10.capital budgeting technique and practice

Copyright © 2011 Pearson Prentice Hall.All rights reserved.

Chapter 10

Capital-Budgeting

Techniques and Practice

10-2 © 2011 Pearson Prentice Hall. All rights reserved.

Learning Objectives

1. Discuss the difficulty of finding profitable projects in competitive markets and the importance of the search.

2. Determine whether a new project should be accepted or rejected using the payback period, net present value, the profitability index, and the internal rate of return.

3. Explain how the capital-budgeting decision process changes when a dollar limit is placed on the capital budget.


Learning Objectives

4. Discuss the problems encountered in project ranking.

5. Explain the importance of ethical considerations in capital-budgeting decisions.

6. Discuss the trends in the use of different capital-budgeting criteria.

7. Explain how foreign markets provide opportunities for finding new capital budgeting projects.


Slide Contents

Capital Budgeting Capital Budgeting Decision Criteria Capital Rationing Ranking Problems Ethics in Capital Budgeting Capital Budgeting Practices Finance and the Multinational Firm: Capital

Budgeting


1. Capital Budgeting

Meaning: The process of decision making with respect to investments in fixed assets—that is, should a proposed project be accepted or rejected.

It is easier to “evaluate” profitable projects than to “find them”


Source of Ideas for projects

Within the Firm: Typically, a firm has a research & development (R&D) department that searches for ways of improving existing products or finding new projects.

Other sources: Other employees, Competition, Suppliers, Customers.


2. Capital Budgeting Decision Criteria

The Payback Period

Net Present Value

Profitability Index

Internal Rate of Return


2.1 The Payback Period

Meaning: Number of years needed to recover the initial cash outlay of a capital budgeting project.

Decision Rule: Project feasible or desirable if the payback period is less than or equal to the firm’s maximum desired payback period. In general, shorter payback period is preferred while comparing two projects.


Payback Period Example

Example: Project with an initial cash outlay of $20,000 with following free cash flows for 5 years.

Payback is 4 years. YEAR CASH FLOW BALANCE

1 $ 8,000 ($ 12,000)

2 4,000 ( 8,000)

3 3,000 ( 5,000)

4 5,000 0

5 10,000 12,000


Trade-offs

Benefits: Uses cash flows rather than accounting profits

Easy to compute and understand

Useful for firms that have capital constraints

Drawbacks: Ignores the time value of money and

Does not consider cash flows beyond the payback period.


Discounted Payback Period

The discounted payback period is similar to the traditional payback period except that it uses discounted free cash flows rather than actual undiscounted cash flows.

The discounted payback period is defined as the number of years needed to recover the initial cash outlay from the discounted free cash flows.


Table 10-2


Payback Period Example

Table 10-2 shows the difference between traditional payback and discounted payback methods.

With undiscounted free cash flows, the payback period is only 2 years while with discounted free cash flows (at 17%), the discounted payback period is 3.07 years.


2.2 Net Present Value (NPV)

Meaning: NPV is equal to the present value of all future free cash flows less the investment’s initial outlay. It measures the net value of a project in today’s dollars.


NPV Example

Example: Project with an initial cash outlay of $60,000 with following free cash flows for 5 years.

Year FCF Year FCF

Initial outlay –60,000 3 13,000

1 –25,000 4 12,000

2 –24,000 5 11,000

The firm has a 15% required rate of return.


NPV Example

PV of FCF = $60,764

Subtracting the initial cash outlay of $60,000 leaves an NPV of $764.

Since NPV > 0, project is feasible.


NPV in Excel

Input cash flows for initial outlay and free cash inflows in cells A1 to A6.

In cell A7 type the following formula:=A1+npv(.15,a2:a6)

Excel will give the NPV = $764


NPV Trade-offs

Benefits Considers cash flows, not profits

Considers all cash flows

Recognizes time value of money

Drawbacks Requires detailed long-term forecast of cash flows

NPV is considered to be the most theoretically correct criterion for evaluating capital budgeting projects.


