Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 1 CHAPTER 10 The Fundamentals of Capital Budgeting

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 2 Introduction to Capital Budgeting Introduction to Capital Budgeting  Capital-budgeting decisions are the most important investment decisions made by management. The Importance of Capital Budgeting  The goal of these decisions is to select capital projects that will increase the value of the firm.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 3 Introduction to Capital Budgeting  The cost of capital is the minimum return that a capital- budgeting project must earn for it to be accepted. Basic Capital-Budgeting Terms  It is an opportunity cost since it reflects the rate of return investors can earn on financial assets of similar risk.  Capital rationing implies that a firm does not have the resources necessary to fund all of the available projects.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 4 Introduction to Capital Budgeting  Capital rationing implies that funding needs exceed funding resources. Basic Capital-Budgeting Terms  Thus, the available capital will be allocated to the projects that will benefit the firm and its shareholders the most.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 5 Net Present Value  The present value of a project is the difference between the present value of the expected future cash flows and the initial cost of the project. NPV – The Basic Concept  Accepting a positive NPV project leads to an increase in shareholder wealth, while accepting a negative NPV project leads to a decline in shareholder wealth.  Projects that have an NPV equal to zero implies that management will be indifferent between accepting and rejecting the project.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 6 Net Present Value  The NPV technique uses the discounted cash flow technique. Framework for Calculating NPV  Our goal is to compute the net cash flow (NCF) for each time period t, where: NCF t = (Cash inflows − Cash outflows) for the period t

Exhibit 10.3: Pocket Pizza Project Timeline and Cash Flows

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 8 Net Present Value 1.Determine the cost of the project. A five-step approach can be utilized to compute the NPV  Identify and add up all expenses related to the cost of the project.  While we are mostly looking at projects whose entire cost occurs at the start of the project, we need to recognize that some projects may have costs occurring beyond the first year also.  The cash flow in year 0 (NCF 0 ) is negative, indicating a cost.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 9 Net Present Value 2.Estimate the project’s future cash flows over its forecasted life. A five-step approach can be utilized to compute the NPV  Both cash inflows (CIF) and cash outflows (COF) are likely in each year of the project. Estimate the net cash flow (NCF t ) = CIF t – COF t for each year of the project.  Remember to recognize any salvage value from the project in its terminal year.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 10 Net Present Value 3.Determine the riskiness of the project and estimate the appropriate cost of capital. A five-step approach can be utilized to compute the NPV  The cost of capital is the discount rate used in determining the present value of the future expected cash flows.  The riskier the project, the higher the cost of capital for the project.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 11 Net Present Value 4.Compute the project’s NPV. A five-step approach can be utilized to compute the NPV  Determine the difference between the present value of the expected cash flows from the project and the cost of the project. 5.Make a decision.  Accept the project if it produces a positive NPV or reject the project if NPV is negative.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 12 Net Present Value NPV Example Find the net present value of the example in Exhibit 10.3.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 13 Using Excel - Net Present Value

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 14 The Payback Period  It is one of the most widely used tools for evaluating capital projects. The Payback Period  The payback period represents the number of years it takes for the cash flows from a project to recover the project’s initial investment.  A project is accepted if its payback period is below some pre-specified threshold.  This technique can serve as a risk indicator–the more quickly you recover the cash, the less risky is the project.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 15 The Payback Period  To compute the payback period, we need to know the project’s cost and estimate its future net cash flows. Computing the Payback Period  Equation 10.2 shows how to compute the payback period.

Exhibit 10.5: Payback Period Cash Flows and Calculations

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 17 The Payback Period Calculate the payback period for the example in Exhibit Payback Period Example

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 18 The Payback Period  There is no economic rationale that links the payback method to shareholder wealth maximization. Computing the Payback Period  If a firm has a number of projects that are mutually exclusive, the projects are selected in order of their payback rank: projects with the lowest payback period are selected first.

Exhibit 10.6: Payback Period with Various Cash-Flow Patterns

Exhibit 10.7: Discounted Payback Period Cash Flows and Calculations

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 21 The Payback Period  However, this method still ignores all cash flows after the arbitrary cutoff period, which is a major flaw. The Discounted Payback Period

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 22 The Payback Period  The standard payback period is widely used in business. Evaluating the Payback Rule  It provides a simple measure of an investment’s liquidity risk.  The greatest advantage of the payback period is its simplicity.  It ignores the time value of money.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 23 Internal Rate of Return  When we use the IRR, we are looking for the rate of return associated with a project so we can determine whether this rate is higher or lower than the firm’s cost of capital.  The IRR is the discount rate that makes the NPV to equal zero.

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 24 Calculating the IRR Internal Rate of Return  The IRR is an expected rate of return, much like the yield to maturity calculation that was made on bonds.  We will need to apply the same trial-and-error method to compute the IRR.

Exhibit 10.9: NPV Profile for the Ford Project

Exhibit 10.8: Time Line and Cash Flows for Ford Project

Chapter 6 – Multiple Cash FlowsCopyright 2008 John Wiley & Sons 27 Using Excel - Internal Rate of Return

28 Net present value: Kingston, Inc., is looking to add a new machine at a cost of $3,940,900. The company expects this equipment will lead to cash flows of Year 1 $756,342 Year 2 $887,619, Year 3 $941,280 Year 4 $1,097,260 Year 5 $1,128,538 Year 6 $1,299,603 over the next six years. If the appropriate discount rate is 15 percent, the NPV of this investment is $

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