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Capital Budgeting

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Capital Budgeting

Chapter 8

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
- Implementing and monitoring the proposals that have been selected.

- Managers should separate investment and financing decisions.

Accounting rate of return (ARR):focuses on project’s impact on accounting profits

- Payback period: most commonly used

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.

- Global Wireless is a worldwide provider of wireless telephony devices.
- Global Wireless is contemplating a major expansion of its wireless network in two different regions:
- Western Europe expansion
- A smaller investment in Southeast U.S. to establish a toehold

Average annual

depreciation

Average annual operating cash inflows

=

Average profits

after taxes

–

Can be computed from available accounting data

- Need only profits after taxes and depreciation.
- Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.

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.

- If the project’s payback period is less than the maximum acceptable payback period, accept the project.
- If the project’s payback period is greater than the maximum acceptable payback period, reject the project.

Management determines maximum acceptable payback period.

- Management’s cutoff is 2.75 years.
- Western Europe project: initial outflow of -$250M
- But cash inflows over first 3 years is only $245 million.
- Global Wireless will reject the project (3>2.75).

- Southeast U.S. project: initial outflow of -$50M
- Cash inflows over first 2 years cumulate to $40 million.
- Project recovers initial outflow after 2.40 years.
- Total inflow in year 3 is $25 million. So, the project generates $10 million in year 3 in 0.40 years ($10 million $25 million).

- Global Wireless will accept the project (2.4<2.75).

Advantages of payback method:

- Computational simplicity
- Easy to understand
- Focus on cash flow

Disadvantages of payback method:

- Does not account properly for time value of money
- Does not account properly for risk
- Cutoff period is arbitrary
- Does not lead to value-maximizing decisions

Reject (166.2 < 250)

Reject (46.3<50)

- Discounted payback accounts for time value.
- Apply discount rate to cash flows during payback period.
- Still ignores cash flows after payback period.

- Global Wireless uses an 18% discount rate.

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.

- r represents the minimum return that the project must earn to satisfy investors.

- r varies with the risk of the firm and /or the risk of the project.

Western Europe project: NPV = $75.3 million

Southeast U.S. project: NPV = $25.7 million

- Assuming Global Wireless uses 18% discount rate, NPVs are:

Should Global Wireless invest in one project or both?

Key benefits of using NPV as decision rule:

- Focuses on cash flows, not accounting earnings
- Makes appropriate adjustment for time value of money
- Can properly account for risk differences between projects

Though best measure, NPV has some drawbacks:

- Lacks the intuitive appeal of payback, and
- Doesn’t capture managerial flexibility (option value) well.

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:

- If IRR is greater thanthe cost of capital, acceptthe project.
- If IRR is less thanthe cost of capital, rejectthe project.

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:

- Properly adjusts for time value of money
- Uses cash flows rather than earnings
- Accounts for all cash flows
- Project IRR is a number with intuitiveappeal

Disadvantages of IRR:

- “Mathematical problems”: multiple IRRs, no real solutions
- Scale problem
- Timing problem

IRR

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.

- There is no real number thatwill make NPV=0, so noreal IRR.

Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!

Project

IRR

NPV (18%)

Western Europe

27.8%

$75.3 mn

Southeast U.S.

36.7%

$25.7 mn

NPV and IRR do not always agreewhen ranking competing projects.

The scale problem:

- The Southeast U.S. project has a higher IRR, but doesn’t increase shareholders’ wealth as much as the Western Europe project.

Why the conflict?

- The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project.
- Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive.

- The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.

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.

Project

PV of CF (yrs1-5)

Initial Outlay

PI

Western Europe

$325.3 million

$250 million

1.3

Southeast U.S.

$75.7 million

$50 million

1.5

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

- Both PI > 1.0, so both acceptable if independent.

Like IRR, PI suffers from the scale problem.

Methods to generate, review, analyze, select, and implement long-term investment proposals:

- Accounting rate of return
- Payback Period
- Discounted payback period
- Net Present Value (NPV)
- Internal rate of return (IRR)
- Profitability index (PI)