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4-1 Business Finance (MGT 232) Lecture 17

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4-2 Capital Budgeting

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4-3 – Creation of Value – Overall Cost of Capital of the Firm Cost of Debt Cost of P. Stock Cost Common Stock – Calculating WACC – Limitations of WACC Overview of the Last Lecture

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4-4 Capital Budgeting and Estimating Cash Flows – The Capital Budgeting Process – Classification of Investment Project Proposals – Capital Budgeting Techniques Payback Period Discounted Payback Period Net Present Value Internal Rate of Return Modified Internal rate of return Profitability index – The Capital Budgeting Process – Classification of Investment Project Proposals – Capital Budgeting Techniques Payback Period Discounted Payback Period Net Present Value Internal Rate of Return Modified Internal rate of return Profitability index

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4-5 What is Capital Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

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4-6 The Capital Budgeting Process Generate investment proposals consistent with the firm’s strategic objectives. Estimate after-tax incremental operating cash flows for the investment projects. Evaluate project incremental cash flows. Generate investment proposals consistent with the firm’s strategic objectives. Estimate after-tax incremental operating cash flows for the investment projects. Evaluate project incremental cash flows.

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4-7 The Capital Budgeting Process Select projects based on a value-maximizing acceptance criterion. Reevaluate implemented investment projects continually and perform postaudits for completed projects. Select projects based on a value-maximizing acceptance criterion. Reevaluate implemented investment projects continually and perform postaudits for completed projects.

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4-8 Classification of Investment Project Proposals 1. New products or expansion of existing products 2. Replacement of existing equipment or buildings 3. Research and development 4. Exploration 5. Other (e.g., safety or pollution related) 1. New products or expansion of existing products 2. Replacement of existing equipment or buildings 3. Research and development 4. Exploration 5. Other (e.g., safety or pollution related)

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4-9 Screening Proposals and Decision Making 1. Section Chiefs 2. Plant Managers 3. VP for Operations 4. Capital Expenditures Committee 5. President 6. Board of Directors 1. Section Chiefs 2. Plant Managers 3. VP for Operations 4. Capital Expenditures Committee 5. President 6. Board of Directors Advancement to the next level depends on cost and strategic importance.

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4-10 Project Evaluation: Alternative Methods – Payback Period (PBP) – Discounted Payback Period (DPP) – Net Present Value (NPV) – Internal Rate of Return (IRR) – Modified Internal Rate of Return (MIRR) – Profitability Index (PI) – Payback Period (PBP) – Discounted Payback Period (DPP) – Net Present Value (NPV) – Internal Rate of Return (IRR) – Modified Internal Rate of Return (MIRR) – Profitability Index (PI)

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4-11 Proposed Project Data Mariam is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be Rs.10,000; Rs.12,000; Rs.15,000; Rs.10,000; and Rs.7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be Rs.40,000.

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4-12 Independent Project Independent Independent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. u For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.

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4-13 Other Project Relationships Mutually Exclusive Mutually Exclusive -- A project whose acceptance prevent the acceptance of one or more alternative projects. u Dependent u Dependent -- A project whose acceptance depends on the acceptance of one or more other projects.

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4-14 Payback Period (PBP) PBP PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. The period in which the project initial investment will be back PBP PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. The period in which the project initial investment will be back 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K

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4-15 Payback Solution PBP 3.3 Years PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. PBP 3.3 Years PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. Cumulative Cash Flows -40 K 10 K 12 K 15 K 10 K 7 K 0 1 2 3 4 5 -40 K -30 K -18 K -3 K 7 K 14 K

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4-16 Payback Period

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4-17 PBP Acceptance Criterion Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.] The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type. Should this project be accepted?

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4-18 PBP Strengths and Weaknesses Strengths: – Easy to use and understand – Can be used as a measure of liquidity – Easier to forecast ST than LT flows Strengths: – Easy to use and understand – Can be used as a measure of liquidity – Easier to forecast ST than LT flows Weaknesses: – Does not account for TVM – Does not consider cash flows beyond the PBP – Cutoff period is subjective

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4-19 Discounted Payback Period (DPP) DPP DPP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow at a discount rate. The period in which the project initial investment will be back DPP DPP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow at a discount rate. The period in which the project initial investment will be back 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K

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4-20 Discounted Payback Period

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4-21 DPP Acceptance Criterion No! The firm is not geetting the initial outlay in projects life time The management of Basket Wonders has set a maximum DPP of 3.5 years for projects of this type. Should this project be accepted?

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4-22 Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow.

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4-23 Basket Wonders has determined that the appropriate discount rate (r) for this project is 13%. NPV Solution

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4-24 NPV Solution

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4-25 NPV Acceptance Criterion Reject NPV0 No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted?

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4-26 NPV Strengths and Weaknesses Strengths: – Cash flows assumed to be reinvested at the hurdle rate. – Accounts for TVM. – Considers all cash flows. Strengths: – Cash flows assumed to be reinvested at the hurdle rate. – Accounts for TVM. – Considers all cash flows. Weaknesses: – May not include managerial options embedded in the project. See Chapter 14.

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4-27 Summary – The Capital Budgeting Process – Classification of Investment Project Proposals – Capital Budgeting Techniques Payback Period Discounted Payback Period Net Present Value

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