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Capital Budgeting guide

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Capital Budgeting

Techniques

13-1

**© Pearson Education Limited 2004
**

Fundamentals of Financial Management, 12/e

Created by: Gregory A. Kuhlemeyer, Ph.D.

Carroll College, Waukesha, WI

**After studying Chapter 13,
**

you should be able to:

13-2

**Understand the payback period (PBP) method of project evaluation and
**

selection, including its: (a) calculation; (b) acceptance criterion; (c)

advantages and disadvantages; and (d) focus on liquidity rather than

profitability.

Understand the three major discounted cash flow (DCF) methods of

project evaluation and selection – internal rate of return (IRR), net

present value (NPV), and profitability index (PI).

Explain the calculation, acceptance criterion, and advantages (over the

PBP method) for each of the three major DCF methods.

Define, construct, and interpret a graph called an “NPV profile.”

Understand why ranking project proposals on the basis of IRR, NPV, and

PI methods “may” lead to conflicts in ranking.

Describe the situations where ranking projects may be necessary and

justify when to use either IRR, NPV, or PI rankings.

Understand how “sensitivity analysis” allows us to challenge the singlepoint input estimates used in traditional capital budgeting analysis.

Explain the role and process of project monitoring, including “progress

reviews” and “post-completion audits.”

Capital Budgeting

Techniques

13-3

Project Evaluation and Selection

Potential Difficulties

Capital Rationing

Project Monitoring

Post-Completion Audit

Project Evaluation: Alternative Methods 13-4 Payback Period (PBP) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI) .

Basket Wonders (BW).Proposed Project Data Julie Miller is evaluating a new project for her firm. and $7.000.000. $10. for each of the Years 1 through 5. She has determined that the after-tax cash flows for the project will be $10. $12. The initial cash outlay will be $40. $15. 13-5 . respectively.000.000.000.000.

Independent Project For this project.A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. 13-6 . assume that it is independent of any other potential projects that Basket Wonders may undertake. Independent -.

13-7 5 7K .Payback Period (PBP) 0 1 2 3 -40 K 10 K 12 K 15 K 4 10 K PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.

3 Years 5 7K 54 K .37) / 10 = 3 + (3) / 10 = 3.Payback Solution (#1) 0 -40 K(-b) Cumulative Inflows 13-8 1 2 10 K 10 K 12 K 22 K PBP 3 (a) 15 K 37 K(c) 4 10 K(d) 47 K =a+(b-c)/d = 3 + (40 .

.3 Years Note: Take absolute value of last negative cumulative cash flow value.Payback Solution (#2) 0 1 2 -40 K 10 K 12 K 15 K 10 K -40 K -30 K -18 K -3 K 7K Cumulative Cash Flows 13-9 3 4 5 7K 14 K PBP = 3 + ( 3K ) / 10K = 3.

] 13-10 .5 Year Max.5 years.3 Years < 3. Should this project be accepted? Yes! The firm will receive back the initial cash outlay in less than 3. [3.5 years for projects of this type.PBP Acceptance Criterion The management of Basket Wonders has set a maximum PBP of 3.

PBP Strengths and Weaknesses Strengths: Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows Weaknesses: Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective 13-11 .

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 project’s initial cash outflow..+ (1+IRR)n . CF1 ICO = (1+IRR)1 13-12 + CF2 (1+IRR)2 CFn +..

000 $40. 13-13 .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.IRR Solution $10.000 = + + (1+IRR)1 (1+IRR)2 $15.000 $12.000.

000(PVIF10%.000(.1) + $12.621) $40.090 + $9.2) + $15.000 = $10.000(.000(.751) + $10.000(.826) + $15.000 = $10.000 = $9.000(PVIF10%.265 + $6.444 [Rate is too low!!] 13-14 .000(PVIF10%.000(PVIF10%.000(PVIF10%.683) + $ 7.347 = $41.909) + $12.3) + $10.IRR Solution (Try 10%) $40.830 + $4.000(.4) + $ 7.912 + $11.5) $40.

