C1 Outline

Capital Budgeting - Decision Criteria

Net Present Value
The Payback Rule
The Discounted Payback
The Average Accounting Return
The Internal Rate of Return
The Profitability Index
The Practice of Capital Budgeting

C2 Outline (continued)

Project Cash Flows: A First Look

Incremental Cash Flows
Pro Forma Financial Statements and Project Cash Flows
More on Project Cash Flows
Alternative Definitions of Operating Cash Flow
Some Special Cases of Discounted Cash Flow Analysis
Summary and Conclusions

C3 NPV Illustrated

Assume you have the following information on Project X:

Initial outlay -$1,100

Required return = 10%

Annual cash revenues and expenses are as follows:

Year

Revenues

Expenses

1
2

$1,000
2,000

$500
1,000

Draw a time line and compute the NPV of project X.

C4 NPV Illustrated (concluded)

Initial outlay
($1,100)

Revenues
Expenses

$1,000
500

Cash flow

$500

$1,100.00
$500 x

2
Revenues
Expenses

Cash flow $1,000

1
1.10

+454.55

$1,000 x

+826.45

1
1.10 2

+$181.00
NPV

$2,000
1,000

C5 Underpinnings of the NPV Rule

Why does the NPV rule work? And what does work mean?

Look at it this way:

A firm is created when securityholders supply the funds to acquire

assets that will be used to produce and sell a good or a service;
The market value of the firm is based on the present value of the
cash flows it is expected to generate;
Additional investments are good if the present value of the
incremental expected cash flows exceeds their cost;
Thus, good projects are those which increase firm value - or, put
another way, good projects are those projects that have positive
NPVs!
Moral of the story: Invest only in projects with positive NPVs.

C6

Payback Rule Illustrated

Initial outlay -$1,000

Year

Cash flow

1
2
3

$200
400
600

Accumulated
1
2
3

$200
600
1,200

Payback period = 2 2/3 years

C7 Discounted Payback Illustrated

Year
1
2
3
4
Year
1
2
3
4

Initial outlay -$1,000

R = 10%
PV of
Cash flow
Cash flow
$ 200$ 182
400331
700526
300205
Accumulated
discounted cash flow
$ 182
513
1,039
1,244

Discounted payback period is just under 3 years

C8 Ordinary and Discounted Payback

Cash Flow
Year

Accumulated Cash Flow

Undiscounted Discounted

$100$89

$100$89

10079

200168

10070

300238

10062

400300

10055

500355

Undiscounted

Discounted

C9 Average Accounting Return Illustrated

Average net income:

Year
1

Sales

$440

$240

$160

Costs

220

120

80

Gross profit

220

120

80

Depreciation

80

80

80

140

40

35

10

$105

$30

$0

Earnings before taxes

Taxes (25%)
Net income

Average net income = ($105 + 30 + 0)/3 = $45

C10 Average Accounting Return Illustrated (concluded)

Average book value:

Initial investment = $240

Average investment = ($240 + 0)/2 = $120

Average accounting return (AAR):

Average net income

$45

C11 Internal Rate of Return Illustrated

Initial outlay = -$200

Year

Cash flow

1
2
3

$ 50
100
150

Find the IRR such that NPV = 0

50

50

100

100

150

150

C12 Internal Rate of Return Illustrated (concluded)

Trial and Error

Discount rates

NPV

0%

$100

5%

68

10%

41

15%

18

20%

-2

IRR is just under 20% -- about 19.44%

C13 Net Present Value Profile

Net present value
120
100
80

Year

Cash flow

0
1
2
3
4

$275
100
100
100
100

60
40
20
0
20
Discount rate

40
2%

6%

10%

14%

18%
IRR

22%

C14 Multiple Rates of Return

Assume you are considering a project for

which the cash flows are as follows:

Year

Cash flows

-$252

1,431

-3,035

2,850

-1,000

C15 Multiple Rates of Return (continued)

Whats the IRR? Find the rate at which

the computed NPV = 0:

at 25.00%:

NPV = _______

at 33.33%:

NPV = _______

at 42.86%:

NPV = _______

at 66.67%:

NPV = _______

C16 Multiple Rates of Return (continued)

Whats the IRR? Find the rate at which the

computed NPV = 0:

at 25.00%:

NPV =

at 33.33%:

NPV =

at 42.86%:

NPV =

at 66.67%:

NPV =

Two questions:

1. Whats going on here?

2. How many IRRs can there be?

C17 Multiple Rates of Return (concluded)

NPV
$0.06
$0.04
IRR = 1/4

$0.02
$0.00

($0.02)

