Presentation on theme: "Processes And Techniques Professor John Zietlow MBA 621"— Presentation transcript:
1Processes And Techniques Professor John Zietlow MBA 621 Chapter 7Capital BudgetingProcesses And TechniquesProfessor John Zietlow MBA 621
2Chapter 7: Overview 7.1 Capital Budgeting Decision Process 7.2 A Capital Budgeting Problem7.3 Payback AnalysisThe payback methodPros and cons of paybackDiscounted paybackPros and cons of discounted payback7.4 Accounting-Based MethodsAccounting rate of returnPros and cons of accounting rates of return7.5 Net Present ValueNet present value calculationsPros and cons of NPV
3Chapter 7: Overview (Continued) 7.6 Internal Rate of ReturnFinding a project’s IRRAdvantages of the IRR methodProblems with the IRR methodLending vs. borrowingMultiple IRRsNo real solutionThe scale problemThe timing problem7.7 Profitability IndexCalculating the profitability indexThe profitability index and capital rationing7.8 Summary
4The 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 grantedImplementing & following up on (monitoring) the proposals that have been selectedFirms typically make many long-term investments, but the most common for most firms are to acquire fixed assetsIncludes land, plant and equipmentAlso computers, telecom equipmentManagers should separate investment & financing decisionsUse a single required return (discount rate) to evaluate investment projects & accept those which have positive NPV
5Capital Expenditure Defined A capital expenditure is an outlay of funds expected to produce benefits for more than one year.Fixed-asset outlays are capital expenditures, but not all capital expenditures are classified as fixed assets.A $150,000 outlay for a long-term advertising program is also a capital expenditure, but not a fixed asset.An operating expenditure is an outlay resulting in benefits received within one year.Most software is treated as an expense, though long-termThe basic motives for capital expenditures are to expand, replace, or renew fixed assets. Critical for firms & nationsCapital spending: 13% of GDP in 1991; over 19% todayTech firms often spend >20% of revenues on cap investment
6Key Motives for Capital Expenditures Key Motives for Making Capital ExpendituresMotive DescriptionExpansionReplacementRenewalOther purposesThe most common motive for a capital expenditure is to expand the level of operations – usually through acquisition of fixed assets. A growing firm often needs to acquire new fixed assets rapidly, such as the purchase of property and plant facilities.As a firm’s growth slows and it reaches maturity, most capital expenditures will be made to replace or renew obsolete or worn-out assets. Each time a machine requires a major repair, the outlay for the repair should be compared to the outlay to replace the machine and the benefits of replacementRenewal, an alternative to replacement, may involve rebuilding, overhauling, or retrofitting an existing fixed asset. For, example, an existing drill press could be renewed by replacing its motor and adding a numeric control system, or a physical facility could be renewed by rewiring and adding air conditioning. To improve efficiency, both replacement and renewal of existing machinery may be suitable solutionsSome capital expenditures do not result in the acquisition or transformation of tangible fixed assets. Instead, they involve a long-term commitment of funds in expectation of a future return. These expenditures include outlays for advertising, research and development, management consulting, and new products. Other capital expenditures proposals – such as the installation of pollution-control and safety devices mandated by the government – are difficult to evaluate because they provide intangible returns rather than clearly measurable cash flows.
7Capital Budgeting Terminology Independent projects are those whose cash flows are unrelated or independent of one anotherThe acceptance of one does not eliminate the others from further consideration.If a firm has unlimited funds to invest, all independent projects with positive-NPVs can be implemented.Mutually exclusive projects are those that have the same function and therefore compete with one another.The acceptance of one eliminates from further consideration all other similar-function projects.Example: A firm needing increased production capacity could:(1) expand its plant, (2) acquire another company, or (3) contract another company for production.The acceptance of one of these projects eliminates the need for either of the others.
