Capital Budgeting: Questions 1.Given the cash flow and risk of an individual project, do you accept or reject the project? (independent project) 2.If you have to choose between 2 or more projects, which one should you accept? (mutually exclusive projects). How do you adjust for differences in lifetime, scale?
I. Accounting based rules: Example - Average accounting return (AAR) A project is acceptable if its average accounting return exceeds a target return. Assume the initial investment required is $240. Average net income = (105 + 30+ 0)/3 = $45 Average book value = (240 + 160 + 80 + 0)/4 = $120 AAR = Ave NI/Ave BV = $45/120 = 37.5%
II. Payback Rules Payback period: the length of time until accumulated cash flows generated by the project cover the initial investment. An investment is acceptable if its calculated payback is less than some prespecified number of years. Discounted payback period: the length of time until accumulated discounted cash flows equal or exceed the initial investment.
III. Net Present Value Difference between the market value of an investment and its costs. The NPV amount determines the additional value created by the firm undertaking the investment. If NPV > 0, accept investment If NPV < 0, reject investment NPV does not account for the scale of the project. NPV(A+B+C) = NPV(A) + NPV(B) + NPV(C) If interest rates are expected to change: NPV = CF1/(1+r1) + CF2/(1+r1)(1+r2)
IV. Internal rate of return (IRR) IRR: the rate that makes the present value of future cash flows equal to the initial cost of the investment. In other words, the discount rate that gives a project a $0 NPV. An investment is acceptable if the required return is less than the IRR. Example of IRR: Initial outlay = -200 YearFCF 150 2100 3150 Find the IRR such that NPV = 0. 0 = -200 + 50/(1+IRR) 1 + 100/(1+IRR) 2 + 150/(1+IRR) 3
Rule conflicts for mutually exclusive projects Conflicts between IRR and NPV may be due to differences in size or timing of the project’s cash flows.
V. Profitability index The NPV of a project is stated in dollar terms and does not factor in the scale of the project. An adjustment to NPV can be made by using the profitability index: Profitability index = PV of cash flows/initial investment in the project The IRR is a percentage of return, which is standardized for the scale of the project.