IRR = 1/3

IRR = 2/3
IRR = 3/7

($0.04)
($0.06)
($0.08)
0.2

0.28

0.36
0.44
0.52
Discount rate

0.6

0.68

C18 IRR, NPV, and Mutually Exclusive Projects

Net present value

Year
0

160
140
120
100
80
60
40
20
0

Project A:

$350

50

100

150

200

Project B:

$250

125

100

75

50

Crossover Point

20
40
60
80
Discount rate

100
0

2%

6%

10%

14%
IRR A

18%
IRR B

22%

26%

C19 Profitability Index Illustrated

Now lets go back to the initial example - we assumed the

following information on Project X:
Initial outlay -$1,100Required return = 10%
Annual cash benefits:
Year
1
2

Cash flows
$ 500
1,000

Whats the Profitability Index (PI)?

C20 Profitability Index Illustrated (concluded)

Previously we found that the NPV of Project X is equal to:

($454.55 + 826.45) - 1,100 = $1,281.00 - 1,100 = $181.00.

The PI = PV inflows/PV outlay = $1,281.00/1,100 = 1.1645.

This is a good project according to the PI rule. Can you explain

why?

Its a good project because the present value of the inflows

exceeds the outlay.

C21 Summary of Investment Criteria

I. Discounted cash flow criteria

A. Net present value (NPV). The NPV of an investment is the
difference between its market value and its cost. The NPV
rule is to take a project if its NPV is positive. NPV has no
serious flaws; it is the preferred decision criterion.
B. Internal rate of return (IRR). The IRR is the discount rate that
makes the estimated NPV of an investment equal to zero. The IRR rule is
to take a project when its IRR exceeds the required return. When project
cash flows are not conventional, there may be no IRR or there may be
more than one.
C. Profitability index (PI). The PI, also called the benefit-cost ratio, is
the ratio of present value to cost. The profitability index rule is to
take an investment if the index exceeds 1.0. The PI
measures the present value per dollar invested.

C22 Summary of Investment Criteria (concluded)

II. Payback criteria

A. Payback period. The payback period is the length of time until the
sum of an investments cash flows equals its cost. The payback period
rule is to take a project if its payback period is less than some
prespecified cutoff.
B. Discounted payback period. The discounted payback period is the
length of time until the sum of an investments discounted cash flows
equals its cost. The discounted payback period rule is to take an
investment if the discounted payback is less than some prespecified
cutoff.

III. Accounting criterion

A. Average accounting return (AAR). The AAR is a measure of
accounting profit relative to book value. The AAR rule is to take an
investment if its AAR exceeds a benchmark.

C23 A Quick Quiz

1. Which of the capital budgeting techniques do account for both the time
value of money and risk?

2. The change in firm value associated with investment in a project is

measured by the projects _____________ .
a. Payback period
b. Discounted payback period
c. Net present value
d. Internal rate of return
3. Why might one use several evaluation techniques to assess a given
project?

C24 A Quick Quiz

1. Which of the capital budgeting techniques do account for both the time
value of money and risk?
Discounted payback period, NPV, IRR, and PI
2. The change in firm value associated with investment in a project is
measured by the projects Net present value.

3. Why might one use several evaluation techniques to assess a given

project?
To measure different aspects of the project; e.g., the payback period
measures liquidity, the NPV measures the change in firm value, and the
IRR measures the rate of return on the initial outlay.

C25 Problem

Offshore Drilling Products, Inc. imposes a payback cutoff of 3

years for its international investment projects. If the company

has the following two projects available, should they accept
either of them?
Year

Cash Flows A

Cash Flows B

-$30,000

-$45,000

15,000

5,000

10,000

10,000

10,000

20,000

5,000

250,000

C26 Solution to Problem (concluded)

Project A:

Payback period

= 1 + 1 + ($30,000 - 25,000)/10,000
= 2.50 years

Project B:

Payback period

= 1 + 1 + 1 + ($45,000 - 35,000)/$250,000
= 3.04 years

Project As payback period is 2.50 years and project Bs

payback period is 3.04 years. Since the maximum acceptable

payback period is 3 years, the firm should accept project A and
reject project B.

C27 Another Problem

A firm evaluates all of its projects by applying the IRR

rule. If the required return is 18 percent, should the firm

accept the following project?
Year

Cash Flow

-$30,000

25,000

15,000

C28 Another Problem (continued)

To find the IRR, set the NPV equal to 0 and solve for the

discount rate:

NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR) 2

+$15,000/(1 + IRR)3
At 18 percent, the computed NPV is ____.
So the IRR must be (greater/less) than 18 percent. How did

you know?