8Unlimited Funds Versus Capital Rationing The availability of funds for capital expenditures affects the firm's decisions.If a firm has unlimited funds for investment, making capital budgeting decisions is quite simple:Accept all independent projects with returns greater than the firm’s cost of capitalImplies firms should use an accept-reject decision ruleFirms often operate as though they face capital rationing.They have a fixed amount of money available for capital spending and numerous projects will compete for this moneyImplicitly assumes firms cannot access capital marketsSuch firms should use a ranking approach to cap budgetingThough frequently observed in practice, this assumption is usually wrong & firms are constraining capex unnecessarily
9Capital Budgeting Decision Techniques At least five capital budgeting decision techniques are commonly used by businessesPayback period: most commonly usedAccounting rate of return (ARR): least appropriateNet present value (NPV): best technique theoreticallyProfitability index (PI): related to NPVInternal rate of return (IRR): one businesspeople like mostPayback and ARR are unsophisticated and ignore the time value of moneyPayback slowly dying out in industry, but still popularNPV, PI, IRR all are tied to shareholder wealth maximization and all account for time value of moneyIRR popular because expressed as rate of returnUnlike IRR, NPV always yields correct answer
10U.S. Wireless Investment U.S. Wireless is a nationwide provider of wireless telephonyBusiness growing rapidly, but expansion is costlyUSW evaluating two investment proposalsMajor expansion of service in Northeast U.S. baseToehold investment establishing service in AtlantaProjects have cash flow patterns below (in $ millions):NortheastAtlanta$850Year 5 inflow$740Year 4 inflow$400Year 3 inflow$250Year 2 inflow$100Year 1 inflow-$1.2 billionInitial outlay$48Year 5 inflow$47Year 4 inflow$41Year 3 inflow$30Year 2 inflow$22Year 1 inflow-$75Initial outlay
12Payback PeriodThe payback period is the exact amount of time required for the firm to recover its initial investment.In the case of an annuity, the payback period can be found by dividing the initial investment by the annual cash inflow.For a mixed stream of cash inflows, the yearly cash inflows must be accumulated until the initial investment is recovered.When the payback period is used to make accept-reject decisions, the decision criterion is: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.The length of the maximum acceptable payback period is determined by management.
13Calculating Payback Periods For USW’s Northeast And Atlanta Projects Assume USW managers select a 3-year payback periodOnly accept projects that recover costs by end-of-year 3The northeast project has initial outflow of -$1.2 billionsBut cash inflows over first 3 years only $750 mnUSW would reject northeast project based on paybackThe Atlanta project has initial outflow of -$75 mnCash inflows over first 3 years cumulate to $93 mnProject recovers initial outflow middle of year 3USW would accept Atlanta project based on paybackPayback: USW would reject Northeast, accept AtlantaWill see this is incorrect if mutually exclusive projects
14Pros And Cons Of Payback Period Payback period is popular because of its computational simplicity and intuitive appeal.Also considers cash flows rather than accounting profits.It also gives some implicit consideration to the timing of cash flows; can thus be viewed as a measure of risk exposure.Frequently used as the primary decision technique for risky foreign investments and for high-risk domestic investments.Major weakness: “appropriate” payback period is arbitrarily determined & is not based on discounting cash flows.Often yields bizarrely short payback periodsTwo other serious weaknesses of payback period:Fails to fully account for time value of money.Zero discount rate years 1-3, infinite after years 3
15Discounted Payback Period Using discounted payback can account for TV problemApply discount rate to CFs during payback periodStill ignores CFs after payback periodTable below assumes USW uses an 18% discount rateReject--Accept / reject$67.531$528.29Cumulative PV$$256.280.6407PV Year 1 inflow$22.296$185.80.7432$$86.210.8621DCFs Atlanta project ($mn)DCFs Northeast project ($mn)PV Factors(16%)Item
16Accounting Rate Of Return (ARR) Accounting rate of return (ARR) is popular because it can be computed from available accounting dataNeed only profits after taxes and depreciation.The most common definition of the accounting rate of return (ARR) for a given project is:Accounting ROR = Avg Profits after taxes Avg InvestmentAverage profits after taxes can be estimated by subtracting average annual depreciation from the average annual operating cash inflows.Average profitsafter taxes=Average annual operating cash inflows-Average annualdepreciationARR uses accounting numbers, not CFs; no TV of money
17Net Present ValueNet present value (NPV) found by subtracting the PV of cash outflows from the PV of cash inflowsBoth discounted at the firm’s cost of capital (r).Cost of capital (discount rate): minimum return firm must earn on a project to satisfy investorsAdjusts cash flows for risk and TV of money(Eq 7.1)Decision rule: Accept positive, reject negative NPV projectsPositive NPV occurs when:
