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11-1 CHAPTER 11 The Basics of Capital Budgeting Should we build this plant?

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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.

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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.

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11-4 Capital Budgeting Techniques (cont.)

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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.

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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.

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11-7 Payback Periods (cont.)

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11-8 What is Project L’s payback? Year CF t 0-100 1 10 2 60 3 80

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11-9 Calculating payback Payback L = 2 + / = 2.375 years CF t -100 10 60 Cumulative -100 -90 50 012 3 = 3080 -30 Project L’s Payback Calculation Payback L = 2.375 years

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11-10 Copyright © 2006 Pearson Addison- Wesley. All rights reserved.9-10 Pros and Cons of Payback Periods The payback method is widely used as a starting point by large firms to evaluate small projects and by small firms to evaluate most projects. It is simple, intuitive. It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.

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11-11 Copyright © 2006 Pearson Addison- Wesley. All rights reserved.9-11 Pros and Cons of Payback Periods (cont.) One major weakness of the payback method is that the appropriate payback period is a subjectively determined number. It also fails to consider the principle of wealth maximization of which CF is assume to be reinvested and thus provides no indication as to whether a project adds to firm value. Thus, payback fails to fully consider the time value of money.

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11-12 Reinvesting cash flow from project 100 CF 100 CF “reinvest cash inflow at going market rates”

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11-13 Copyright © 2006 Pearson Addison- Wesley. All rights reserved.9-13 Pros and Cons of Payback Periods (cont.) It fails to consider the timing of the cash flows of which are assumed to be reinvested at going market rate. ( ie. the 40,000 CF of project silver in year1 if reinvested would generate higher return compare to the 5,000 CF of project gold in year1)

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11-14 Copyright © 2006 Pearson Addison- Wesley. All rights reserved.9-14 Pros and Cons of Payback Periods (cont.)

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11-15 Copyright © 2006 Pearson Addison- Wesley. All rights reserved.9-15 Pros and Cons of Payback Periods (cont.) Payback method fails to recognize cash flows that occur after the payback period.

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11-16 Copyright © 2006 Pearson Addison- Wesley. All rights reserved.9-16 Pros and Cons of Payback Periods (cont.)

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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

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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.

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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

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11-20 Capital Budgeting Techniques (cont.)

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11-21 Capital Budgeting Techniques (cont.)

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11-22 Net Present Value (NPV) (cont.)

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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

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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

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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.

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11-26 Internal Rate of Return (IRR) (cont.)

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11-27 9-27 Net Present Value Profiles &Conflicting Rankings

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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

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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)

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1 The Basics of Capital Budgeting: Evaluating and Estimating Cash Flows Corporate Finance Dr. A. DeMaskey Should we build this plant?

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