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Capital Investment
Decision Analysis I
Learning Objectives
1.
2.
3.
4.
10-2
FINDING PROFITABLE
PROJECTS
10-3
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
10-4
10-5
CAPITAL-BUDGETING
DECISION CRITERIA
10-6
Capital-Budgeting
Decision Criteria
10-7
10-8
Payback is 4 years.
YEAR CASH
FLOW
1
8,000
BALANCE
($ 12,000)
4,000 (
8,000)
3,000 (
5,000)
5,000
10,000
12,000
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
10-10
10-11
10-12
Table 10-2
10-13
10-14
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
11,000
24,000
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.
10-17
NPV in Excel
Input cash flows for initial outlay and free
cash inflows in cells A1 to A6.
In cell A7 type the following formula:
=A1+npv(0.15,A2:A6)
Excel will give the result NPV = $764.
10-18
NPV Trade-Offs
Benefits
Considers all cash flows
Recognizes time value of money
Drawbacks
Requires detailed long-term forecast of cash
flows
10-19
10-20
Profitability Index
Decision Rule:
PI 1 = accept;
PI < 1 = reject
10-21
10-22
PVF @ 10%
PV
Initial
Outlay
Year 1
$50,000
1.000
$50,000
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
10-23
10-24
NPV and PI
When the present value of a projects 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.
10-25
10-26
10-27
Figure 10-1
10-28
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.
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 A1:A4.
In cell A5 input
=IRR(A1:A4)
Excel will give the result IRR = 22%.
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.
10-32
10-33
10-34
Modified IRR
Accept if MIRR required rate of return
Reject if MIRR < required rate of return
10-35
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
$6,000
Year 1
FCFs
Year 2
Year 3
$3,000
$4,000
$2,000
Copyright 2014 Pearson Education, Inc. All rights reserved.
10-36
MIRR Example
Step 1: Determine the PV of the projects
free cash outflows. $6,000 is already at the
present.
Step 2: Determine the terminal value of the
projects free cash inflows. To do this use
the projects required rate of return to
calculate the FV of the projects three cash
inflows. They turn out to be $2,420 +
$3,300 + $4,000 = $9,720 for the terminal
value.
10-37
MIRR Example
Step 3: Determine the discount rate that
equates the PV of the terminal value
and the PV of the projects cash outflows.
MIRR = 17.446%.
Decision: MIRR is greater than required rate
of return, so accept.
10-38
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.
10-39
CAPITAL RATIONING
10-40
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.
10-41
Capital Rationing
How to select? Select a set of projects with
the highest NPVsubject to the capital
constraint.
Note, using NPV may preclude accepting the
highest ranked project in terms of PI or IRR.
10-42
Figure 10-4
10-43
Table 10-7
10-44
RANKING MUTUALLY
EXCLUSIVE PROJECTS
10-45
Ranking Mutually
Exclusive Projects
Size Disparity
Time Disparity
Unequal Life
10-46
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
10-47
Table 10-8
10-48
Size-Disparity
Ranking Problem
Project A
Project B
NPV
72.73
227.28
PI
1.36
1.15
IRR
50%
27%
Ranking Conflict:
Using NPV, Project B is better;
Using PI and IRR, Project A is better.
10-49
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.
10-50
10-51
10-52
10-53
Project A
Project B
758.83
616.45
1.759
1.616
35%
43%
NPV
PI
IRR
Ranking Conflict:
10-54
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).
10-55
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
10-56
Computing EAA
Calculate the projects NPV:
A = $243.43 and B = $306.58
Calculate EAA = NPV/annual annuity factor
A = $97.89
B = $70.39
Project A is better
10-57
Figure 10-5
10-58
Figure 10-6
10-59
Key Terms
Capital budgeting
Capital rationing
Discounted payback period
Equivalent annual annuity (EAA)
Internal rate of return (IRR)
Modified internal rate of return (MIRR)
Mutually exclusive projects
Net present value (NPV)
Net present value profile
Payback period
Profitability index (PI) or benefit-cost ratio
10-60
Table 10-1
10-61
Table 10-3
10-62
Table 10-4
10-63
Table 10-5
10-64
Table 10-6
10-65
Table 10-10
10-66
10-67
Figure 10-3
10-68