18Calculating NPVs For US Wireless’ Projects Assuming US Wireless uses 16% discount rate, NPVs are:Northeast project: NPV = $ mnAtlanta project: NPV = $41.43 mnBoth projects have positive NPVs, so both acceptableIf mutually exclusive, select Northeast since higher NPV
19Pros & Cons Of Using NPV As Decision Rule NPV is the “gold standard” of investment decision rulesAlmost always yields correct answerKey benefits of using NPV as decision ruleFocuses on cash flows, not Accounting earningsMakes appropriate adjustment for TV of moneyDecision rule based on market values (reqd return)Can properly account for risk differences between projectsIncorporates all CFs; doesn’t ignore those after paybackThough best measure, NPV has some drawbacksAnswer in $ amounts, not rate of return or years to paybackDoesn’t capture managerial flexibility (option value) well
20Internal Rate of Return Internal rate of return (IRR) is the discount rate that equates the PV of cash inflows, with the PV of cash outflows.IRR found by computer/calculator or manually by trial & errorActually computed by trial and error—even by computerThe decision criterion when IRR is used to make accept-reject decisions is:If IRR is greater than the cost of capital, accept the project.If IRR is less than the cost of capital, reject the projectGuarantees that the firm earns at least its required return
21Calculating IRRs For US Wireless’ Projects US Wireless will accept all projects with at least 16% IRR:Northeast project: IRR (rNE) = 19.63%Atlanta project: IRR (rA) = 36.53%Both projects have positive IRRs, so both acceptableIf mutually exclusive, pick Atlanta: higher IRR (wrong answer)
22Comparing NPV and IRR Techniques IRR has many good features; almost as good as NPV.Properly adjusts for TV of money; uses CFs rather than earnings; accounts for all CFs; uses market valuesIRR also yields intuitive rate of return (%) answerNPV and IRR are found by specifying either the discount rate or NPV and solving Eq 7.1 for the other value.NPV calculated with known discount rate (the cost of capital)IRR is calculated using a known NPV (i.e., $0).NPV and IRR usually give the same accept-reject decisionbut differences in their underlying assumptions can cause them to rank projects differently.Three key problems encountered in using IRR:(1) Lending versus borrowing?(2) Multiple IRRs(3) No real solutions
23Problems With IRR (1) Lending Versus Borrowing IRR can give incorrect answers for projects with non-standard cashflows. Consider two mirror image projects:Project 1: Invest $120 today, receive $170 in one year.Project 2: Receive $120 today, pay back $170 in one year.Project 1 amounts to lending; project 2 to borrowing (Fig 7.4)Both projects have same IRR, but #1 obviously superiorWhen borrowing, a low IRR is preferred on the loan.
24Lending Versus Borrowing Project #1: LendingNPV41.67%Discount rateIRR
25Lending Versus Borrowing Project #2: BorrowingNPV41.67%Discount rateIRR
26Problems With IRR (2) Multiple IRRS If a project has more than one change in the sign of cash flows, there may be multiple IRRs.Can have as many IRRs as sign changes.Consider project with following CFs:Though odd pattern, can beobserved in high-tech andother industries.Four changes in sign of CFs,and have four different IRRs.Next figure plots project’s NPVat various discount rates.NPV is the only decision rulethat works for this project type.
28Multiple IRRs: Example 2 Project doesn’t have to have bizarre CF patterns. Consider the following project: Initial investment of $10,000Followed by a $50,000 cash inflow at end-of-year 1 and a $60,000 cash outflow at EOY 2.This project has two sign changes in its cash flows, and has two IRRs:100% and 200%, as shown in its NPV profile next page.This project would be acceptable using NPV only when the firm’s COC is between IRR1 of 100% and IRR2 of 200%.At discount rates below 100% and above 200% the project would have a negative NPV and would be rejected.
29Example 2: NPV Profile For A Project With Multiple IRRs $000Discount Rate, %
30Problems With IRR (3) No Real Solution Sometimes projects do not have a real IRR solution.Modify USW’s Northeast project to include a large negative outflow (-$1.3 bn) in year 6.There is no real number that, used in Eq 7.1, will make NPV=0, so no real IRR.Project is a bad idea based on NPV. At r =16%, project has NPV= -$ mn, so reject!
31Sources Of Conflicting NPV And IRR Rankings For Mutually Exclusive Projects The Scale Problem: High IRRs may have low total payoff.Northeast project has lower IRR, but increases wealth more.$41.34 mn36.53%Atlanta$ mn19.63%NortheastNPV (16%)IRRProjectThe Timing Problem: One project has most of its payoff in early years; other pays more in later yearsAssume firm must choose between two $1 billion projectsProject 1: New product development, biggest payoff year 5Project 2: Marketing blitz, biggest payoffs early years (1-3)
32The Timing Problem With IRR $ mn$ mnNPV (10%)16.35%13.24%IRR$100$1,325Year 5$120$225Year 4$285$135Year 3$375$75Year 2$500$0Year 1-$1,000 mnInitial OutlayMarketing blitzProduct developmentCash FlowMarketing project has higher IRR (16.35% vs 13.24%), while developmentproject has higher NPV ($ mn vs $ mn). Which to take?
