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Capital Budgeting

Capital Budgeting. Arguing for your project. Arguing for your project. Capital budgeting CFO receives proposals from divisions Projects described by cash flows. Arguing means applying measures. Net present value is the right measure. Many smart people use the wrong ones.

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Capital Budgeting

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  1. Capital Budgeting Arguing for your project

  2. Arguing for your project • Capital budgeting • CFO receives proposals from divisions • Projects described by cash flows

  3. Arguing means applying measures • Net present value is the right measure. • Many smart people use the wrong ones. • Alternative ways to the same end.

  4. Uses of measures • Project acceptance • Mutually exclusive alternatives.

  5. Capital Budgeting Techniques • Kim, Crick, and Kim, Management Accounting • Nov. 1986, p. 49-52

  6. Survey of use of measures by corporations

  7. Make no mistake • NPV is the right measure always. • Others work sometimes. • NPV measures value to owners, their wealth.

  8. Objectives of a good measure • Value cash flows. • Respond to the market.

  9. NPV’s merits • Values cash flows as the market does. • Responsive because the discount rate is the current market rate. • Measures increase in shareholder value.

  10. Payback period is • The time required for undiscounted cash flows to add up to the initial investment. • e.g., build a Wendy’s if it “pays for itself” in two years or less.

  11. Payback merits • Based on cash flows

  12. Payback defects • No market response.When r is high, payback period should be shorter. • Subtracts time-t dollars from time-0 dollars, a cardinal sin. • Ignores cash flow after payback. • Ignores timing during payback.

  13. Defects are not necessarily fatal • Repeated, similar investments. • Stable financial conditions.

  14. The well-informed capital budgeter knows • When to accept payback period as a measure. • When it is likely to fail.

  15. Accounting rate of return • Doesn’t value cash flows • No market response • Ignores market values • Scaling problems: melons or malls

  16. Merits of accounting r.o.r. • Easily understood. • Sometimes okay in stable markets. • Smart application can overcome defects.

  17. Internal rate of return • Definition: IRR is the discount rate that makes NPV = 0 That is, IRR is the r such that

  18. Internal rate of return • Definition: IRR is the discount rate that makes NPV(r) = 0. • NPV(r) is a function. • RWJ Figures 6.4 and 6.5.

  19. Project

  20. IRR =23.37 48.685 .1 NPV(r) Figure 6.4: NPV(r)=0 at r=23.37% NPV NPV(.1) = 48.68520 100 r

  21. Figure 6.4 • NPV (r) = 0 at r = 23.37%

  22. Applications of IRR measure • Hurdle rate = market rate • Project acceptance: Accept a project if IRR > hurdle rate. • Mutually exclusive projects: Take the one with the highest IRR (> hurdle rate)????? Don’t rely on it.

  23. Project acceptance: • NPV and IRR give the same conclusion when ... • Cash flows have one sign change. • In the example: IRR = 23.37% > hurdle = 10% for an investment project. • IRR = 23.37% < hurdle rate = 30% for a financing or “borrowing from nature” project.

  24. Merits • Uses cash flows. • Responds to the market when the hurdle rate changes

  25. Objective • Learn to recognize the times when NPV and IRR are the same. • and also the problems with IRR

  26. Defects of IRR -- project acceptance • Lending to nature or borrowing from her? • Multiple IRR's may occur.

  27. Financing (borrowing from nature) • Seek IRR < hurdle rate • Same as NPV > 0

  28. Multiple IRR's

  29. IRR’s at r = 1 and r = 2 • 100% per decade = 7.17735% per year. • 200% per decade = 11.61232% per year.

  30. IRR’s at r=1 and r=2. NPV 100% 200% r

  31. Descartes’ Rule • The number of internal rates of return is no more than the number of sign changes.

  32. Defects of IRR -- mutually exclusive projects • Ignores market values. • Scale problems -- melons or malls.

  33. Typical hour exam question • What is the scale problem in using IRR to choose between mutually exclusive projects?

  34. Scale problem in IRR One canyon, one dam.

  35. Sketch of answer • The smaller dam has the higher IRR. • The big dam has higher value. • The big dam extends consumption possibility of owners more than the little dam does. • It is wrong to take the higher IRR in this case.

  36. Scale problems in IRR

  37. More answer • Consider the project of replacing the little dam by the big dam. • Cash flows are -900, +1300. • IRR of the project is 4/9 = .4444 > .1 • NPV is 281.8181… • So replace the little dam. • Capital budgeting jiu jitsu.

  38. NPV 500 Big dam 100 Little dam r IRR IRR 50% 100%

  39. Big dam, little dam For hurdle rates below r*, the big dam is preferred. NPV NPV of the big dam 500 NPV of the small dam 100 r 1 r* .5 r* = .4444...

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