Capital Budgeting guide

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Capital Budgeting guide

© All Rights Reserved

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You are on page 1of 60

Capital Budgeting

Techniques

13-1

Fundamentals of Financial Management, 12/e

Created by: Gregory A. Kuhlemeyer, Ph.D.

Carroll College, Waukesha, WI

you should be able to:

13-2

selection, including its: (a) calculation; (b) acceptance criterion; (c)

advantages and disadvantages; and (d) focus on liquidity rather than

profitability.

Understand the three major discounted cash flow (DCF) methods of

project evaluation and selection internal rate of return (IRR), net

present value (NPV), and profitability index (PI).

Explain the calculation, acceptance criterion, and advantages (over the

PBP method) for each of the three major DCF methods.

Define, construct, and interpret a graph called an NPV profile.

Understand why ranking project proposals on the basis of IRR, NPV, and

PI methods may lead to conflicts in ranking.

Describe the situations where ranking projects may be necessary and

justify when to use either IRR, NPV, or PI rankings.

Understand how sensitivity analysis allows us to challenge the singlepoint input estimates used in traditional capital budgeting analysis.

Explain the role and process of project monitoring, including progress

reviews and post-completion audits.

Capital Budgeting

Techniques

13-3

Potential Difficulties

Capital Rationing

Project Monitoring

Post-Completion Audit

Project Evaluation:

Alternative Methods

13-4

Julie Miller is evaluating a new project

for her firm, Basket Wonders (BW).

She has determined that the after-tax

cash flows for the project will be

$10,000; $12,000; $15,000; $10,000;

and $7,000, respectively, for each of

the Years 1 through 5. The initial

cash outlay will be $40,000.

13-5

Independent Project

For

independent of any other potential

projects that Basket Wonders may

undertake.

Independent -- A project whose

acceptance (or rejection) does not

prevent the acceptance of other

projects under consideration.

13-6

0

-40 K

10 K

12 K

15 K

4

10 K

required for the cumulative

expected cash flows from an

investment project to equal

the initial cash outflow.

13-7

5

7K

0

-40 K(-b)

Cumulative

Inflows

13-8

10 K

10 K

12 K

22 K

PBP

3 (a)

15 K

37 K(c)

4

10 K(d)

47 K

=a+(b-c)/d

= 3 + (40 - 37) / 10

= 3 + (3) / 10

= 3.3 Years

5

7K

54 K

0

-40 K

10 K

12 K

15 K

10 K

-40 K

-30 K

-18 K

-3 K

7K

Cumulative

Cash Flows

13-9

5

7K

14 K

Years

Note: Take absolute value of last

negative cumulative cash flow value.

The management of Basket Wonders

has set a maximum PBP of 3.5

years for projects of this type.

Should this project be accepted?

Yes! The firm will receive back the

initial cash outlay in less than 3.5

years. [3.3 Years < 3.5 Year Max.]

13-10

PBP Strengths

and Weaknesses

Strengths:

understand

Can be used as a

measure of liquidity

Easier to forecast

ST than LT flows

Weaknesses:

for TVM

cash flows beyond

the PBP

Cutoff period is

subjective

13-11

IRR is the discount rate that equates the

present value of the future net cash

flows from an investment project with

the projects initial cash outflow.

CF1

ICO =

(1+IRR)1

13-12

CF2

(1+IRR)2

CFn

+...+

(1+IRR)n

IRR Solution

$10,000

$12,000

$40,000 =

+

+

(1+IRR)1 (1+IRR)2

$15,000

$10,000

$7,000

+

+

(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000.

13-13

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +

$15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $

7,000(PVIF10%,5)

$40,000 = $10,000(.909) + $12,000(.826) +

$15,000(.751) + $10,000(.683) +

$ 7,000(.621)

$40,000 = $9,090 + $9,912 + $11,265 +

$6,830 +

$4,347

= $41,444

[Rate is too low!!]

13-14

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +

$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +

$ 7,000(PVIF15%,5)

$40,000 = $10,000(.870) + $12,000(.756) +

$15,000(.658) + $10,000(.572) +

$ 7,000(.497)

$40,000 = $8,700 + $9,072 + $9,870 +

$5,720 + $3,479

= $36,841

[Rate is too high!!]

13-15

.05

.10

IRR $40,000

.15

X

.05

13-16

$41,444

$36,841

$1,444

$4,603

$1,444

$4,603

.05

.10

IRR $40,000

.15

X

.05

13-17

$41,444

$36,841

$1,444

$4,603

$1,444

$4,603

.05

.10

$41,444

IRR $40,000

.15

$1,444

$4,603

$36,841

X = ($1,444)(0.05)

$4,603

X = .0157

13-18

The management of Basket Wonders

has determined that the hurdle rate

is 13% for projects of this type.

Should this project be accepted?

No! The firm will receive 11.57% for

each dollar invested in this project at

a cost of 13%. [ IRR < Hurdle Rate ]

13-19

We will use the

cash flow registry

to solve the IRR

for this problem

quickly and

accurately!

