Chapter 9Chapter 9

Investment In Long-Term Investment In Long-Term AssetsAssets

Chapter ObjectivesChapter Objectives

Difficulty in finding profitable projects Use capital budget techniques to evaluate new

projects Dollar limitation on capital budgeting Project rankings Ethical considerations in capital budgeting Trends in capital budgeting International markets and new capital budgeting

projects

Capital BudgetingCapital Budgeting

Evaluating the profitability of projectsOften choosing between one or more

projects

R & DR & D

Typically, a firm has a research & development department that searches for ways of improving existing products or finding new projects.

Capital BudgetingCapital Budgeting

Payback PeriodNet Present ValueProfitability IndexInternal Rate of Return Capital Rationing

Payback PeriodPayback Period

Number of years needed to recover the initial cash outlay of a project

Payback PeriodPayback Period Example: Project with an initial cash outlay of $10,000 Free Cash Flows of $2,500 per year for 6 years Year Cash Flow Balance

$10,0001 $2,500 $7,5002 $2,500 $5,0003 $2,500 $2,5004 $2,500 --------

Payback is 4 years

Payback Period Payback Period

Ignores Time Value of Money Ignores cash flows beyond payback period

Net Present Value or NPVNet Present Value or NPV

Present value of the free cash flows less the initial outlay

Gives a measurement of the net value of a project in today’s dollars

If NPV > 0, acceptIf NPV < 0, reject

NPVNPV

Example:Project cost $10,000Cash flows$2,500 a year for 6 yearsRequired rate of return 10%PV of 2,500, 6 years, 10% is $10,888NPV of the project = $10,888 - $10,000= $ 888

NPVNPV

Examines cash flows, not profitsRecognizes time value of moneyBy accepting only positive NPV projects,

increases value of the firm

Profitability IndexProfitability Index

Benefit-cost ratioRatio of the present value of the future free

cash flows to the initial outlayGenerates same results as NPVPI = PV FCF/ Initial outlayPI > 1 = accept PI < 1 reject

Profitability IndexProfitability Index

Example:Purchase $10,000Cash flows $ 2,500 6 years Required rate of return 10%PV of the cash flows $10,888PI = 10,888/10,000 = 1.088

NPV and PINPV and PI

When the present value of a project’s cash flows 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

Internal Rate of Return Internal Rate of Return or IRRor IRR

Discount rate that equates the present value of a project’s cash flows with the project’s initial cash outlay

If IRR > Required rate of return, acceptIF IRR < Required rate of return, reject

IRR and NPVIRR 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.

IRRIRR

Purchase $10,000 Cash flows $2,500 6 yearsDiscount rate NPV8% 1,55710% 88812% 27813% -6.12IRR is between 12% and 13%True IRR 12.97% via financial calculator

Capital RationingCapital Rationing

Limit on the dollar size of the capital budgetOften a firm may select a set of projects

with the highest NPV– subject to the capital constraint

May preclude accepting the highest ranked project in terms of PI or IRR

Ranking ProblemsRanking Problems

Size DisparityTime DisparityUnequal Life

Popularity of Capital Popularity of Capital Budgeting TechniquesBudgeting Techniques

Percent of Firms Using Each

Method used Primary Secondary Total

Method Method Firms

IRR 88% 11% 99%

NPV 63% 22% 85%

Payback 24% 59% 83%

PI 15% 18% 33%