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Chapters 6 & 7 – MBA5041 Capital Budgeting Net Present Value Rule Payback Period Rule Discounted Payback Period Rule Average Accounting Return Internal Rate of Return Profitability Index Practice of Capital Budgeting Incremental Cash Flow

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Chapters 6 & 7 – MBA5042 Net Present Value (NPV) Rule Net Present Value (NPV) = Total PV of future CF’s + Initial Investment Estimating NPV: –1. Estimate future cash flows: how much? and when? –2. Estimate discount rate –3. Estimate initial costs Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV

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Chapters 6 & 7 – MBA5043 Assume you have the following information on Project X: Initial outlay -$1,100Required return = 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1,000 $500 2 2,000 1,000 Calculate its NPV. Example

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Chapters 6 & 7 – MBA5044 The Payback Period Rule How long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria: –set by management Disadvantages –Ignores the time value of money –Ignores cash flows after the payback period –Biased against long-term projects

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Chapters 6 & 7 – MBA5045 Initial outlay -$1,000 YearCash flow 1$200 2400 3600 Accumulated YearCash flow 1 2 3 Payback period =

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Chapters 6 & 7 – MBA5046 Discounted Payback Period Rule How long does it take the project to “pay back” its initial investment taking the time value of money into account? By the time you have discounted the cash flows, you might as well calculate the NPV.

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Chapters 6 & 7 – MBA5047 Initial outlay -$1,000 R = 10% PV of Year Cash flow Cash flow 1 $ 200$ 182 2400 331 3700 526 4300 205 Accumulated: Year discounted cash flow 1 $ 182 2 513 31,039 41,244 Discounted payback period is Example

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Chapters 6 & 7 – MBA5048 Average Accounting Return Rule Another attractive but fatally flawed approach. Ranking Criteria and Minimum Acceptance Criteria set by management Disadvantages: –Ignores the time value of money –Uses an arbitrary benchmark cutoff rate –Based on book values, not cash flows and market values Advantages: –The accounting information is usually available –Easy to calculate

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Chapters 6 & 7 – MBA5049 Internal Rate of Return (IRR) Rule IRR: the discount that sets NPV to zero Minimum Acceptance Criteria: –Accept if the IRR exceeds the required return. Ranking Criteria: –Select alternative with the highest IRR Reinvestment assumption: –All future cash flows assumed reinvested at the IRR.

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Chapters 6 & 7 – MBA50410 Example Consider the following project: 0123 $50$100$150 -$200 The internal rate of return for this project is 19.44%

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Chapters 6 & 7 – MBA50411 NPV Payoff Profile for The Example If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept. IRR = 19.44%

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Chapters 6 & 7 – MBA50412 Problems with the IRR Approach Multiple IRRs. The Scale Problem. The Timing Problem.

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Chapters 6 & 7 – MBA50413 Multiple IRRs There are two IRRs for this project: 0 1 2 3 $200 $800 -$200 - $800 100% = IRR 2 0% = IRR 1 Which one should we use?

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Chapters 6 & 7 – MBA50414 The Scale Problem Would you rather make 100% or 50% on your investments? What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment?

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Chapters 6 & 7 – MBA50415 The Timing Problem (page 161) 0 1 2 3 $10,000 $1,000$1,000 -$10,000 Project A 0 1 2 3 $1,000 $1,000 $12,000 -$10,000 Project B The preferred project in this case depends on the discount rate, not the IRR.

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Chapters 6 & 7 – MBA50416 Mutually Exclusive vs. Independent Project Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system. –RANK all alternatives and select the best one. Independent Projects: accepting or rejecting one project does not affect the decision of the other projects. –Must exceed a MINIMUM acceptance criteria.

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Chapters 6 & 7 – MBA50417 Discount rate 2% 6% 10% 14%18% 60 40 20 0 – 20 – 40 Net present value – 60 – 80 – 100 22% IRR A IRR B 0 140 120 100 80 160 Year 0 1 2 3 4 Project A:– $35050100150200 Project B:– $2501251007550 26% Crossover Point Which project is good?

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Chapters 6 & 7 – MBA50418

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Chapters 6 & 7 – MBA50419 Decision Rule If required rate of return < crossover return, take the project with lower IRR If required rate of return > crossover return, take the project with higher IRR Don’t think a project with higher IRR is always good Projects with higher NPV is always good

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Chapters 6 & 7 – MBA50420 Profitability Index (PI) Rule Minimum Acceptance Criteria: Accept if PI > 1 Ranking Criteria: Select alternative with highest PI Disadvantages: Problems with mutually exclusive investments Advantages: –May be useful when available investment funds are limited –Easy to understand and communicate –Correct decision when evaluating independent projects

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Chapters 6 & 7 – MBA50421 Practice of Capital Budgeting Varies by industry: –Some firms use payback, others use accounting rate of return. The most frequently used technique for large corporations is IRR or NPV.

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Chapters 6 & 7 – MBA50422 Example of Investment Rules Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%. Year Project A Project B 0-$200-$150 1$200$50 2$800$100 3-$800$150

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Chapters 6 & 7 – MBA50423 Incremental Cash Flows Cash flows matter—not accounting earnings. Sunk costs don’t matter. Incremental cash flows matter. Opportunity costs matter. Side effects like cannibalism and erosion matter. Taxes matter: we want incremental after-tax cash flows. Inflation matters.

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Chapters 6 & 7 – MBA50424 Cash Flows—Not Accounting Earnings Consider depreciation expense. You never write a check made out to “depreciation”. Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.

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Chapters 6 & 7 – MBA50425 Incremental Cash Flows Sunk costs are not relevant –Just because “we have come this far” does not mean that we should continue to throw good money after bad. Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed.

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Chapters 6 & 7 – MBA50426 Incremental Cash Flows Side effects matter (page 180) –Erosion –Synergy

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Chapters 6 & 7 – MBA50427 Estimating Cash Flows Cash Flows from Operations –Recall that: Operating Cash Flow = EBIT – Taxes + Depreciation Net Capital Spending –Don’t forget salvage value (after tax, of course). Changes in Net Working Capital –Recall that when the project winds down, we enjoy a return of net working capital.

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Chapters 6 & 7 – MBA50428 The Baldwin Company: An Example (page 181) Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $150,000. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5- year life). Salvage value of 30,000. Increase in net working capital: $10,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $10 per unit and increase 10% per year thereafter. Annual inflation rate: 5% Tax rate is 34 percent Working Capital: initially $10,000 changes with sales.

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Chapters 6 & 7 – MBA50429 Key Issues Dis-regard sunk costs Consider incremental cash flow – additional cash flows Figure out revenue, cost, depreciation, tax, capital spending, addition to net work capital Refer to this example when you take advanced corporate finance to deal with capital budgeting or meet this kind of problem in your work

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