Presentation on theme: "Chapter 2 Capital Budgeting Principles and Techniques"— Presentation transcript:
1 Chapter 2 Capital Budgeting Principles and Techniques Capital budgeting and investment Analysis by Alan Shapiro
2 Net Present Value (NPV) NPV is the present value of the project’s cash flows minus the cost of the projectThe value placed on an investment project must satisfy three criteria:Focus on cashAccount for TVMAccount for Risk
3 NPV Decision Rule Invest in positive NPV projects Reject negative NPV projectsUse the appropriate discount rateIf two projects are mutually exclusive, accept the one with higher NPVCost of capital is the minimum acceptable rate of return on projects with similar risk.
4 NPV cont. NPV=-Initial cash investment+ PV of future CFs Initial investment includes any working capital requirementsNet CF is after tax profit plus depreciation and other non-cash charges such as deferred taxes less any additions to working capital during the periodIt is cash, and only cash that matters to shareholders
5 Example 1 Plant and equipment of $6 million 5 year contract Sale of $10 per pound800,000 pounds of dye in the 1st year1,600,000 pounds per year in each of the next 4 yearsPlant is expected to be sold at its book value in end of year 5 for $1 million
6 Example 1 cont. Variable cost = $6.5 per pound Fixed cost = $1,700,000 per yearDeprecation = $1,000,000 per yearTax rate = 40%Working capital requirement =$1,200,000 and will be freed at end of year 5Required return = 10%
7 Example 1 cont. Calculate the following: Initial investment for this projectNet Cash Flow for years 1-5.NPVDecide whether you would accept or reject this project and Why?
8 Example 2 (Contingent projects) Purchase and transport mining equipment which costs $90 millionCost of extracting ore = $50 per tonExpected to sell ore for $150 a tonProduce 200,00 tons a year20 YearsConstruct a rail line at cost of $30 millionCost of transport = $10 per tonRequired rate of return= 15%What are the NPVs for the mine and the railway? Which project(s) should they take?
9 Strengths of NPVIt evaluates investments in the same way that shareholders doIt is a theoretically correct techniqueIt obeys the value additivity principleThe NPV of a set of independent projects is just the sum of the NPVs of the individual projectsIt implies that the value of a firm equals the sum of the values of its component parts
10 Weakness of NPVMany corporate executives and non technical people have a tough time understanding the conceptApplying the NPV has the problem of computing the proper discount rate.
11 Payback PeriodPayback period is the length of time necessary to recoup the initial investment from net cash flowsDiscounted payback period is the length of time it takes to the present value of CFs to equal the cost of the initial investmentFind the payback period (PB) for example 1.
12 Payback period decision rule Projects with a payback less than a specified cutoff period are accepted whereas those with a payback beyond this figure are rejectedThe riskier the project is, the shorter the required payback will be
13 Payback period Strengths and Weaknesses Strength: It is simple to understand and easy to applyWeaknesses:It ignores time value of moneyIt ignores cash flows beyond the payback period: it is biased against longer projects
14 Accounting rate of return Also known as average rate of return or average return on book valueIt is the ratio of average after tax profit to average book investment (the initial investment less accumulated depreciation).Decision RuleInvestments yielding a return greater than this standard are accepted, whereas those falling below it would be rejected.
15 Strengths and Weaknesses of Accounting rate of return Strength: It is simple to applyWeakness:It ignores the time value of moneyIt is based on accounting income rather than cash flow. Cash flow and reported income often differ
16 Internal Rate of Return (IRR) IRR is the discount rate that sets the present value of the project cash flow to the initial investment outlayIt is the discount rate that equates the project NPV to zeroCalculate the IRR of Example 1
17 IRR Decision RuleIf the IRR exceeds the cost of capital, the firm should undertake the project; otherwise, the project should be rejected
18 IRR Strengths and Weaknesses Managers seem to visualize and understand more easily the concept of a rate of return rather than they do the concept of a sum discounted dollarsIt permits an investment analysis without requiring advance specification of the discount rateWeaknesses:When cash flows change more than once (Multiple IRR)When mutually exclusive projects are involved
19 Multiple IRRs IRR of 0%, 100%, and 200% Year 1 2 3 Cash flow -$200 123Cash flow-$200+$1,200-$2,200
20 Mutually exclusive projects In case of mutually exclusive projects choices, NPV and IRR can favor conflicting projectsWhen forced to choose between two mutually exclusive investments, the NPV will always provide the correct answer.When projects are substantially different inTiming of cash flowsMost of CFs coming in early years vs. later yearsScale differencesDifferences in the amount of the initial investment
21 Differences between rankings of NPV and IRR YearXY-$100,000-$1,000,0001$140,000$1,250,000NPV (k=15%)$21,739$86,957IRR40%25%YearAB-1,000,0001800,000100,0002300,000400,0003200,000500,0004NPV (k=17%)$81,154$116,781IRR22.99%21.46%
22 Profitability Index (PI) It is also called the benefit-cost ratioIt equals the present value of future cash flows divided by the initial cash investmentCalculate Profitability Index (PI) for Example 1The project returns a present value of $X for every $1 of the initial investment
23 PI Decision RuleAs long as the profitability index exceeds 1, the project should be acceptedStrength:NPV and PI give the same accept/reject signalWeakness:NPV and PI sometimes disagree in the rank ordering of acceptable projectsWhen there are mutually exclusive projects and when there is capital rationing
24 Surveys of Capital budgeting used in practice Graham and Harvey (2002)US companies75% of CFOs always or almost always use NPV75.7 always or almost always use IRRMost popular secondary or supplemental method of evaluation is the payback period due to its simplicity along with top management’s lack of familiarity with more sophisticated techniquesOnly about 20% of companies used accounting rate of returnWhat about Kuwait? Other international surveys?
25 Capital RationingSome firms constrain the size of their capital budgets. Whenever such a constraint exist, we have the situation known as capital rationingCapital rationing may be self-imposed or externally imposedLimit CapEx to internally generated cash flowsLimit # of attractive projects to undertakeCurrent lenders may restrict the amount of future borrowing
26 Heuristic approach Calculate the PI for each project Rank all projects in term of their PIs, from highest to lowestStarting with the project having the highest PI, go down the list and select all projects having PI>1 until the capital budget is exhausted
27 Capital Rationing: NPV vs. PI The NPV method does not necessarily select the best combination of projects under capital rationingThe PI approach will select the optimal combination of projects provided that:The budget constraint is for 1 period onlyThe entire budget can be consumed by accepting projects in descending order of PI.
28 Example on Capital Rationing Capital budget of $5 million ProjectInitial investmentNPVPIRanking NPVRanking PIA500,000100,0001.201. DFB70,0001.142. CC2,000,000300,0001.153. EED3,000,000480,0001.164. F1,000,000170,0001.175. A125,0001.256. B
29 Mutually exclusive projects with Different Lives Equivalent annual cost of an asset is an annuity that has the same life as the asset whose present value equals the cost of the assetRule:Compute the equivalent annual cost of each asset.Select the asset with the lowest equivalent annual costFor a revenue generating project, this rule becomes select the project with the highest equivalent annual net cash flow
30 Example: Different Lives YearDoleDaihatsu$12,000$7,5001$3,000$4,0002345-Present value of cost at 8%$23,978.10$20,740.40Dole TruckDaihatsu truckInitial cost$12,000$7,500Salvage ValueLife5 years4 yearsOperating cost$3,000/year$4,000/year