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© 2009 Cengage Learning/South-Western Capital Budgeting Chapter 8

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2 The capital budgeting process involves three basic steps: Generating long-term investment proposals; Reviewing, analyzing, and selecting from the proposals that have been granted, and Implementing and monitoring the proposals that have been selected. Managers should separate investment and financing decisions. The Capital Budgeting Decision Process

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3 Payback period: most commonly used Accounting rate of return (ARR): focuses on project’s impact on accounting profits 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 Capital Budgeting Decision Techniques

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4 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. A Capital Budgeting Process Should:

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5 Example: Global Wireless Global Wireless is a worldwide provider of wireless telephony devices. Global Wireless is contemplating a major expansion of its wireless network in two different regions: –Western Europe expansion –A smaller investment in Southeast U.S. to establish a toehold

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6 Global Wireless Initial Outlay-$250 Year 1 inflow$35 Year 2 inflow$80 Year 3 inflow$130 Year 4 inflow$160 Year 5 inflow$175 Initial Outlay-$50 Year 1 inflow$18 Year 2 inflow$22 Year 3 inflow$25 Year 4 inflow$30 Year 5 inflow$32

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7 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. Accounting Rate Of Return (ARR)

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8 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. Payback Period

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9 Management’s cutoff is 2.75 years. Western Europe project: initial outflow of -$250M –But cash inflows over first 3 years is only $245 million. –Global Wireless will reject the project (3>2.75). Southeast U.S. project: initial outflow of -$50M –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. So, the project generates $10 million in year 3 in 0.40 years ($10 million $25 million). –Global Wireless will accept the project (2.4<2.75). Payback Analysis For Global Wireless

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10 Advantages of payback method: Computational simplicity Easy to understand Focus on cash flow Disadvantages of payback method: Does not account properly for time value of money Does not account properly for risk Cutoff period is arbitrary Does not lead to value-maximizing decisions Pros and Cons of the Payback Method

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11 Discounted payback accounts for time value. Apply discount rate to cash flows during payback period. Still ignores cash flows after payback period. Global Wireless uses an 18% discount rate. Discounted Payback Reject (46.3<50)Reject (166.2 < 250)

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12 NPV: The sum of the present values 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. Net Present Value (NPV)

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13 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 firm and /or the risk of the project. Net Present Value (NPV)

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

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15 The NPV Rule and Shareholder Wealth

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16 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. Pros and Cons of NPV

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17 IRR: the discount rate that results in a zero NPV for a project. The IRR decision rule for an investing project 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. Internal Rate of Return (IRR)

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18 NPV Profile and Shareholder Wealth

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19 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. IRR Analysis for Global Wireless

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20 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 Pros and Cons of IRR

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21 Which IRR do we use? IRR When project cash flows have multiple sign changes, there can be multiple IRRs. Multiple IRRs

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22 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! No Real Solution

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23 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 The Southeast U.S. project has a higher IRR, but doesn’t increase shareholders’ wealth as much as the Western Europe project. The scale problem: Conflicts Between NPV and IRR: The Scale Problem

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24 Conflicts Between NPV and IRR: The Scale Problem Why the conflict? The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project. Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive.

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25 Conflicts Between NPV and IRR: The Timing Problem The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.

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26 Conflicts Between NPV and IRR: The Timing Problem Because of the differences in the timing of the two projects’ cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign.

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27 Decision rule: Accept project with PI > 1.0, equal to NPV > 0 Both 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 initial cash outflows. Like IRR, PI suffers from the scale problem. Profitability Index

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28 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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Other Criteria for Capital Budgeting Text: Chapter 6.

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