000(PVIF15%.072 + $9.000(.870 + $5.700 + $9.000 = $10.000(.756) + $15.720 + $3.658) + $10.000(PVIF15%.479 = $36.2) + $15.1) + $12.000(PVIF15%.572) + $ 7.3) + $10.000(PVIF15%.000(PVIF15%.000(.IRR Solution (Try 15%) $40.5) $40.000 = $10.000(.000 = $8.841 [Rate is too high!!] 13-15 .4) + $ 7.000(.497) $40.870) + $12.

IRR Solution (Interpolate) .841 $1.10 IRR $40.05 13-16 = $41.000 .444 $4.603 .15 X .444 $36.444 $4.603 $1.05 X .

**IRR Solution (Interpolate)
**

.05

X

.10

**IRR $40,000
**

.15

X

.05

13-17

=

$41,444

$36,841

$1,444

$4,603

$1,444

$4,603

**IRR Solution (Interpolate)
**

.05

X

.10

$41,444

**IRR $40,000
**

.15

$1,444

$4,603

$36,841

X = ($1,444)(0.05)

$4,603

X = .0157

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

13-18

**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 ]

13-19

IRRs on the Calculator We will use the cash flow registry to solve the IRR for this problem quickly and accurately! 13-20 .

Actual IRR Solution Using Your Financial Calculator Steps in the Process Step 1: Press CF Step 2: Press 2nd Step 3: For CF0 Press key CLR Work keys -40000 Enter keys Step 4: Step 5: Step 6: Step 7: For C01 Press For F01 Press For C02 Press For F02 Press 10000 1 12000 1 Enter Enter Enter Enter keys keys keys keys Step 8: For C03 Press 13-21 Step 9: For F03 Press 15000 1 Enter Enter 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 13-22 10000 1 7000 1 Enter Enter Enter Enter keys keys keys keys Step 14: Step 15: Press Press IRR Step 16: Press CPT Result: Internal Rate of Return = 11.47% keys key key .

IRR Strengths and Weaknesses Strengths: Accounts for TVM Weaknesses: Considers all cash flows Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs Less subjectivity 13-23 .

Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow..+ (1+k)n .. CF1 NPV = (1+k)1 13-24 CF2 + (1+k)2 CFn ICO +.

13)3 $10.13)1 (1.000 $7.000 + (1. NPV = $10.000 4 + 5 (1.13) (1.NPV Solution Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%.13)2 (1.000 $40.13) 13-25 .000 +$15.000 +$12.

000(.000(PVIF13%.NPV Solution NPV = $10.000(PVIF13%.428 13-26 .885) + $12.2) + $15.000(.000 NPV = $8.000(.000 = .000(PVIF13%.3) + $10.000(PVIF13%.783) + $15.130 + $3.395 + $6.801 .1) + $12.000 NPV = $10.000(.4) + $ 7.543) .$40.$40.693) + $10.613) + $ 7.$40.000(PVIF13%.5) .$1.396 + $10.850 + $9.000(.

NPV Acceptance Criterion The management of Basket Wonders has determined that the required rate is 13% for projects of this type. [Reject as NPV < 0 ] 13-27 . Should this project be accepted? No! The NPV is negative. This means that the project is reducing shareholder wealth.

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. 13-28 .

Actual NPV Solution Using Your Financial Calculator Steps in the Process Step 1: Press CF Step 2: Press 2nd Step 3: For CF0 Press key CLR Work keys -40000 Enter keys Step 4: Step 5: Step 6: Step 7: For C01 Press For F01 Press For C02 Press For F02 Press 10000 1 12000 1 Enter Enter Enter Enter keys keys keys keys Step 8: For C03 Press 13-29 Step 9: For F03 Press 15000 1 Enter Enter keys keys .

