Chapter 9 Capital Budgeting Techniques. Learning Outcomes Chapter 9. Describe the importance of capital budgeting decisions and the general process that is followed when making investment (capital budgeting) decisions.
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Learning Outcomes Chapter 9 • Describe the importance of capital budgeting decisions and the general process that is followed when making investment (capital budgeting) decisions. • Describe how (a) the net present value (NPV) technique and (b) the internal rate of return (IRR) technique are used to make investment (capital budgeting) decisions. • Compare the NPV technique with the IRR technique, and discuss why the two techniques might not always lead to the same investment decisions. • Describe how conflicts that might arise between NPV and IRR can be resolved using the modified internal rate of return(MIRR) technique. • Describe other capital budgeting techniques
What is Capital Budgeting? • The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year • Analysis of potential additions to fixed assets • Long-term decisions; involve large expenditures • Very important to firm’s future
Generating Ideas for Capital Projects • A firm’s growth and its ability to remain competitive depend on a constant flow of ideas for new products, ways to make existing products better, and ways to produce output at a lower cost. • Procedures must be established for evaluating the worth of such projects.
Project Classifications • Replacement Decisions: whether to purchase capital assets to take the place of existing assets to maintain or improve existing operations • Expansion Decisions: whether to purchase capital projects and add them to existing assets to increase existing operations • Independent Projects: Projects whose cash flows are not affected by decisions made about other projects • Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted
The Post-Audit • Compares actual results with those predicted by the project’s sponsors and explains why any differences occurred • Two main purposes: • To improve forecasts • To improve operations
Similarities between Capital Budgeting and Asset Valuation • Estimate the cash flows expected from the project. • Evaluate the riskiness of cash flows. • Compute the present value of the expected cash flows to obtain as estimate of the asset’s value to the firm. • Compare the present value of the future expected cash flows with the initial investment.
Net Present Value: Sum of the PVs of Inflows and Outflows • NPV Decision Rule: A project is acceptable if NPV > $0
Rationale for the NPV method: NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Which adds most value?
Using NPV method, which project(s) should be accepted? • If Projects S and L are mutually exclusive, accept S because NPVS = 161.33 > NPVL = 108.67. • If S & L are independent, accept both; NPV > 0.
Calculating IRR • IRR Decision Rule: A project is acceptable if IRR > r
Financial Calculator Method • Enter the cash flows sequentially, and then press the IRR button • For Project S, IRRS = 13.1%. • For Project L, IRRL = 11.4%.
Rationale for the IRR Method • If IRR (project’s rate of return) > the firm’s required rate of return, r, then some return is left over to boost stockholders’ returns. Example: r = 10%, IRR = 15%. Profitable.
Decisions on Projects S and L per IRR • If S and L are independent, accept both. IRRS > IRRL > r = 10%. • If S and L are mutually exclusive, based on IRR, Project S is more acceptable because IRRS > IRRL.
To Find the Crossover Rate: • Find cash flow differences between the projects. • Enter these differences in CF register, then press IRR. Crossover rate = 8.11, rounded to 8.1%. • Can subtract S from L or vice versa. • If profiles don’t cross, one project dominates the other.
Two Reasons NPV Profiles Cross: • Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects. • Timing differences. Project with faster payback provides more CF in early years for reinvestment.
Reinvestment Rate Assumptions • NPV assumes reinvest at r. • IRR assumes reinvest at IRR. • Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
Multiple IRRs • Suppose a project exists with the following cash flow pattern: Year Cash Flow 0 $(1,600,000) 1 10,000,000 2 (10,000,000) • Two IRRs exist for this project.
Modified Internal Rate of Return • A better indicator of relative profitability • Better for use in capital budgeting • MIRR Rule: A project is acceptable if MIRR > r
Traditional Payback Period • The length of time it takes to recover the original cost of an investment from its expected cash flows • Payback period = • PB Decision Rule: A project is acceptable if PB < n* (years determined by the firm)
Discounted Payback Period • The length of time it takes for a project’s discounted (PV of) cash flows to repay the cost of the investment • DPB Decision Rule: A project is acceptable if DPB < Project’s useful life