Capital Budgeting. Chapter 8. The Capital Budgeting Decision Process. The capital budgeting process involves three basic steps:. Generating long-term investment proposals; Reviewing, analyzing, and selecting from the proposals that have been granted, and
The capital budgeting process involves three basic steps:
Accounting rate of return (ARR):focuses on project’s impact on accounting profits
Net present value(NPV):best technique theoretically; difficult to calculate realistically
Internal rate of return(IRR): widely used with strong intuitive appeal
Profitability index(PI):related to NPV
Account for the time value of money;
Account for risk;
Focus on cash flow;
Rank competing projects appropriately, and
Lead to investment decisions that maximize shareholders’ wealth.
Average annual operating cash inflows
Can be computed from available accounting data
ARR uses accounting numbers, not cash flows;
no time value of money.
The payback period is the amount of time required for the firm to recover its initial investment.
Management determines maximum acceptable payback period.
Advantages of payback method:
Disadvantages of payback method:
Reject (166.2 < 250)
NPV: The sum of the present values of a project’s cash inflows and outflows.
Discounting cash flows accounts for the time value of money.
Choosing the appropriate discount rate accounts for risk.
Accept projects if NPV > 0.
A key input in NPV analysis is the discount rate.
Western Europe project: NPV = $75.3 million
Southeast U.S. project: NPV = $25.7 million
Should Global Wireless invest in one project or both?
Key benefits of using NPV as decision rule:
Though best measure, NPV has some drawbacks:
NPV is the “gold standard” of investment decision rules.
IRR: the discount rate that results in a zero NPV for a project.
The IRR decision rule for an investing project is:
Western Europe project: IRR (rWE) = 27.8%
Southeast U.S. project: IRR (rSE) = 36.7%
Global Wireless will accept all projects with at least 18% IRR.
Advantages of IRR:
Disadvantages of IRR:
When project cash flows have multiple sign changes, there can be multiple IRRs.
Which IRR do we use?
Sometimes projects do not have a real IRR solution.
Modify Global Wireless’s Western Europe project to include a large negative outflow (-$355 million) in year 6.
Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!
NPV and IRR do not always agreewhen ranking competing projects.
The scale problem:
Why the conflict?
Because of the differences in the timing of the two projects’ cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign.
PV of CF (yrs1-5)
Calculated by dividing the PV of a project’s cash inflows by the PV of its initial cash outflows.
Decision rule: Accept project with PI > 1.0, equal to NPV > 0
Like IRR, PI suffers from the scale problem.
Methods to generate, review, analyze, select, and implement long-term investment proposals: