Chapter 9

Capital Budgeting Techniques and Practice  2000, Prentice Hall, Inc.

Capital Budgeting: the process of planning for purchases of long- term assets. n example: Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? n Will the machine be profitable? n Will our firm earn a high rate of return on the investment?

Decision-making Criteria in Capital Budgeting How do we decide if a capital investment project should be accepted or rejected?

n The Ideal Evaluation Method should: a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project. Decision-making Criteria in Capital Budgeting

Three Basic Methods of Evaluating Projects 1. Payback Method 2. Net Present Value (NPV) 3. Internal Rate of Return (IRR)

Payback Period n How long will it take for the project to generate enough cash to pay for itself? (500) Payback period = 3.33 years.

n Is a 3.33 year payback period good? n Is it acceptable? n Firms that use this method will compare the payback calculation to some standard set by the firm. n If our senior management had set a cut- off of 5 years for projects like ours, what would be our decision? n Accept the project. Payback Period

Drawbacks of Payback Period n Firm cutoffs are subjective. n Does not consider time value of money. n Does not consider any required rate of return. n Does not consider all of the project’s cash flows.

Drawbacks of Payback Period n Does not consider all of the project’s cash flows. n This project is clearly unprofitable, but we would accept it based on a 4- year payback criterion! (500) (300) 0 0

Other Methods 1) Net Present Value (NPV) 2) Internal Rate of Return (IRR) Each of these decision-making criteria: n Examines all net cash flows, n Considers the time value of money, and n Considers the required rate of return.

Net Present Value  NPV = the total PV of the annual net cash flows - the initial outlay. NPV = - IO ACF t ACF t (1 + k) t nt=1 

Net Present Value  Decision Rule:  If NPV is positive, accept.  If NPV is negative, reject.

NPV Example , , , , , ,000 n Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15%.

Net Present Value (NPV) NPV is just the PV of the annual cash flows minus the initial outflow. Using TVM: P/Y = 1 N = 5 I = 15 PMT = 100,000 PV of cash flows = $335,216 PV of cash flows = $335,216 - Initial outflow: ($250,000) - Initial outflow: ($250,000) = Net PV $85,216 = Net PV $85,216

NPV with the TI BAII Plus: n Select CF mode. n CFo=? -250,000 ENTER n C01=? 100,000 ENTER n F01= 1 5 ENTER n NPV I= 15 ENTER CPT n You should get NPV = 85,215.51

Internal Rate of Return (IRR) n IRR: the return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

Internal Rate of Return (IRR) NPV = - IO ACF t ACF t (1 + k) t nt=1

Internal Rate of Return (IRR) NPV = - IO ACF t ACF t (1 + k) t nt=1 n t=1  IRR: = IO ACF t (1 + IRR) t

Internal Rate of Return (IRR) n IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay. n This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond. n t=1  IRR: = IO ACF t (1 + IRR) t

Calculating IRR n Looking again at our problem: n The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay , , , , , ,000

IRR with your Calculator n IRR is easy to find with your financial calculator. n Just enter the cash flows as you did with the NPV problem and solve for IRR. n You should get IRR = 28.65%!

IRR  Decision Rule:  If IRR is greater than or equal to the required rate of return, accept.  If IRR is less than the required rate of return, reject.

Summary Problem n Enter the cash flows only once. n Find the IRR. n Using a discount rate of 15%, find NPV (900)

Summary Problem n IRR = 34.37%. n Using a discount rate of 15%, NPV = $ NPV = $ (900)

Capital Rationing n Suppose that you have evaluated 5 capital investment projects for your company. n Suppose that the VP of Finance has given you a limited capital budget. n How do you decide which projects to select?

Capital Rationing n You could rank the projects by IRR: IRR5% 10% 15% 20% 25% $

Capital Rationing n You could rank the projects by IRR: IRR5% 10% 15% 20% 25% $ $X Our budget is limited so we accept only projects 1, 2, and 3.

Capital Rationing n You could rank the projects by IRR: IRR5% 10% 15% 20% 25% $ 1 23 $X Our budget is limited so we accept only projects 1, 2, and 3.

Problems with Project Ranking 1) Mutually exclusive projects of unequal size (the size disparity problem) n The NPV decision may not agree with IRR. n Solution: select the project with the largest NPV.

Size Disparity example Project A yearcash flow yearcash flow 0(135,000) 0(135,000) 1 60, , , , , ,000 required return = 12% IRR = 15.89% NPV = $9,110

Size Disparity example Project B yearcash flow yearcash flow 0 (30,000) 0 (30,000) 1 15, , , , , ,000 required return = 12% IRR = 23.38% NPV = $6,027 Project A yearcash flow 0(135,000) 1 60, , ,000 required return = 12% IRR = 15.89% NPV = $9,110

Problems with Project Ranking 2) The time disparity problem with mutually exclusive projects. n NPV assumes cash flows are reinvested at the required rate of return for the project. n IRR assumes cash flows are reinvested at the IRR. n The NPV decision may not agree with the IRR. n Solution: select the largest NPV.

Time Disparity example Project B yearcash flow yearcash flow 0 (46,500) 0 (46,500) 1 36, , , , , , , ,400 required return = 12% IRR = 25.51% NPV = $8,455 Project A yearcash flow 0 (48,000) 1 1, , , ,000 required return = 12% IRR = 18.10% NPV = $9,436