criteria

Payback is a commonly used secondary investment

criteria

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 50

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