Professional Documents
Culture Documents
Capital Budgeting
A major part of the financial management of the firm
Kinds Of Spending In Business
Short term - to support day to day operations
Long term - to support long lived equipment and projects
Long term money and the things acquired with it are both called capital
Capital Budgeting
Planning and Justifying How Capital Dollars Are Spent On Long
Term Projects
Provides methods for evaluating whether projects make financial
sense and for choosing among them
Capital Budgeting
3
Characteristics of Business Projects
4
Characteristics of Business Projects
C0 $(50,000)
C1 (10,000)
C2 15,000
C3 15,000
C4 15,000
C5 5,000
5
Characteristics of Business Projects
6
Capital Budgeting Techniques
Payback Period
How many years to recover initial cost
Net Present Value
Present value of inflows less outflows
Internal Rate of Return
Projects return on investment
Profitability Index
Ratio of present value of inflows to outflows
7
Capital Budgeting Techniques
Payback
Payback period is the time it takes to recover early
cash outflows
Shorter paybacks are better
Payback Decision Rules
Stand-alone projects
Mutually Exclusive Projects
Weaknesses of the Payback Method
Ignores time value of money
Ignores cash flows after payback period
8
Concept Connection Example 10-1
Payback Period
9
Example 10-2: Weakness of the
Payback Technique
Use the payback period technique to choose between mutually exclusive
projects A and B.
10
NET PRESENT VALUE (NPV)
The present value of future cash flows is what counts
when making decisions based on value.
The Net Present Value of all of a project's cash flows is its expected
contribution
to the firm's value and shareholder wealth
PVs are taken at k, the cost of capital
C C Cn
NPV = C0 1 2 ...
(1 k) (1 k)2 (1 k)n
12
Net Present Value (NPV)
Decision Rules
Stand-alone Projects
NPV > 0 accept
NPV < 0 reject
13
Concept Connection Example 10-3
Net Present Value (NPV)
Project Alpha has the following cash flows. If
the firm considering Alpha has a cost of capital
of 12%, should the project be undertaken?
14
Concept Connection Example 10-3
Net Present Value (NPV)
15
Internal Rate of Return (IRR)
The IRR is the interest rate at which the present value of the three
inflows just equals the $5,000 outflow
16
Defining IRR Through the NPV Equation
At the IRR the PVs of project inflows and
outflows are equal, so NPV = 0
C C Cn
NPV = C0 1 2 ...
(1 k) (1 k)2 (1 k)n
Decision Rules
Stand-alone Projects
If IRR > cost of capital (k) accept
If IRR < cost of capital (k) reject
18
Internal Rate of Return (IRR)
Calculating IRRs
Finding IRRs usually requires an iterative,
trial-and-error technique
Guess at the projects IRR
Calculate the projects NPV using this interest
rate
If NPV = zero, guessed interest rate is the projects
IRR
If NPV > 0, try a higher interest rate
If NPV < 0, try a lower interest rate
19
Concept Connection Example 10-5
IRR Iterative Procedure
20
Example 10-5
IRR Iterative Procedure
Start by guessing IRR = 12% and calculate NPV.
21
Figure 10-1 NPV Profile
A projects NPV profile is a graph of its NPV vs. the cost
of capital. It crosses the horizontal axis at the IRR.
22
Concept Connection Example 10-5
IRR Iterative Procedure
Well try a different, lower interest rate, say 10%. At 10%, the projects
NPV is ($184). Since the NPV is still less than zero, we need to try a still
lower interest rate, say 9%. The following table lists the projects NPV at
different interest rates.
Interest Rate Calculated
Guess NPV
12% ($377)
Since NPV becomes positive
10 ($184) somewhere between 8% and
9 ($83) 9%, the projects IRR must be
between 8% and 9%. If the
8 $22 firms cost of capital is 8%, the
7 $130 project is marginal. If the
firms cost of capital is 10%,
the project is not a good idea.
23
Techniques: Internal Rate of Return
(IRR)
Technical Problems with IRR
Multiple Solutions
Unusual projects can have more than one IRR
The number of positive IRRs to a project
depends on the number of sign reversals to the
projects cash flows
The Reinvestment Assumption
IRR method implicitly assumes cash inflows will
be reinvested at the projects IRR
24
Comparing IRR and NPV
25
Figure 10-2 Projects for Which IRR and
NPV Can Give Different Solutions
At a cost of capital of
k1, Project A is better
than Project B, while
at k2 the opposite is
true.
26
PROJECTS WITH A SINGLE OUTFLOW
AND REGULAR INFLOWS
Many projects are characterized by an initial outflow
and a series of equal, regular inflows:
IRR: 0 = C0 + C [PVFAIRR,n]
Example 10-6 Regular Cash Inflows
Find the NPV and IRR for the following project if the cost of capital is
12%.
C0 C1 C2 C3
($5,000) $2,000 $2,000 $2,000
29
Profitability Index (PI)
PI
C0
or
present value of inflows
PI
present value of outflows
30
Profitability Index (PI)
Decision Rules
Stand-alone Projects
If PI > 1.0 accept
If PI < 1.0 reject
Mutually Exclusive Projects
PIA > PIB choose Project A over Project B
Comparison with NPV
With mutually exclusive projects the two
methods may not lead to the same choices
31
Comparing Projects with Unequal Lives
32
Comparing Projects with Unequal Lives
33
Concept Connection Example 10-8
Replacement Chain
The IRR method argues for undertaking the Short-Lived
Project while the NPV method argues for the Long-Lived
Project. Well correct for the unequal life problem by using
both the Replacement Chain Method and the EAA Method.
Both methods will lead to the same decision.
34
Concept Connection Example 10-8
Replacement Chain
Which of the two following mutually exclusive projects should a firm
purchase?
35
Concept Connection Example 10-9
Equivalent Annual Annuity (EAA)
The EAA Method equates each projects original NPV to an
equivalent annual annuity. For the Short-Lived Project the EAA is
$167.95 (the equivalent of receiving $432.82 spread out over 3 years
at 8%); while the Long-Lived Project has an EAA of $187.58 (the
equivalent of receiving $867.16 spread out over 6 years at 8%).
36
Concept Connection Example 10-9
Equivalent Annual Annuity (EAA)
37
Capital Rationing
38
Figure 10-6 Capital Rationing
39