Presentation on theme: "Capital Budgeting Processes And Techniques"— Presentation transcript:
1 Capital Budgeting Processes And Techniques Professor XXXXXCourse Name / Number
2 The Capital Budgeting Decision Process The Capital Budgeting Process involves three basic steps:Generating long-term investment proposalsReviewing, analyzing, and selecting from the proposals that have been generatedImplementing and monitoring the proposals that have been selectedManagers should separate investment and financing decisions
3 Capital Budgeting Decision Techniques Payback period: most commonly usedAccounting rate of return (ARR): focuses on project’s impact on accounting profitsNet present value (NPV): best technique theoreticallyInternal rate of return (IRR): widely used with strong intuitive appealProfitability index (PI): related to NPV
4 A Capital Budgeting Process Should: Account for the time value of moneyAccount for riskFocus on cash flowRank competing projects appropriatelyLead to investment decisions that maximize shareholders’ wealth
5 Entropica InvestmentEntropica is a provider of magnetic resonance imaging devicesEntropica evaluating two investment proposalsConstruction of completely new manufacturing plantRefurbishing an existing plantConstruction ($ millions)Refurbishing ($ millions)$850Year 5 inflow$740Year 4 inflow$400Year 3 inflow$250Year 2 inflow$100Year 1 inflow-$1,200Initial outlay$48Year 5 inflow$47Year 4 inflow$41Year 3 inflow$30Year 2 inflow$22Year 1 inflow-$75Initial outlay
6 Management determines maximum acceptable payback period The payback period is the amount of time required for the firm to recover its initial investmentIf the project’s payback period is less than the maximum acceptable payback period, accept the projectIf the project’s payback period is greater than the maximum acceptable payback period, reject the projectManagement determines maximum acceptable payback period
7 Calculating Payback Periods For Entropica Projects Management selects a 3-year payback periodConstruction project has initial outflow of -$1,200 millionBut cash inflows over first 3 years only $750 millionEntropica would reject construction project based on paybackRefurbishing project has initial outflow of -$75 millionCash inflows over first 3 years cumulate to $93 millionProject recovers initial outflow middle of year 3Entropica would accept the project
8 Pros And Cons Of Payback Method Advantages of payback method:Computational simplicityEasy to understandFocus on cash flowDisadvantages of payback method:Does not account properly for time value of moneyDoes not account properly for riskCutoff period is arbitraryDoes not lead to value-maximizing decisions
9 Discounted Payback Period Discounted payback accounts for time valueApply discount rate to cash flows during payback periodStill ignores cash flows after payback periodEntropica uses a 16% discount rateReject--Accept / reject$67.53$528.26Cumulative PV$26.27$256.260.6407PV Year 3 inflow$22.29$185.790.7432PV Year 2 inflow$18.97$86.210.8621PV Year 1 inflowRefurbishing project ($million)Construction project ($million)PV Factors(16%)Item
10 Accounting Rate Of Return (ARR) Can be computed from available accounting dataNeed only profits after taxes and depreciationAccounting ROR = Average profits after taxes Average investmentAverage profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflowsAverage profitsafter taxesAverage annual operating cash inflowsAverage annualdepreciation=-ARR uses accounting numbers, not cash flows; no time value of money
11 Net Present ValueThe present value of a project’s cash inflows and outflowsDiscounting cash flows accounts for the time value of moneyChoosing the appropriate discount rate accounts for riskAccept projects if NPV > 0
12 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 investorsr varies with the risk of the firm and/or the risk of the project
13 Calculating NPVs For Entropica’s Projects Assuming Entropica uses 16% discount rate, NPVs are:Construction project: NPV = $ millionRefurbishing project: NPV = $41.43 millionShould Entropica invest in one project or both?
