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CAPITAL BUDGETING CHAPTER 11 Decision Rules Reinvestment Rate Assumptions Sensitivity Analysis

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CAPITAL BUDGETING Investors require stock price appreciation. To increase stock price, companies must become more profitable in order to increase the value of the firm’s stock. Accordingly, [Financial] managers must make certain that new investments will increase the value of the firm.

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CAPITAL BUDGETING A. Learning Objectives 1.Learn key decision rules. 2.Learn analytical methodology B. Business Objectives 1.Minimize the probability of losses 2.Recall that many new products / ventures fail and failures are expensive. 3.We want to make the most informed decision.

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CAPITAL BUDGETING C. Capital Investment [Classifications] 1. Renewal: Modernize, Overhaul, Retrofit 2. Replacement: Replace worn out equipment 3. Expansion: Adding physical capacity 4. Other: A variety of corporate objectives. Primary Objective: Increase value of firm!

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CAPITAL BUDGETING D. The Data Inputs; What Information Is Necessary? 1. Type of project; new investment or replacement? 2. Expected economic life of the project (in years). 3. Initial outlay of cash required to finance project. 4. Identifying timing and magnitude of future cash flows.

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CAPITAL BUDGETING E.The Hurdle Rate 1.Capital investments subject to one important constraint: Investment must earn a rate of return greater than the cost of capital (WACC). 2.The hurdle rate is the market derived weighted average of investor required rates of return on company’s stocks and bonds.

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FIVE STEP CAPITAL BUDGETING PROCESS A.Proposal Generation: Schedule the Investment Opportunity Set. B.Analysis: Evaluate Each Opportunity. C.Decision Making: Select best of the Opportunity Set. D. Implementation: Assure Project Development Compliance E.Control: Performance Assessment

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CAPITAL INVESTMENT DECISION RULES A.Net Present Value: NPV >> 0 1.Note my use of the much greater than symbol (>>) rather than the text’s ( ). If I am going to put capital at risk - I don’t want to just breakeven ! B.Internal Rate of Return: IRR > k a 1. IRR is the discount rate which makes NPV = zero. 2. The assumed reinvestment rate for cash flows. 3. If NPV greater than zero, then IRR is greater than k a.

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CAPITAL INVESTMENT DECISION RULES C.Payback Period 1. How long will it take to recover the initial outlay from After-Tax Cash Flows (ATCF)? 2. Many smaller companies are asked for this information by banks before getting loans. 3. Problem: Ignores the time value of money.

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CAPITAL INVESTMENT DECISION RULES D.NPV Profile 1. To create a profile, calculate net present value at different discount rates. 2. The rate for a zero NPV is the IRR for the project. E. Problem of Multiple IRR 1. When signs change more than once. 2. Cartesian Rule of Signs; number if solutions.

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CAPITAL INVESTMENT DECISION RULES F. Modified Internal Rate of Return 1.The NPV and IRR models assume that ATCF are reinvested at the WACC or the IRR, respectively. 2.A problem with the IRR is that it may be unattainable over the long run. 3.The MIRR is that rate which takes the terminal value (TV) of the reinvested cash flows and computes the discount rate that makes the TV equal to the initial outlay. See text for MIRR model example.

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HOMEWORK CHAPTER 11 A.Self-test: ST-1, parts b, c, e, g B.Questions: 11-4, 11-7, 11-9 C.Problems: 11-1, 11-2, 11-4, 11-13 Re 11-13: How do the timing and magnitudes of future cash flows influence the IRR? MIRR?

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