Fina Capital Budgeting

Fin2010 Financial Management
Capital Budgeting
Dr. Albert Wang, November, 2012
Chapter Outline
Why Use Net Present Value? Payback Period Method Problems with the IRR Approach The Practice of Capital Budgeting
Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.
Good Decision Criteria

We need to ask ourselves the following questions when evaluating capital budgeting decision rules:
Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm?
Net Present Value

The difference between the market value of a project and its cost How much value is created from undertaking an investment?
The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment.
Why Use Net Present Value?

Accepting positive NPV projects benefits shareholders. NPV uses cash flows NPV uses all the cash flows of the project NPV discounts the cash flows properly
The Net Present Value (NPV) Rule

Net Present Value (NPV) = Total PV of future CFs + Initial Investment Estimating NPV:
1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV
Good Attributes of the NPV Rule

1. Uses cash flows 2. Uses ALL cash flows of the project 3. Discounts ALL cash flows properly Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.
The Payback Period Method

How long does it take the project to pay back its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria:
Set by management
Ranking Criteria:
Set by management
Computing Payback for the Project

Project has initial investment of $165,000. First year cash inflow is $63,120. Second year cash inflow is $70,800. Third year cash inflow is $91,080. Assume we will accept the project if it pays back within two years.
Year 1: 165,000 63,120 = 101,880 still to recover Year 2: 101,880 70,800 = 31,080 still to recover Year 3: 31,080 91,080 = -60,000 project pays back in year 3
Do we accept or reject the project?
The Payback Period Method

Disadvantages:
Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria A project accepted based on the payback criteria may not have a positive NPV
Advantages:
Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity
10
The Discounted Payback Period

How long does it take the project to pay back its initial investment, taking the time value of money into account? Decision rule: Accept the project if it pays back on a discounted basis within the specified time. By the time you have discounted the cash flows, you might as well calculate the NPV
11
Computing Discounted Payback for the Project

Assume we will accept the project if it pays back on a discounted basis in 2 years. Compute the PV for each cash flow and determine the payback period using discounted cash flows
Year 1: 165,000 63,120/1.121 = 108,643 Year 2: 108,643 70,800/1.122 = 52,202 Year 3: 52,202 91,080/1.123 = -12,627 project pays back in year 3
Do we accept or reject the project?
12
Advantages and Disadvantages of Discounted Payback Advantages

Includes time value of money Easy to understand Does not accept negative estimated NPV investments when all future cash flows are positive Biased towards liquidity
Disadvantages
May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff point Biased against long-term projects, such as R&D and new products
13
The Internal Rate of Return: Example

Consider the following project:
$50 $100 $150
0 -$200
The internal rate of return for this project is 19.44%

$50 $100 $150 NPV 0 200 2 3 (1 IRR) (1 IRR) (1 IRR)
14
The NPV Payoff Profile for This Example

If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.
Discount Rate 0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% NPV $100.00 $71.04 $47.32 $27.79 $11.65 ($1.74) ($12.88) ($22.17) ($29.93) ($36.43) ($41.86)
$120.00 $100.00 $80.00 $60.00 NPV $40.00 $20.00 $0.00 -1% ($20.00) ($40.00) ($60.00) Discount rate 9% 19%
IRR = 19.44%
29% 39%
15
Advantages of IRR
Knowing a return is intuitively appealing It is a simple way to communicate the value of a project to someone who doesnt know all the estimation details If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task
16
Problems with the IRR Approach

Multiple IRRs. Are We Borrowing or Lending? The Scale Problem. The Timing Problem.
17
Multiple IRRs
There are two IRRs for this project: $200 0 -$200
NPV $100.00 $50.00 $0.00 -50% 0% ($50.00) ($100.00) ($150.00)
$800 2 3 - $800
Which one should we use?
100% = IRR2
50%
100%
150%
200%
0% = IRR1
Discount rate
18
Borrowing or Lending
Consider two projects Project A: (-$100, $130) Project B: ($100, -$130) The IRR for both projects is 30% For project A, accept if discount rate is less than 30% For project B, accept if discount rate is greater than 30% We refer project A as in investing-type project and project B as a financing-type project
19
The Scale Problem

Would you rather make 100% or 50% on your investments? What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment?
20
The Timing Problem

$10,000 Project A 0 -$10,000 $1,000 Project B 0 -$10,000 The preferred project in this case depends on the discount rate, not the IRR.
$1,000 2
$1,000 3
$1,000 2
$12,000 3
21
The Timing Problem

$5,000.00 $4,000.00 $3,000.00 $2,000.00
Project A Project B
NPV
$1,000.00 $0.00 ($1,000.00) 0% ($2,000.00) ($3,000.00) ($4,000.00) 12.94% 10%
10.55% = crossover rate

20% 30% 40%
= IRRB
16.04% = IRRA
Discount rate
22
IRR and Mutually Exclusive Projects

Mutually exclusive projects
If you choose one, you cant choose the other Example: You can choose to attend graduate school at either Harvard or Stanford, but not both
Intuitively you would use the following decision rules:

NPV choose the project with the higher NPV IRR choose the project with the higher IRR
23
Example With Mutually Exclusive Projects

Period 0 1 2 IRR NPV Project A -500 325 325 19.43% 64.05 Project B -400 325 200 22.17% 60.74
The required return for both projects is 10%.
Which project should you accept and why?
24
NPV Profiles
$160.00 $140.00 $120.00 $100.00 $80.00 NPV $60.00 $40.00 $20.00 $0.00 ($20.00) 0 ($40.00) Discount Rate
IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8%

A B
0.05
0.1
0.15
0.2
0.25
0.3
25
Conflicts Between NPV and IRR

NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV IRR is unreliable in the following situations
Non-conventional cash flows Mutually exclusive projects
26
Capital Budgeting In Practice

We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is a commonly used secondary investment criteria
27
28
Conclusions
Be able to compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their shortcomings Be able to compute internal rates of return (standard and modified) and understand their strengths and weaknesses Be able to compute the net present value and understand why it is the best decision criterion

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Fin2010 Financial Management

Dr. Albert Wang, November, 2012

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Good Decision Criteria

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Net Present Value

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Why Use Net Present Value?

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

The Net Present Value (NPV) Rule

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Good Attributes of the NPV Rule

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

The Payback Period Method

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Computing Payback for the Project

Do we accept or reject the project?

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

The Payback Period Method

The Discounted Payback Period

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Computing Discounted Payback for the Project

Do we accept or reject the project?

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Advantages and Disadvantages of Discounted Payback Advantages

Fin2010 Financial Management

The Internal Rate of Return: Example

The internal rate of return for this project is 19.44%

The NPV Payoff Profile for This Example

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Problems with the IRR Approach

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Which one should we use?

Fin2010 Financial Management

The Scale Problem

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

The Timing Problem

The Timing Problem

$1,000.00 $0.00 ($1,000.00) 0% ($2,000.00) ($3,000.00) ($4,000.00) 12.94% 10%

10.55% = crossover rate

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

IRR and Mutually Exclusive Projects

Intuitively you would use the following decision rules:

Fin2010 Financial Management

Copyright 2012 by Yan (Albert) Wang. All Rights Reserved.

Example With Mutually Exclusive Projects

The required return for both projects is 10%.