Capital Budgeting Decision Rules

What real investments should firms make?

Alternative Rules in Use Today
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NPV IRR Profitability Index Payback Period

Discounted Payback Period

Accounting Rate of Return

the choice should be governed by maximizing shareholder wealth given any relevant constraints. . The rule should discount cash flows appropriately taking into account the time value of money and properly adjusting for the risk inherent in the project. . The rule should incorporate all the incremental cash flows attributable to the project. When forced to choose between projects.What Provides Good Decision-Making?  Our work has shown that several criteria must be satisfied by any good decision rule:     The decision rule must be based on cash flow.Opportunity cost of capital.

reject those with negative NPVs.NPV Analysis  The recommended approach to any significant capital budgeting decision is NPV analysis.  NPV = PV of the incremental benefits – PV of the incremental costs. When evaluating interdependent projects. When evaluating independent projects. take those with positive NPVs. take the feasible combination with the highest combined NPV.  NPV based decision rule:   .

To examine the decision to invest in the TriStar project. Then we can ask: What is a valid estimate of the NPV of the Tri-Star project at a volume of 210 planes as of 1967. .Lockheed Tri-Star    As an example of the use of NPV analysis we will use the Lockheed Tri-Star case. we first need to forecast the cash flows associated with the Tri-Star project for a volume of 210 planes.

. To use the rule effectively we compare the IRR to a market rate.  IRR asks: “What is the project’s rate of return?” Standard Rule: Accept a project if its IRR is greater than the appropriate market based discount rate. Why does this make sense? For independent projects with “normal cash flow patterns” IRR and NPV give the same conclusions. IRR is completely internal to the project. reject if it is less.Internal Rate of Return     Definition: The discount rate that sets the NPV of a project to zero (essentially project YTM) is the project’s IRR.

IRR – “Normal” Cash Flow Pattern  Consider the following stream of cash flows: 0 1 $400 2 $400 3 $400 -$1. That’s all you do to find IRR. .000   Calculate the NPV at different discount rates until you find the discount rate where the NPV of this set of cash flows equals zero.

NPV = 0 Discount Rate .IRR – NPV Profile Diagram  Evaluate the NPV at various discount rates: 250 200 150 100 NPV 50 0 -50 0 -100 -150 -200 Rate NPV 0 $200 10 -$5.7%.4 10 20  At r = 9.3 20 -$157.

r) accounts for the time value of money and risk (the opportunity cost of capital). In short. . does not ignore any cash flows. What interest rate must the bank account pay in order that we may make withdrawals equal to the cash flows generated by the project? As with NPV. it can be useful. Suppose that the initial investment is placed in a bank account instead of this project. the IRR is also based on incremental cash flows. and (by comparison to the appropriate discount rate.The Merit to the IRR Approach    The IRR can be interpreted as the answer to the following question.

. Consider: 0 1 2 -$100  $230 -$132 This can (and does) have two IRRs.Pitfalls of the IRR Approach  Multiple IRRs   There can be as many solutions to the IRR definition as there are changes of sign in the time ordered cash flow series.

00% 20.Rate 0.00% 40.5 0 10 15 20 40 NPV -1 -1.06 IRR1 IRR2 0.5 0 -0.00% 10.5 -2 -2.19 $0.00% NPV -$2.Pitfalls of IRR cont… Disc.00 $0.00 $0.5 -3 Discount Rate .00% 15.00 -$3.

5 2 NPV 1.5 0 10 15 Discount Rate 20 40 .5 0 -0.5 1 0.Pitfalls of IRR cont… 3 2.

 Store toxic waste. IRRs and NPVs. B. Let’s look at the cash flows.Pitfalls of IRR cont…   Mutually exclusive projects: IRR can lead to incorrect conclusions about the relative worth of projects. Ralph owns a warehouse he wants to fix up and use for one of two purposes: A. . Store fresh produce.

000 1.000 12.000 1.04% 12.000 NPV @ 0% $2000 $4000 NPV @ NPV@ 10% 15% $669 $109 $751 -$484 IRR 16.Mutually Exclusive Projects and IRR Project A B Project A B Year 0 Year 1 Year 2 Year 3 -10.94% .000 1.000 -10.000 10.000 1.

At high discount rates. . B is better. r. for the life of the project. project A is a better choice.5000 4000 3000 NPV A B 2000 1000 0 -1000 0% 10% 15% Discount Rate    At low discount rates. But A always has the higher IRR. A common mistake to make is choose A regardless of the discount rate. Simply choosing the project with the larger IRR would be justified only if the project cash flows could be reinvested at the IRR instead of the actual market rate.

using others as backup. For Multi-period projects with several changes in sign of the cash flows multiple IRRs exist. IRR can give conflicting signals relative to NPV when ranking projects. the decision rule for IRR must be reversed.  I recommend NPV analysis. NPV  IRR analysis can be misleading if you don’t fully understand its limitations. . For projects with inflows followed by outlays. Must compute the NPVs to see what is appropriate decision rule.     For individual projects with a normal cash flow pattern NPV and IRR provide the same conclusion.Summary of IRR vs.

