FINS1613: Business Finance

Semester 2, 2014
Topic: Capital Budgeting I
Contact Details
Emma Jincheng Zhang (Weeks 5-7)
jin.zhang@unsw.edu.au
Rm 302
Consultation hours: Monday 9-11am
Outline
1. Introduction to capital budgeting
a. Independent and mutually exclusive projects
2. Investment decision rules
a. Net present value (NPV)
b. Payback rule
c. Average accounting return (AAR)
d. Internal rate of return (IRR)
e. Modified internal rate of return (MIRR)
f. Profitability index (PI)
3
1. Introduction to capital
budgeting
4
Role of the financial manager
5
It is the role of the financial manager to make some
important decisions
Capital budgeting (investment decision)
What long-term investments should the firm take on?
Capital structure (financing decision)
Where will we get the long-term financing to pay for the investment?
Working capital management
How will we manage the everyday financial activities of the firm?

Capital budgeting decision criteria
6
We need to ask ourselves the following questions when
evaluating decision criteria:
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?

Independent projects
7
What are independent projects?
Independent Projects are investments that have no impact on
each others cash flows.
This means that the company decides to accept or reject each
project and that decision will have no impact on whether
another project is accepted or rejected.
The firm could accept one or more projects or it could reject
them all.

Mutually exclusive projects
8
What are mutually exclusive projects?
Mutually exclusive projects are investments in which accepting
one project requires reject of all other options.
This may be due to financial constraints or limitations to
available assets.
Projects need to be ranked in order to determine which to
undertake.

Mutually exclusive projects
9
An example of two mutually exclusive projects is:
A company has a piece of land and it is debating either building
an office block on the land or building a warehouse.
It cannot use the same piece of land for two different things at
the same time.
These are mutually exclusive projects.

Mutually exclusive projects
10
A second example of two mutually exclusive projects is:
A company has a fixed budget of $20,000 for investment this
year. The firm is considering two projects. The first will take
$15,000 to establish and the second project will require
$18,000.
Clearly, only one project can be carried out this year so they
are mutually exclusive.

2. Investment Decision Rules
11
Net Present Value
12
Net present value (NPV): The difference between an
investments market value and its initial investment.
Steps in calculating the NPV:
Step 1: Estimate the expected future cash
flows.
Step 2: Estimate the required return for projects
of this risk level.
Step 3: Find the present value of the cash flows
and subtract the initial investment to
arrive at the net present value.
NPV Rule: An investment should be accepted if the net
present value is positive and rejected if it is negative
Net Present Value
13

=

1 +

=1


C
t
: Cash flows from the project. These cash flows are
usually inflows (positive).
C
0
: Initial cost of the project. This is usually an outflow
(negative)
r: the discount rate for the project
Net Present Value
14
Cash inflows:
Receipts from sale of goods and services
Receipts from sale of physical assets
Cash outflows:
Expenditure on materials, labour, and indirect expenses for
manufacturing
Selling and administrative
Inventory and taxes

Net Present Value Decision Rule
15
If NPV is positive, accept the project
NPV > 0 means:
project is expected to add value to the firm
project will increase the wealth of the owners
NPV is a direct measure of how well this project will
achieve the goal of increasing shareholder wealth.
NPV represents the net gain in shareholder wealth

Example: Net Present Value
16
You are looking at a new project and have estimated the
following cash flows and net income:





The average book value is $72,000
Your required return for assets of this risk is 12%
We will use this project for all investment decision rules.
Year Cash Flow Net Income
0 -165,000
1 63,120 13,620
2 70,800 3,300
3 91,080 29,100
Example: Net Present Value
17
=

1 +

=1

=
63,120
1.12
+
70,800
1.12
2
+
91,080
1.12
3
165,000
= $12,627.41

t = 0

t = 1

t = 2

$63,120
t = 3

$70,800 $91,080 -$165,000
Analysing the NPV rule
18
Meets all desirable criteria
Considers all cash flows
Considers time value of money
Adjusts for risk
Can rank mutually exclusive projects
NPV method is consistent with the companys objective
of maximising shareholders wealth.
Dominant method; always prevails

Payback rule
19
Payback Period: The amount of time required for an
investment to generate net cash flows sufficient to
recover its initial cost (investment).
Steps in calculating the payback period:
Step 1: Estimate the expected future cash
flows.
Step 2: Subtract the future cash flows from the initial
cost until initial investment is recovered.
Payback Rule: Accept if the payback period is less than
some predetermined limit.

Example: Payback rule
20





= 2 + 3
= 2 +
31,080
91,080
= 2.34
Do we accept or reject the project?
Depends on the companys predetermined limit.
Year Cash Flow Cumulative Cash Flow
0 -165,000 -165,000
1 63,120 -101,880
2 70,800 -31,080
3 91,080 60,000
Example: Payback rule
21
Your companys payback period is 2 years. According to
the payback rule, which of the following projects will you
accept?


