Capital Budgeting Net Present Value Rule Payback Period Rule Discounted Payback Period Rule Average Accounting Return Internal Rate of Return Profitability Index Practice of Capital Budgeting Incremental Cash Flow Chapters 6 & 7 – MBA504

Net Present Value (NPV) Rule Total PV of future CF’s + Initial Investment Estimating NPV: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV Chapters 6 & 7 – MBA504

Example Assume you have the following information on Project X: Initial outlay -$1,100 Required return = 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1,000 $500 2 2,000 1,000 Calculate its NPV. Chapters 6 & 7 – MBA504

The Payback Period Rule How long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria: set by management Disadvantages Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Chapters 6 & 7 – MBA504

Initial outlay -$1,000 Year Cash flow 1 $200 2 400 3 600 Accumulated 1 1 $200 2 400 3 600 Accumulated 1 2 3 Payback period = Chapters 6 & 7 – MBA504

Discounted Payback Period Rule How long does it take the project to “pay back” its initial investment taking the time value of money into account? By the time you have discounted the cash flows, you might as well calculate the NPV. Chapters 6 & 7 – MBA504

Example 1 $ 200 $ 182 Initial outlay -$1,000 R = 10% PV of Year Cash flow Cash flow 1 $ 200 $ 182 2 400 331 3 700 526 4 300 205 Accumulated: Year discounted cash flow 1 $ 182 2 513 3 1,039 4 1,244 Discounted payback period is Chapters 6 & 7 – MBA504

Average Accounting Return Rule Another attractive but fatally flawed approach. Ranking Criteria and Minimum Acceptance Criteria set by management Disadvantages: Ignores the time value of money Uses an arbitrary benchmark cutoff rate Based on book values, not cash flows and market values Advantages: The accounting information is usually available Easy to calculate Chapters 6 & 7 – MBA504

Internal Rate of Return (IRR) Rule IRR: the discount that sets NPV to zero Minimum Acceptance Criteria: Accept if the IRR exceeds the required return. Ranking Criteria: Select alternative with the highest IRR Reinvestment assumption: All future cash flows assumed reinvested at the IRR. Chapters 6 & 7 – MBA504

Example Consider the following project: 1 2 3 $50 $100 $150 -$200 The internal rate of return for this project is 19.44% Chapters 6 & 7 – MBA504

NPV Payoff Profile for The Example If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept. IRR = 19.44% Chapters 6 & 7 – MBA504

Problems with the IRR Approach Multiple IRRs. The Scale Problem. The Timing Problem. Chapters 6 & 7 – MBA504

Multiple IRRs There are two IRRs for this project: 0 1 2 3 $200 $800 -$200 - $800 Which one should we use? 100% = IRR2 0% = IRR1 Chapters 6 & 7 – MBA504

The Scale Problem Would you rather make 100% or 50% on your investments? What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment? Chapters 6 & 7 – MBA504

The Timing Problem (page 161) 0 1 2 3 $10,000 $1,000 $1,000 -$10,000 Project A 0 1 2 3 $1,000 $1,000 $12,000 -$10,000 Project B The preferred project in this case depends on the discount rate, not the IRR. Chapters 6 & 7 – MBA504

Mutually Exclusive vs. Independent Project Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system. RANK all alternatives and select the best one. Independent Projects: accepting or rejecting one project does not affect the decision of the other projects. Must exceed a MINIMUM acceptance criteria. Chapters 6 & 7 – MBA504

Which project is good? Chapters 6 & 7 – MBA504 Net present value Year 0 1 2 3 4 Project A: – $350 50 100 150 200 Project B: – $250 125 100 75 50 160 140 120 100 80 60 40 Crossover Point 20 – 20 – 40 – 60 – 80 – 100 Discount rate 2% 6% 10% 14% 18% 22% 26% IRR A IRR B Chapters 6 & 7 – MBA504

Chapters 6 & 7 – MBA504

Decision Rule If required rate of return < crossover return, take the project with lower IRR If required rate of return > crossover return, take the project with higher IRR Don’t think a project with higher IRR is always good Projects with higher NPV is always good Chapters 6 & 7 – MBA504

Profitability Index (PI) Rule Minimum Acceptance Criteria: Accept if PI > 1 Ranking Criteria: Select alternative with highest PI Disadvantages: Problems with mutually exclusive investments Advantages: May be useful when available investment funds are limited Easy to understand and communicate Correct decision when evaluating independent projects Chapters 6 & 7 – MBA504

Practice of Capital Budgeting Varies by industry: Some firms use payback, others use accounting rate of return. The most frequently used technique for large corporations is IRR or NPV. Chapters 6 & 7 – MBA504

Example of Investment Rules Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%. Year Project A Project B 0 -$200 -$150 1 $200 $50 2 $800 $100 3 -$800 $150 Chapters 6 & 7 – MBA504

Incremental Cash Flows Cash flows matter—not accounting earnings. Sunk costs don’t matter. Incremental cash flows matter. Opportunity costs matter. Side effects like cannibalism and erosion matter. Taxes matter: we want incremental after-tax cash flows. Inflation matters. Chapters 6 & 7 – MBA504

Cash Flows—Not Accounting Earnings Consider depreciation expense. You never write a check made out to “depreciation”. Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows. Chapters 6 & 7 – MBA504

Incremental Cash Flows Sunk costs are not relevant Just because “we have come this far” does not mean that we should continue to throw good money after bad. Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed. When I was an undergrad at the University of Missouri-Rolla, a good friend of mine abandoned college three credit hours shy of graduation. Really. Entreaties from his friends and parents regarding how far he had come and how hard he had worked could not change Louis’ mind. That was all a sunk cost to Louis. He already had a job and didn’t value the degree as much as the incremental work of an easy three-hour required class called ET-10 engineering drafting. Fifteen years later, he still has a good job, a great wife and two charming daughters. Louis taught me a lot about sunk costs. Chapters 6 & 7 – MBA504

Incremental Cash Flows Side effects matter (page 180) Erosion Synergy When I was an undergrad at the University of Missouri-Rolla, a good friend of mine abandoned college three credit hours shy of graduation. Really. Entreaties from his friends and parents regarding how far he had come and how hard he had worked could not change Louis’ mind. That was all a sunk cost to Louis. He already had a job and didn’t value the degree as much as the incremental work of an easy three-hour required class called ET-10 engineering drafting. Fifteen years later, he still has a good job, a great wife and two charming daughters. Louis taught me a lot about sunk costs. Chapters 6 & 7 – MBA504

Estimating Cash Flows Cash Flows from Operations Net Capital Spending Recall that: Operating Cash Flow = EBIT – Taxes + Depreciation Net Capital Spending Don’t forget salvage value (after tax, of course). Changes in Net Working Capital Recall that when the project winds down, we enjoy a return of net working capital. Chapters 6 & 7 – MBA504

The Baldwin Company: An Example (page 181) Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $150,000. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Salvage value of 30,000. Increase in net working capital: $10,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $10 per unit and increase 10% per year thereafter. Annual inflation rate: 5% Tax rate is 34 percent Working Capital: initially $10,000 changes with sales. See the text for the details of the case. Chapters 6 & 7 – MBA504

Key Issues Dis-regard sunk costs Consider incremental cash flow – additional cash flows Figure out revenue, cost, depreciation, tax, capital spending, addition to net work capital Refer to this example when you take advanced corporate finance to deal with capital budgeting or meet this kind of problem in your work Chapters 6 & 7 – MBA504