2.3 Profitability Index (PI)

(Benefit-Cost ratio)

Meaning: PI is the ratio of the present value of the future free cash flows (FCF) to the initial outlay. It yields the same accept/reject decision as NPV.

PI = PV of FCF/Initial outlay


Profitability Index

Decision Rule:

PI 1 = accept;

PI < 1 = reject


PI Example

A firm with a 10% required rate of return is considering investing in a new machine with an expected life of six years. The initial cash outlay is $50,000.


PI Example

FCF PVF @ 10% PV

Initial Outlay –$50,000 1.000 –$50,000

Year 1 15,000 0.909 13,636

Year 2 8,000 0.826 6,612

Year 3 10,000 0.751 7,513

Year 4 12,000 0.683 8,196

Year 5 14,000 0.621 8,693

Year 6 16,000 0.564 9,032


PI Example

PI = ($13,636 + $6,612+$7,513 + $8,196 + $8,693+ $9,032) / $50,000= $53,682/$50,000

= 1.0736

Project’s PI is greater than 1. Therefore, accept.


NPV and PI

When the present value of a project’s free cash inflows are greater than the initial cash outlay, the project NPV will be positive. PI will also be greater than 1.

NPV and PI will always yield the same decision.


2.4 Internal Rate of Return (IRR)

Meaning: IRR is the discount rate that equates the present value of a project’s future net cash flows with the project’s initial cash outlay.


Internal Rate of Return

Decision Rule:

If IRR Required Rate of Return, accept

If IRR < Required Rate of Return, reject


Figure 10-1


IRR and NPV

If NPV is positive, IRR will be greater than the required rate of return

If NPV is negative, IRR will be less than required rate of return

If NPV = 0, IRR is the required rate of return.


IRR Example

Initial Outlay: $3,817

Cash flows: Yr.1=$1,000, Yr. 2=$2,000, Yr. 3=$3,000

Discount rate NPV15% $4,35620% $3,95822% $3,817

IRR is 22% because the NPV equals the initial cash outlay at that rate.


IRR in Excel

IRR can be easily computed in Excel

In the previous example, input cash outflow and three year cash inflows in cells A1:A4

In cell A5 input “=IRR(a1:a4)”

Excel will give the IRR = 22%


Multiple IRRs

A normal cash flow pattern for project is negative initial outlay followed by positive cash flows (–, +, +, + …)

However, if the cash flow pattern is not normal (such as –, +, –) there can be more than one IRRs.

Figure 10-2 is based on cash flows of:–1,600; +10,000; –10,000 in years 0,1, 2


Figure 10-2


Modified IRR

Primary drawback of the IRR relative to the net present value is the reinvestment rate assumption made by the internal rate of return. Modified IRR allows the decision maker to directly specify the appropriate reinvestment rate.


Modified IRR

Accept if MIRR required rate of return

Reject if MIRR < required rate of return


MIRR Example

Project having a 3 year life and a required rate of return of 10% with the following cash flows:

FCF’s FCF’sInitial Outlay

–$6,000 Year 2 $3,000

Year 1 2,000 Year 3 4,000


MIRR Example

Step 1: Determine the PV of the project’s cash outflows. $6,000 is already at present.

Step 2: Determine the terminal value of the project’s free cash flows. To do this use the project’s required rate of return to calculate the FV of the project’s three cash flows of the project’s cash outflows. They turn out to be $2,420 + $3,300 + $4,000 = $9,720 for the terminal value


MIRR Example

Step 3: Determine the discount rate that equates to the PV of the terminal value and the PV of the project’s cash outflows. MIRR = 17.446%. It is greater than required rate of return so Accept.


MIRR in Excel

= MIRR (values, finance rate, reinvestment rate)

where values is simply the range of cells where the cash flows are stored, and k is entered for both the finance rate and the reinvestment rate.