C29 Another Problem (concluded)

To find the IRR, set the NPV equal to 0 and solve for the

discount rate:

NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR)2

+$15,000/(1 + IRR)3
At 18 percent, the computed NPV is $316.
So the IRR must be greater than 18 percent. We know this

because the computed NPV is positive.

By trial-and-error, we find that the IRR is 18.78 percent.

T30 Fundamental Principles of Project Evaluation

Fundamental Principles of Project Evaluation:

Project evaluation - the application of one or more capital
budgeting decision rules to estimated relevant project cash
flows in order to make the investment decision.
Relevant cash flows - the incremental cash flows associated with
the decision to invest in a project.
The incremental cash flows for project evaluation consist
of any and all changes in the firms future cash flows that
are a direct consequence of taking the project.
Stand-alone principle - evaluation of a project based on the
projects incremental cash flows.

T31 Incremental Cash Flows

Incremental Cash Flows

Key issues:

When is a cash flow incremental?

Terminology
A. Sunk costs
B. Opportunity costs
C. Side effects
D. Net working capital
E. Financing costs
F. Other issues

T32 Example: Preparing Pro Forma Statements

Suppose we want to prepare a set of pro forma financial statements

for a project for Norma Desmond Enterprises. In order to do so, we

must have some background information. In this case, assume:
1. Sales of 10,000 units/year @ $5/unit.
2. Variable cost per unit is $3. Fixed costs are $5,000 per year.
The project has no salvage value. Project life is 3 years.
3. Project cost is $21,000. Depreciation is $7,000/year.
4. Additional net working capital is $10,000.
5. The firms required return is 20%. The tax rate is 34%.

T33 Example: Preparing Pro Forma Statements (continued)

Pro Forma Financial Statements

Projected Income Statements
Sales
Var. costs

$______
______
$20,000

Fixed costs

5,000

Depreciation

7,000

EBIT
Taxes (34%)
Net income

$______
2,720
$______

T34 Example: Preparing Pro Forma Statements (continued)

Pro Forma Financial Statements

Projected Income Statements
Sales
Var. costs

$50,000
30,000
$20,000

Fixed costs

5,000

Depreciation

7,000

EBIT
Taxes (34%)
Net income

$ 8,000
2,720
$ 5,280

T35 Example: Preparing Pro Forma Statements (concluded)

Projected Balance Sheets

0

$______

$10,000

$10,000

$10,000

NFA

21,000

______

______

Total

$31,000

$24,000

$17,000

$10,000

NWC

T36 Example: Preparing Pro Forma Statements (concluded)

Projected Balance Sheets

0

NWC

$10,000

$10,000

$10,000

$10,000

NFA

21,000

14,000

7,000

Total

$31,000

$24,000

$17,000

$10,000

T37 Example: Using Pro Formas for Project Evaluation

Now lets use the information from the previous example to do

a capital budgeting analysis.

Project operating cash flow (OCF):

EBIT

$8,000

Depreciation

+7,000

Taxes

-2,720

OCF

$12,280

T38 Example: Using Pro Formas for Project Evaluation (continued)

Project Cash Flows

0
OCF
Chg. NWC

______

Cap. Sp.

-21,000

Total

______

$12,280

$12,280

$12,280
______

$12,280

$12,280

$______

T39 Example: Using Pro Formas for Project Evaluation (continued)

Project Cash Flows

0
OCF
Chg. NWC

-10,000

Cap. Sp.

-21,000

Total

-31,000

$12,280

$12,280

$12,280
10,000

$12,280

$12,280

$22,280

T40 Example: Using Pro Formas for Project Evaluation (concluded)

Capital Budgeting Evaluation:

NPV

=
=

-$31,000 + $12,280/1.201 + $12,280/1.20 2 + $22,280/1.20 3

$655

IRR

21%

PBP

2.3 years

AAR

$5280/{(31,000 + 24,000 + 17,000 + 10,000)/4} = 25.76%

Should the firm invest in this project? Why or why not?

