CapitalBudgeting Techniques and Practice

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Capital-Budgeting Techniques and Practice

• Chapter 9

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Principles Used in this Chapter

• Principle 2
• The Time Value of Money A Dollar Received Today
  is Worth More Than a Dollar Received in the
  Future.
• Principle 5
• The Curse of Competitive Markets Why Its Hard
  to Find Exceptionally Profitable Projects.

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Capital-Budgeting

• 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.

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Source of Ideas for projects

• Within the Firm Typically, a firm has a research
  development (RD) department that searches for
  ways of improving existing products or finding
  new projects.
• Other sources Competition, Suppliers, Customers

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Capital-Budgeting Decision Criteria

• Payback Period
• Net Present Value
• Profitability Index
• Internal Rate of Return
• Capital Rationing

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Payback Period

• 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
  firms maximum desired payback period.

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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
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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.

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Net Present Value or NPV

• NPV is equal to the present value of all future
  free cash flows less the investments initial
  outlay. It measures the net value of a project in
  todays dollars.
• NPV ? FCF - Initial outlay
• (1k)n
• Decision Rule
• If NPV gt 0, accept
• If NPV lt 0, reject

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NPV Example

• Example Project with an initial cash outlay of
  60,000 with following free cash flows for 5
  years.
• Yr FCF Yr 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.

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• NPV ? FCF - Initial outlay
• (1k)n
• PV of FCF 60,764
• Subtracting the initial cash outlay of 60,000
  leaves an NPV of 764.
• Since NPVgt0, project is feasible.

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NPV Trade-offs

• Benefits
• Considers cash flows, not profits
• Considers all cash flows
• Recognizes time value of money
• By accepting only positive NPV projects,
  increases value of the firm
• Drawbacks
• Requires detailed long-term forecast of cash
  flows
• NPV is considered to be the most theoretically
  correct criterion for evaluating
  capital-budgeting projects.

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Profitability Index (PI)

• PI is the ratio of the present value of the
  future free cash flows to the initial outlay. It
  yields the same accept/reject decision as NPV.
• PI PV FCF/ Initial outlay
• Decision Rule
• PI gt 1 accept
• PI lt 1 reject

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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.

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PI Example

• PI (13,636 6,6127,513 8,196 8,693
  9,032) / 50,000
• 53,682/50,000
• 1.0736
• Project PI gt 1, accept.

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NPV and PI

• When the present value of a projects 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.

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Internal Rate of Return or IRR

• IRR is the discount rate that equates the present
  value of a projects future net cash flows with
  the projects initial cash outlay
• Decision Rule
• If IRR gt Required rate of return, accept
• IF IRR lt Required rate of return, reject

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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.

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IRR Example

• Initial Outlay 3,817
• Cash flows
• Yr.11,000, Yr. 22,000, Yr. 33,000
• Discount rate PV of FCF
• 15 4,356
• 20 3,958
• 22 3,817
• IRR is 22 because the NPV equals the initial
  cash outlay

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IRR in Excel

• IRR can be easily computed in Excel
• In the previous example, input cash outflow and
  three year cash inflows in cells A1A4
• In cell A5 input IRR(a1a4)
• Excel will give the IRR 22

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Multiple IRRs

• A normal cash flow pattern for a 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 9-2 is based on cash flows of
• -1,600 10,000 -10,000 in years 0,1,2

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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
• MIRRgt required rate of return, accept
• MIRRlt required rate of return, reject

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MIRR Example

• Project having a 3yr. Life and a required rate of
  return of 10 with the following cash flows

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MIRR Example

• Step 1 Determine the PV of the projects cash
  outflows. 6,000 is already at present.
• Step 2 Determine the terminal value of the
  projects free cash flows. To do this use the
  projects required rate of return to calculate
  the FV of the projects three cash flows of the
  projects cash outflows. They turn out to be
  2,420 3,300 4,000 9,720 for the terminal
  value

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MIRR Example

• Step 3 Determine the discount rate that equates
  to the PV of the terminal value and the PV of the
  projects cash outflows. MIRR 17.446. It is gt
  required rate of return Accept

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Capital Rationing

• Capital rationing occurs when a limit is placed
  on the dollar size of the capital budget.
• How to select Select a set of projects with the
  highest NPVs subject to the capital constraint.
  Using NPV may preclude accepting the highest
  ranked project in terms of PI or IRR.

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Ranking Problems

• Size Disparity
• Time Disparity
• Unequal Life

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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

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Size Disparity

• Project A Project B
• NPV 72.73 227.28
• PI 1.36 1.15
• IRR 50 27
• Ranking Conflict
• Using NPV, Project B is better
• Using PI and IRR, Project A is better.

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Size Disparity

• Which technique to use to select the better
  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.

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Time Disparity Problem

• Time Disparity problems arise because of
  differing reinvestment assumptions made by the
  NPV and IRR decision criteria.
• Cash flows reinvested at
• According to NPV Required rate of return
• According to IRR IRR

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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

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Time Disparity Problem

• Project A Project B
• NPV 758.83 616.45
• PI 1.759 1.616
• IRR 35 43
• Ranking Conflict
• Using NPV, A is better
• Using IRR, B is better
• Which technique to use to select the superior
  project?
• Use NPV

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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)

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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

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Computing EAA

• Calculate projects NPV
• A 243.43 and B 306.58
• Calculate EAA NPV/annual annuity factor
• A 97.89 B 70.39
• Project A is better

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Popularity of Capital-Budgeting Techniques

• Percent of Firms Using Each
• Method used Primary Secondary Total
• Method Method
• IRR 88 11 99
• NPV 63 22 85
• Payback 24 59 83
• PI 15 18 33

Source Harold Bierman, Jr.,Capital-Budgeting in
1992 A Survey, Financial Management (Autumn
1993)24.
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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 the
  continued success of firms.
• For many companies, finding new projects involves
  going overseas through joint ventures or
  strategic alliances or establishing subsidiaries
  abroad.
• Some companies generate gt 50 of their revenues
  from sales abroad.