Presentation on theme: "11-1 CHAPTER 11 The Basics of Capital Budgeting Should we build this plant?"— Presentation transcript:
11-1 CHAPTER 11 The Basics of Capital Budgeting Should we build this plant?
11-2 What is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future.
11-3 Steps to capital budgeting 1. Estimate CFs (inflows & outflows). 2. Determine the appropriate cost of capital. 3. Find payback period, NPV and/or IRR. 4. Accept project if 1. payback period is less than the maximum acceptable payback period, 2.NPV > 0 3. and/or 2.IRR > WACC.
11-5 What is the difference between independent and mutually exclusive projects? Mutually Exclusive Projects are investments that compete in some way for a company’s resources—a firm can select one or another but not both. Independent Projects, on the other hand, do not compete with the firm’s resources. A company can select one, or the other, or both—so long as they meet minimum profitability thresholds.
11-6 Payback Period The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. The maximum acceptable payback period is determined by management. If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project.
11-17 Discounted payback period Uses discounted cash flows rather than raw CFs. Disc Payback L = 2 + / = 2.7 years CF t -100 10 60 80 Cumulative -100 -90.91 18.79 012 3 = 60.11 -41.32 PV of CF t -100 9.09 49.59* 41.3260.11 10% *FV = 60, n = 2, I/yr = 10%, Pmt = 0, PV = 49.59
11-18 Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent Net Present Value (NPV) (cont.) Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.
11-19 Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1. Capital Budgeting Techniques Chapter Problem
11-23 Using financial Calculator to solve for NPV & IRR ( Project A) - 2th –> CF -2th -> CE/C (clear work) CO 0 = 42,000 enter CO 1 = 14,000 enter FO 1 CO 2 = 14,000 enter FO 2 CO 3 = 14,000enterFO 3 CO 4 = 14,000enterFO 4 CO 5 = 14,000enter FO 5 -> NPV I= 10% enter NPV CPT => “Answer” (NPV) -> IRR CPT => “Answer” (IRR) *using financial Calculator to solve for NPV & IRR
11-24 Using financial Calculator to solve for NPV & IRR ( Project B) - 2th –> CF -2th -> CE/C (clear work) CO 0 = 45,000 enter CO 1 = 28,000 enter FO 1 CO 2 = 12,000 enter FO 2 CO 3 = 10,000enterFO 3 CO 4 = 10,000enterFO 4 CO 5 = 10,000enter FO 5 -> NPV I= 10% enter NPV CPT => “Answer” (NPV) -> IRR CPT => “Answer” (IRR) *using financial Calculator to solve for NPV IRR
11-25 Decision Criteria If IRR > k, accept the project If IRR < k, reject the project If IRR = k, technically indifferent Internal Rate of Return (IRR) (cont.) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return.
11-27 9-27 Net Present Value Profiles &Conflicting Rankings
11-28 9-28 Conflicting Rankings This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project. NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR. Conflicting rankings between two or more projects using NPV and IRR sometimes occurs also because of differences in the timing and magnitude of cash
11-29 9-29 Which Approach is Better? On a purely theoretical basis, NPV is the better approach because: NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return (ie. managers are so used describing return in a project in percentage form- rates of return is in percentage form)