Capital Budgeting: the process of planning for purchases of long-term assets.

example:
Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment?

Decision-making Criteria in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected?

Project Evaluation: Alternative Methods Payback Period (PBP) Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI)

Decision-making Criteria in Capital Budgeting

The

Ideal Evaluation Method should:

a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project.

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.

Independent Project
For

this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.
Independent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.

Other Project Relationships

-- A project whose acceptance depends on the acceptance of one or more other projects. Mutually Exclusive -- A project whose acceptance precludes the acceptance of one or more alternative projects.
Dependent

Payback Period (PBP)

0
-40 K

1
10 K

2
12 K

3
15 K

4
10 K

5
7K

PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.
(The number of years needed to recover the initial cash outlay).

Payback Solution (#1)

0
-40 K (-b)

1
10 K 10 K

2
12 K 22 K

3 (a)
15 K 37 K(c)

4
10 K(d) 47 K

5
7K 54 K

Cumulative Inflows

PBP

=a+(b-c)/d = 3 + (40 - 37) / 10 = 3 + (3) / 10 = 3.3 Years

Payback Solution (#2)

0
-40 K -40 K

1
10 K -30 K

2
12 K -18 K

3
15 K -3 K

4
10 K 7K

5
7K 14 K

PBP
Cumulative Cash Flows

= 3 + ( 3K ) / 10K = 3.3 Years

Note: Take absolute value of last negative cumulative cash flow value.

PBP Acceptance Criterion

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

Drawbacks of Payback Period:

Firm

cutoffs are subjective. Does not consider time value of money. Does not consider any required rate of return. Does not consider all of the projects cash flows.

Other Methods
1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Each of these decision-making criteria: Examines all net cash flows, Considers the time value of money, and Considers the required rate of return.

Net Present Value

NPV = the total PV of the annual net cash flows - the initial cash outlay.

NPV =

S
t=1

ACFt (1 + k) t

- ICO

Refer to the nest slide

Net Present Value (NPV) NPV is the present value of an investment projects net cash flows minus the projects initial cash outflow.
CF1 NPV = (1+k)1
+

CF2 (1+k)2

CFn - ICO +...+ n (1+k)

Net Present Value

Decision Rule:

If NPV is positive, ACCEPT. If NPV is negative, REJECT.

NPV Solution
Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%.

NPV = $10,000 +$12,000 +$15,000 + (1.13)1 (1.13)2 (1.13)3

$10,000 $7,000 -$40,000 4 + (1.13)5 (1.13)

= $-1424.423

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(.885) + $12,000(.783) + $15,000(.693) + $10,000(.613) + $ 7,000(.543) - $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000 = - $1,428 (due to rounding)

NPV Acceptance Criterion

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

Net Present Value Profile

Net Present Value

$000s 15
10 5

Sum of CFs

Plot NPV for each discount rate.

IRR (discussed later) NPV@13%

0
-4 0 3 6 9 12 Discount Rate (%) 15

NPV Example

Suppose Small Wonders is considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firms required rate of return is 15%.

83,000 83,000 83,000 83,000 116,000 (276,400)

You should get NPV = $18,235.71

Profitability Index

NPV =

S
t=1

ACFt (1 + k) t

- IO

Profitability Index

NPV =

S
t=1

ACFt (1 + k) t

- IO

PI =

S
t=1

ACFt t (1 + k)

IO

Profitability Index (PI)

PI is the ratio of the present value of a projects future net cash flows to the projects initial cash outflow.
CF1 PI = (1+k)1
+

CF2 CFn +...+ 2 (1+k) (1+k)n

<< OR >>

ICO

PI = 1 + [ NPV / ICO ]

Profitability Index

Decision Rule:

If PI is greater than or equal to 1, ACCEPT. If PI is less than 1, REJECT.

PI Acceptance Criterion
PI = $38,572 / $40,000 = 0.9643

Should this project be accepted?

No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI < 1.00 ]

PI Example
Suppose

we are required to find PI for Small Wonders . Recall that the firms required rate of return is 15%.

83,000 83,000 83,000 83,000 116,000 (276,400)

You should get PI = 1.066

Internal Rate of Return (IRR)

IRR: the return on the firms invested capital.

IRR is simply the rate of return that the firm earns on its capital budgeting projects.It is the discount rate that equates the present value of the future net cash flows from an investment project with the projects initial cash outflow.

Internal Rate of Return (IRR)

NPV =

S
t=1

ACFt (1 + k) t

- IO

Internal Rate of Return (IRR)

NPV =

S
t=1 n

ACFt (1 + k) t

- IO

IRR:

S
t=1

ACFt t (1 + IRR)

= IO

Internal Rate of Return (IRR)

CF1 CF2 + ICO = 1 (1+IRR) (1+IRR)2

+...+

CFn (1+IRR)n

IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay. This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.

