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Chapter 13

Chapter 13. Capital Budgeting Techniques. After Studying Chapter 13, you should be able to:.

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Chapter 13

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  1. Chapter 13 Capital Budgeting Techniques

  2. After Studying Chapter 13, you should be able to: • Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability. • Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and profitability index (PI). • Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. • Define, construct, and interpret a graph called an “NPV profile.” • Understand why ranking project proposals on the basis of IRR, NPV, and PI methods “may” lead to conflicts in rankings. • Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or PI rankings. • Understand how “sensitivity analysis” allows us to challenge the single-point input estimates used in traditional capital budgeting analysis. • Explain the role and process of project monitoring, including “progress reviews” and “post-completion audits.”

  3. Capital Budgeting Techniques • Project Evaluation and Selection • Potential Difficulties • Capital Rationing • Project Monitoring • Post-Completion Audit

  4. Overview Of Capital Budgeting Techniques • Capital budgeting techniques are used to assess and rank proposed projects. • Preferred techniques should include: • Time value considerations • Risk and return considerations • Valuation considerations • Are used to ensure projects selected are consistent with the firm’s goal of maximising shareholder wealth.

  5. Project Evaluation: Alternative Methods • Payback Period (PBP) • Internal Rate of Return (IRR) • Net Present Value (NPV) • Profitability Index (PI) • Refer to the additional PowerPoint slides and the Excel spreadsheet “VW13E-13b.xlsx” for computer-based solutions.

  6. Proposed Project Data Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.

  7. Independent Project • Independent – A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. • For this project, assume that it is independentof any other potential projects that Basket Wonders may undertake.

  8. Payback Period (PBP) PBPis the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. 0 1 2 3 4 5 –40 K 10 K 12 K 15 K 10 K 7 K

  9. Payback Solution (#1) PBP = a + ( b– c ) / d = 3 + (40 – 37) / 10 = 3 + (3) / 10 = 3.3 Years (a) 0 1 2 3 4 5 (-b) (d) –40 K 10 K 12 K 15 K 10 K 7 K (c) 10 K 22 K 37 K 47 K 54 K Cumulative Inflows

  10. Payback Solution (#2) PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. 0 1 2 3 4 5 –40 K 10 K 12 K 15 K10 K 7 K –40 K –30 K –18 K –3 K 7 K 14 K Cumulative Cash Flows

  11. Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.] The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type. Should this project be accepted? PBP Acceptance Criterion

  12. Payback Period • Peng Xi is currently contemplating two projects: project A, requiring an initial investment of $42,000; and project B, requiring an initial investment of $45,000. The projected incremental (relevant) operating net cash inflows for the two projects are shown below:

  13. Payback Period • Project A: $42,000 • $14,000 • = 3 years • Project B: $28,000 (Year 1) + • $12,000 (Year 2) • $40,000 + • $5,000/$10,000 (Year 3) • = 3.5 years

  14. Strengths: Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows Weaknesses: Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective PBP Strengths and Weaknesses

  15. IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. We equate the NPV of the investment opportunity with $0. Internal Rate of Return (IRR) CF1 CF2 CFn ICO = + + . . . + • (1 + IRR)1 (1 + IRR)2 (1 + IRR)n

  16. Internal Rate of Return (IRR) • Calculated by: • [Equation 13.1] • Where: • CF0 = Project’s initial investment • CFt = Net cash inflows for year t • t = Year t

  17. Internal Rate of Return (IRR) • Requires a trial and error approach, substituting different discount rates until the equation balances. • Get 2 NPVs – one positive, the other negative, then interpolate. • Decision criteria: • Accept if IRR > Hurdle rate (Cost Of Capital) • Reject if IRR < Hurdle rate (Cost Of Capital)

  18. Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000. IRR Solution $10,000 $12,000 $40,000 = + + (1+IRR)1(1+IRR)2 $15,000 $10,000 $7,000 + + (1+IRR)3(1+IRR)4(1+IRR)5

