CAPITAL BUDGETING

LONG-TERM INVESTMENTS REQUIRE A CAPITAL BUDGETING DECISION

SHOULD THE INVESTMENT BE MADE? TWO METHODS: NET PRESENT VALUE INTERNAL RATE OF RETURN

CAPITAL BUDGETING
ATTEMPS TO DETERMINE IF AN INVESTMENT OPPORTUNITY IS WORTH MORE THAN IT COST BY VALUING THE INVESTMENT BY DISCOUNTING ITS FUTURE CASH FLOWS

NET PRESENT VALUE

AN INVESTMENT IS WORTH UNDERTAKING IF IT CREATES WEALTH FOR THE OWNERS NPV = PV REVENUES PV COSTS AT THE FIRMS REQUIRED RATE OF RETURN (INTEREST RATE)

IF NPV > 0 THE ACTIVITY OR OPPORTUNITY IS WORTH MORE THAN IT COST

ANALYSIS: DETERMINING COSTS

GREATLY SIMPLIFIED IF THERE IS A MARKET FOR ASSETS SIMILAR TO THE INVESTMENT UNDER CONSIDERATION OTHERWISE MUST IMPUTE RESOURCE VALUES

CALCULATING NPV: REQUIRED INFORMATION

START-UP COST (CAN BE ESTIMATED WITH SOME ACCURACY) DIFFICULTY IN DETERMINING: FUTURE CASH FLOWS (MUST FORECAST) REQUIRED RATE OF RETURN

ACCEPT OR REJECT?
NPV > 0, ACCEPT NPV < 0, REJECT

CALCULATING NPV
ESTIMATE THE DIFFERENCE BETWEEN THE PRESENT VALUE OF DISCOUNTED CASH FLOWS AND COST OF THE INVESTMENT

EXAMPLE OF NPV
YOUR COMPANY IS CONSIDERING INVESTING $1,000,000 NOW FOR AN EXPECTED INCREASE IN NET CASH FLOWS OF $100,000 A YEAR FOR THE NEXT 20 YEARS. THE RRR= 10% WHAT IS THE NET PRESENT VALUE OF THIS PROJECT?

ANALYSIS
INVESTMENT = ($1,000,000) PMTS = $100,000 N = 20 I = 10% PV OF CASH FLOW = $851,356

NPV = $851,356 - $1,000,000 = ($148,643) NEGATIVE MEANS REJECT

USING NPV FUNCTION BA-II

CF KEY CF0 = ($1,000,000) CF1 = $100,000 CFF1 = 20 NPV I = 10 NPV CPT = (148,643)

TI-83
NPV(I,CF0,{CFlist},{CFFlist}) ENTER NPV(10,-1000000,{100000},{20}) ENTER ($148,643)

NETTING CASH FLOWS

WHEN TWO FLOWS OCCUR IN THE SAME YEAR THEY MUST BE COMBINED OR NETTED.

EXAMPLE OF NPV
INVESTMENT = ($500,000) PAYMENTS = $70,000 SALVAGE VALUE = $150,000 N = 10 I = 8%

ANALYSIS BA-II
CF CF0 = ($500,000) CF1 = $70,000 CFF1 = 9 CF2 = $150,000 + $70,000 = $220,000 CFF2 = 1 I=8 CPT NPV = $39,184 ACCEPT NPV > 0