Enter 13-30 Enter Enter Enter Enter keys keys keys keys keys key 13 Enter keys Step 17: Press CPT key Result: Net Present Value = -$1.42 .424.Actual NPV 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 10000 1 7000 1 Step 14: Step 15: Press Press NPV Step 16: For I=.

NPV Strengths and Weaknesses Weaknesses: Strengths: Cash flows assumed to be reinvested at the hurdle rate. . See Chapter 14. Considers all cash flows. 13-31 May not include managerial options embedded in the project. Accounts for TVM.

of th e se p oint IRR s ar 0 3 6 9 12 Discount Rate (%) e ea sy n NPV@13% 0 -4 13-32 Sum of CF’s 15 ow! .Net Present Value Profile Net Present Value $000s 15 Thre e 10 5 Plot NPV for each discount rate.

Each resulting NPV will provide a “point” for your NPV Profile! 13-33 .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.

..+ CFn (1+k)n << OR >> Method #2: 13-34 PI = 1 + [ NPV / ICO ] ICO .Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. Method #1: CF1 PI = (1+k)1 CF2 + (1+k)2 +.

PI Acceptance Criterion PI = $38. [Reject as PI < 1.572 / $40.00.000 = .9643 (Method #1. This means that the project is not profitable.00 ] 13-35 . 13-34) Should this project be accepted? No! The PI is less than 1.

PI Strengths and Weaknesses Strengths: Weaknesses: Same as NPV Same as NPV Allows comparison of different scale projects Provides only relative profitability Potential Ranking Problems 13-36 .

Evaluation Summary Basket Wonders Independent Project Method Project Comparison Decision 13-37 PBP 3.3 3.96 1.424 $0 Reject PI .00 Reject .47% 13% Reject NPV -$1.5 Accept IRR 11.

A project whose acceptance depends on the acceptance of one or more other projects. Mutually Exclusive -. 13-38 .A project whose acceptance precludes the acceptance of one or more alternative projects.Other Project Relationships Dependent -.

Scale of Investment B. A. Project Life 13-39 .Potential Problems Under Mutual Exclusivity Ranking of project proposals may create contradictory results. Cash-flow Pattern C.

A.250 . Scale Differences Compare a small (S) and a large (L) project. END OF YEAR 13-40 NET CASH FLOWS Project S Project L 0 -$100 -$100.000 1 0 0 2 $400 $156.

132 1. NPV@10%.29 . and PI@10%.Scale Differences Calculate the PBP. IRR.31 $29. Which project is preferred? Why? Project IRR S 100% L 25% 13-41 NPV $ PI 231 3.

END OF YEAR 0 1 2 3 13-42 NET CASH FLOWS Project D Project I -$1.000 100 500 600 100 1.B.200 1.080 . Cash Flow Pattern Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project.200 -$1.

Which project is preferred? Project 13-43 IRR NPV PI D 23% $198 1.17 . NPV@10%.17 I 17% $198 1. and PI@10%.Cash Flow Pattern Calculate the IRR.

400 Project I 200 NPV@10% IRR Project D 0 -200 Net Present Value ($) Examine NPV Profiles 0 5 10 15 20 Discount Rate (%) 25 .13-44 600 Plot NPV for each project at various discount rates.

Net Present Value ($) -200 0 200 400 600 Fisher’s Rate of Intersection 0 13-45 At k<10%. I is best! Fisher’s Rate of Intersection At k>10%. D is best! 5 10 15 20 Discount Rate ($) 25 .

Project Life Differences Let us compare a long life (X) project and a short life (Y) project. END OF YEAR 0 1 2 3 13-46 NET CASH FLOWS Project X Project Y -$1.375 0 .000 -$1.000 0 0 3.C.000 0 2.

IRR.536 2. and PI@10%. Which project is preferred? Why? 13-47 Project IRR NPV PI X 50% $1.54 Y 100% $ 818 1.Project Life Differences Calculate the PBP. NPV@10%.82 .