Year A B C D E
0 -$100 -$200 -$200 -$200 -$50
1 30 40 40 100 100
2 40 20 20 100 -50,000,000
3 50 10 10 -200
4 60 130 200
Payback period
2.6 Never 4 2 or 4 0.5
Analysing the payback rule
22
Advantages
Easy to understand
Adjusts for uncertainty of
later cash flows
Biased towards liquidity
Disadvantages
Ignores the time value of
money
Requires an arbitrary
cut-off point
Ignores cash flows
beyond the cut-off date
Biased against long-term
projects, such as research
and development, and
new projects
Average Accounting Return
23
Many different definitions for average accounting
return (AAR).
In your textbook: =



Average book value depends on how the asset is
depreciated.
Requires a target cut-off rate
Decision rule: Accept the project if the AAR is greater
than target rate.

Example: Average Accounting Return
24
Sample project data:







Average book value = $72 000
Required average accounting return = 25%
Average net income:
($13 620 + 3300 + 29 100) / 3 = $15 340
AAR = $15 340 / 72 000 = 0.213 = 21.3%
Do we accept or reject the project?

Year Cash Flow Net Income
0 -165,000
1 63,120 13,620
2 70,800 3,300
3 91,080 29,100
Analysing AAR
25
Advantages
Easy to calculate
Needed information
usually available
Disadvantages
Not a true rate of
return
Time value of money
ignored
Uses an arbitrary
benchmark cut-off rate
Based on accounting
net income and book
values, not cash flows
and market values
Internal Rate of Return
26
Most important alternative to NPV
Widely used in practice
Intuitively appealing
Based entirely on the estimated cash flows
Independent of interest rates

Internal Rate of Return
27
Internal Rate of Return (IRR): the discount rate that
makes the NPV equal to 0.
= 0 =

1 +

=0


Decision rule: Accept the project if the IRR is greater
than the required return.
Finding the IRR often involves trial and error.
Example: IRR
28
Sample project data:





To solve for the IRR:
0 = 165,000 +
63,120
1 +
+
70,800
1 +
2
+
91,080
1 +
3


Using trial and error, IRR = 16.132%
Year Cash Flow
0 -165,000
1 63,120
2 70,800
3 91,080
Example: IRR
29
The NPV of the project at various discount rates:








To calculate the NPV at a discount rate of 4%:
= 165,000 +
63,120
1.04
+
70,800
1.04
2
+
91,080
1.04
3
= $42,121
We can plot the NPV profile (next slide).

Discount rate NPV
0% $60,000
4% $42,121
8% $26,446
12% $12,627
16% $380.83
20% -$10,525
Example: IRR
30
-20,000
-10,000
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
Discount Rate
N
P
V
NPV and IRR
31
The NPV and IRR rules always lead to identical decisions
if:
1. Cash flows are conventional
Conventional cash flows: First cash flow (the initial investment) is
negative and all the rest are positive
2. The project is independent
The decision to accept or reject this project does not affect the
decision to accept or reject any other.
Whenever there is a conflict between NPV and another
decision rule, you should always use NPV.


Non-conventional cash flows: Multiple IRRs
32
It is possible for a project to have more than one IRR
value.
This happens in situations when there is a large cash
outflow at the beginning of the project and then
another large outflow at some later time.
This makes it difficult to use the IRR methodology as it
is not possible to know which IRR result should be
used.

Example: Multiple IRRs
33
0 1 2 IRR (%)
Project X -$100 $230 -$132 ??
General equation:
0 = 100 +
230
1+

132
1+
2


At 10%:
= 100 +
230
1.10

132
1.10
2
= 0
At 20%:
= 100 +
230
1.20

132
1.20
2
= 0

Example: Multiple IRRs
34
-2500
-1500
-500
500
0 5 10 15 20 25 30 35
Discount rate (%)
N
e
t

P
r
e
s
e
n
t

V
a
l
u
e

(
$
)
Example: Mutually Exclusive Investments
35
Consider a Projects A and B with the following cash flows:

Year Project A Project B
0 -1,000 -1,500
1 400 599
2 500 400
3 150 600
4 200 350
5 400 400
Example: Mutually Exclusive Investments
36
The NPV of the project at various discount rates:

Discount rate Project A NPV Project B NPV
0% $650.00 $849.00
4% $479.97 $607.13
8% $337.35 $403.36
12% $216.58 $230.17
16% $113.41 $81.79
20% $24.56 -$46.29
24% -$52.53 -$157.61
Mutually Exclusive Investments
37
-400
-200
0
200
400
600
800
1000
0% 5% 10% 15% 20% 25%
N
P
V

(
$
)

Discount rate
Project A Project B
IRR Project B
(18.49%)
Cross-over point
NPV
A
= NPV
B
(13.14%)

