Capital Budgeting Techniques

Discounted Cash Flow Techniques

Prepared by:

Joan C. Basay

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 P10,000; P12,000; P15,000; P10,000; and P7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be P40,000.

Internal Rate of Return (IRR)

IRR 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.

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

+...+

CFn (1+IRR)n

IRR Solution
P10,000 P12,000 P40,000 = + + (1+IRR)1 (1+IRR)2 P15,000 P10,000 P7,000 + + (1+IRR)3 (1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the discounted cash flows to equal P40,000.

IRR Solution (Try 10%)

P40,000 = P10,000(PVIF10%,1) + P12,000(PVIF10%,2) + P15,000(PVIF10%,3) + P10,000(PVIF10%,4) + P 7,000(PVIF10%,5) P40,000 = P10,000(.909) + P12,000(.826) + P15,000(.751) + P10,000(.683) + P 7,000(.621) P40,000 = P9,090 + P9,912 + P11,265 + P6,830 + P4,347 = P41,444 [Rate is too low!!]

IRR Solution (Try 15%)

P40,000 = P10,000(PVIF15%,1) + P12,000(PVIF15%,2) + P15,000(PVIF15%,3) + P10,000(PVIF15%,4) + P 7,000(PVIF15%,5) P40,000 = P10,000(.870) + P12,000(.756) + P15,000(.658) + P10,000(.572) + P 7,000(.497) P40,000 = P8,700 + P9,072 + P9,870 + P5,720 + P3,479 = P36,841 [Rate is too high!!]

IRR Solution (Interpolate)

.05

.10 IRR .15

P41,444 P40,000 P36,841

P1,444 P4,603

X .05

P1,444 P4,603

IRR Solution (Interpolate)

.05

.10 IRR .15

P41,444 P40,000 P36,841

P1,444 P4,603

X .05

P1,444 P4,603

IRR Solution (Interpolate)

.05

.10 IRR .15

P41,444 P40,000 P36,841

P1,444 P4,603

(P1,444)(0.05) P4,603

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 ]

IRRs on the Calculator

We will use the cash flow registry to solve the IRR for this problem quickly and accurately!

Actual IRR Solution Using Your Financial Calculator

Steps in the Process
Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: Step 7: Step 8: Step 9: Press Press For CF0 Press For C01 Press For F01 Press For C02 Press For F02 Press For C03 Press For F03 Press CF 2nd CLR Work -40000 Enter 10000 Enter 1 Enter 12000 Enter 1 Enter 15000 Enter 1 Enter

key keys keys keys keys keys keys keys keys

Actual IRR Solution Using Your Financial Calculator

Steps in the Process (Part II)
Step 10:For C04 Press Step 11:For F04 Press Step 12:For C05 Press Step 13:For F05 Press Step 14: Press Step 15: Press Step 16: Press 10000 1 7000 1

Enter Enter Enter Enter

IRR CPT

keys keys keys keys keys key key

Result:

Internal Rate of Return = 11.47%

IRR Strengths and Weaknesses

Strengths:
Accounts for TVM Considers all cash flows Less subjectivity

Weaknesses:
Assumes all cash flows reinvested at the IRR

Difficulties with project rankings and Multiple IRRs

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)

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

NPV = P10,000 + P12,000 + P15,000+ (1.13)1 (1.13)2 (1.13)3

P10,000 P7,000 + P40,000 4 5 (1.13) (1.13)

NPV Solution
NPV = + + NPV = P10,000(PVIF13%,1) + P12,000(PVIF13%,2) P15,000(PVIF13%,3) + P10,000(PVIF13%,4) P 7,000(PVIF13%,5) - P40,000 P10,000(.885) + P12,000(.783) + P15,000(.693) + P10,000(.613) + P 7,000(.543) - P40,000 NPV = P8,850 + P9,396 + P10,395 + P6,130 + P3,801 - P40,000 = - P1,428

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 ]

NPV on the Calculator

We will use the cash flow registry to solve the NPV for this problem quickly and accurately!

Hint: If you have not cleared the cash flows from your calculator, then you may skip to Step 15.

Actual NPV Solution Using Your Financial Calculator

Steps in the Process
Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: Step 7: Step 8: Step 9: Press Press For CF0 Press For C01 Press For F01 Press For C02 Press For F02 Press For C03 Press For F03 Press CF key 2nd CLR Work keys -40000 Enter 10000 Enter keys 1 Enter keys 12000 Enter keys 1 Enter keys 15000 Enter keys 1 Enter keys keys

Actual NPV Solution Using Your Financial Calculator

Steps in the Process (Part II)
Step 10:For C04 Press 10000 Enter keys Step 11:For F04 Press 1 Enter keys Step 12:For C05 Press 7000 Enter keys Step 13:For F05 Press 1 Enter keys Step 14: Press keys Step 15: Press NPV key Step 16: For I=, Enter 13 Enter keys Step 17: Press CPT key

Result:

Net Present Value = -P1,424.42

NPV Strengths and Weaknesses

Strengths:
Cash flows assumed to be reinvested at the hurdle rate. Accounts for TVM. Considers all cash flows.

Weaknesses:
May not include managerial options embedded in the project. See Chapter 14.

Net Present Value Profile

Net Present Value

P000s 15
10 5

Sum of CFs

Plot NPV for each discount rate.

