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Capital Budgeting Professor Thomson Fin 3013

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2 Capital Budgeting Should you... –Build a new factory –Upgrade your current factory –Start a marketing campaign –Install in a new computer system How do we determine if these are good investments?

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3 Review: Goal of Financial Manager The goal of the Financial Manager is to maximize the current stock price So we should ask, “Will undertaking this investment increase the current share price?” Another way to ask this is, “Does the increase in my Cash Flows due to this project, more than compensate for the costs of this project?”

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4 Cash Flow Timing The cash flows (revenues) from a project flow over time (I.e. in the future), while the investment cost is today. This discounted cash flows have to cover the cost of the project to ensure that the marginal benefits exceed the marginal cost of investing in the project.

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5 The Capital Budgeting Decision Process The capital budgeting process involves three basic steps: 1. Generating long-term investment proposals; 2. Reviewing, analyzing, and selecting from the alternative proposals, and 3. Implementing and monitoring the proposals that have been selected. Managers should focus on the investment decision. After suitable projects have been identified, a following decision is how to to pay for it (the financing decision).

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6 A Capital Budgeting Process Should: Account for the time value of money; Account for risk; Focus on cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders’ wealth.

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7 Capital Budgeting Decision Techniques Payback period: most commonly used Accounting rate of return (ARR): focuses on project’s impact on accounting profits (Not covered in this course) Net present value (NPV): best technique theoretically; difficult to calculate realistically Internal rate of return (IRR): widely used with strong intuitive appeal Profitability index (PI): related to NPV

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8 Accounting Rate Of Return (ARR) Can be computed from available accounting data ARR uses accounting numbers, not cash flows; no time value of money. Average profits after taxes Average annual operating cash inflows Average annual depreciation =- Need only profits after taxes and depreciation Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.

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9 Payback Period The payback period is the amount of time required for the firm to recover its initial investment. If the project’s payback period is less than the maximum acceptable payback period, accept the project. If the project’s payback period is greater than the maximum acceptable payback period, reject the project. Management determines maximum acceptable payback period. It’s not clear how this relates to wealth maximization

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10 Global Wireless Global Wireless is a worldwide provider of wireless telephony devices. Global Wireless evaluating major expansion of its wireless network in two different regions: Western Europe expansion A smaller investment in Southeast U.S. to establish a toehold $175Year 5 inflow $160Year 4 inflow $130Year 3 inflow $80Year 2 inflow $35Year 1 inflow -$250Initial outlay $32Year 5 inflow $30Year 4 inflow $25Year 3 inflow $22Year 2 inflow $18Year 1 inflow -$50Initial outlay Western Europe ($ millions)Southeast U.S. ($ millions)

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11 Computing payback TimeCFCumulative CF The project pays back during the 4 th year. We prorate the remaining CF to be recovered to the cash generated that year to compute the fraction of a year.

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12 Prorating the final year’s CF So, the payback period for this project is years.

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13 Calculating Payback Periods for Global Wireless Projects Management selects a 2.75 years payback period. Western Europe project has initial outflow of -$250 million, But cash inflows over first 3 years only $245 million. Global Wireless would reject Western Europe project. Southeast U.S. project: initial outflow of -$50 million Cash inflows over first 2 years cumulate to $40 million. Project recovers initial outflow after 2.40 years. Total inflow in year 3 is $25 million. We estimate that the projects generates $10 million in year 3 in 0.40 years ($10 million $25 million). Global Wireless would accept the project.

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14 Pros and Cons of Payback Method Advantages of payback method: Computational simplicity Easy to understand Focus on cash flow Disadvantages of payback method: Does not directly account for time value of money Does not account properly for risk Cutoff period is arbitrary (gives no value to CF’s that occur after the payback cutoff) Does not link to value-maximization

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15 Discounted Payback Period Discounted payback accounts for time value. Apply discount rate to cash flows during payback period (say 3 years). Still ignores cash flows after payback period Global Wireless uses an 18% discount rate. Reject --Accept / reject $46.2$ Cumulative PV $15.2$ PV Year 3 inflow $15.8$ PV Year 2 inflow $15.2$ PV Year 1 inflow Southeast U.S. project ($million) Western Europe project ($million) PV Factors (18%) Item

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16 NPV: Net Present Value The theoretically correct investment criteria is: If NPV > 0, then invest NPV = PV of Cash Flows – Investment Cost If the NPV > 0 then the current stock price of the firm should increase if we undertake the project (and vice versa) NPV measure the wealth increase from implementing the project The marginal cost is the investment costs and the marginal benefits are the discounted cash flows

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17 Using NPV To use the NPV criterion we need to know: 1. The investment cost 2. The incremental Cash Flows due to the project (these are often the cash flows of the project). 3. The appropriate discount rate to apply to the Cash Flows which reflect the risk of the project

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18 Net Present Value A key input in NPV analysis is the discount rate. r represents the minimum return that the project must earn to satisfy investors. r varies with the risk of the project which is often related to the risk of the firm.

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19 Calculating NPVs for Global Wireless Projects Assuming Global Wireless uses 18% discount rate, NPVs are: Western Europe project: NPV = $75.3 million Southeast U.S. project: NPV = $25.7 million Should Global Wireless invest in one project or both?

