2 A major part of the financial management of the firm Capital BudgetingA major part of the financial management of the firmKinds Of Spending In BusinessShort term - to support day to day operationsLong term - to support long lived equipment and projectsLong term money and the things acquired with it are both called capitalCapital BudgetingPlanning and Justifying How Capital Dollars Are Spent On Long Term ProjectsProvides methods for evaluating whether projects make financial sense and for choosing among them
3 Capital BudgetingCapital budgeting involves planning and justifying large expenditures on long-term projectsProjects can be classified as:Replacement – low riskExpansion – moderate riskNew venture – high risk
4 Characteristics of Business Projects Project Types and RiskCapital projects have increasing risk according to whether they are replacements, expansions or new venturesStand-Alone and Mutually Exclusive ProjectsStand-alone project has no competing alternativesMutually exclusive projects involve selecting one project from among two or more alternatives
5 Characteristics of Business Projects Project Cash FlowsReduce projects to a series of cash flows:C0 $(50,000)C1 (10,000)C ,000C ,000C ,000C ,000Business projects: early cash outflows and later inflowsC0 is the Initial Outlay and usually required to get started
6 Characteristics of Business Projects The Cost of CapitalThe average rate a firm pays investors for use of its long term moneyFirms raise money from two sources: debt and equity
7 Capital Budgeting Techniques Payback PeriodHow many years to recover initial costNet Present ValuePresent value of inflows less outflowsInternal Rate of ReturnProject’s return on investmentProfitability IndexRatio of present value of inflows to outflows
8 Capital Budgeting Techniques Payback Payback period is the time it takes to recover early cash outflowsShorter paybacks are betterPayback Decision RulesStand-alone projectsMutually Exclusive ProjectsWeaknesses of the Payback MethodIgnores time value of moneyIgnores cash flows after payback period
9 Concept Connection Example 10-1 Payback Period Payback period is easily visualized by the cumulative cash flows
10 Example 10-2: Weakness of the Payback Technique Use the payback period technique to choose between mutually exclusive projects A and B.Project A’s payback is 3 years as its initial outlay is fully recovered in that time. Project B doesn’t fully recover until sometime in the 4th year. Thus, according to the payback method, Project A is better than B. But project B is clearly better because of the large inflows in the last two years
11 NET PRESENT VALUE (NPV) The present value of future cash flows is what countswhen making decisions based on value.The Net Present Value of all of a project's cash flows is its expected contributionto the firm's value and shareholder wealthPVs are taken at k, the cost of capitalCalculate NPV usingNPV = C0 + C1[PVFk,1] + C2[PVFk,2] + · · · + Cn[PVFk,n]Outflows are Ci with negative values and tend to occur firstNPV: Difference between the present values of positives and negativesProjects with positive NPVs increase the firm’s valueProjects with negative NPVs decrease the firm’s value
12 Net Present Value (NPV) NPV and Shareholder WealthA project’s NPV is the net effect that it is expected to have on the firm’s valueTo maximize shareholder wealth, select the capital spending program with the highest NPV
13 Net Present Value (NPV) Decision RulesStand-alone ProjectsNPV > 0 acceptNPV < 0 rejectMutually Exclusive ProjectsNPVA > NPVB choose Project A over B
14 Concept Connection Example 10-3 Net Present Value (NPV) Project Alpha has the following cash flows. If the firm considering Alpha has a cost of capital of 12%, should the project be undertaken?
15 Concept Connection Example 10-3 Net Present Value (NPV) The NPV is found by summing the present value of the cash flows when discounted at the firm’s cost of capital.Since Alpha’s NPV<0, it should not be undertaken.
16 Internal Rate of Return (IRR) A project’s IRR is the return it generates on the investment of its cash outflowsFor example, if a project has the following cash flowsThe “price” of receivingthe inflowsThe IRR is the interest rate at which the present value of the three inflows just equals the $5,000 outflow
17 Defining IRR Through the NPV Equation At the IRR the PVs of project inflows andoutflows are equal, so NPV = 0Set NPV=0 and substitute IRR for k0 = C0 + C1[PVFIRR,1] + C2[PVFIRR,2] + · · + Cn[PVFIRR,n]IRR is the solution to this equation for a given set of CiRequires an iterative approach if the Ci are irregular
18 Internal Rate of Return (IRR) Decision RulesStand-alone ProjectsIf IRR > cost of capital (k) acceptIf IRR < cost of capital (k) rejectMutually Exclusive ProjectsIRRA > IRRB choose Project A over Project B
19 Internal Rate of Return (IRR) Calculating IRRsFinding IRRs usually requires an iterative, trial-and-error techniqueGuess at the project’s IRRCalculate the project’s NPV using this interest rateIf NPV = zero, guessed interest rate is the project’s IRRIf NPV > 0, try a higher interest rateIf NPV < 0, try a lower interest rate
20 Concept Connection Example 10-5 IRR – Iterative Procedure Find the IRR for the following series of cash flows:If the firm’s cost of capital is 8%, is the project a good idea? What if the cost of capital is 10%?