IRR NPV@13%

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

Creating NPV Profiles Using the Calculator

Hint: As long as you do not clear the cash flows from the registry, simply start at Step 15 and enter a different discount rate. Each resulting NPV will provide a point for your NPV Profile!

Profitability Index (PI)

PI is the ratio of the present value of a projects future net cash flows to the projects initial cash outflow.
Method #1:

CF1 PI = (1+k)1

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

<< OR >>

ICO

Method #2:

PI = 1 + [ NPV / ICO ]

PI Acceptance Criterion
PI = P38,572 / P40,000 = .9643 (Method #1, 13-34)

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 Strengths and Weaknesses

Strengths:
Same as NPV Allows comparison of different scale projects

Weaknesses:
Same as NPV Provides only profitability Potential Ranking Problems relative

Evaluation Summary
Basket Wonders Independent Project

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

Other Project Relationships

Dependent

-- 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.

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

-P100 0 P400 -P100,000 0 P156,250

Scale Differences
Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why?
Project IRR NPV PI

S L

100% 25%

P 231 P29,132

3.31 1.29

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 -P1,200 1,000 500 100 -P1,200 100 600 1,080

Cash Flow Pattern

Calculate the IRR, NPV@10%, and PI@10%. Which project is preferred?
Project D I IRR 23% 17% NPV P198 P198 1.17 1.17 PI

Examine NPV Profiles

600 Net Present Value (P)

400

Project I

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

IRR Project D

-200

0 0

200

10 15 20 Discount Rate (%)

25

Fishers Rate of Intersection

Net Present Value (P) 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 (P)

25

C. Project Life Differences

Let us compare a long life (X) project project. and a short life (Y)

END OF YEAR 0 1 2 3

NET CASH FLOWS Project X Project Y -P1,000 0 0 3,375 -P1,000 2,000 0 0

Project Life Differences

Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why?
Project IRR NPV PI

X Y

50% 100%

P1,536 P 818

2.54 1.82

Another Way to Look at Things

1. Adjust cash flows to a common terminal year if project Y will NOT be replaced.
Compound Project Y, Year 1 @10% for 2 years.

Year CF

0 -P1,000

1 P0

2 P0

3 P2,420

Results: IRR* = 34.26%

NPV = P818

*Lower IRR from adjusted cash-flow stream. X is still Best.

Replacing Projects with Identical Projects

2.
0 -P1,000
Use Replacement Chain Approach (Appendix B) when project Y will be replaced.

1 P2,000 -1,000

P2,000 -1,000

P2,000

-P1,000
Results:

P1,000
IRR = 100%

P1,000

P2,000

NPV* = P2,238.17

*Higher NPV, but the same IRR. Y is Best.

Capital Rationing
Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.

Example: Julie Miller must determine what investment opportunities to undertake for Basket Wonders (BW). She is limited to a maximum expenditure of P32,500 only for this capital budgeting period.

Available Projects for BW

Project ICO IRR NPV PI
B C D E F H A P 500 18% 5,000 25 5,000 37 7,500 20 12,500 26 15,000 28 17,500 19 25,000 15 P 50 1.10 6,500 2.30 5,500 2.10 5,000 1.67 500 1.04 21,000 2.40 G 7,500 1.43 6,000 1.24

Choosing by IRRs for BW

Project
C F E B

ICO

IRR

NPV

PI

P 5,000 37% P 5,500 2.10 15,000 28 21,000 2.40 12,500 26 500 1.04 5,000 25 6,500 2.30 Projects C, F, and E have the three largest IRRs. The resulting increase in shareholder wealth is P27,000 with a P32,500 outlay.

Choosing by NPVs for BW

Project ICO IRR NPV PI
G B F P15,000 28% 17,500 19 5,000 25 P21,000 2.40 7,500 1.43 6,500 2.30

Projects F and G have the largest NPVs.

two

The resulting increase in shareholder wealth is P28,500 with a P32,500 outlay.

Choosing by PIs for BW

Project ICO IRR NPV PI
F P15,000 28% P21,000 2.40 B 5,000 25 6,500 2.30 C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 G 17,500 19 7,500 1.43 Projects F, B, C, and D have the four largest PIs. The resulting increase in shareholder wealth is P38,000 with a P32,500 outlay.

Summary of Comparison
Method Projects Accepted Value Added PI F, B, C, and D P38,000 NPV F and G P28,500 IRR C, F, and E P27,000

PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period.

Single-Point Estimate and Sensitivity Analysis

Sensitivity Analysis: A type of what-if uncertainty analysis in which variables or assumptions are changed from a base case in order to determine their impact on a projects measured results (such as NPV or IRR).

Allows us to change from single-point (i.e., revenue, installation cost, salvage, etc.) estimates to a what if analysis Utilize a base-case to compare the impact of individual variable changes
E.g., Change forecasted sales units to see impact on the projects NPV

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!

Multiple IRR Problem*

Let us assume the following cash flow pattern for a project for Years 0 to 4: -P100 +P100 +P900 -P1,000 How many potential IRRs could this project have?

Two!! There are as many potential

IRRs as there are sign changes.

* Refer to Appendix A

NPV Profile -- Multiple IRRs

75
Net Present Value (P000s) 50 25 0 Multiple IRRs at k = 12.95% and 191.15%

-100

40

80 120 160 Discount Rate (%)

200

NPV Profile -- Multiple IRRs

Hint: Your calculator will only find ONE IRR even if there are multiple IRRs. It will give you the lowest IRR. In this case, 12.95%.