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Chapter 6 Capital Budgeting Techniques © 2005 Thomson/South-Western

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

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3 Generating Ideas for Capital Projects 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. Procedures must be established for evaluating the worth of such projects.

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

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5 Similarities between Capital Budgeting and Asset Valuation Uses same steps as in general 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. [Note that we will explicitly address the risk issue in the next chapter. For now, risk is taken as given.] 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.

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6 Net Cash Flows for Project S and Project L 1,500 1,200 800 300 400 900 1,300 1,500 ^ Net CashFlows, CF t r edpAExctefte-Tax Year(T)ProjectSPro tL 0 a $(3,000)$( 0) 1 2 3 4

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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.

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

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

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

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11 Net Present Value: Sum of the PVs of Inflows and Outflows NPV= PV inflows - Cost = Net gain in wealth. Rule: Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV: Which project adds the most value?

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12 Calculator Solution, NPV for S : NPV S = 161.33 = NPV S Enter in CF for S: I -3,000 1500 1200 800 300 10% CF 0 CF 1 CF 2 CF 3 CF 4

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13 Calculator Solution, NPV for L : NPV L = 108.67 = NPV L Enter in CF for L: I -3,000 400 900 1,300 1,500 10% CF 0 CF 1 CF 2 CF 3 CF 4

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14 Using NPV method, which project(s) should be accepted? If Projects S and L are mutually exclusive accept S because NPV S > NPV L If Projects S & L are independent accept both since NPV > 0.

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15 Internal Rate of Return: IRR 0123 CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows to equal the cost. IRR forces NPV = 0.

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16 What is Project S’s IRR? NPV S = IRR S = 13.1% Enter CFs in CF register, then press IRR: 0 (3,000) IRR = ? 01234 Sum of PVs for CF 1-4 = 3,000 1,5008001,200300

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17 What is Project L’s IRR? NPV L = Enter CFs in CF register, then press IRR: IRR L = 11.4% 0 IRR = ? 40013009001500 01234 Sum of PVs for CF 1-4 = 3,000 (3,000)

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18 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 = ? -1134.20 IRR = 7.08% (use TVM or CF register)

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19 Rationale for the IRR Method: If IRR (project’s rate of return) > the firm’s required rate of return, k, then some return is left over to boost stockholders’ returns. Example: k = 10%, IRR = 15%. The project is profitable.

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20 IRR acceptance criteria: If IRR > k (= the firm’s required rate of return), accept project. If IRR < k (= the firm’s required rate of return), reject project.

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21 Decisions on Projects S and L per IRR If S and L are independent, accept both. IRRs > k = 10%. If S and L are mutually exclusive, accept S because IRR S > IRR L.

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22 Construct NPV Profiles Enter CFs in your calculator and find NPV L and NPV S at several discount rates (k): k 0 5 10 15 20 NPV L 1,100 554 109 (259) (566) NPV S 800 455 161 ( 91) (309)

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23 IRR L = 11.4% IRR S = 13.1% Crossover Point = 8.1% k 0 5 10 15 20 NPV L 1,100 554 109 (259) (566) NPV S 800 455 161 ( 91) (309) NPV Profiles for Project S and Project L Project L Project S

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

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25 Mutually Exclusive Projects k NPV S, IRR L < IRR S CONFLICT k> 8.1: NPV S > NPV L, IRR S > IRR L NO CONFLICT 8.1 NPV % IRR s IRR L S L

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26 To Find the Crossover Rate: 1. Find cash flow differences between the projects. See data at beginning of the case (repeated on next slide). 2. Enter these differences in CF register, then press IRR. Crossover rate = 8.11, rounded to 8.1%. 3. Can subtract S from L or vice versa. 4. If profiles don’t cross, one project dominates the other.

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27 Net Cash Flows for Project S and Project L 1,500 1,200 800 300 400 900 1,300 1,500 ^ Net CashFlows, CF t r edpAExctefte-Tax Year(T)ProjectSPro tL 0 a $(3,000)$( 0) 1 2 3 4

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28 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 opportunity 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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29 Reinvestment Rate Assumptions NPV assumes reinvest at k. IRR assumes reinvest at IRR. Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

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30 Before Next Class: 1.Review Chapter 6 materials 2.Do chapter 6 homework 3.Prepare for Quiz on Ch 6 4.Read chapter 7

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