USING THE CASH FLOW WORKSHEET TI-83

npv(8,-500000,{70000,220000},{9,1}) ENTER $39,184

SAMPLE PROBLEM
PV = -5,000,000 PMTS = 750,000 N = 15 SALVAGE VALUE $500,000 I = 10

INPUT BA-II
CF0 = -5,000,000 CF1 = 750,000 CFF1 = 14 CF2 = 750,000 + 500,000 = 1,250,000 CFF2 = 1 I = 10 NPV = $824,255

INPUT TI-83
npv(10,5000000,{750000,1250000},{14,1}) ENTER $824,255

SAMPLE PROBLEM
PV = -$2,500,000 PMTS = $275,000 N = 20 ENVIRONMENTAL CLEAN-UP = -$200,000 I=8

INPUT BA-II
CF0 = -2500000 CF1 = 275000 CFF1 = 19 CF2 = 275000 - 200000 = 75000 CFF2 = 1 I=8 NPV = 157,080

INPUT TI-83
npv(8,-2500000,{275000,75000},{19,1}) ENTER $157,080

PROBLEM
YOUR COMPANY IS CONSIDERING BUILDING A NEW STORE. THE INITIAL COST WILL BE $3,000,000 WITH THE EXPECTATION THAT THE STORE WILL GENERATE $330,000 IN FREE CASH FLOW FOR THE FIRST 15 YEARS, $220,000 IN PROFITS FOR THE NEXT 10 YEARS. THERE ARE ADDITIONAL MAINTENANCE COSTS IN YEAR 15 OF $50,000 AND THE BUILDING WILL BE SOLD FOR $200,000 AT THE END OF THE 25 YEAR PERIOD. THE RRR = 8%. WHAT IS THE NPV?

SOLUTION BA-11
CF0 = -3000000 CF1 = 330000 CFF1 = 14 CF2 = 280,000 CFF2 = 1 CF3 = 220,000 CFF3 = 9 CF4 = 420000 CFF4 = 1 ENTER $303,435

SOLUTION TI-83
Npv(8,3000000,{330000,280000,220000,420000 },{14,1,9,1}) ENTER $303,435

INTERNAL RATE OF RETURN

(IRR) CALCULATION OF THE RATE OF RETURN THAT CAN BE USED TO JUDGE THE MERITS OF THE PROJECT

IRR AND NPV

IRR IS THE RATE OF RETURN THAT MAKES NPV = 0 IS AN INTERNAL RATE IN THAT IT DEPENDS ON THE CASH FLOWS OF A PARTICULAR INVESTMENT, NOT ON ANY OTHER RATES. SAME AS YIELD TO MATURITY.

IRR RULE
ACCEPT: IRR > REQUIRED RATE OF RETURN REJECT: IRR < REQUIRED RATE OF RETURN

PROBLEM
You have the following cash flows YEAR CASH FLOW 0 -$90,000 1 35,000 2 43,000 3 40,000 IF THE RRR = 18% ACCEPT?

ANALYSIS BA-II
CF0 -90,000 CF1 35,000 CFF 1 CF2 43,000 CFF 1 CF3 40,000 CFF 1 IRR CPT = 14.5% < 18%, REJECT

TI-83
IRR(-90000,{35000,43000,40000},{1,1,1}) 14.51%

PROBLEM
CALCULATE THE IRR FOR THE FOLLOWING CASH FLOWS: YEAR CASH FLOW 0 -$2,200 1 640 2 800 3 1,900

ANALYSIS
CF0 -$2,200 CF1 640 CF2 800 CF3 1,900 IRR CPT = 19.7%

IRR(-2200,{640,800,1900},{1,1,1})

PROBLEMS WITH IRR

NONCONVENTIONAL CASH FLOWS CAN RESULT IN THE MULTIPLE RATES OF RETURN PROBLEM, MORE THAN ONE DISCOUNT RATE MAKES NPV = 0 KNOWN AS THE MULTIPLE RATES OF RETURN PROBLEM

SOLUTION
ALWAYS USE NPV WHEN PROJECT HAS NONCONVENTIONAL CASH FLOWS.

PROBLEMS WITH IRR

MUTUALLY EXLCUSIVE INVESTMENTS, MAKING ONE INVESTMENT EXCLUDES THE ALTERNATIVE. IRR CAN GIVE HIGHER VALUE TO PROJECT WITH LOWER NPV

SOLUTION
USE NPV TO DETERMINE CHOICE OF MUTUALLY EXCLUSIVE INVESTMENTS

Capital Budgeting Problem

You have decided to purchase a rental house to keep until you retire in 30 years. You have located a house to purchase for $130,000. Your annual mortgage and expenses are $12,000 and you expect a gross cash flow of $22,000. You expect to replace the roof and h/c unit in 15 years at a total cost of $10,000. You expect to sell the house at the end of the period for $230,000. The RRR is 6.5 percent. Should you make this investment?