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CHAPTER 12

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

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  1. CHAPTER 12 THE CAPITAL BUDGETING DECISION

  2. 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

  3. Areas of Uncertainty in CE Decision • Expected cash flows • Product life • Interest rates • Economic conditions • Technological change

  4. 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

  5. Example - Project A

  6. Project A cont’

  7. 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)

  8. Example - Project B

  9. Project B cont’

  10. 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?

  11. 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

  12. 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)

  13. 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

  14. 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)

  15. 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

  16. 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

  17. IRR of Project A

  18. IRR of Project B

  19. 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.

  20. 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)

  21. 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

  22. Graphical Illustration of NPV and IRR See Examples Below

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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

  30. 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

  31. 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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