  19. $40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5) $40,000 = $10,000(0.909) + $12,000(0.826) + $15,000(0.751) + $10,000(0.683) + $ 7,000(0.621) $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 = $41,444 [Rate is too low!!] IRR Solution (Try 10%)

  20. $40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5) $40,000 = $10,000(0.870) + $12,000(0.756) + $15,000(0.658) + $10,000(0.572) + $ 7,000(0.497) $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 = $36,841 [Rate is too high!!] IRR Solution (Try 15%)

  21. 0.10 $41,444 0.05IRR$40,000$4,603 0.15 $36,841 X$1,4440.05$4,603 IRR Solution (Interpolate) $1,444 X =

  22. 0.10 $41,444 0.05IRR$40,000$4,603 0.15 $36,841 X$1,4440.05$4,603 IRR Solution (Interpolate) $1,444 X =

  23. 0.10 $41,444 0.05 IRR $40,000 $4,603 0.15 $36,841 ($1,444)(0.05) $4,603 IRR Solution (Interpolate) $1,444 X X = X = 0.0157 IRR = 0.10 + 0.0157 = 0.1157 or 11.57%

  24. IRR Interpolation Formula • Interpolate for IRR using this formula • [(N1k2) – (N2k1)] / (N1 – N2) • Where: • N1 = Positive NPV • N2 = Negative NPV • k1 = discount rate for positive NPV • k2 = discount rate for negative NPV

  25. IRR Interpolation Formula • Interpolate for IRR • [(N1k2) – (N2k1)] / (N1 – N2) • [(1,444 x 0.15) – (- 3,159 x .1)]/(41,444 – 36,841) • [(216.6 – -315.9)/4,603 • 532.5/4,603 • 11.57%

  26. No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR< Hurdle Rate ] The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted? IRR Acceptance Criterion

  27. IRRs on the Calculator We will use the cash flow registry to solve the IRR for this problem quickly and accurately!

  28. Actual IRR Solution Using Your Financial Calculator Steps in the Process Step 1: Press CF key Step 2: Press 2nd CLR Work keys Step 3: For CF0 Press -40000 Enter  keys Step 4: For C01 Press 10000 Enter  keys Step 5: For F01 Press 1 Enter  keys Step 6: For C02 Press 12000 Enter keys Step 7: For F02 Press 1 Enter  keys Step 8: For C03 Press 15000 Enter  keys Step 9: For F03 Press 1 Enter  keys

  29. Actual IRR Solution Using Your Financial Calculator Steps in the Process (Part II) Step 10:For C04 Press 10000 Enter keys Step 11:For F04 Press 1 Enter  keys Step 12:For C05 Press 7000 Enter keys Step 13:For F05 Press 1 Enter  keys Step 14: Press  keys Step 15: Press IRR key Step 16: Press CPT key Result: Internal Rate of Return = 11.47%

  30. Strengths: Accounts for TVM Considers all cash flows Less subjectivity Weaknesses: Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs IRR Strengths and Weaknesses

  31. NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. Net Present Value (NPV) CF1CF2CFn -ICO NPV = + + . . . + • (1+k)1 (1+k)2 (1+k)n

  32. Net Present Value (NPV) • Decision criteria: • Accept if NPV > $0 • Reject if NPV < $0 • If the NPV is greater than $0, the firm will earn a return greater than its hurdle rate (cost of capital).

  33. Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. NPV Solution $10,000$12,000$15,000 NPV= + + + (1.13)1(1.13)2(1.13)3 $10,000$7,000 + - $40,000 (1.13)4(1.13)5

  34. NPV Solution NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $ 7,000(PVIF13%,5) – $40,000 NPV = $10,000(0.885) + $12,000(0.783) + $15,000(0.693) + $10,000(0.613) + $ 7,000(0.543) – $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 – $40,000 = - $1,428

  35. NPV Solution(alternative layout) Period CF PVIF13%,5 PV • 0 -40,000 1.000 -40,000 • 1 10,000 0.885 8,850 • 2 12,000 0.783 9,396 • 3 15,000 0.693 10,395 • 4 10,000 0.613 6,130 • 5 7,000 0.543 3,801 • Net present value - 1,428

  36. No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV< 0 ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted? NPV Acceptance Criterion

  37. NPV on the Calculator We will use the cash flow registry to solve the NPV for this problem quickly and accurately! Hint: If you have not cleared the cash flows from your calculator, then you may skip to Step 15.

