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© 2003 McGraw-Hill Ryerson Limited 12 Chapter The Capital Budgeting Decision McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by P Chua April 5, 2005 Based on Slides by: Terry Fegarty, Carol Edwards, Lawrence J. Gitman, and Sean Hennessey

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© 2003 McGraw-Hill Ryerson Limited Chapter 12 - Outline What is Capital Budgeting? Stages in Capital Budgeting Process Decision-making Criteria in Capital Budgeting Capital Budgeting Selection Strategies Methods of Evaluating Investment Proposals Payback Period Net Present Value (NPV) Profitability Index Internal Rate of Return (IRR) Capital Rationing NPV vs IRR Summary and Conclusions PPT 12-2

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© 2003 McGraw-Hill Ryerson Limited What is Capital Budgeting? Capital Budgeting is the process of evaluating and selecting long-term investment projects that achieve the goal of owner wealth maximization. The purposes of Capital Budgeting Projects include: to expand, replace, or renew fixed assets over a long period. Examples of Capital Budgeting projects: buying a new computer system, expanding the production capacity of an existing plant or modernizing its operations. PPT 12-3

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© 2003 McGraw-Hill Ryerson Limited What is Capital Budgeting? Capital Budgeting requires intensive planning. Once a Capital budgeting decision is made, it sets a strategic direction that is difficult to change. Because capital budgeting decisions involve a firm’s commitment of sizable financial resources to a project on a long-term basis, it is extremely important that a firm makes the right decision. A wrong decision can lead to huge financial distress and even bankruptcy for a firm.

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© 2003 McGraw-Hill Ryerson Limited What is Capital Budgeting? The longer the time horizon associated with a capital expenditure, the greater the uncertainty. Areas of uncertainty include: Annual outflows and inflows Product life Economic conditions Cost of capital Technological change PPT 12-3

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© 2003 McGraw-Hill Ryerson Limited Stages in Capital Budgeting Process 1. Finding Projects 2. Estimating the incremental cash flows associated with projects 3. Evaluating and selecting projects 4. Implementing and monitoring projects

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© 2003 McGraw-Hill Ryerson Limited Decision-making Criteria in Capital Budgeting The Ideal Evaluation Method: considers the time value of money, focuses on resultant cash flows, uses a firm’s cost of capital as the discount rate to evaluate a project.

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© 2003 McGraw-Hill Ryerson Limited Earnings before amortization and taxes (EBAT).... $20,000 Amortization (non-cash expense)........ 5,000 Earnings before taxes............ 15,000 Taxes (50%).............. 7,500 Earnings aftertaxes............7,500 Amortization.............. + 5,000 Cash flow...............$12,500 Alternative method of cash flow calculation EBAT............... $20,000 Taxes............... 7,500 Cash flow...............$12,500 PPT 12-5 Converting Accounting Flow to Cash Flow

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© 2003 McGraw-Hill Ryerson Limited Methods of Evaluating Investment Proposals Payback Period (PP) Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR) PPT 12-7

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© 2003 McGraw-Hill Ryerson Limited NetCash Inflows (of a $10,000 investment) YearInvestment AInvestment B 1 $5,000 $1,500 25,0002,000 32,0002,500 45,000 55,000 cost of capital = 10%....... PPT 12-10 Project Data

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© 2003 McGraw-Hill Ryerson Limited Payback Period Payback Period (PP): computes the amount of time required to recover the initial investment a cutoff period is established for comparison Accept/Reject Decision: if PP < cutoff period, accept the project if PP > cutoff period, reject the project PPT 12-9

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© 2003 McGraw-Hill Ryerson Limited Payback Period Advantages: Easy to understand and use Places premium on liquidity Emphasizes the shorter time-horizon Disadvantages: ignores inflows after the cutoff period fails to consider the time value of money fails to consider any required rate of return

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© 2003 McGraw-Hill Ryerson Limited Net Present Value Net Present Value (NPV): the present value of the cash inflows minus the present value of the cash outflows the future cash flows are discounted back over the life of the investment the basic discount rate is usually the firm’s cost of capital (WACC, assuming similar risk) Accept/Reject Decision: if NPV > 0, accept the project if NPV < 0, reject the project PPT 12-11

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© 2003 McGraw-Hill Ryerson Limited Profitability Index (PI) Profitability Index (PI): is computed by dividing the present value of inflows by the present value of outflows. Accept/Reject Decision: if PI > 1, accept the project if PI < 1, reject the project

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© 2003 McGraw-Hill Ryerson Limited Internal Rate of Return Internal Rate of Return (IRR): Is the Rate of Return that equates the initial cash outflow (cost) with the future cash inflows (benefits) is the discount rate where the cash outflows equal the cash inflows (or NPV = 0), that is, IRR is simply the discount rate at which the NPV of the project equals zero. Accept/Reject Decision: if IRR > cost of capital, accept the project if IRR < cost of capital, reject the project PPT 12-12

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© 2003 McGraw-Hill Ryerson Limited Investment AInvestment BSelection Payback period....2 years3.8 yearsQuickest payback: Investment A Net present value... $177 $1,413Highest net present value: Investment B Internal rate of return 11.18%14.33%Highest yield: Investment B Profitability Index..1.0181.141Highest relative profitability: Investment B PPT 12-13 Capital budgeting results

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© 2003 McGraw-Hill Ryerson Limited Capital Budgeting – Selection Strategies Independent Projects vs. Mutually Exclusive Projects as investment opportunities. Unlimited Funds vs. Capital Rationing to funding considerations. Accept/Reject Approach vs. Ranking Approach to project selection.