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
Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000

IRR Solution (Try 10%)

$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(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) + $ 7,000(.621) $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 = $41,444 [Rate is too low!!]

IRR Solution (Try 15%)

$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(.870) + $12,000(.756) + $15,000(.658) + $10,000(.572) + $ 7,000(.497) $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 = $36,841 [Rate is too high!!]

IRR Solution (Interpolate)

.05

.10 IRR .15

$41,444 $40,000 $36,841

$1,444 $4,603

X .05

$1,444 $4,603

IRR Solution (Interpolate)

.05

.10 IRR .15

$41,444 $40,000 $36,841

$1,444 $4,603

($1,444)(0.05) $4,603 X=

X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

IRR Acceptance Criterion

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

IRR Example
Looking

again at same Small Wonders problem for IRR.

83,000 83,000 83,000 83,000 116,000 (276,400)

You should get IRR = 17.63%

IRR

Decision Rule:
If IRR is greater than or equal to the required rate of return, ACCEPT. If IRR is less than the required rate of return, REJECT.

IRR
IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)

(500)
0

200
1

100
2

(200)
3

400
4

300
5

Evaluation Summary
Basket Wonders Independent Project

Method Project Comparison Decision PBP IRR NPV PI 3.3yrs 11.47% -$1,424 .96 3.5yrs 13% $0 1.00 Accept Reject Reject Reject

Summary Problem:
(900) 0 300 1 400 2 400 3 500 4 600 5

Using a required rate of return of 15%, find the NPV, IRR and PI for the cash flows given above.
NPV = $510,52 IRR = 34.37% PI = 1.57

Practice Question
A project has the following after-tax cash inflows for years 1 through 4 :$34,444,$39,877,$25,000 & $52,800
Given that the initial cash outflow is $104,000. discount rate is 12%, hurdle rate is 13% & the maximum payback period is 3.5 years, calculate the PBP, NPV, PI & IRR and prepare an evaluation summary.

47

Potential Problems Under Mutual Exclusivity

Ranking of project proposals may create contradictory results.

A. Scale of Investment B. Cash-flow Pattern C. Project Life

A. Scale Differences
Compare a small (S) and a large (L) project.

END OF YEAR 0 1 2

NET CASH FLOWS Project S Project L

-$100 0 $400 -$100,000 0 $156,250

Scale Differences
Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why?
Project S L IRR 100% 25% NPV $ 231 $29,132 3.31 1.29 PI

B. Cash Flow Pattern

Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project.

END OF YEAR 0 1 2 3

NET CASH FLOWS Project D Project I -$1,200 1,000 500 100 -$1,200 100 600 1,080

Cash Flow Pattern

Calculate the IRR, NPV@10%, PI@10%. Which project is preferred?
Project IRR
D I 23% 17%

and

NPV
$197.45 $198.20

PI
1.16 1.17

Examine NPV Profiles

600 Net Present Value ($)

400

Plot NPV for each project at various discount rates. NPV@10%

IRR

-200

0 0

200

10 15 20 Discount Rate (%)

25

Fishers Rate of Intersection

Net Present Value ($) 600 -200 0 200 400

At k<10%, I is best!

Fishers Rate of Intersection

At k>10%, D is best!

10 15 20 Discount Rate ($)

25

C. Project Life Differences

Let us compare a long life (X) project and a short life (Y) project.
END OF YEAR 0 1 2 3 NET CASH FLOWS Project X Project Y -$1,000 0 0 3,375 -$1,000 2,000 0 0

Project Life Differences

Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why?
Project X Y IRR 50% 100% NPV $1,536 $ 818 PI 2.54 1.82

Choosing by IRRs for BW

Project
C F E B

ICO
$ 5,000 15,000 12,500 5,000

IRR
37% 28 26 25

NPV
$ 5,500 21,000 500 6,500

PI
2.10 2.40 1.04 2.30

Projects C, F, and E have the three largest IRRs. The resulting increase in shareholder wealth is $27,000 with a $32,500 outlay.

Multiple IRR Problem

Let us assume the following cash flow pattern for a project for Years 0 to 4: -$100 +$100 +$900 -$1,000

How many potential IRRs could this project have?

Two!! There are as many potential IRRs as there are sign changes.

NPV Profile -- Multiple IRRs

75
Net Present Value ($000s) 50 25 0 Multiple IRRs at k = 12.95% and 191.15%

-100

40

80 120 160 Discount Rate (%)

200

Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and benefits of a project with original estimates.

Identify any project weaknesses Develop a possible set of corrective actions Provide appropriate feedback
Result: Making better future decisions!

END OF CHAPTER