14 Independent versus Mutually Exclusive Projects Independent projects – accepting/rejecting one project has no impact on the accept/reject decision for the other projectMutually exclusive projects – accepting one project implies rejecting anotherBoth Entropica projects deal with production capacityIf demand is high enough, projects may be independentIf demand warrants only one investment, projects are mutually exclusiveWhen ranking mutually exclusive projects, choose the project with highest NPV
15 Pros and Cons Of Using NPV As Decision Rule NPV is the “gold standard” of investment decision rulesKey benefits of using NPV as decision ruleFocuses on cash flows, not accounting earningsMakes appropriate adjustment for time value of moneyCan properly account for risk differences between projectsThough best measure, NPV has some drawbacksLacks the intuitive appeal of paybackDoesn’t capture managerial flexibility (option value) well
16 Internal Rate of Return IRR found by computer/calculator or manually by trial and errorInternal rate of return (IRR) is the discount rate that results in a zero NPV for the projectThe IRR decision rule is:If IRR is greater than the cost of capital, accept the projectIf IRR is less than the cost of capital, reject the project
17 Calculating IRRs For Entropica’s Projects Entropica will accept all projects with at least 16% IRR:Construction project: IRR (rC) = 19.63%Refurbishing project: IRR (rR) = 34.54%Which project looks better if Entropica can invest only in one?
18 Advantages of IRR Properly adjusts for time value of money Uses cash flows rather than earningsAccounts for all cash flowsProject IRR is a number with intuitive appeal
19 Disadvantages of IRR Three key problems encountered in using IRR: Lending versus borrowing?Multiple IRRsNo real solutionsIRR and NPV rankings do not always agree
20 Lending Versus Borrowing IRR can give incorrect answers for projects with non-standard cashflowsProject 1: Invest $120 today, receive $170 in one yearProject 2: Receive $120 today, pay back $170 in one yearProject 1 amounts to lending; project 2 to borrowingBoth projects have same IRR, but #1 obviously superiorWhen borrowing, a low IRR is preferred on the loan.
21 Multiple IRRsNPV ($)NPV>0IRRNPV>0Discount rateNPV<0NPV<0IRRWhen project cash flows have multiple sign changes, there can be multiple IRRsWith multiple IRRs, which do we compare with the cost of capital to accept/reject the project?
22 Sometimes projects do not have a real IRR solution No Real SolutionSometimes projects do not have a real IRR solutionModify Entropica’s construction project to include a large negative outflow (-$1,300 million) in year 6.There is no real number that will make NPV=0, so no real IRR.Project is a bad idea based on NPV. At r =16%, project has NPV= -$ million, so reject!
23 Conflicts Between NPV and IRR NPV and IRR do not always agree when ranking competing projectsThe scale problem$41.34 mn36.53%Refurbishing$ mn19.63%ConstructionNPV (16%)IRRProjectRefurbishing project has higher IRR, but doesn’t increase shareholders’ wealth as much as construction project
24 The Timing ProblemLong-term projectNPVIRR = 15%Short-term projectIRR = 17%Discount rate13%15%17%The NPV of the long-term project is more sensitive to the discount rate than the NPV of the short-term project isLong-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%
25 Reconciling NPV and IRR Timing and scale problems can cause NPV and IRR methods to rank projects differentlyIn these cases, calculate the IRR of the incremental projectCash flows of large project minus cash flows of small projectCash flows of long-term project minus cash flows of short-term projectIf incremental project’s IRR exceeds the cost of capitalAccept the larger projectAccept the longer term project
26 Like IRR, PI suffers from the scale problem Profitability IndexCalculated by dividing the PV of a project’s cash inflows by the PV of its outflowsDecision rule: Accept projects with PI > 1.0, equal to NPV > 0Both projects’ PI > 1.0, so both acceptable if independent1.55$75 mn$ mnRefurbishing1.12$1.2 bn$ mnConstructionPIInitial OutlayPV of CF (yrs1-5)ProjectLike IRR, PI suffers from the scale problem
27 Capital BudgetingGenerating, reviewing, analyzing, selecting, and implementing long-term investment proposalsPayback PeriodDiscounted payback periodAccounting rate of returnNet Present Value (NPV)Internal rate of return (IRR)Profitability index (PI)