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9. Capital Budgeting: Decision Criteria and Real Option Considerations. Introduction. This chapter looks at capital budgeting decision models. It discusses and illustrates their relative strengths and weaknesses.
9 Capital Budgeting: Decision Criteria and Real Option Considerations
Introduction • This chapter looks at capital budgeting decision models. • It discusses and illustrates their relative strengths and weaknesses. • It examines project review and post-audit procedures, and traces a sample project through the capital budgeting process.
Capital Budgeting Criteria • Net present value(NPV) • Internal rate of return(IRR) • Profitability index(PI) • Payback period(PB)
Net Present Value • The net present value—that is, the present value (PV) of the expected future cash flows minus the initial outlay—of an investment made by a firm represents the contribution of that investment to the value of the firm, and accordingly, to the wealth of the firm’s shareholders.
Net Present Value • The net present value (NPV) of a capital expenditure project is defined as the present value of the stream of net (operating) cash flows from the project minus the project’s net investment.
Net Present Value • The net present value method is also sometimes called the discounted cash flow (DFC) technique. The cash flows are discounted at the firm’s required rate of return; that is, its cost of capital. • A firm’s cost of capital is defined as its minimum acceptable rate of return for projects of average risk.
Net Present Value • The net present value of a project may be expressed as follows: NPV = PVNCF – NINV where NPV is the net present value, PVNCF is the present value of net (operating) cash flows, and NINV is the net investment.
Net Present Value • In general, the net present value of a project can be defined as follows: where k is the cost of capital, n is the expected project life, and is the arithmetic sum of the discounted net cash flows for each year t over the life of the project (n years); that is, the present value of the net cash flows.
NPV Characteristics • Decision Rule: NPV > 0 acceptable above-normal profits • Considers the time value of money • Absolute measure of wealth • Positive NPVs increase owner’s wealth • Negative NPVs decrease owner’s wealth • CFs over the project’s life reinvested at k • If two or more mutually exclusive investments have positive net present values, the project having the largest net present value is the one selected.
Conditions Allowing Above-Normal Profits • Buyers preferences for established brand names • Ownership or control of distribution systems • Patent control of superior product designs or production systems • Exclusive ownership of superior natural resources
Conditions Allowing Above-Normal Profits • Inability of new firms to acquire factors of production (management, labor, equipment) • Superior access to financial resources at lower costs (economies of scale in attracting capital) • Economies of large-scale production and distribution • Access to superior labor or managerial talents at costs that are not fully reflective of their value
Conditions Allowing Above-Normal Profits • The net present value of a project can be thought of as the contribution to the value of a firm resulting from undertaking that particular project. • If a firm identifies projects having expected positive net present values, efficient capital markets can quickly reflect these positive net present value projects in the market value of the firm’s securities.
NPV: Advantage • The net present value of a project is the expected number of dollars by which the present value of the firm is increased as a result of adopting the project. The NPV method is consistent with the goal of shareholder wealth maximization. • The NPV approach considers both the magnitude and the timing of cash flows over a project’s entire expected life.
NPV: Advantage • A firm can be thought of as a series of projects, and the firm’s total value is the sum of the net present values of all the independent projects that make it up. Therefore, when the firm undertakes a new project, the firm’s value is increased by the (positive) net present value of the new project. The additivity of net present values of independent projects is referred to in finance as the value additivity principle.
NPV: Advantage • The net present value approach also indicates whether a proposed project will yield the rate of return required by the firm’s investors. The cost of capital represents this rate of return; when a project’s net present value is greater than or equal to zero, the firm’s investors can expect to earn at least their required rate of return.
NPV: Disadvantage • The net present value criterion has a weakness in that many people find it difficult to work with a present value dollar return rather than a percentage return. As a result, many firms use another present value-based method that is interpreted more easily: the internal rate of return method.
Internal Rate of Return • The internal rate of return is defined as the discount rate that equates the PV of net cash flows of a project with the PV of the NINV. • It is the discount rate that causes a project’s net present value to equal zero. • The internal rate of return for a capital expenditure project is identical to the yield to maturity for a bond investment.
Internal Rate of Return • A project’s internal rate of return (IRR) can be determined by means of the following equation: where NCFt /(1 + r)t is the present value of net (operating) cash flows in period t discounted at the rate r, NINV is the net investment in the project, and r is the internal rate of return.
Internal Rate of Return • NPV versus IRR: The only difference is that in the NPV approach a discount rate, k, is pre-specified and the net present value is computed, whereas in the IRR method the discount rate, r, which causes the project net present value to equal to, is the unknown.
Internal Rate of Return • Figure 9.1 illustrates the relationship between NPV and IRR. The figure plots the net present value of Project B (from Table 9.1) against the discount rate used to evaluate its cash flows. Note that at a 14% cost of capital, the net present value of Project B is $7,735. The internal rate of return for Project B is approximately equal to 18.2%. Thus, the internal rate of return is a special case of the net present value computation.
Internal Rate of Return: Project A • The internal rate of return for Projects A and B can now be calculated. Because Project A is an annuity of $12,500 for six years requiring a net investment of $50,000, its internal rate of return may be computed directly with the aid of a PVIFA table, such as Table IV, or with a financial calculator.
