1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University Principles of Finance Instructor: Asif Shamilov Spring 2010 Should we build this plant?

2 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Profitability Index Profitability Index is the ratio of project PV to initial cost or. Decision rule Take the project if PI > 1

3 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Capital rationing Happens when the firm (or division) has a limited amount of capital to invest In the case of capital rationing, it is better to select projects based on the profitability index When funds are limited, a firm should choose those projects that give more for each dollar invested Rank projects based upon their PIs. Invest in the projects with the highest PIs until all capital is exhausted (provided PI > 1).

4 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Profitability Index Example Suppose your division has been given a capital budget of $6,000. Which projects do you choose?

5 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Profitability Index Example Suppose your budget increases to $7,000. Choosing projects in descending order of PIs no longer maximizes the aggregate NPV. Projects A and C provide the highest aggregate NPV = $3,000 and stay within budget.

6 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Strengths and Weaknesses of PI Method Strength - It measures the wealth created per dollar of initial outlay Weakness - It does not take into account any investments in future periods (PV index is better in this case )

7 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Example:

8 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 PI(x) < PI(y) but NPV(x) > NPV(y) Example:

9 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0: In other words, IRR makes the present value of the project equal to its initial cost. Internal Rate of Return (IRR)

10 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Decision rule: Take the project If the IRR exceeds the required rate of return If IRR > k, accept project. If IRR < k, reject project. If projects are independent, accept both projects if IRR > k. If projects are mutually exclusive, accept one with the highest IRR IRR Acceptance Criteria

11 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 If IRR > the required rate of return, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns. Rationale for the IRR method

12 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 IRR Example Consider the company that has the opportunity to invest $100 million into the new equipment that will the following after-tax cash flows: Then, the IRR is IRR = 18.29% Therefore, accept the project if r<18.29% IRR = 18.29% Therefore, accept the project if r<18.29%

13 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 How is a project’s IRR similar to a bond’s YTM? They are the same thing. Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project. EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1, –Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

14 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Strengths: Many people find it a more intuitive measure than NPV Usually gives the same signal as NPV Weaknesses: Reinvestment rate assumption is unrealistic (IRR method assumes CFs are reinvested at IRR, whereas NPV method assumes CFs are reinvested at the required rate of return) Multiple IRR Strengths and Weaknesses of IRR Method

15 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 IRR Problems I: Borrowing or Lending? Consider the following two investment projects faced by a firm with k = 10%. Both projects have an IRR = 40%, but only project B is acceptable. –What is happening here?

16 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 IRR Problems II: Multiple IRRs/No IRRs Consider a firm with the following investment project and a discount rate of k= 25%. Typical if investment at the end: a) Repair environmental damage b) Dismantling of machine This project has two IRRs: one above k and the other below k. Which should be compared to the required rate of return? Happens with the non-conventional cash flows Year012IRR A %, 20%

17 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 IRR Problems III: Mutually Exclusive Projects with different time horizon Consider the following two mutually exclusive projects. The discount rate is k = 20%. Despite having a higher IRR, project A is less valuable than project B.

18 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Consider the following two mutually exclusive projects: –Project A has higher IRR –Project D has higher NPV at discount rates of 10% or 20% IRR Problems IV: Mutually Exclusive Projects with different scale

19 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 NPV Profiles A graphical representation of project NPVs at various different costs of capital. Year0123 Project L Project S

PF Lecture 5“Capital Budgeting Techniques”Spring 2008 NPV ($) Discount Rate (%) IRR L = 18.1% IRR S = 23.6% Crossover Point = 8.7% k NPV L (4) NPV S S L

21 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 If projects are independent, the two methods always lead to the same accept/reject decisions. If NPV says accept the IRR also says accept If projects are mutually exclusive … –If k > crossover point, the two methods lead to the same decision and there is no conflict. –If k < crossover point, the two methods lead to different accept/reject decisions. Comparing the NPV and IRR methods

22 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Size (scale) differences – the 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. Timing differences – the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPV S > NPV L. Reasons why NPV profiles cross

23 PF Lecture 5“Capital Budgeting Techniques”Spring 2008 Conclusions NPV has strong attractions: –based on cash flows –fully reflects time value of money –takes into account riskiness of project –gives clear go/no go answer