Capital Budgeting Project Selection Methods

1
Capital Budgeting Project Selection Methods

• 4 Methods in Chapter 9
• Payback
• Net Present Value
• Profitability Index
• Internal Rate of Return

2
Characteristics of a Good Project Selection Method

• Considers all project cash flows (from NICO
  through DCF)
• Adjusts cash flows for timing (finds PV
  of future cash flows)
• Incorporates firms cost of capital (uses MCC
  in analysis)

3
Payback Method

• Determine how long ( years) it takes to recover
  NICO from OCFs
• Compare payback period to company determined
  standard
• No universal guidelines
• Payback method fails to meet any of the criteria
  for good selection method

4
Net Present Value

• Find the PV of the OCFs and the DCF using the
  firms MCC
• Subtract NICO from the sum of the PVs
• Result is NPV
• If NPV gt 0, accept project
• If NPV lt 0, reject project

5
Profitability Index

• Find the PV of the OCFs and the DCF using the
  firms MCC
• Divide the sum of the PVs by NICO
• Result is PI
• If PI gt 1.0, accept project
• If PI lt 1.0, reject project

6
Internal Rate of Return

• Solving for unknown interest rate
• Looking for rate that makes the PV of the OCFs
  and the DCF equal to NICO
• If IRR gt MCC, accept project
• If IRR lt MCC, reject project

7
Incorporating Risk into the Capital Budgeting
Process

• What can go wrong with incremental cash flow
  estimates?
• NICO can be larger than expected
• OCFs and DCF can be smaller than expected
• Useful life can be shorter than expected

8
Options for Incorporating Risk

• Scenario Analysis
• Sensitivity Analysis
• Risk Adjusted Discount Rates

9
Scenario Analysis

• Set up different scenarios for the projects cash
  flows
• Best Case Lowest NICO, Highest OCFs and DCF,
  longest life
• Worst Case Highest NICO, Lowest OCFs and DCF,
  shortest life
• Most Likely Case Cash flows fall in between Best
  and Worst Cases

10
Sensitivity Analysis

• What if analysis
• Change one variable by a certain . Hold other
  variables constant. Recalculate NPV, PI, or IRR.
  Look at change in NPV, PI, or IRR.
• Identifies which variables have biggest impact on
  success/failure of project

11
Risk Adjusted Discount Rates (RADR)

• Average risk projects should be evaluated using
  MCC
• Average risk means projects similar to what
  company has done in the past
• MCC represents investors required rates of
  return based on what the firm currently does

12
Above Average Risk Projects

• When firm undertakes new kind of work, investors
  want higher rates of return to compensate for
  increased risk
• Use MCC extra points for projects that are
  different from what firm usually does

13
Purpose of RADR

• The higher the risk of a project, the higher the
  discount rate used to evaluate the project
• The higher the discount rate, the lower the PV of
  future cash flows
• The lower the PV, the harder it will be to cover
  NICO
• Higher risk projects have to meet a tougher
  standard

14
Example of RADR

• Risk Class 1 Replacement projects. Use MCC.
• Risk Class 2 Expansion projects. Use MCC 3
  points.
• Risk Class 3 New projects. Use MCC
  5 points.