3. Capital Rationing

Meaning: Capital rationing refers to situation where there is a limit on the dollar size of the capital budget. This may be due to:

(a) temporarily adverse conditions in the market;(b) shortage of qualified personnel to direct new projects; and/or (c) other factors such as not willing to take on excess debt to finance new projects.


Capital Rationing

How to select? Select a set of projects with the highest NPV—subject to the capital constraint. Using NPV may preclude accepting the highest ranked project in terms of PI or IRR.


Figure 10-4


Table 10-7


4. Ranking Mutually Exclusive Projects

Size Disparity

Time Disparity

Unequal Life


4.1 Size Disparity

This occurs when we examine mutually exclusive projects of unequal size.

Example: Consider the following cash flows for one-year Project A and B, with required rates of return of 10%.

Initial Outlay: A = $200; B = $1,500

Inflow: A = $300; B = $1,900


Table 10-8


Size-Disparity Ranking Problem

Ranking Conflict:

Using NPV, Project B is better;

Using PI and IRR, Project A is better.

Project A Project B

NPV 72.73 227.28

PI 1.36 1.15

IRR 50% 27%


Size-Disparity Ranking Problem

Which technique to use to select the project?

Use NPV whenever there is size disparity. If there is no capital rationing, project with the largest NPV will be selected. When capital rationing exists, select set of projects with the largest NPV.


4.2 Time Disparity Problem

Time Disparity problem arises because of differing reinvestment assumptions made by the NPV and IRR decision criteria.

How are Cash flows reinvested?

According to NPV: Required rate of return

According to IRR: IRR


4.2 Time Disparity Problem

Example: Consider two projects, A and B, with initial outlay of $1,000, cost of capital of 10%, and following cash flows in years 1, 2, and 3:

A: $100 $200 $2,000

B: $650 $650 $650


Table 10-9


Time Disparity Problem

Ranking Conflict: Using NPV or PI, A is better

Using IRR, B is better

Which technique to use to select the superior project? Use NPV

Project A Project B

NPV 758.83 616.45

PI 1.759 1.616

IRR 35% 43%


4.3 Unequal Lives Problem

This occurs when we are comparing two mutually exclusive projects with different life spans.

To compare projects, we compute the Equivalent Annual Annuity (EAA)


Unequal Lives Problem

Example: If you have two projects, A and B, with equal investment of $1,000, required rate of return of 10%, and following cash flows in years 1-3 (for project A) and 1-6 (for project B)

Project A = $500 each in years 1-3

Project B = $300 each in years 1-6


Computing EAA

Calculate the project’s NPV:A = $243.43 and B = $306.58

Calculate EAA = NPV/annual annuity factorA = $97.89B = $70.39

Project A is better


5. Ethics in Capital Budgeting

Ethics play a role in capital budgeting

Any actions that violate ethical standards can have a negative impact on the image of the firm and consequently, future cash flows.


6. Actual Capital Budgeting Practices

Percent of Firms Using Each

Method used

Primary Method

Secondary Method

Total

IRR 88% 11% 99%

NPV 63% 22% 85%

Payback 24% 59% 83%

PI 15% 18% 33%

Popularity of Capital Budgeting Techniques

Source: Harold Bierman, Jr.,”Capital Budgeting in 1992: A Survey,” Financial Management (Autumn 1993):24.


7. Finance and The Multinational Firm: Capital

Budgeting

The key to success in capital budgeting is finding good projects. Finding new projects and correctly evaluating them are key to continued success of firms.

For many companies, finding new projects involves going overseas through joint ventures or strategic alliances or establishing subsidiary abroad.

Some companies have more than 50% of their revenues from sales abroad.


Figure 10-3


Figure 10-5


Figure 10-6


Table 10-1


Table 10-3


Table 10-4


Table 10-5


Table 10-6


Key Terms

Capital budgeting Capital rationing Discounted payback Equivalent annual annuity (EAA) Internal rate of return (IRR) Mutually exclusive projects Net present value (NPV) Payback period Profitability index (PI)

10.capital budgeting technique and practice

Economy & Finance

Transcript of 10.capital budgeting technique and practice