Chapter 11: The Basics of Capital Budgeting

I. What is Capital Budgeting? The process of determining what capital projects to accept Project Classification is the starting point for determining the appropriate discount rate Replacement to maintain current operations Replacement to reduce costs Expansion of existing products or markets Expansion into new products or markets Pure research & development (example: pharmaceutical firms) Exploration (example: energ firms) !afet and "or environmental (government mandated) projects II. Decision Criteria

What are the major investment decision criteria? #et Present $alue % #P$ &nternal Rate of Return % &RR 'odified &nternal Rate of Return % '&RR Pa (ack Period % Pa (ack )iscounted Pa (ack Period * )iscounted Pa (ack Profita(ilit &ndex % P& What are they used for? To evaluate the cash flows from capital investment projects To make the accept or reject decision

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. 1. %

The !"# $ule: Why Is !et "resent #alue the Best Decision Criteria? &t considers the time value of money (T$')1 a dollar toda is worth more than a dollar in the future &t considers all cash flows during the project2s entire life #P$ lets ou know exactl how much value is (eing added ( the project 3ou can set the appropriate re4uire rate of return (discount rate or hurdle rate) depending on a project2s risk Calculating !et "resent #alue &!"#: #P$ 5/+6 7 /+0 7 /+8 7 999 7 /+t (0 7 r)0 (0 7 r)8 (0 7 r)t

% % %

%.

'.

The !"# decision &accept/reject( rule: % % Accept the project (investment) if #P$ : ;ero Reject the project if #P$ < ;ero

).

What does a positive !"# mean? % % % The PV of cash inflows : PV of cash outflows The value of the compan is (eing increased ( the amount of #P$ The project meets the re4uired rate of return1and then some

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!"# *+ample 1: = friend asks ou to invest >86.666 and promises to pa ou >8?.666 at the end of 8 ears9 3our re4uired rate of return is 0-@9 )o ou take the offerA #P$ 5/+6 7 /+8 (0 7 r)8 %86.666 7 0B.??6

#P$ 5 %86.666 7 8?.666 5: 090- 8 !"# , -.')/ C C

0ou should reject your friend1s offer2

&f this were a capital investment project. acceptance would reduce the value of the compan ( >,D6E =cceptance of the project would not increase the value of the compan ( >?.666E

The ke varia(le here is the re4uired rate of return (or discount rate)9 The re4uired rate of return (RRR) is: C C C !ote: &n a competitive market. positive #P$ projects are considered rare and re4uire diligent effort to uncover The hurdle rate The cost of capital (funds) The (est rate of return the compan could expect on other projects of similar risk

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!"# *+ample %: Two projects with identical cash outflows (investment 5>0.666) (ut different timing of cash inflows9 )iscount rate 5 06@ !"# for project 3: &4arge cash inflo5s come sooner(

#et /+

6 0 8 , D F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%F %0.666 -66 D66 ,66 066

!"#&3( ,

-67.7% &4arge cash inflo5s come later(

!"# for project 4:

#et /+

6 0 8 , D F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%F %0.666 066 ,66 D66 -66

!"#&4( , .-18.1%

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B.

The "ay9ac: $ule:

Time period re4uired for a project to generate enough cash inflows to recover the initial cost9 The "ay9ac: decision &accept/reject( rule: % % Accept if pa (ack period < maximum accepta(le pa (ack period9 Reject if pa (ack period : maximum accepta(le pa (ack period9 dvantages % % Eas to understand: the shorter the pa (ack period. the (etter Guick indicator of the liquidity risk of the project (how long funds will (e tied up)

Disadvantages % % % &gnores time value of mone &gnores cash flows (e ond accepta(le pa (ack date =ccepta(le pa (ack date is usuall an ar(itrar cutoff point9 Risk is not 4uantified in a re4uired rate of return9 The li4uidit risk is simpl a Hrule of thum(I

"roject 3: 6 0 8 , D F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F #et /+ %0.666 -66 D66 ,66 066 /umulative %0.666 %-66 %066 866 ,66 #/+ Pa (ack 5 ears (efore 7 full recover 5 5 uncovered cost at end of ear #/+ during following ear 7 066",66

8 89,, ears

If accepta9le pay9ac: period is %.'' or more years; you accept project 3

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C.

The Discounted "ay9ac: $ule:

Time period re4uired for a project to generate enough discounted cash inflows to recover the initial cost9 The Discounted "ay9ac: decision &accept/reject( rule: % % Accept if discounted pa (ack period < maximum accepta(le pa (ack period9 Reject if discounted pa (ack period : maximum accepta(le pa (ack period9 dvantages % % % Eas to understand: the shorter the pa (ack period. the (etter Guick indicator of the liquidity risk of the project (how long funds will (e tied up) )oes consider the time value of mone

Disadvantages % % &gnores cash flows (e ond accepta(le pa (ack date =ccepta(le pa (ack date is usuall an ar(itrar cutoff point9 ssume a 1/ percent discount rate 6 0 8 , D F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F %0.666 -66 D66 ,66 066 %0.666 D-D ,,0 88?J %0.666 %-D? %8006 5 ears (efore 7 full recover 5 5 uncovered cost at end of ear #/+ during following ear 7 80-"88-

"roject 3: #et /+ P$#/+ /umulative P$#/+ Pa (ack

8 89B? ears

If accepta9le pay9ac: period is %.8< or more years; you accept project 3

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D.