Yes -- the NPV > 0, and the IRR > required return

T41 Example: Estimating Changes in Net Working Capital

In estimating cash flows we must account for the fact that some of the incremental

sales associated with a project will be on credit, and that some costs wont be paid
at the time of investment. How?
Answer: Estimate changes in NWC. Assume:
1. Fixed asset spending is zero.
2. The change in net working capital spending is $200:

Change

S/U

A/R

$100

$200

+100

___

INV

100

150

+50

___

-A/P

100

50

(50)

___

NWC

$100

$300

Chg. NWC = $_____

T42 Example: Estimating Changes in Net Working Capital

In estimating cash flows we must account for the fact that some of the incremental

sales associated with a project will be on credit, and that some costs wont be paid
at the time of investment. How?
Answer: Estimate changes in NWC. Assume:
1. Fixed asset spending is zero.
2. The change in net working capital spending is $200:

Change

S/U

A/R

$100

$200

+100

INV

100

150

+50

-A/P

100

50

(50)

NWC

$100

$300

Chg. NWC = $200

T43 Example: Estimating Changes in Net Working Capital (continued)

Now, estimate operating and total cash flow:

Sales

$300

Costs

200

Depreciation
EBIT
Tax
Net Income

0
$100
0
$100

OCF = EBIT + Dep. Taxes = $100

Total Cash flow = OCF Change in NWC Capital Spending
= $100 ______ ______ = ______

T44 Example: Estimating Changes in Net Working Capital (continued)

Now, estimate operating and total cash flow:

Sales

$300

Costs

200

Depreciation
EBIT
Tax
Net Income

0
$100
0
$100

OCF = EBIT + Dep. Taxes = $100

Total Cash flow = OCF Change in NWC Capital Spending
= $100 200

= $100

T45 Example: Estimating Changes in Net Working Capital (concluded)

Where did the - $100 in total cash flow come from?

What really happened:

Cash sales

= $300 - ____

= $200 (collections)

Cash costs

= $200 + ____ + ____ = $300 (disbursements)

T46 Example: Estimating Changes in Net Working Capital (concluded)

Where did the - $100 in total cash flow come from?

What really happened:

Cash sales

= $300 - 100

= $200 (collections)

Cash costs

= $200 + 50 + 50 = $300 (disbursements)

Cash flow

= $200 - 300 = - $100 (= cash in cash out)

T47 Modified ACRS Property Classes

Class

Examples

3-year

Equipment used in research

5-year

Autos, computers

7-year

Most industrial equipment

T48 Modified ACRS Depreciation Allowances

Property Class
Year

3-Year

5-Year

7-Year

33.33%

20.00%

14.29%

44.44

32.00

24.49

14.82

19.20

17.49

7.41

11.52

12.49

11.52

8.93

5.76

8.93

8.93

4.45

T49 MACRS Depreciation: An Example

Calculate the depreciation deductions on an asset which costs

$30,000 and is in the 5-year property class:

Year

MACRS %

Depreciation

20%

$_____

32%

_____

19.20%

5,760

11.52%

3,456

11.52%

3,456

5.76%

1,728

100%

$ _____

T50 MACRS Depreciation: An Example

Calculate the depreciation deductions on an asset which costs

$30,000 and is in the 5-year property class:

Year

MACRS %

Depreciation

20%

$6,000

32%

9,600

19.20%

5,760

11.52%

3,456

11.52%

3,456

5.76%

1,728

100%

$30,000

T51 Example: Fairways Equipment and Operating Costs

Two golfing buddies are considering opening a new driving range, the
Fairways Driving Range (motto: We always treat you fairly at Fairways).
Because of the growing popularity of golf, they estimate the range will
generate rentals of 20,000 buckets of balls at $3 a bucket the first year, and
that rentals will grow by 750 buckets a year thereafter. The price will remain
$3 per bucket.
Capital spending requirements include:
Ball dispensing machine
Ball pick-up vehicle
Tractor and accessories

$ 2,000
8,000
8,000
$18,000
All the equipment is 5-year ACRS property, and is expected to have a salvage
value of 10% of cost after 6 years.
Anticipated operating expenses are as follows:

T52 Example: Fairways Equipment and Operating Costs (concluded)

Working Capital

Operating Costs (annual)

Land lease

$ 12,000

Water

1,500

Electricity

3,000

Labor

30,000

Seed & fertilizer

2,000

Gasoline

1,500

Maintenance

1,000

Insurance

1,000

Misc. Expenses

1,000

$53,000

Initial requirement = $3,000

Working capital requirements
are expected to grow at 5%
per year for the life of the
project

T53 Example: Fairways Revenues, Depreciation, and Other Costs

Projected Revenues
Year

Buckets

Revenues

20,000

$60,000

20,750

62,250

21,500

64,500

22,250

66,750

23,000

69,000

23,750

71,250

T54 Example: Fairways Revenues, Depreciation, and Other Costs (continued)

Cost of balls and buckets

Year

Cost

$3,000

3,150

3,308

3,473

3,647

3,829

T55 Example: Fairways Revenues, Depreciation, and Other Costs (concluded)

