Chapter 6 Capital Budgeting Techniques Sept 2010 Dr. B. Asiri © 2005 Thomson/South-Western

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; involve large expenditures  Very important to firm’s future

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.

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

5 Net Cash Flows for Project S and Project L 1,500 1, ,300 1,500 ^ Net CashFlows, CF t r edpAExctefte-Tax Year ProjectSPro tL 0$(3,000)$( 0)

6 1. Payback Period: PB 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.

7 Payback Period for Project S = Payback S /800 = years Net Cash Flow Cumulative Net CF 1,500 -1, , , PB S 01234

8 = Payback L /1,500 = 3.3 years Net Cash Flow Cumulative Net CF ,600 1, , ,000 1,500 1,100 PB L Payback Period for Project L

9 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:

10 2.Net Present Value: NPV Sum of the PVs of Inflows + Outflows Cost is CF 0 and is generally negative. ^ ^ ^

11 What is Project S’s NPV? k = 10% 1, ,200(3,000) 1, NPV S =

12 What is Project L’s NPV? k = 10% (3,000) NPV L =

13 Rationale for the NPV method: NPV= PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Which adds most value?

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 S & L are independent, accept both; NPV > 0.

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

16 NPV: IRR: Calculating IRR

17 What is Project S’s IRR? NPV S = IRR S = 13.1% 0 (3,000) IRR = ? Sum of PVs for CF 1-4 = 3,000 1, ,200300

18 What is Project L’s IRR? NPV L = IRR L = 11.4% 0 IRR = ? Sum of PVs for CF 1-4 = 3,000 (3,000)

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%. Profitable.

20 IRR acceptance criteria:  If IRR > k, accept project.  If IRR < k, reject project. 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.