Internal $ate of $eturn

The &RR is similar to a (ond2s ield to maturit 9 &t is the rate that makes the present value of cash inflows (/&+) e4ual to the present value of cash outflows (/K+)9 Thus. it is the rate of return that results in a ;ero #P$ when it is used as the discount rate9 #P$ 6 5 5 /+6 /+6 7 7 /+0 7 0 (0 7 r) /+0 7 (0 7 &RR) 0 /+8 7 (0 7 r)8 999 7 /+t (0 7 r)t /+t (0 7 &RR)t

/+8 7 999 7 (0 7 &RR) 8

I$$ Decision $ule % % Accept the project if &RR : re42d rate of return (discount rate) Reject the project if &RR < re42d rate of return (discount rate) dvantages % % % /onsiders T$' /onsiders all cash flows Eas to understand

Disadvantages % % 'a use unreasona(le discount rate /an conflict with #P$ if projects are mutually exclusive

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I$$ *+amples: I$$ for "roject 3 "roject 3 6 0 8 , D F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F %0.666 -66 D66 ,66 066 -66 7 D66 0 (07&rr) (07&rr) 8 7 ,66 (07&rr) , 7 066 (07&rr)D

6 5

%0666 7

3olve for the I$$. That is the discount rate that solves this e4uation and makes the answer (#P$) e4ual to ;ero9 &RR for Project ! 5 I$$ for "roject 4 "roject 4 6 0 8 , D F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%%F %0.666 066 ,66 D66 -66 066 7 ,66 0 (07&rr) (07&rr) 8 8.%6= 7 D66 (07&rr) , 7 -66 (07&rr)D 0D9DB@

6 5

%0666 7

I$$ for "roject 4,

The &RR is the most popular method. after #P$. for evaluating cash flows and is almost as good9

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"ro9lems 5ith I$$: There are pro(lems with using &RR rather than #P$ with ou are choosing (etween mutually exclusive projects: % Independent projects: Mhen evaluating multiple projects and an . none. or all of them can (e accepted9 =cceptance of an project has no (earing on the acceptance or rejection of another9 utually exclusive projects: Mhen evaluating multiple projects and onl one can (e accepted9 =cceptance of one project means rejection of the other(s)9

There is never a conflict (etween &RR and #P$ criterion when evaluating independent projects9 Nut when choosing (etween mutuall exclusive projects. the &RR choice ma conflict with the #P$ choice under certain conditions9 The Scale Problem: = potential conflict exists when there are significant differences in the si;e of the cash flows9 =n example would (e if comparing a project with a >066.666 initial investment (/K+) with another project with a >0.666.666 initial investment9 The Timing Problem: = potential conflict exists when the timing of the cash flows for two projects are radicall different9 This can result in a conflict (etween the #P$ choice and the &RR choice at low discount rates9 Multiple IRRs: Projects with non!normal "non!conventional# cash flows ma have multiple &RRs9 = normal (or conventional) cash flow is a cash outflow at the (eginning of a project. followed ( cash inflows thereafter9

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The !"# "rofile: !"# graphed against the discount rate Recall the #P$ & &RR acceptance rules: #P$: &RR: #P$ >,66 /ash +lows %0666 -66 D66 ,66 066 &RR 6 90DDB =n project with a positive #P$ will also have an &RR that exceeds the discount rate (re4uired rate of return)9 #P$ Profiles for Mutually Exclusive Projects: #P$ Project N /ash +lows = %06.666 06.666 0.666 0.666 N %06.666 0.666 0.666 08.666 r Accept the project if #P$ : ;ero Accept the project if &RR : RRR

/rossover rate Project = r

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*+ample: I$$ vs !"# for >utual *+clusive "rojects /ash +lows = %06.666 06.666 0.666 0.666 N %06.666 0.666 0.666 08.666 &RR for N is OOOOOOOOOOO #P$ at 6@ OOOOOOOOOOOO #P$ at 06@ OOOOOOOOOOO #P$ at 0-@ OOOOOOOOOOO

&RR for = OOOOOOOOOOOOO #P$ at 6@ OOOOOOOOOOOO #P$ at 06@ OOOOOOOOOOO #P$ at 0-@ OOOOOOOOOOO

Mhich project is accepta(le if the are independentA Mh A Mhich project is accepta(le if the are mutuall exclusiveA Mh A *. % % >odified Internal $ate of $eturn Accept the project if '&RR : re42d rate of return (discount rate) Reject the project if '&RR < re42d rate of return (discount rate) dvantage: /ost 5 Piven: !olve: 4et1s you decide the reinvestment rate2 Terminal $alueT (0 7 '&RR)T /ost. T$ '&RR

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?. "I

"rofita9ility Inde+ &"I( , &"# of Cash Inflo5s(@&"# of Cash Autflo5s(

The P& is the ratio of the P$ of the project2s cash inflows to the P$ of the project2s cash outflows9 "I for "roject 3 P$/&+! P$/K+! P&! 5 -66 7 D66 7 ,66 7 066 (07906)0 (07906)8 (07906), (07906)D 5 0.666 5 0.6LJ9J8"0.666 5 096LJJ8 5 0.6LJ9J8

"I Decision $ule % % Accept if P& : 0966 Reject if P& < 0966 dvantages % % % % /onsiders T$' /onsiders all cash flows Qses reasona(le discount rate Qseful when faced with capital rationing9

Disadvantages % % /annot distinguish projects of vastl different scale 'a conflict with #P$ when evaluating mutuall exclusive projects

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"rofita9ility Inde+ vs !"# for Mutually Exclusive "rojects 6 0 F%%%%%%%%%%%%%%%%%%%%%F Cash ?lo5s Project = Project N #P$ at 906 P& at 906 %>06 %>0.666 = > ,9?D 09,?D >0>0.8-6 N >0,?9,? 090,?

=ccording to #P$. ou choose N9 =ccording to P&. ou choose =9

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