  38. Actual NPV Solution Using Your Financial Calculator Steps in the Process Step 1: Press CF key Step 2: Press 2nd CLR Work keys Step 3: For CF0 Press -40000 Enter  keys Step 4: For C01 Press 10000 Enter  keys Step 5: For F01 Press 1 Enter  keys Step 6: For C02 Press 12000 Enter keys Step 7: For F02 Press 1 Enter  keys Step 8: For C03 Press 15000 Enter  keys Step 9: For F03 Press 1 Enter  keys

  39. Actual NPV Solution Using Your Financial Calculator Steps in the Process (Part II) Step 10:For C04 Press 10000 Enter keys Step 11:For F04 Press 1 Enter  keys Step 12:For C05 Press 7000 Enter keys Step 13:For F05 Press 1 Enter  keys Step 14: Press  keys Step 15: Press NPV key Step 16: For I=, Enter 13 Enter  keys Step 17: Press CPT key Result: Net Present Value = -$1,424.42

  40. Strengths: Cash flows assumed to be reinvested at the hurdle rate. Accounts for TVM. Considers all cash flows. Weaknesses: May not include managerial options embedded in the project. See Chapter 14. NPV Strengths and Weaknesses

  41. Ranking & Conflicting Rankings • Ranking is necessary when: • Projects are mutually exclusive • Capital rationing is necessary • Conflicting rankings arise due to differences in cash flow: • Timing • Magnitude • Which are a result of differences in the underlying assumptions concerning the reinvestment of intermediate net cash flows.

  42. Ranking & Conflicting Rankings • NPV assumes minimum opportunity cost – the opportunity cost of the current project would be the return on a hypothetical alternative project that just covers the cost of capital. • IRR assumes maximum opportunity cost – the maximum cost of capital a project could sustain and still be acceptable or the opportunity cost on a hypothetical alternative project offering a return equal to the IRR.

  43. Which Is Better – NPV Or IRR? • On a theoretical basis NPV is preferred as: • it assumes intermediate flows are reinvested at the firm’s cost of capital. • avoids possibility of time consuming multiple IRR’s. • it directly reflects the actual project return. • On a practical basis, many financial managers prefer IRR because: • it works with rates of return not dollars. • NPV does not measure benefits relative to the amount invested • Most organisations use both.

  44. Net Present Value Profile $000s Sum of CF’s Plot NPV for each discount rate. 15 10 Three of these points are easy now! Net Present Value 5 IRR NPV@13% 0 -4 0 3 6 9 12 15 Discount Rate (%)

  45. Creating NPV Profiles Using the Calculator Hint: As long as you do not “clear” the cash flows from the registry, simply start at Step 15 and enter a different discount rate. Each resulting NPV will provide a “point” for your NPVProfile!

  46. PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. Profitability Index (PI) Method #1: CF1CF2CFn PI = ICO + + . . . + • (1+k)1 (1+k)2 (1+k)n << OR >> PI = 1 + [ NPV / ICO] Method #2:

  47. No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI< 1.00 ] PI = $38,572 / $40,000 = .9643 (Method #1, previous slide) Should this project be accepted? PI Acceptance Criterion

  48. Strengths: Same as NPV Allows comparison of different scale projects Weaknesses: Same as NPV Provides only relative profitability Potential Ranking Problems PI Strengths and Weaknesses

  49. Evaluation Summary Basket Wonders Independent Project

  50. Project Evaluation: Remember Chapter 12 ‘New Asset’ project? We will start with the cash flows of the project and also calculate the cumulative cash flow values. We can use Excel functions / approaches to calculate each of the following methods from the above cash flows.

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