13-20

Your Financial Calculator

Steps in the Process

Step 1:

Press CF

Step 2:

Press 2nd

Step 3: For CF0 Press

key

CLR Work keys

-40000 Enter

keys

Step 4:

Step 5:

Step 6:

Step 7:

For F01 Press

For C02 Press

For F02 Press

10000

1

12000

1

Enter

Enter

Enter

Enter

keys

keys

keys

keys

13-21 Step 9: For F03 Press

15000

1

Enter

Enter

keys

keys

Your Financial Calculator

Steps in the Process (Part II)

Step 10:For C04 Press

Step 11:For F04 Press

Step 12:For C05 Press

Step 13:For F05 Press

13-22

10000

1

7000

1

Enter

Enter

Enter

Enter

keys

keys

keys

keys

Step 14:

Step 15:

Press

Press IRR

Step 16:

Press CPT

Result:

keys

key

key

IRR Strengths

and Weaknesses

Strengths:

Accounts for

TVM

Weaknesses:

Considers all

cash flows

flows reinvested at

the IRR

Difficulties with

project rankings and

Multiple IRRs

Less

subjectivity

13-23

NPV is the present value of an

investment projects net cash

flows minus the projects initial

cash outflow.

CF1

NPV =

(1+k)1

13-24

CF2

+

(1+k)2

CFn

ICO

+...+

(1+k)n

NPV Solution

Basket Wonders has determined that the

appropriate discount rate (k) for this

project is 13%.

NPV = $10,000 +$12,000 +$15,000 +

(1.13)1 (1.13)2 (1.13)3

$10,000 $7,000

$40,000

4 +

5

(1.13)

(1.13)

13-25

NPV Solution

NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +

$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +

$ 7,000(PVIF13%,5) - $40,000

NPV = $10,000(.885) + $12,000(.783) +

$15,000(.693) + $10,000(.613) +

$ 7,000(.543) - $40,000

NPV = $8,850 + $9,396 + $10,395 +

$6,130 + $3,801 - $40,000

= - $1,428

13-26

The management of Basket Wonders

has determined that the required

rate is 13% for projects of this type.

Should this project be accepted?

No! The NPV is negative. This means

that the project is reducing shareholder

wealth. [Reject as NPV < 0 ]

13-27

We will use the cash

flow registry to solve

the NPV for this

problem quickly and

accurately!

Hint: If you have not

cleared the cash flows

from your calculator, then

you may skip to Step 15.

13-28

Your Financial Calculator

Steps in the Process

Step 1:

Press CF

Step 2:

Press 2nd

Step 3: For CF0 Press

key

CLR Work keys

-40000 Enter

keys

Step 4:

Step 5:

Step 6:

Step 7:

For F01 Press

For C02 Press

For F02 Press

10000

1

12000

1

Enter

Enter

Enter

Enter

keys

keys

keys

keys

13-29 Step 9: For F03 Press

15000

1

Enter

Enter

keys

keys

Your Financial Calculator

Steps in the Process (Part II)

Step 10:For C04 Press

Step 11:For F04 Press

Step 12:For C05 Press

Step 13:For F05 Press

10000

1

7000

1

Step 14:

Step 15:

Press

Press NPV

13-30

Enter

Enter

Enter

Enter

keys

keys

keys

keys

keys

key

13

Enter

keys

Step 17:

Press CPT

key

Result:

NPV Strengths

and Weaknesses

Weaknesses:

Strengths:

Cash flows

assumed to be

reinvested at the

hurdle rate.

Considers all

cash flows.

13-31

managerial

options embedded

in the project. See

Chapter 14.

Net Present Value

$000s

15

Thre

e

10

5

discount rate.

of th

e

se p

oint

IRR

s ar

6

9

12

Discount Rate (%)

e ea

sy n

NPV@13%

0

-4

13-32

Sum of CFs

15

ow!

Using the Calculator

Hint: As long as you

do not clear the

cash flows from the

registry, simply start

at Step 15 and enter

a different discount

rate. Each resulting

NPV will provide a

point for your NPV

Profile!

13-33

PI is the ratio of the present value of

a projects future net cash flows to

the projects initial cash outflow.

Method #1:

CF1

PI =

(1+k)1

CF2

+

(1+k)2

+...+

CFn

(1+k)n

<< OR >>

Method #2:

13-34

PI = 1 + [ NPV / ICO ]

ICO

PI Acceptance Criterion

PI

= $38,572 / $40,000

= .9643 (Method #1, 13-34)

No! The PI is less than 1.00. This

means that the project is not profitable.