If this is true what is true of the NPV? Thus for independent projects the rules make exactly the same decision. Rule: Take any/only projects with a PI>1.  The PI does a benefit/cost (bang for the buck) analysis. PI  CFt /(1  r )t  t 1 N CF0 .Profitability Index   Definition: The present value of the cash flows that accrue after the initial outlay divided by the initial cash outlay. When the PV of the future benefits is larger than the current cost PI > 1.

500 $364 1.818 1.PI and Mutually Exclusive Projects  Example: Project CF0 CF1 NPV @ 10% PI A -$1.000 $1. This is larger for A but since we invest more in B it will create more wealth for us. It measures the bang per buck invested.36 B -$10. We must take B.18  Since you can only take one and not both the NPV rule says B. Which is right?   The projects are mutually exclusive so the NPV of one is an opportunity cost to the other. the PI rule would suggest A. in this respect A has a negative NPV. .000 $1.000 $13. PI treats scale strangely.

000 $1.     Payback period is defined as the number of years before the cumulative cash inflows equal the initial outlay.000 $5. Is that good or bad? .000 $2. Example: A project has the following cash flows Year 0 Year 1 Year 2 Year 3 Year 4 -$10. Provides a rough idea of how long invested capital is at risk.Payback Period Rule  Frequently used as a check on NPV analysis or by small firms or for small decisions.000 $3.000 The payback period is 3 years.

This “new” rule continues to suffer from the problem of ignoring cash flows received after an arbitrary cutoff date. why mess up the simplicity of the rule? Simplicity is its only virtue. If this is true. At times the payback or discounted payback period may be valuable information but it is not often that this information alone makes for good decisionmaking. .Payback Period Rule     An adjustment to the payback period rule that is sometimes made is to discount the cash flows and calculate the discounted payback period.

This is essentially a measure of return on assets (ROA).Average Accounting Return    Definition: The average net income after depreciation and taxes (before interest) divided by the average book value of the investment. . Rule: If the AAR is above some cutoff take the project.

Uses an arbitrarily specified cutoff rate. Ignores the time value of money. Other than that it’s a beautiful decisionmaking tool. .AAR  Issues      Doesn’t use cash flows but rather accounting numbers. Does not adjust for risk.

Applying the NPV Method   While other approaches (particularly IRR) can be of use. . we will continue to assume that firms are all equity financed. I recommend NPV. Select the appropriate discount rate to reflect current capital market conditions and risk. The three steps to apply NPV:     For now. To be continued… Estimate the incremental cash flows (today). Compute the present value of the cash flows.

. Never. never neglect taxes. never.Our Golden Rules (1) (2) (3) (4) (5) (6) (7) (8) Cash flows are the concern. Don’t ignore opportunity costs. Treat inflation consistently. Don’t forget induced changes in NWC. Consider only incremental cash flows. Don’t include financing costs in cash flow. Recognize project interactions.

Side effects. These are costs. What else could be done? Capital expenditures versus depreciation expense. . Increased investment in working capital. related to the project. that have already been incurred.Incremental Cash Flow   The incremental cash flow is the company’s total free cash flow with the proposed project minus the company’s total cash flow without the project. Some issues that arise:       Sunk costs. Opportunity costs. Does the new project affect other cash flows of the firm? Taxes.

you purchased a plot of land for $2. Currently. How should the land cost be evaluated for purposes of projecting the cash flows that will become part of the NPV analysis? .5 million. Opportunity Costs    Last year.0 million. its market value is $2. You are considering placing a new retail outlet on this land.Sunk Costs vs.

What if a competitor would introduce the new product if your company does not? .   Chrysler’s introduction of the minivan. The most important side effect is called erosion. This is cash flow transferred from existing operations to the project.Side Effects  A further difficulty in determining cash flows from a project comes from effects the proposed project may have on other parts of the firm.

Capital expenditures are not deductible.Taxes  Typically. .  tax depreciation can differ from that reported on financial statements. Expenses are deductible when accrued.     Revenues are taxable when accrued. Sale of an asset for a price other than its tax basis (original price less accumulated tax depreciation) leads to a capital gain/loss with tax implications. but  depreciation can be deducted as it is accrued.

 If you are basing your measure of cash flow on cash revenues no adjustment is required. increases in receivables mean that accrued revenues exceed actual cash collections. .   increases in inventory and/or the cash balance* require actual uses of cash.  If you are basing your measure of cash flow on accrued revenues you need a correcting adjustment.Working Capital  Increases in Net Working Capital should typically be viewed as requiring a net cash outflow.