33The Timing ProblemNPVMarketing CampaignIRR = 16.35%Discount rate10%10.7%Product developmentIRR = 13.24%Select project with higher NPV (product development project)
34Profitability IndexProfitability index (PI) calculated by dividing the PV of a project’s cash inflows by the PV of its outflowsAlso called the benefit-cost ratio, calculated as Eq 7.3:(Eq 7.3)Decision rule: Accept projects with PI > 1.0, equal to NPV > 0Calculate PIs for U.S. Wireless’ two projects:1.55$75 mn$ mnAtlanta1.12$1.2 bn$ mnNortheastPIInitial OutlayPV of CF (yrs1-5)ProjectBoth projects’ PI > 1.0, so both acceptable if independentIf mutually exclusive, Atlanta project looks better (but isn’t)
35Net Present Value Profiles Projects can be compared graphically with net present value profiles depicting their NPVs for various discount rates.These are useful in evaluating and comparing projects, especially when conflicting rankings exist.To prepare NPV profiles, first develop a set of discount-rate/NPV coordinates.Three coordinates can easily be obtained for each project; discount rates of 0%, 16% (the COC, r), and the IRR.The NPV at a 0% discount rate is found by adding all the cash inflows and subtracting the initial investmentCompute NPV profiles for two USW projects.Northeast, NPV0 = $1.14bn; NPV16% = $141.65mn; NPV19.63% =0Atlanta, NPV0 = $113mn; NPV16%= $41.34mn; NPV36. 53% = 0
36Net Present Value Profiles (Continued) Plotting these data results in the net present value profiles for Northeast and Atlanta projects (next slide).Note that, graphically, the IRRs occur where each NPV profile crosses the discount-rate axis due to the definition of IRR as the discount rate that causes NPV = $0.Figure shows that for any r below about 18.73%, the NPV for Northeast is greater than the NPV for Atlanta.For any r > 18.73%, NPV for Atlanta > NPV for Northeast.Since the NPV profiles cross at a positive NPV, the IRRs cause conflicting rankings whenever they are compared to NPVs calculated at discount rates below 18.73%.At USW’s r =16%, Northeast’s NPV ($141.65mn) is preferredBut Atlanta has a higher IRR (36.53% vs 19.63%)Basic cause of conflicting rankings: implicit assumptions regarding reinvestment rate for intermediate cash flows
37Net Present Value Profiles MnIRRATL =36.53%•IRRNE=19.63%
38Causes Of Conflicting Project Rankings: Differing Reinvestment Rate Assumptions The underlying cause of conflicting rankings is the implicit assumption about reinvestment of intermediate cash flows.An ability to reinvest intermediate cash flows at the stated discount rate is embedded in time value mathematics.NPV assumes that intermediate cash flows are reinvested at the cost of capital.IRR assumes that intermediate cash flows are reinvested at a rate equal to the project’s IRR.Consider a project requiring a $850,000 initial investment with expected operating cash flows of $200,000, $300,000, and $600,000 at the end of each of the next three years.The project’s NPV (at the firm’s 10 % cost of capital) is $30,540.95, and its IRR is 11.7%.
39Differing Reinvestment Rate Assumptions The NPV of the project (at the firm’s 10% COC) is $30,540.9, and its IRR is 11.7%. Clearly, the project is acceptable.NPV = $30,540.9 > $0 and IRR = 11.7% > 10% cost of capital.Next slide calculates the project’s FV at the end of year 3, assuming both a 10% and a 11.7% (its IRR) rate of return.FV of $1,172,000 results from reinvestment at the 10% COCFV of $1,184,637.8 results from reinvestment at the 11.7% IRR.If the FVs in next slide are viewed as the return received in three years from the $850,000 initial investment:At the 10% reinvestment rate, the NPV remains at $30,540.95Reinvestment at the 11.7% IRR produces an NPV of $40,035.9NPV assumes reinvestment at the cost of capital (10%).IRR assumes an ability to reinvest intermediate CF at IRR.If reinvestment doesn’t occur at this rate, IRR won’t be 11.7%
40Reinvestment Rate Comparisons: NPV at 10% versus IRR
41Reconciling IRR and NPV Have seen that NPV is theoretically superior to IRR for making accept-reject decisions for projectsBut IRR much more popular with managers because it yields an intuitively pleasing rate of return measureGenerally both IRR and NPV yield the same decision, but IRR has several problems:Non-standard cash flows (outflows followed by inflows), multiple IRRs, imaginary IRRs (not covered)IRR also incorrectly assumes intermediate CFs can be reinvested at IRR, not firm’s cost of capital