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© 2003 McGraw-Hill Ryerson Limited Capital Rationing Occurs when a limit is set on the amount of funds available to a firm for investment. Firm must rank investments based on their NPVs Those with positive NPVs greater than the cost of capital are accepted until all funds are exhausted PPT 12-17

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© 2003 McGraw-Hill Ryerson Limited CapitalA$2,000,000$400,000 rationingB2,000,000 380,000 solutionC1,000,000$5,000,000 150,000 D1,000,000100,000 Best E800,0006,800,000 40,000 solution F800,000(30,000.) Net TotalPresent ProjectInvestmentInvestmentValue PPT 12-18 Capital Rationing

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© 2003 McGraw-Hill Ryerson Limited NPV – most reliable measure Payback period is the least reliable measure of project acceptability. NPV, PI and IRR are more reliable measure. In case of conflict among NPV, PI and IRR, NPV should prevail. NPV has proven to be the only reliable measure of a project’s acceptability. So, remember: NPV is the only measure which always gives the correct decision when evaluating projects. Only NPV measures the amount by which a project would increase the value of the firm.

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© 2003 McGraw-Hill Ryerson Limited High IRR for a project does not necessarily mean a high NPV. Calculate the IRR and NPV for the projects below: Cash Flows in Dollars Project:C 0 C 1 IRR NPV @ 6% J-100+150 K+100 -150 Both projects have the same IRR … but Project J contributes more to the value of the firm.. Obviously, you should prefer Project J! 50% + $41.5 50% - $41.5 Pitfalls of IRR

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© 2003 McGraw-Hill Ryerson Limited Lending vs Borrowing Project J involves lending $100 at 50% interest. Project K involves borrowing $100 at 50% interest. Which option should you choose? Remember: When you lend money, you want a high rate of return. When you borrow money, you want a low rate of return.. Pitfalls of IRR

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© 2003 McGraw-Hill Ryerson Limited IRR can mislead you when choosing among mutually exclusive projects. Calculate the IRR and NPV for the following projects: Cash Flows in Dollars Project:C 0 C 1 C 2 C 3 IRR NPV @ 6% H-350400 - - I-350 1616466 Project H has a higher IRR … but Project I contributes more to the value of the firm.. Obviously, you should prefer Project I! 14.29% $27.36 12.96% $70.60 Pitfalls of IRR

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© 2003 McGraw-Hill Ryerson Limited Other Pitfalls with IRR Some projects will generate multiple internal rates of return. Here is an example. Cash Flow @20%@500% 0............. -1,528 -1,528 -1,528 1............. 11,000 9,167 1,833 2............. -11,000 -7,639 -305 NPV 0 0 How should you evaluate a project in cases like this?. You should calculate NPV! Pitfalls of IRR

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© 2003 McGraw-Hill Ryerson Limited Other Pitfalls with IRR Some projects have no internal rate of return. For example, there is no IRR for a project that has cash flows of +$1,000 in year 0, -$3,000 in year 1, and +$2,500 in year 2. If you don’t believe this, try plotting NPV for different discount rates. How should you evaluate a project in cases like this?. You should calculate NPV! Pitfalls of IRR

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© 2003 McGraw-Hill Ryerson Limited Net Present Value Profile Net Present Value Profile: The NPV profile is the relationship between the NPV of a project and the discount rate used to calculate that NPV. Since the IRR is the discount rate that makes a project’s NPV zero, the NPV profile also identifies a project’s IRR. a graph of the NPV of a project at different discount rates shows the NPV at 3 different points: a zero discount rate the normal discount rate (or cost of capital) the IRR allows an easy way to visualize whether or not an investment should be undertaken PPT 12-19

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© 2003 McGraw-Hill Ryerson Limited 6,000 4,000 2,000 0 Net present value ($) 5%10%15%20%25% IRR B = 14.33% IRR A = 11.16% Discount rate (percent) Investment B Investment A PPT 12-20 Net present value Profile B B A A

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© 2003 McGraw-Hill Ryerson Limited Net Cash Inflows (of a $10,000 investment) Year Investment BInvestment C 1 $1,500 $9,000 2 2,000 3,000 3 2,500 1,200 4 5,000 5 5,000 cost of capital = 10% Net present value profile with crossover

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© 2003 McGraw-Hill Ryerson Limited 6,000 4,000 2,000 0 Net present value ($) 5% 10% 15% 20%25% IRR C = 22.49% IRR B = 14.33% Discount rate (percent) Crossover point Investment C Investment B Investment C Investmen t B PPT 12-21 Net present value profile with crossover B B C C

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© 2003 McGraw-Hill Ryerson Limited Net present value profile with crossover Cross-Over Rate is the discount rate where NPV profiles of two (or more) projects intersect, meaning that they are equal. When this occurs ranking projects will have different results depending on what discount rate is used. A rate below the Cross-Over Rate will produce one ranking, a rate above it will produce another ranking.

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© 2003 McGraw-Hill Ryerson Limited Summary and Conclusions A capital budgeting decision involves planning cash flows for a long-term investment Several methods are used to analyze investment proposals: payback, net present value, internal rate of return, and profitability index The net present value method, in particular, considers the amount and timing of cash flows The analysis is based upon estimates of incremental cash flows aftertax that will result from the investment PPT 12-30

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