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Learning Objectives

Learning Objectives. Define capital budgeting decisions as long-run investment decisions. (LO 1 ) Explain that cash flows rather than accounting earnings are evaluated in the capital budgeting decision. (LO 2 )

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Learning Objectives

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  1. Learning Objectives • Define capital budgeting decisions as long-run investment decisions. (LO1) • Explain that cash flows rather than accounting earnings are evaluated in the capital budgeting decision. (LO2) • Evaluate investments by the average accounting return, the payback period, the internal rate of return, the net present value and the profitability index. (LO3)

  2. LO3 5 Methods of Evaluating Investment Proposals • Average Accounting Return (AAR) • Payback Period (PB) • Internal Rate of Return (IRR) • Net Present Value (NPV) • Profitability Index (PI)

  3. LO3 Average Accounting Return (AAR) AAR = Average Earnings Aftertax Average Book Value of Investment Advantage: Relatively easy to calculate Disadvantages: Uses accounting earnings, not cash flows Ignores the timing of the earnings Uses book value, not market value of investment Does not suggest an objective evaluation yardstick

  4. LO3 Payback Period • computes the amount of time required to recoup the initial investment • a cutoff period is arbitrarily established • Advantages: • easy to use (“quick and dirty” approach) • emphasizes liquidity • one measure of the risk of an investment • Disadvantages: • ignores inflows after the cutoff period and • fails to consider the time value of money • does not have an objective yardstick • not a good measures of risk

  5. LO3 Net Present Value Net Present Value (NPV): • the present value of the cash inflows minus the present value of the cash outflows • the future cash flows are discounted back over the life of the investment • the basic discount rate is usually the firm’s cost of capital (WACC)(assuming similar risk)

  6. LO3 Internal Rate of Return • Yield on an investment or a rate of return • Discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits) • Discount rate where the cash outflows equal the cash inflows (or NPV = 0)

  7. LO3 Profitability Index P.I. = Present value of the inflows Present value of the outflows • an alternative presentation of the NPV method • used to compare investments of different sizes especially in a capital rationing situation

  8. LO3 Capital Budgeting: An Example Table 12-3 Investment alternatives

  9. LO3 Evaluating These 2 Investments • Payback Period: Investment A: $5,000 + $5,000 = $10,000 (2 years) Investment B: $1,500 + $2,000 + $2,500 + $4,000 ( = 0.8 of $5,000) = $10,000 (3.8 years) • Net Present Value: Investment A: $5,000 $5,000 $2,000 0 1 2 3 |----------------|-----------------|-------------------| PV = -$10,000 n = 3 %i = 10% Using the NPV function in a financial calculator: CF0= -10000; C01= 5000; F01 = 2; C02 = 2000; F02 = 1;I = 10; Compute NPV = 180.32

  10. LO3 Evaluating These 2 Investments • Net Present Value: Investment B: $1,500 $2,000 $2,500 $5,000 $5,000 0 1 2 3 4 5 |---------------|---------------|---------------|----------------|---------------| PV= -$10,000 n = 5 i% = 10 Using the NPV function in a financial calculator: CF0= -10000; C01= 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; I = 10; Compute NPV = 1414.49

  11. LO3 Evaluating These 2 Investments • Internal Rate of Return: Investment A: Investment B: • Profitability Index: Investment A: PI = $10,180/$10,000 = 1.0180 Investment B: PI = $11,414/$10,000 = 1.1414 Using the IRR function in a financial calculator: CF0= -10000;C01= 5000; F01 = 2; C02 = 2000; F02 = 1; Compute IRR = 11.16(%) Using the IRR function in a financial calculator: CF0= -10000; C01= 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; Compute IRR = 14.33 (%)

  12. LO3 Table 12-4Capital budgeting results

  13. LO3 Accept/Reject Decision Payback Method (PB): – if PB period < cutoff period, accept the project – if PB period > cutoff period, reject the project Internal Rate of Return (IRR): – if IRR > cost of capital, accept the project – if IRR < cost of capital, reject the project Net Present Value (NPV): – if NPV > 0, accept the project – if NPV < 0, reject the project Profitability Index (PI): – if PI > 1, accept the project – if PI < 1, reject the project

  14. LO3 Comparing Methods • PI is a variation of NPV method. • IRR and NPV methods are superior to PB and AAR methods, because – IRR and NPV evaluate all the resultant cash flows – they employ the time value of money – they have an objective yardstick – the cost of capital • IRR method has some flaws: – inconsistency with NPV for some mutually exclusive projects – discounting considerations – multiple IRRs • NPV is the best methodology.

  15. LO3 Modified Internal Rate of Return • The reinvestment assumption of the IRR method may be unrealistic. • To remedy this flaw, the more realistic reinvestment assumption of the NPV method is combined with the IRR method, producing the modified internal rate of return (MIRR). • MIRR is the discount rate that will equate the initial investment with the future value of inflows. • Each of these inflows grows at the cost of capital.

  16. LO3 Modified Internal Rate of Return Cost of capital = 10% $6,000 FV = $7,260 $5,000 FV = $5,500 $2,850 FV = $2,850 0 1 2 3 FV = $15,610 PV = -$10,000 Using the PV function in a financial calculator N = 3; PV = -10000; PMT = 0; FV = $15,610; Compute I/Y = 16(%) MIRR = 16%

  17. LO3 Table 12-6Multiple IRRs

  18. LO3 Capital Rationing • A limit or constraint on the amount of funds that can be invested • Firm must rank investments based on their NPVs • Those with positive NPVs are accepted until all funds are exhausted

  19. LO3 Table 12-7Capital rationing

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