Professional Documents
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Capital Budgeting
Road Map
Main Issues
• NPV Rule
Contents
1 NPV Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14-3
2 Cash Flow Calculations . . . . . . . . . . . . . . . . . . . . . 14-5
2.1 Use Cash Flows, Not Accounting Earnings . . . . . . . . . . . . . 14-7
2.2 Use After-tax Cash Flows . . . . . . . . . . . . . . . . . . . . . . 14-8
2.3 Investment In WC Is A Capital Expenditure . . . . . . . . . . . . . 14-9
3 Discount Rates . . . . . . . . . . . . . . . . . . . . . . . . . 14-13
3.1 Using CAPM to Estimate Cost of Capital . . . . . . . . . . . . . . 14-15
3.2 Using APT to Estimate Cost of Capital . . . . . . . . . . . . . . . 14-17
3.3 Discount Rate and Time Horizon . . . . . . . . . . . . . . . . . . 14-18
4 Project Interaction . . . . . . . . . . . . . . . . . . . . . . . 14-20
5 Alternatives to NPV . . . . . . . . . . . . . . . . . . . . . . 14-22
5.1 Payback Period . . . . . . . . . . . . . . . . . . . . . . . . . . . 14-23
5.2 Internal Rate of Return (IRR) . . . . . . . . . . . . . . . . . . . . 14-25
5.3 Profitability Index . . . . . . . . . . . . . . . . . . . . . . . . . . 14-29
5.4 The Practice of Capital Budgeting . . . . . . . . . . . . . . . . . 14-30
6 Other Issues in Capital Budgeting . . . . . . . . . . . . . . . 14-31
7 Appendix: Additional Issues . . . . . . . . . . . . . . . . . . 14-32
7.1 Consistent Treatment of Inflation . . . . . . . . . . . . . . . . . . 14-32
7.2 Use Appropriate Discount Rates . . . . . . . . . . . . . . . . . . 14-33
7.3 Use Market Values . . . . . . . . . . . . . . . . . . . . . . . . . 14-33
8 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 14-34
1 NPV Rule
The objective of investment decisions is to increase the firm’s
current market value. Let the cash flow of an investment (a
project) be
{CF 0 , CF 1 , · · · , CF t}.
Investment Criteria:
3. For mutually exclusive projects, take the one with positive and
highest NPV.
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-4 Capital Budgeting Chapter 14
1. Cash flows
2. Discount rates
3. Strategic options.
These three factors are the focus of the rest of this chapter.
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-6 Capital Budgeting Chapter 14
= [Operating Revenues]
− [Operating Expenses without depreciation]
− [Capital Expenditures]
− [Income Taxes].
+ (τ )[Depreciation].
0 0 0 - 1,000,000
1 300,000 - 100,000 - 100,000 = (1-0.4)(100,000) = (1-0.4) (300,000-100,00) +
100,000 60,000 40,000 = 160,000
2 100,000 60,000 160,000
3 100,000 60,000 160,000
4 100,000 60,000 160,000
5 100,000 60,000 160,000
6 100,000 60,000 160,000
7 100,000 60,000 160,000
8 100,000 60,000 160,000
9 100,000 60,000 160,000
10 100,000 60,000 160,000
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-8 Capital Budgeting Chapter 14
Year 0 1 2 3 4 5
Invest 500
Operating CF 0 100 300 300 300
Depreciation 100 100 100 100 100
Income -100 0 200 200 200
Tax -50 0 100 100 100
After-tax CF -500 50 100 200 200 200
PV at 10% -500 45.45 82.64 150.26 136.60 124.18
NPV = +39.13.
1. Suppose we want to earn 10% after tax and tax rate is 50%
2. Then, it is OK to earn 20% before tax.
In the above example, the pre-tax return is 20.5% while the after-
tax return is 12.5%. (Here, the return on a cash flow is defined
as its IRR.)
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-10 Capital Budgeting Chapter 14
0 0 (1)(30) = 30 -30
Note:
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-12 Capital Budgeting Chapter 14
6. Salvage value is fully taxable since the book value at the end
of year 10 is $0 (the machine cost has been fully depreciated).
3 Discount Rates
Recall that, given a project’s (expected) cashflows
{CF 0 , CF 1 , . . . , CF t}
its NPV is
CF 1 CF t
NPV = CF 0 + + ··· + .
1 + r1 (1 + rt)t
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-14 Capital Budgeting Chapter 14
r̄ = rF + β (r̄m − rF)
where
• McGraw Hill should not use its own beta to discount Super-
Soft’s cash flows.
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-16 Capital Budgeting Chapter 14
Answer:
Caveat:
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-18 Capital Budgeting Chapter 14
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-20 Capital Budgeting Chapter 14
4 Project Interaction
• With the cash flows of a project and the appropriate (timing-
and risk-adjusted) discount rates, we can compute its NPV
and make a decision on whether or not to take the project.
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-22 Capital Budgeting Chapter 14
5 Alternatives to NPV
In practice, other investment rules are also used:
• Payback Period
Firms use these rules because they were used historically and they
may have worked (in combination with common sense) in the
particular cases encountered by these firms.
CF 1 + CF 2 + · · · + CF s ≥ −CF 0 = I0
CF 0 CF 1 CF 2 CF 3 CF 4 CF 5 CF 6 t∗
Project 1 -100 20 40 30 10 40 60 4
Project 2 -100 10 10 80 5 10 10 3
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-24 Capital Budgeting Chapter 14
• It ignores discounting.
CF 1 CF 2 CF t∗
+ + · · · + ≥ −CF 0
1+r (1 + r)2 (1 + r)t∗
CF 0 CF 1 CF 2 CF 3 CF 4 CF 5 CF 6
Project 1 -100 20 40 30 10 40 60
Project 2 -100 10 10 80 5 10 10
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-26 Capital Budgeting Chapter 14
CF 0 CF 1
Project 1 -100 120
Project 2 100 -120
However,
• Project 1 has a positive NPV only if r < 20%.
• Project 2 has a positive NPV only if r > 20%.
• Should take project 1 and reject project 2.
2. Non-existence of IRR
CF 0 CF 1 CF 2
Project 1 -105 250 -150
Project 2 105 -250 150
3. Multiple IRR’s
CF 0 CF 1 CF 2 CF 3
Project 1 -500,000 1,575,000 -1,653,750 578,815
Project 2 -500,000 1,605,000 -1,716,900 612,040
IRR1 = 7%
4%
IRR2 = 7%
10%
40
20
0
0 0.02 0.04 0.06 0.08 0.1
NPV
-20
-40
-60
-80
Discount rate
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-28 Capital Budgeting Chapter 14
Problems with PI
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14-30 Capital Budgeting Chapter 14
1. Competitive Response
• CF forecasts should take into account responses of com-
petitors.
2. Capital Rationing.
• Noise.
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-32 Capital Budgeting Chapter 14
Year 0 1 2 3 4
Project A -1 0.6 0.5 0.4 0.3
Project B -10 3.0 4.0 5.0 4.0
Current evaluation:
NPV at r = 10%
Project A +0.46
Project B +2.52
NPV at r = 21%
Project A +0.20
Project B -0.10
However, Project B is still better after the increase in expected inflation if one
is consistent in treating inflation:
NPV at r = 20%
A +0.22
B 0
Year 1 2 3 4
Bias 10% 21% 33% 46%
c Jiang Wang Fall 2003 15.407 Lecture Notes
14-34 Capital Budgeting Chapter 14
8 Homework
Readings:
• BM Chapters 5, 6, 9.
Assignment:
• Problem Set 9.