21 Example 10-5 IRR – Iterative Procedure Start by guessing IRR = 12% and calculate NPV.NPV = C0 + C1[PVFk,1] + C2[PVFk,2] + · · · + Cn[PVFk,n]NPV = -5, ,000[PVF12,1] + 2,000[PVF12,2] + 3,000[PVF12,3]NPV = -5, ,000[.8929] + 2,000[.7972] + 3,000[.7118]NPV = -5, , ,135.40NPV = -$377.30Since NPV<0, the project’s IRR must be < 12%.
22 Figure 10-1 NPV ProfileA project’s NPV profile is a graph of its NPV vs. the cost of capital. It crosses the horizontal axis at the IRR.
23 Concept Connection Example 10-5 IRR – Iterative Procedure We’ll try a different, lower interest rate, say 10%. At 10%, the project’s NPV is ($184). Since the NPV is still less than zero, we need to try a still lower interest rate, say 9%. The following table lists the project’s NPV at different interest rates.Interest Rate GuessCalculated NPV12%($377)Since NPV becomes positive somewhere between 8% and 9%, the project’s IRR must be between 8% and 9%. If the firm’s cost of capital is 8%, the project is marginal. If the firm’s cost of capital is 10%, the project is not a good idea.10($184)9($83)8$227$130
24 Techniques: Internal Rate of Return (IRR) Technical Problems with IRRMultiple SolutionsUnusual projects can have more than one IRRThe number of positive IRRs to a project depends on the number of sign reversals to the project’s cash flowsThe Reinvestment AssumptionIRR method implicitly assumes cash inflows will be reinvested at the project’s IRR
25 Comparing IRR and NPVNPV and IRR do not always select the same project in mutually exclusive decisionsA conflict can arise if NPV profiles cross in the first quadrantIn the event of a conflict The selection of the NPV method is preferred
26 Figure 10-2 Projects for Which IRR and NPV Can Give Different Solutions At a cost of capital of k1, Project A is better than Project B, while at k2 the opposite is true.
27 PROJECTS WITH A SINGLE OUTFLOW AND REGULAR INFLOWS Many projects are characterized by an initial outflow and a series of equal, regular inflows:PV of annuity formula makes the pattern easy to work withNPV: NPV = C0 + C [PVFAk,n]IRR: = C0 + C [PVFAIRR,n]
28 Example 10-6 – Regular Cash Inflows Find the NPV and IRR for the following project if the cost of capital is 12%.C C C C3($5,000) $2, $2, $2,000Solution: For NPVNPV = C0 + C[PVFAk,n]= -$5,000 + $2,000[PVFA12,3]= -$5,000 + $2,000(2.4018)= -$196.40For IRR0 = C0 + C[PVFAIRR,n]= -$5,000 + $2,000[PVFAIRR,3]PVFAIRR,3 = $5,000 / $2,000=From which IRR is between 9% and 10%
29 Profitability Index (PI) Is a variation on the NPV methodA ratio of the present value of a project’s inflows to the present value of a project’s outflowsProjects are acceptable if PI>1
30 Profitability Index (PI) Also known as the benefit/cost ratioPositive future cash flows are the benefitNegative initial outlay is the cost
31 Profitability Index (PI) Decision RulesStand-alone ProjectsIf PI > 1.0 acceptIf PI < 1.0 rejectMutually Exclusive ProjectsPIA > PIB choose Project A over Project BComparison with NPVWith mutually exclusive projects the two methods may not lead to the same choices
32 Comparing Projects with Unequal Lives If a significant difference exists between mutually exclusive projects’ lives, a direct comparison is meaninglessThe problem arises due to the NPV methodLonger lived projects almost always have higher NPVs
33 Comparing Projects with Unequal Lives Two solutions existReplacement Chain MethodExtends projects until a common time horizon is reachedEquivalent Annual Annuity (EAA) MethodReplaces each project with an equivalent perpetuity that equates to the project’s original NPV
34 Concept Connection Example 10-8 Replacement Chain The IRR method argues for undertaking the Short-Lived Project while the NPV method argues for the Long-Lived Project. We’ll correct for the unequal life problem by using both the Replacement Chain Method and the EAA Method. Both methods will lead to the same decision.Thus, choosing the Long-Lived Project is a better decision than choosing the Short-Lived Project twice.
35 Concept Connection Example 10-8 Replacement Chain Which of the two following mutually exclusive projects should a firm purchase?
36 Concept Connection Example 10-9 Equivalent Annual Annuity (EAA) The EAA Method equates each project’s original NPV to an equivalent annual annuity. For the Short-Lived Project the EAA is $ (the equivalent of receiving $ spread out over 3 years at 8%); while the Long-Lived Project has an EAA of $ (the equivalent of receiving $ spread out over 6 years at 8%).
37 Concept Connection Example 10-9 Equivalent Annual Annuity (EAA) Because the Long-Lived Project has the higher EAA, it should be chosen. This is the same decision reached by the Replacement Chain Method.
38 Capital RationingUsed when capital funds for new projects are limitedGenerally rank projects in descending order of IRR and cut off at the cost of capitalHowever this doesn’t always make the best use of capital so a complex mathematical process called constrained maximization can be used
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