Capital Budgeting

FIN 502: Managerial Finance
George W. Gallinger Associate Professor of Finance W. P. Carey School of Business Arizona State University

Typical Capital Budgeting System

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Illustration of Sustainable Growth

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Calculating Accounting Rate of Return

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Calculating Payback Period

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Calculating Discounted Payback Period

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Calculating NPV

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Calculating NPV…

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Use Nominal or Real WACC?

Nominal return reflects the actual dollar return; real return measures the increase in purchasing power gained by holding a certain investment

(1 + nominal rate) = (1 + inflation rate) ×(1 + real rate), 1 + nom  or, real rate =   −1  1 + inf 

Common in capital budgeting is the use of market rates of return at the time of the analysis

Market interest rates have embedded an assumption about inflation Use nominal cash flows to reflect the same inflation rate as that embedded in discount rate.
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Projects plotting above the security market line (SML) have rates of return in excess of their required market rates

Positive NPVs

Projects plotting below the SML have rates of return less than their required market rates

Negative NPVs

Projects plotting on the SML earn their market rates

Zero NPVs.
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Calculating IRR

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Illustration for Calculating IRR

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Appropriate rates for comparing project returns are those falling on the upward sloping market risk-return tradeoff curve

Not the firm’s horizontal cost of capital line, WACC WACC is only appropriate for evaluating projects with risk comparable to the level of risk of the firm

“Carbon copy” projects.
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Size Problem

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Cash Flow Pattern Problems

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Multiple IRR Solutions

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Undervaluation of Later Cash Flows

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Calculating the Profitability Index

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Comparison of Project Rankings

Project B is better than project A

Project B continues to earn cash flows longer

Project D is more desirable than project C

Although both projects generate the same amount of cash flows, project D does it earlier

Is Project D better than project B? W. P. Carey Executive MBA Program

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Sunk Costs

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Salvage Value Comparisons

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Calculating Initial Investment

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Calculating Annual Operating Cash Flows

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Alternatively, Calculating Annual Operating Cash Flows…

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Calculating Terminal Cash Flows

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Salvage Value: Present vs. Future

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Another Topic: Competing Projects

Assume projects
  

Mutually exclusive On-going Different economic lives

How do you select the correct project?

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Example
 

There are times when application of the NPV rule can lead to the wrong decision Consider a factory which must have an air cleaner

The equipment is mandated by law, so there is no “doing without” The “Cadillac cleaner” costs \$4,000 today, has annual operating costs of \$100 and lasts for 10 years The “cheaper cleaner” costs \$1,000 today, has annual operating costs of \$500 and lasts for 5 years
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There are two choices:

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Which one should we choose?

Example …

At first glance, the cheap cleaner has the “better” NPV (r = 10%):

\$100 = −\$4,000 − ∑ = −4,614.46 t t =1 (1.10)
5

10

NPVcheap

\$500 = −\$1,000 − ∑ = −2,895.39 t t =1 (1.10)

 Overlooks the fact that the Cadillac cleaner lasts twice as

long  When we incorporate project life, the Cadillac cleaner is actually cheaper.
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Example …

The Cadillac cleaner time line of cash flows: -100 -100 -100 -100 -100 -100 -100 -100

-\$4,000 –100 -100

0

1

2

3

4
10

5

6

7

8

9

10

\$100 = −\$4,000 − ∑ = −4,614.46 t t =1 (1.10)

The “cheaper cleaner” time line of cash flows over ten years: -\$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

0
NPVcheap

1

2

3
5

4

5

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9

10

\$500 \$1,000 10 \$500 = −\$1,000 − ∑ − −∑ = −\$4,693.20 t 5 t (1.10) t =6 (1.10) t =1 (1.10)
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Investments of Unequal Lives

Replacement Chain

Repeat the projects forever, find the PV of that perpetuity Assumption: Both projects can and will be repeated Repeat projects until they begin and end at the same time—like we just did with the air cleaners Compute NPV for the “repeated projects”

Matching Cycle

The Equivalent Annual Annuity (EAA) Method.

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Equivalent Annual Cost Method

Equivalent Annual Annuity Method

 

Provides the value of the level payment annuity that has the same PV as the original set of cash flows NPV = EAA × ArT For example, the EAA for the Cadillac air cleaner is \$750.98

− \$4,000 −

∑ (1.10)
t =1

10

\$100
t

= −4,614.46 =

∑ (1.10)
t =1

10

\$750.98
t

Annuity Table 10%, 10 years = 6.1446

The EAA for the cheaper air cleaner is \$763.80, which confirms our earlier decision to reject it.
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Another Example: Calculating EAA

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Human Face of Capital Budgeting

NPV of a project  based on assumptions

Managers must be aware of optimistic bias in these assumptions made by supporters of the project

Companies need control measures to remove bias
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Analysis done by a group independent of individual or group proposing the project Analysts must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential

Another side of determining which projects receive funding – storytelling

Best analysts not only provide numbers to highlight a W.good investment, but also can explain why this P. Carey Executive MBA Program Slide 34 investment makes sense.

The End

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