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CHAPTER 12. THE CAPITAL BUDGETING DECISION. Capital Expenditures Decision. CE usually require initial cash outflows in hope of future benefits or cash inflows Examples: new plant construction, acquisition of business, purchase of new machine, etc. Projects often last for more than a year

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chapter 12

CHAPTER 12

THE CAPITAL BUDGETING DECISION

capital expenditures decision
Capital Expenditures Decision
  • CE usually require initial cash outflows in hope of future benefits or cash inflows
  • Examples: new plant construction, acquisition of business, purchase of new machine, etc.
  • Projects often last for more than a year
  • The longer the time horizon, the greater the uncertainty
areas of uncertainty in ce decision
Areas of Uncertainty in CE Decision
  • Expected cash flows
  • Product life
  • Interest rates
  • Economic conditions
  • Technological change
capital budgeting
Capital Budgeting
  • To see if the CE is economically acceptable - if it creates or adds value to the firm
  • To examine the CE from an investment perspective
  • The basic concept is to determine if it makes sense to commit to an initial cash outflows in order to receive future cash inflows
project evaluation
Project Evaluation
  • Discount Rate = Cost of Capital
  • Positive NPV indicates that the yield or rate of return on the project exceeds the cost of capital (thus add value to the firm)
  • Project is financially acceptable when the PV of the total cash inflows greater than the PV of the total cash outflows ( +ve NPV)
project b cont1
Project B cont’
  • Both projects A and B require an initial capital outflow of $10000
  • Both of them will generate a total return of $12000 in the next three years
  • However, project A has a positive NPV while project B has a negative NPV
  • Why?
cash flows of project a b
Project A

Yr 0 -$10,000

Yr 1 $5,000

Yr 2 $5,000

Yr 3 $2,000

Project B

Yr 0 -$10,000

Yr 1 $2,000

Yr 2 $5,000

Yr 3 $5,000

Cash Flows of Project A & B
reasons
Reasons
  • For Project A, the cash inflows mainly occur at the first two years
  • For Project B, the cash inflows mainly come in at the last two years
  • Due to the time value of money, money received earlier has higher value than that received later
  • Hence, Project B is not acceptable -(negative NPV)
flexibility of npv using various discount rates across time
Flexibility of NPV - Using various discount rates across time
  • The longer the time horizon, the higher the risk
  • Sometimes, we may have to use a higher discount rate for income in the latest year
  • Instead of 10%, we may use 12% to discount the latest cash inflow at the end of third year
  • NPV method provides such a flexibility
flexibility of npv allow reversal of cash flows
Flexibility of NPV – allow reversal of cash flows
  • NPV method can be applied to any type of cash flows even cash flows with reversal
  • Cash flows with reversal means that there are more than one cash outflows
  • Example: a 2-year project with cash flows:
  • Yr 0 – Initial cash outflow – (-$1000)
  • Yr 1 – Cash inflow – (+$5000)
  • Yr 2 – Another cash outflow – (-$3000)
profitability index
Profitability Index
  • It is a variation of the NPV method
  • Profitability index (PI)

= PV of cash inflows/PV of cash outflows

  • If PI > 1, PV of cash inflows is greater than PV of cash outflows. That is NPV > 0
  • Hence project with PI > 1 is financially viable
another method irr
Another method - IRR
  • IRR = Internal Rate of Return
  • The IRR is the discount rate at which the PV of cash inflows = PV of the cash outflows
  • I.E., IRR is the discount rate which makes the NPV = 0
  • Project is financially acceptable when the IRR is greater than the cost of capital
project evaluation1
Project Evaluation
  • Project A has an IRR of 11.16% which is higher than the cost of capital, 10%. Hence project A is financially acceptable.
  • Project B has an IRR of 8.53% which is lower than the cost of capital, 10%. Hence project B is financially not acceptable.
why bother to use irr
Why bother to use IRR?
  • Since both NPV and IRR generate similar results, why bother to use IRR
  • Yield derived from IRR may be more comprehensible than the absolute value derived from NPV
  • In fact, we use IRR when we cannot use the cost of capital (the risk of the project differs from the risk of the firm)
limitations of irr method
Limitations of IRR method
  • A single discount rate (the IRR) throughout the project life – inability to account for cash flows of different risk levels
  • Possibly unrealistic to assume reinvestment of the generated cash inflow at the IRR
  • Inapplicable when more than one reversal of cash flows exists – will generate multiple IRRs in that case
cash flows of investment a b
Investment A

Yr 0 -10000

Yr 1 5000

Yr 2 5000

Yr 3 2000

Investment B

Yr 0 -10000

Yr 1 1500

Yr 2 2000

Yr 3 2500

Yr 4 5000

Yr 5 5000

Cash Flows of Investment A&B
npv profile npvs at different discounting rate

NPV

6000

4000

2000

IRR= 14.33%

0

15

5

10

IRR= 11.16%

Discount Rate

NPV Profile – NPVs at different Discounting rate

INV. B

INV. A

cash flows of investment b c
Investment B

Yr 0 -10000

Yr 1 1500

Yr 2 2000

Yr 3 2500

Yr 4 5000

Yr 5 5000

Investment C

Yr 0 -10000

Yr 1 9000

Yr 2 3000

Yr 3 1200

Cash Flows of Investment B & C
npv profile with crossover
NPV Profile with crossover

NPV

6000

Crossover point

INV.B

4000

2000

INV.C

IRR= 14.33%

0

15

20

5

10

IRR= 22.49%

Discount Rate

where are we
Where are we?
  • How to raise capital?
  • We have learned the three ways of raising long-term capital for a firm. What are they?
  • How to use the capital to generate more money?
  • Underlying principle – to generate an investment return that is greater than cost of capital
  • The lowest required rate of return = cost of capital
project valuation
Project Valuation
  • Similar to the valuation of financial instruments, we must assess the fair market value for any capital expenditure project.
  • The highest price we pay is the present value of expected cash flows (derived from the project) discounted at the rate equivalent to the cost of capital
  • Basic concept – lowest rate of return = highest price to be paid
cash flows determination
Cash Flows Determination
  • Net of tax i.e. after tax net cash flow
  • Gross of all financing costs (they have been reflected in the discount rate)
  • Shortfalls:

- Future projection may base on extrapolation

- Bias built into the cash flows estimation

- Over/under estimate of the inflation

- Neglect other qualitative factors such as better corporate image, fairer treatment of employee, etc

capital rationing
Capital Rationing
  • Management, for some reasons, may impose a dollar constraint in certain kind of investment
  • Projects become mutually exclusive
  • Project is selected based on the amount of benefit generated by the project
  • That is, projects with the greatest NPV or the highest IRR
slide31

Table 12-7Capital rationing

Net

Total Present

Project Investment Investment Value

  • CapitalA $2,000,000 400,000 rationing B 2,000,000 380,000
  • solution C 1,000,000 $5M 150,000
  • Best D 1,000,000 100,000
  • solution E 800,000 $6.8M 40,000
  • F 800,000 (30,000.)
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