IRR Project A
(21.22%)
Analysing the IRR
38
Advantages
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
Disadvantages
Can produce multiple
answers
Cannot rank mutually
exclusive projects
Modified IRR
39
Controls for some problems with IRR
Three methods:
1.Discounting approach = Discount future outflows to present
and add to CF
0
2. Reinvestment approach = Compound all CFs except the
first one forward to end
3. Combination approach = Discount outflows to present;
compound inflows to end
MIRR will be unique number for each method
Discount (finance) /compound (reinvestment) rate
externally supplied

Example: Discounting approach
40



Discounting approach: Discount all negative cash flows to
the present and add to the initial cost.
Solving for the MIRR:
Time 0: -$60 + (-$100/1.20
2
) = -129.44
Time 1: +$155
Time 2: $0
MIRR is 19.75%
0 1 2
Project X -$60 $155 -$100
Adjusted cash flows -$129.44 $155 0
Example: Reinvestment approach
41



Reinvestment approach: Compound all CFs except the
first one to the end of the projects life and calculate IRR.
Solving for the MIRR:
Time 0: -$60
Time 1: $0
Time 2: -$100 + ($155 1.20) = $86
MIRR is 19.72%
0 1 2
Project X -$60 $155 -$100
Adjusted cash flows -$60 0 $86
Example: Combination approach
42



Combination approach: Negative cash flows discounted
back to the present, positive cash flows compounded to
the end of the project.
Solving for the MIRR:
Time 0: -$60 + (-$100/1.20
2
) = -$129.44
Time 1: $0
Time 2: $155 1.20 = $186
MIRR is 19.87%
0 1 2
Project X -$60 $155 -$100
Adjusted cash flows -$129.44 0 $186
MIRR vs. IRR
43
Different opinions about MIRR and IRR.
MIRR avoids the multiple IRR problem.
Managers like rate of return comparisons, and MIRR is
better for this than IRR.
Problem with MIRR: different ways to calculate with no
evidence of the best method.
Interpreting a MIRR is not obvious.

Profitability Index
44
Profitability index: The present value of an investments
future cash flows divided by its initial cost.
Measures the value created per dollar invested (bang for the
buck).
E.g. A profitability index of 1.1 implies that for every $1 of
investment, we create an additional $0.10 in value.
This measure can be very useful in situations where we
have limited capital.
Decision Rule (Independent projects): Accept the project
if PI > 1.0.

Example: Profitability index
45
What is the profitability index for the following set of cash
flows if the relevant discount rate is 10%? Should we accept
the project?






=
13,500
1.10
+
8,500
1.10
2
+
5,500
1.10
3
$20,000
= 1.171
We should accept the project because PI > 1.0.

Year Cash Flow
0 -$20,000
1 13,500
2 8,500
3 5,500
Example: Profitability index
46
What if the discount rate is 22%?

=
13,500
1.22
+
8,500
1.22
2
+
5,500
1.22
3
$20,000
= 0.990

We should reject the project because PI < 1.0.

Example: Profitability index
47
Consider two mutually exclusive projects with the
following cash flows:





The required return is 11%.
According to the PI rule, which project will you choose?
According to the NPV rule, which project will you
choose?

Year Project A Project B
0 -$45,000 -$20,000
1 17,000 6,000
2 20,000 13,000
3 24,000 9,000
Example: Profitability index
48
According to the PI rule, which project will you choose?






According to the PI rule, we choose Project B.
( ) =
17,000
1.11
+
20,000
1.11
2
+
24,000
1.11
3
45,000
= 1.091
( ) =
6,000
1.11
+
13,000
1.11
2
+
9,000
1.11
3
20,000
= 1.127
Example: Profitability index
49
According to the NPV rule, which project will you choose?






According to the NPV rule, we choose Project A.
The profitability index does not consider the scale of the
project. Project A is approximately double the size of project
B.

=
17,000
1.11
+
20,000
1.11
2
+
24,000
1.11
3
45,000
= $4,096.36
=
6,000
1.11
+
13,000
1.11
2
+
9,000
1.11
3
20,000
= $2,537.22
Analysing the Profitability index
50
Advantages
Closely related to
NPV, generally
leading to identical
decisions
Easy to understand
and communicate
May be useful when
available investment
funds are limited
Disadvantages
May lead to incorrect
decisions in
comparisons of
mutually exclusive
investment
Project Evaluation Methods
51
Method Percentage
Accounting Rate of Return 20.29
Profitability Index 11.87
Internal Rate of Return 75.61
Net Present Value 74.93
Payback Period 56.74
Source: Graham & Harvey (2001)
Tutorial Questions
52
Textbook (Chapter 8)
Critical Thinking and Concepts Review
8.3 8.4 8.5 8.7
Questions and Problems
2 4 10 11 12 13 18 21 24 25