Depreciation on $18,000 of 5-year equipment

Year

ACRS %

Depreciation

1 20.00

$3,600$14,400

2 32.00

5,7608,640

3 19.20

3,4565,184

4 11.52

2,0743,110

5 11.52

2,0741,036

6 5.76

1,0360

Book value

T56 Example: Fairways Pro Forma Income Statement

Year
1
Revenues

3,0003,1503,308

3,6005,7603,456
$

Taxes
Net income

3,4733,6473,829

53,00053,00053,000 53,00053,00053,000

Depreciation
EBIT

$60,000$62,250$64,500$66,750$69,000$71,250

Variable costs
Fixed costs

400$
6051

340$

2,0742,0741,036

340$ 4,736$ 8,203 $10,279$13,385

7101,2301,542
289$ 4,026$ 6,973

2,008
$ 8,737$11,377

T57 Example: Fairways Projected Changes in NWC

Projected increases in net working capital

Year
0$ 3,000

Net working capital

$ 3,000

1 3,150

150

2 3,308

158

3 3,473

165

4 3,647

174

5 3,829

182

6 4,020

- 3,829

Change in NWC

T58 Example: Fairways Cash Flows

Operating cash flows:

Year
0

EBIT
$

+ Depreciation
$

Taxes
$

Operating
= cash flow
$

400

3,600

60

3,940

340

5,760

51

6,049

4,736

3,456

710

7,482

8,203

2,074

1,230

9,047

10,279

2,074

1,542

10,811

13,385

1,036

2,008

12,413

T59 Example: Fairways Cash Flows (concluded)

Total cash flow from assets:

Year
0

OCF
$

Chg. in NWC Cap. Sp. = Cash flow

$ 3,000

$18,000

$21,000

3,940

150

3,790

6,049

158

5,891

7,482

165

7,317

9,047

174

8,873

10,811

182

10,629

12,413

3,829

1,530

17,772

T60 Alternative Definitions of OCF

Let:
OCF = operating cash flow
S = sales
C = operating costs
D = depreciation
T = corporate tax rate

T61 Alternative Definitions of OCF (concluded)

The Tax-Shield Approach
(S - C - D) + D - (S - C - D) T

OCF

(S - C) (1 - T) + (D T)

(S - C) (1 - T) + Depreciation x T

The Bottom-Up Approach

(S - C - D) + D - (S - C - D) T

OCF

(S - C - D) (1 - T) + D

Net income + Depreciation

The Top-Down Approach

(S - C - D) + D - (S - C - D) T

OCF

(S - C) - (S - C - D) T

Sales - Costs - Taxes

T62 Quick Quiz -- Part 1 of 3

Now lets put our new-found knowledge to work. Assume we have the

following background information for a project being considered by Gillis, Inc.

See if we can calculate the projects NPV and payback period. Assume:

Required NWC investment = $40; project cost = $60; 3 year life

Annual sales = $100; annual costs = $50; straight line
depreciation to $0
Tax rate = 34%, required return = 12%

Step 1: Calculate the projects OCF

OCF = (S - C)(1 - T) + Dep T

OCF = (___ - __)(1 - .34) + (____)(.34) = $_____

T63 Quick Quiz -- Part 1 of 3

Now lets put our new-found knowledge to work. Assume we have the

following background information for a project being considered by Gillis, Inc.

See if we can calculate the projects NPV and payback period. Assume:

Required NWC investment = $40; project cost = $60; 3 year life

Annual sales = $100; annual costs = $50; straight line
depreciation to $0
Tax rate = 34%, required return = 12%

Step 1: Calculate the projects OCF

OCF = (S - C)(1 - T) + Dep T

OCF = (100 - 50)(1 - .34) + (60/3)(.34) = $39.80

T64 Quick Quiz -- Part 1 of 3 (concluded)

Project cash flows are thus:

0
OCF
Chg. in NWC

-40

Cap. Sp.

-60
-$100

$39.8

$39.8

$39.8
40

$39.8

Payback period = ___________

NPV = ____________

$39.8

$79.8

T65 Quick Quiz -- Part 1 of 3 (concluded)

Project cash flows are thus:

0
OCF
Chg. in NWC

40

Cap. Sp.

60
100

$39.8

$39.8

$39.8
40

$39.8

$39.8

$79.8

Payback period = 1 + 1 + (100 79.6)/79.8 = 2.26 years

NPV = $39.8/(1.12) + $39.8/(1.12)2 + 79.8 /(1.12)3 - 100 = $24.06