Adjust cash flows to a common terminal year if project “Y” will NOT be replaced. 13-48 .000 $0 $0 $2. Year 1 @10% for 2 years. X is still Best. Year CF 0 1 2 3 -$1.Another Way to Look at Things 1. Compound Project Y.26% NPV = $818 *Lower IRR from adjusted cash-flow stream.420 Results: IRR* = 34.

but the same IRR.000 -1.000 IRR = 100% 2 3 $2. 0 1 -$1.000 -$1.17 *Higher NPV.000 Results: 13-49 $2.000 NPV* = $2.Replacing Projects with Identical Projects 2.238. Use Replacement Chain Approach (Appendix B) when project “Y” will be replaced.000 $2.000 -1. Y is Best.000 $2.000 $1. Best .000 $1.

She is limited to a maximum expenditure of $32. Example: Julie Miller must determine what investment opportunities to undertake for Basket Wonders (BW).500 only for this capital budgeting period. 13-50 .Capital Rationing Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.

000 17.40 1.24 .000 IRR 18% 25 37 20 26 28 19 15 $ NPV PI 50 6.500 15.500 12.000 1.500 25.43 1.67 1.Available Projects for BW Project A B C D E F G H 13-51 ICO $ 500 5.500 5.000 7.500 5.10 1.10 2.000 7.30 2.500 6.000 500 21.04 2.000 5.

000 37% 28 26 25 $ 5.000 12.000 500 6.500 21.500 5. and E have the three largest IRRs.000 with a $32.10 2.Choosing by IRRs for BW Project C F E B ICO IRR NPV PI $ 5.30 Projects C.000 15.04 2.500 outlay. 13-52 . The resulting increase in shareholder wealth is $27.500 2.40 1. F.

13-53 .500 2.40 1.500 with a $32.500 outlay.Choosing by NPVs for BW Project F G B ICO $15.000 17. The resulting increase in shareholder wealth is $28.500 5.000 IRR NPV PI 28% 19 25 $21.500 6.000 7.43 2.30 Projects F and G have the two largest NPVs.

000 7.000 5.500 2. C.Choosing by PIs for BW Project F B C D G ICO IRR NPV PI $15. The resulting increase in shareholder wealth is $38.500 5.000 6.40 2.000 5. and D have the four largest PIs.10 1.30 2.67 1.500 17.000 7.500 28% 25 37 20 19 $21. B. 13-54 .43 Projects F.500 outlay.000 with a $32.500 5.

000 NPV F and G $28. F. and D Value Added $38. and E $27.Summary of Comparison Method Projects Accepted PI F. C.500 IRR C.000 PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period. 13-55 . B.

etc. Change forecasted sales units to see impact on the project’s NPV . 13-56 Allows us to change from “single-point” (i. installation cost.g..) estimates to a “what if” analysis Utilize a “base-case” to compare the impact of individual variable changes E.. salvage.Single-Point Estimate and Sensitivity Analysis Sensitivity Analysis: 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 project’s measured results (such as NPV or IRR). revenue.e.

Identify any project weaknesses Develop a possible set of corrective actions Provide appropriate feedback Result: Making better future decisions! 13-57 .Post-Completion Audit Post-completion Audit A formal comparison of the actual costs and benefits of a project with original estimates.

000 How many potential IRRs could this project have? Two!! There are as many potential IRRs as there are sign changes.Multiple IRR Problem* Let us assume the following cash flow pattern for a project for Years 0 to 4: -$100 +$100 +$900 -$1. 13-58 * Refer to Appendix A .

Multiple IRRs Net Present Value ($000s) 75 50 25 0 -100 13-59 Multiple IRRs at k = 12.NPV Profile -.15% 0 40 80 120 160 Discount Rate (%) 200 .95% and 191.

95%. 13-60 . In this case. 12.NPV Profile -. It will give you the lowest IRR.Multiple IRRs Hint: Your calculator will only find ONE IRR – even if there are multiple IRRs.

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