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Capital Budgeting

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(CHAPTER 12)

Capital Budgeting: An Overview

Estimating Incremental Cash Flows

Payback Period

Net Present Value

Internal Rate of Return

Ranking Problems

Capital Rationing

Risk Adjustment

CAPITAL BUDGETING: AN OVERVIEW

Search for investment opportunities. This process

will obviously vary among firms and industries.

Estimate all cash flows for each project.

Evaluate the cash flows. a) Payback period. b) Net

Present Value. c) Internal Rate of Return. d)

Modified Internal rate of Return.

Make the accept/reject decision.

Independent projects: Accept/reject decision for a

project is not affected by the accept/reject decisions of

other projects.

Mutually exclusive projects: Selection of one

alternative precludes another alternative.

Periodically reevaluate past investment decisions.

ESTIMATING INCREMENTAL CASH

FLOWS

Only changes in after-tax cash flows that

would occur if the project is accepted

versus what they would be if the project is

rejected are relevant.

Initial Outlay: Includes purchase price of the

asset, shipping and installation, after-tax sale of

asset to be replaced if applicable, additional

required investments in net working capital (e.g.,

increases in accounts receivable and inventory

less any spontaneous increases in accounts

payable and accruals), plus any other cash flows

necessary to put the asset in working order.

Differential Cash Flows

Over the Project’s Life:

Change in revenue

- Change in operating expenses

= Change in operating income before

taxes

- Change in taxes

= Change in operating income after

taxes

+ Change in depreciation

= Differential cash flow

Note: Interest expenses are excluded when

calculating differential cash flow. Instead,

they are accounted for in the discount rate

used to evaluate projects.

Terminal Cash Flow: Includes after-tax salvage

value of the asset, recapture of nonexpense

outlays that occurred at the asset’s initiation

(e.g., net working capital investments), plus

any other cash flows associated with project

termination.

PAYBACK PERIOD

The number of years required to recoup the initial

outlay. What is (n) such that:

CF CF

t

t

n

=

=

=

¿

0

1

(n) = payback period (PP)

CF = initial outlay

CF after - tax cash flow in period (t)

0

t

PAYBACK PERIOD (CONTINUED)

Decision Rules:

PP = payback period

MDPP = maximum desired payback period

Independent Projects:

PP s MDPP - Accept

PP > MDPP - Reject

Mutually Exclusive Projects:

Select the project with the fastest payback, assuming

PP s MDPP.

Problems: (1) Ignores timing of the cash flows, and

(2) Ignores cash flows beyond the payback

period.

NET PRESENT VALUE (NPV)

The present value of all future after-tax cash flows

minus the initial outlay

return) (required capital of cost = k : where

) 1 (

...

) 1 ( ) 1 (

=

) 1 (

0

2

2 1

1

0

CF

k

CF

k

CF

k

CF

CF

k

CF

NPV

n

n

n

t

t

t

÷

(

¸

(

¸

+

+ +

+

+

+

÷

+

=

¿

=

NPV (CONTINUED)

Decision Rules:

Independent Projects:

NPV > 0 - Accept

NPV < 0 - Reject

Mutually Exclusive Projects:

Select the project with the highest NPV, assuming NPV > 0.

INTERNAL RATE OF RETURN (IRR)

Rate of return on the investment. That rate of

discount which equates the present value of all

future after-tax cash flows with the initial outlay.

What is the IRR such that:

When only one interest factor is required, you can

solve for the IRR algebraically. Otherwise, trial

and error is necessary.

) 1 (

1

0 ¿

=

=

+

n

t

t

t

CF

IRR

CF

IRR (CONTINUED)

If you are not using a financial calculator:

1. Guess a rate.

2. Calculate:

3. If the calculation = CF

0

you guessed right

If the calculation > CF

0

try a higher rate

If the calculation < CF

0

try a lower rate

Note: Financial calculators do the trial and

error calculations much faster than we

can!

CF

IRR

t

t

t

n

( ) 1

1

+

=

¿

IRR (CONTINUED)

Decision Rules (No Capital Rationing):

Independent Projects:

IRR > k - Accept

IRR < k - Reject

Mutually Exclusive Projects:

Select the project with the highest IRR, assuming IRR > k.

Multiple IRRs:

There can be as many IRRs as there are sign

reversals in the cash flow stream. When multiple IRRs

exist, the normal interpretation of the IRR loses its

meaning.

RANKING PROBLEMS

When NPV = 0, IRR = k

When NPV > 0, IRR > k

When NPV < 0. IRR < k

Therefore, given no capital rationing and

independent projects, the NPV and IRR methods

will always result in the same accept/reject

decisions.

However, the methods may rank projects differently.

As a result, decisions could differ if projects are

mutually exclusive, or capital rationing is

imposed. Ranking problems can occur when (1)

initial investments differ, or (2) the timing of

future cash flows differ. (See discussion on NPV

profiles)

RANKING PROBLEMS (CONTINUED)

Ranking Conflicts: Due to reinvestment rate

assumptions, the NPV method is generally more

conservative, and is considered to be the

preferred method.

NPV - Assumes reinvestment of future cash flows at

the cost of capital.

IRR - Assumes reinvestment of future cash flows at

the project’s IRR.

In addition, the NPV method maximizes the value of

the firm.

CAPITAL RATIONING

Note:

Capital rationing exists when an artificial constraint is placed on the amount of

funds that can be invested. In this case, a firm may be confronted with more

“desirable” projects than it is willing to finance. A wealth maximizing firm would

not engage in capital rationing.

CAPITAL RATIONING: AN EXAMPLE

(FIRM’S COST OF CAPITAL = 12%)

Independent projects ranked according to

their IRRs:

Project Project Size IRR

E $20,000 21.0%

B 25,000 19.0

G 25,000 18.0

H 10,000 17.5

D 25,000 16.5

A 15,000 14.0

F 15,000 11.0

C 30,000 10.0

CAPITAL RATIONING EXAMPLE

(CONTINUED)

No Capital Rationing - Only projects F and C

would be rejected. The firm’s capital budget

would be $120,000.

Capital Rationing - Suppose the capital budget is

constrained to be $80,000. Using the IRR

criterion, only projects E, B, G, and H, would

be accepted, even though projects D and A

would also add value to the firm. Also note,

however, that a theoretical optimum could be

reached only be evaluating all possible

combinations of projects in order to determine

the portfolio of projects with the highest NPV.

REQUIRED RETURNS FOR INDIVIDUAL

PROJECTS THAT VARY IN RISK LEVELS

Higher hurdle rates should be used for

projects that are riskier than the

existing firm, and lower hurdle rates

should be used for lower risk projects.

Measuring risk and specifying the tradeoff

between required return and risk,

however, are indeed difficult endeavors.

Interested students should read Chapter

13 entitled Risk and Capital Budgeting.

RISK ADJUSTED REQUIRED RETURNS

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6

Required Return

Firm’s Risk Level

Risk

k

a

Risk-Return

Tradeoff

k

a

= Cost of

Capital for the

existing firm.

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