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8-1 Chapter 8: Capital Budgeting Techniques

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8-2 n The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year. n Analysis of potential additions to fixed assets. n Long-term decisions; involve large expenditures. n Very important to firm’s future. What is Capital Budgeting?

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8-3 Generating Ideas for Capital Projects 4 A firm’s growth and its ability to remain competitive depend on a constant flow of ideas for new products, ways to make existing products better, and ways to produce output at a lower cost. 4 Procedures must be established for evaluating the worth of such projects.

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8-4 Project Classifications èReplacement Decisions: èReplacement Decisions: whether to purchase capital assets to take the place of existing assets to maintain or improve existing operations. èExpansion Decisions: èExpansion Decisions: whether to purchase capital projects and add them to existing assets to increase existing operations. èIndependent Projects: èIndependent Projects: Projects whose cash flows are not affected by decisions made about other projects. èMutually Exclusive Projects: èMutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted.

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8-5 Similarities between Capital Budgeting and Asset Valuation 1 Determine the cost, or purchase price, of the asset. 2 Estimate the cash flows expected from the project. 3 Assess the riskiness of cash flows. 4 Compute the present value of the expected cash flows to obtain as estimate of the asset’s value to the firm. 5 Compare the present value of the future expected cash flows with the initial investment. Uses same steps as in general asset valuation

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8-6 Net Cash Flows for Project S and Project L ^

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8-7 What is the Payback Period? The length of time before the original cost of an investment is recovered from the expected cash flows or... How long it takes to get our money back. PB = Number of years before full recovery of original investment Uncovered cost at start of full-recovery year Total cash flow during full-recovery year ( () ) Payback = +

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8-8 Payback Period for Project S Net Cash Flow Cumulative Net CF = Payback S 2 + 300/800 = 2.375 years 1,500 -1,500 800 500 1,200 -300 -3,000 300 800 PB S 01234

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8-9 Payback Period for Project L Net Cash Flow Cumulative Net CF = Payback L 3 + 400/1,500 = 3.3 years 400 - 2,600 1,300 - 400 900 - 1,700 - 3,000 1,500 1,100 PB L 01234

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8-10 Strengths of Payback: Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses of Payback: Ignores the TVM. Ignores CFs occurring after the payback period. Strengths an Weaknesses of Payback:

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8-11 Net Present Value: Sum of the PVs of Inflows and Outflows Cost often is CF 0 and is negative ^ ^ ^

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8-12 k = 10% 1,500 8001,200(3,000) 1,363.64 991.74 601.05 204.90 161.33 300 01234 What is Project S’s NPV? NPV S =

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8-13 k = 10% 400 1300900(3,000) 363.60 743.40 976.30 1024.50 107.80 1500 01234 What is Project L’s NPV? NPV L =

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8-14 Calculator Solution, NPV for L : Enter in CFLO for L: -3,000 400 900 1,300 1,500 CF 0 CF 1 NPV CF 2 CF 3 I = 107.80 = NPV L CF 4

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8-15 Rationale for the NPV method: NPV= PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

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8-16 n If Projects S and L are mutually exclusive, accept S because NPV s > NPV L n If S & L are independent, accept both; NPV > 0 Using NPV method, which project(s) should be accepted?

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8-17 Internal Rate of Return: IRR 0123 CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows = cost This is the same as forcing NPV = 0

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8-18 NPV: Enter k, solve for NPV. IRR: Enter NPV = 0, solve for IRR. Calculating IRR

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8-19 What is Project S’s IRR? IRR = ? 1,500 8001,200(3,000)300 01234 NPV S = IRR S = 13.1% Enter CFs in CF register, then press IRR: Sum of PVs for CF 1-4 = 3,000 0

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8-20 What is Project L’s IRR? IRR = ? 400 1300900(3,000)1500 01234 NPV L = Enter CFs in CF register, then press IRR: IRR L = 11.4% Sum of PVs for CF 1-4 = 3,000 0

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8-21 How is a Project’s IRR Related to a Bond’s YTM? They are the same thing. A bond’s YTM is the IRR if you invest in the bond. 90109090 012 10 IRR = ? -1134.2 IRR = 7.08% (use TVM or CF register)

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8-22 Rationale for the IRR Method: If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns. Example: WACC = 10%, IRR = 15%. Profitable.

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8-23 n If IRR > k, accept project. n If IRR < k, reject project. IRR acceptance criteria:

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8-24 Decisions on our Projects S and L per IRR: n If S and L are independent, accept both. IRRs > k = 10%. n If S and L are mutually exclusive, accept S because IRR S > IRR L.

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8-25 Construct NPV Profiles Enter CFs in CFLO and find NPV L and NPV S at several discount rates: k 0 5 10 15 20 NPV L 50 33 19 7 (4) NPV S 40 29 20 12 5

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8-26 NPV ($) Discount Rate (%) IRR L = 16.1% IRR S = 23.6% Crossover Point = 8.7% k 0 5 10 15 20 NPV L 50 33 19 7 (4) NPV S 40 29 20 12 5 S L NPV Profiles for Project S and Project L

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8-27 NPV and IRR always lead to the same accept/reject decision for independent projects: k > IRR and NPV < 0. Reject. NPV ($) k (%) IRR IRR > k and NPV > 0 Accept.

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8-28 Mutually Exclusive Projects 8.7 NPV % IRR s IRR L S k NPV S, IRR S > IRR L CONFLICT k> 8.7: NPV S > NPV L, IRR S > IRR L NO CONFLICT

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8-29 To Find the Crossover Rate: 1. Find cash flow differences between the projects. See data at beginning of the case. 2. Enter these differences in CF register, then press IRR. Crossover rate = 8.68, rounded to 8.7%. 3. Can subtract S from L or vice versa, but better to have first CF negative. 4. If profiles don’t cross, one project dominates the other.

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8-30 Two Reasons NPV Profiles Cross: 1) Size (scale) differences. 1) Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opp. cost, the more valuable these funds, so high k favors small projects. 2) Timing differences. 2) Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPV S > NPV L.

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8-31 Reinvestment Rate Assumptions n NPV assumes reinvest at k. n IRR assumes reinvest at IRR. n Reinvest at opp. cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

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1 Capital Budgeting Techniques © 2007 Thomson/South-Western.

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