Internal Rate of Return: Project A • In this case, the present value of the annuity, PVAN0, $50,000, the annuity payment, PMT, is $12,500, and n = 6 years. The following equation, PVAN0 = PMT(PVIFAr,n) can be rewritten to solve for the PVIFA: PVIFAr,n = PVAN0PMT
Internal Rate of Return: Project A • In this case, PVIFA = $50,000/$12,500 = 4.000. Referring to Table IV and reading across the table for n = 6, it can be seen that the interest factor of 4.000 occurs near 13 percent, where it is 3.998. Thus, the internal rate of return fro Project A is about 13 percent.
Internal Rate of Return: Project A • 6 → N -50,000 → PV 12,500 → PMT 0 → FV (You can skip this step.) Compute i% (= 12.98)
Internal Rate of Return: Project B • -50,000 → CF0 5,000 → CF1 10,000 → CF2 15,000 → CF3 15,000 → CF4 25,000 → CF5 30,000 → CF6 Compute IRR (= 18.19)
IRR Characteristics • Decision Rule: IRR >k acceptable • Generally, the internal rate of return method indicates that a project whose internal rate of return is greater than or equal to the firm’s cost of capital should be acceptable, whereas a project whose internal rate of return is less than the firm’s cost of capital should be rejected. • IRR assumes CF is reinvested at IRR.
IRR: Advantage • The internal rate of return technique takes into account both the magnitude and the timing of cash flows over the entire life of a project in measuring the project’s economic desirability. • The greater popularity of the internal rate of return method may be due to the fact that some people feel more comfortable dealing with the concept of a project’s percentage rate of return than with its dollar amount of net present value.
IRR: Disadvantage • If the pattern of cash flows over the project’s life contains more than one sign change (for example, - + + -.), it has multiple internal rates of return.
NPV versus IRR • If the NPV and IRR criteria disagree, NPV is preferred. • Always agree if NPV > 0, IRR > k; and if NPV < 0, IRR < k.
NPV versus IRR • As was indicated, both the NPV and the IRR methods result in identical decisions to either accept or reject an independent project. This is true because the net present value is greater than (less than) zero if and only if the internal rate of return is greater than (less than) the required rate of return, k(or cost of capital).
NPV versus IRR • In the case of mutually exclusive projects, however, the net present value and the internal rate of return methods may yield contradictory results; one project may have a higher internal rate of return than another and, at the same time, a lower net present value.
NPV versus IRR • Consider, for example, mutually exclusive projects L and M described in the following table:
NPV versus IRR • The outcome depends on what assumptions the decision maker chooses to make about the implied reinvestment rate for the net cash flows generated from each projects. This can be seen in Figure 9.2.
NPV versus IRR • For discount (reinvestment) rates below 10 percent, Project M has a higher net present value than Project L and therefore is preferred. • For discount rates greater than 10 percent, Project L is preferred using both the present value and internal rate of return approaches. • Hence, a conflict only occurs in this case for discount (cost-of-capital) rates below 10 percent.
NPV versus IRR • The net present value method assumes that cash flows are reinvested at the firm’s cost of capital, whereas the internal rate of return method assumes that these cash flows are reinvested at the computed internal rate of return.
NPV versus IRR • Generally, the cost of capital is considered to be a more realistic reinvestment rate than the computed internal rate of return because the cost of capital is the rate the next (marginal) investment project can be assumed to earn.
NPV versus IRR • Consequently, in the absence of capital rationing, the net present value approach is normally superior to (both the profitability index and) the internal rate of return when choosing among mutually exclusive investment.
Profitability Index • The profitability index (PI), or benefit-cost ratio, is the ratio of the present value of expected net cash flows over the life of a project to the net investment (NINV). It is expressed as follows:
Profitability Index • Assume a 14 percent cost of capital, k, and using the data from Table 9.2, the profitability index for Projects A and B can be calculated as follows: PIA = $48,613/$50,000 = 0.97 PIB = $57,735/$50,000 = 1.15
Profitability Index • The profitability index is interpreted as the present value return for each dollar of initial investment. • In comparison, the net present value approach measures the total present value dollar return.
PI Characteristics • Decision Rule: PI > 1 acceptable • A project whose profitability index is greater than or equal to 1 is considered acceptable (+NPV), whereas a project having a profitability index less than 1 is considered unacceptable (-NPV). • In the previous case, which project is acceptable? • The profitability index considers the time value of money.
PI Characteristics • When two or more independent projects with normal cash flows (for example, - + + + ….) are considered, the profitability index, net present value, and internal rate of return approaches all will yield identical accept-reject signals; this is true, for example, with Projects A and B in the previous case.
PI Characteristics • When dealing with mutually exclusive investments, conflicts may arise between the net present value and the profitability index criteria. This is most likely to occur if the alternative projects require significantly different net investments.
PI Characteristics • Consider, for example, the following information on Projects J and K. • According to the net present value criterion, Project J would be preferred because of its larger net present value. According to the profitability index criterion, Project K would be preferred.
PI Characteristics • When a conflict arises, the final decision must be made on the basis of other factors. For example, if a firm has no constraint on the funds available to it for capital investment—that is, no capital rationing—the net present value approach is preferred because it will select the projects that are expected to generate the largest total dollar increase in the firm’s wealth and, by extension, maximize shareholder wealth.
PI Characteristics • If, however, the firm is in a capital rationing situation and capital budgeting is being done for only one period, the profitability index approach may be preferred because it will indicate which projects will maximize the returns per dollar of investment—an appropriate objective when a funds constraint exists.
Net Investment PB = Annual net CF Payback Period • Number of years for the cumulative net cash flows from a project to equal the initial cash outlay When net CFs are unequal, interpolation is required.