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20 Computing the NPV on the HP10BII Set calculator to correct P/YR Enter the CF’s. Usually the time period 0 cash flow will be negative Enter the discount rate as I/YR Press the

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21 Demonstration tCF P/YR=1 Type 18, press I/YR Press NPV = 75.26

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22 Pros and Cons of Using NPV as Decision Rule Key benefits of using NPV as decision rule: Focuses on cash flows, not accounting earnings Makes appropriate adjustment for time value of money Can properly account for risk differences between projects Though best measure, NPV has some drawbacks: Lacks the intuitive appeal of payback, and Doesn’t capture managerial flexibility (option value) well. NPV is the “gold standard” of investment decision rules.

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23 NPV Profile As we increase the discount rate, the NPV will fall. We give a special name for the discount rate that causes NPV to exactly equal zero The Internal Rate or Return (IRR) is the discount rate that cause the NPV to equal zero It is the return that money invested in the project earns

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25 Internal Rate of Return IRR found by computer/calculator or manually by trial and error. Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project: The IRR decision rule is: If IRR is greater than the cost of capital, accept the project. If IRR is less than the cost of capital, reject the project.

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26 Calculating IRRs for Global Wireless Projects Western Europe project: IRR (r WE ) = 27.8%Southeast U.S. project: IRR (r SE ) = 36.7% Global Wireless will accept all projects with at least 18% IRR.

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27 Demonstration: Compute IRR tCF P/YR=1 Press IRR/YR = 27.79

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28 IRR v. NPV IRR and NPV are in some ways, different ways of saying the same thing By inspection of the NPV profile we see that if the IRR > required rate of return, the NPV is positive, so either criteria would say to accept the project as one that build wealth. (The converse is also true).

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29 Advantages and Disadvantages of IRR Advantages of IRR: Properly adjusts for time value of money Uses cash flows rather than earnings Accounts for all cash flows Project IRR is a number with intuitive appeal Disadvantages of IRR “Mathematical problems”: multiple IRRs, no real solutions Scale problem Timing problem

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30 Multiple IRRs NPV ($) NPV<0 NPV>0 Discount rate NPV<0 With multiple IRRs, which do we compare with the cost of capital to accept/reject the project? IRR When project cash flows have multiple sign changes, there can be multiple IRRs.

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31 No Real Solution Sometimes projects do not have a real IRR solution. Modify Global Wireless’s Western Europe project to include a large negative outflow (-$355 million) in year 6. There is no real number that will make NPV=0, so no real IRR. Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!

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32 Competing projects Competing projects are those which cannot all be chosen, even if all appear desirable. For example, say you have a chuck of commercial property and you are considering –Shopping mall –Office building –Apartments You cannot do them all, so can choose only one of the alternatives

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33 Funding or other constraints If a firm feels it can only raise a limited amount of funds, or only has the managerial or other talent to take on some of the available projects, the projects will have to be ranked Best solution, choose the set of projects that will maximize the NPV of the sum of the projects This is called the “knapsack” problem of management science

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34 Conflicts Between NPV and IRR NPV and IRR do not always agree when ranking competing projects. $25.7 mn36.7%Southeast U.S. $75.3 mn27.8%Western Europe NPV (18%)IRRProject Southeast U.S. project has higher IRR, but doesn’t increase shareholders’ wealth as much as Western Europe project. The scale problem: Small scale projects often have higher IRR’s

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36 Often larger scale projects are disadvantaged by using IRR Example – you have land that could be developed for parking. The alternatives, listed by investment cost are: –Gravel parking lot –Paved parking lot –Parking garage IRR will tend to favor the one with the lowest capital cost, that generates some funds very quickly

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37 Long vs. Short Term Projects Discount rate Short-term project Long-term project 17% 15% NPV 13% The NPV of long-term project is more sensitive to the discount rate than the NPV of the short-term project is. IRR = 15% IRR = 17% Long-term project has higher NPV if the cost of capital is less than 13%. Short-term project has higher NPV if the cost of capital is greater than 13%.

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38 Which is a more effective wealth builder (your alternative rate = 10%) ? You can lend your brother $100 who will pay you back $ (i.e. an extra six cents) tomorrow Or lend your sister $100 for a year who will pay you back $120 after one year What is the EAR of each investment? P/YR=363 I/YR(PV=100, FV=100.05, N=1) = Press EFF% = 24.47

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39 Profitability Index Decision rule: Accept project with PI > 1.0, equal to NPV > 0 Both projects’ PI > 1.0, so both acceptable if independent. 1.5$50 million$75.7 millionSoutheast U.S. 1.3$250 million$325.3 millionWestern Europe PIInitial OutlayPV of CF (yrs1-5)Project Calculated by dividing the PV of a project’s cash inflows by the PV of its outflows: Like IRR, PI suffers from the scale problem.

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Methods to generate, review, analyze, select, and implement long-term investment proposals: Accounting rate of return Payback Period Discounted payback period Net Present Value (NPV) Internal rate of return (IRR) Profitability index (PI) Capital Budgeting

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41 Net Present Value Compute the present value of a project’s cash inflows and outflows Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk. Accept projects if NPV > 0.

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