[Reject as PI < 1.00 ]

13-35

PI Strengths

and Weaknesses

Strengths:

Weaknesses:

Same as NPV

Same as NPV

Allows

comparison of

different scale

projects

Provides only

relative profitability

Potential Ranking

Problems

13-36

Evaluation Summary

Basket Wonders Independent Project

13-37

PBP

3.3

3.5

Accept

IRR

11.47%

13%

Reject

NPV

-$1,424

$0

Reject

PI

.96

1.00

Reject

Other Project

Relationships

Dependent -- A project whose

acceptance depends on the

acceptance of one or more other

projects.

Mutually Exclusive -- A project

whose acceptance precludes the

acceptance of one or more

alternative projects.

13-38

Potential Problems

Under Mutual Exclusivity

Ranking of project proposals may

create contradictory results.

A. Scale of Investment

B. Cash-flow Pattern

C. Project Life

13-39

A. Scale Differences

Compare a small (S) and a

large (L) project.

END OF YEAR

13-40

Project S

Project L

-$100

-$100,000

$400

$156,250

Scale Differences

Calculate the PBP, IRR, NPV@10%,

and PI@10%.

Which project is preferred? Why?

Project

IRR

100%

25%

13-41

NPV

PI

231

3.31

$29,132

1.29

Let us compare a decreasing cash-flow (D)

project and an increasing cash-flow (I) project.

END OF YEAR

0

1

2

3

13-42

Project D

Project I

-$1,200

-$1,200

1,000

100

500

600

100

1,080

Calculate the IRR, NPV@10%, and

PI@10%.

Which project is preferred?

Project

13-43

IRR

NPV

PI

23%

$198

1.17

17%

$198

1.17

13-44

600

project at various

discount rates.

400

Project I

200

NPV@10%

IRR

Project D

0

-200

10

15

20

Discount Rate (%)

25

-200 0 200 400

600

13-45

At k<10%, I is best!

Fishers Rate of

Intersection

At k>10%, D is best!

10

15

20

Discount Rate ($)

25

Let us compare a long life (X) project

and a short life (Y) project.

END OF YEAR

0

1

2

3

13-46

Project X

Project Y

-$1,000

-$1,000

0

2,000

0

0

3,375

0

Calculate the PBP, IRR, NPV@10%,

and PI@10%.

Which project is preferred? Why?

13-47

Project

IRR

NPV

PI

50%

$1,536

2.54

100%

$ 818

1.82

Another Way to

Look at Things

1.

year if project Y will NOT be replaced.

Compound Project Y, Year 1 @10% for 2 years.

Year

CF

-$1,000

$0

$0

$2,420

Results:

IRR* = 34.26%

NPV = $818

13-48

Replacing Projects

with Identical Projects

2.

when project Y will be replaced.

0

-$1,000

-$1,000

Results:

13-49

$2,000

-1,000

$1,000

IRR = 100%

$2,000

-1,000

$2,000

$1,000

$2,000

NPV* = $2,238.17

Best

Capital Rationing

Capital Rationing occurs when a

constraint (or budget ceiling) is placed

on the total size of capital expenditures

during a particular period.

Example: Julie Miller must determine what

investment opportunities to undertake for

Basket Wonders (BW). She is limited to a

maximum expenditure of $32,500 only for

this capital budgeting period.

13-50

Project

A

B

C

D

E

F

G

H

13-51

ICO

$

500

5,000

5,000

7,500

12,500

15,000

17,500

25,000

IRR

18%

25

37

20

26

28

19

15

NPV

PI

50

6,500

5,500

5,000

500

21,000

7,500

6,000

1.10

2.30

2.10

1.67

1.04

2.40

1.43

1.24

Project

C

F

E

B

ICO

IRR

NPV

PI

$ 5,000

15,000

12,500

5,000

37%

28

26

25

$ 5,500

21,000

500

6,500

2.10

2.40

1.04

2.30

three largest IRRs.

The resulting increase in shareholder wealth

is $27,000 with a $32,500 outlay.

13-52

Project

F

G

B

ICO

$15,000

17,500

5,000

IRR

NPV

PI

28%

19

25

$21,000

7,500

6,500

2.40

1.43

2.30

two largest NPVs.

The resulting increase in shareholder wealth

is $28,500 with a $32,500 outlay.

13-53

Project

F

B

C

D

G

ICO

IRR

NPV

PI

$15,000

5,000

5,000

7,500

17,500

28%

25

37

20

19

$21,000

6,500

5,500

5,000

7,500

2.40

2.30

2.10

1.67

1.43

The resulting increase in shareholder wealth is

$38,000 with a $32,500 outlay.

13-54

Summary of Comparison

Method Projects Accepted

PI

F, B, C, and D

Value Added

$38,000

NPV

F and G

$28,500

IRR

C, F, and E

$27,000

shareholder wealth when a limited capital

budget exists for a single period.

13-55

Single-Point Estimate

and Sensitivity Analysis

Sensitivity Analysis:

Analysis A type of what-if

uncertainty analysis in which variables or

assumptions are changed from a base case in

order to determine their impact on a projects

measured results (such as NPV or IRR).

13-56

revenue, installation cost, salvage, etc.) estimates

to a what if analysis

Utilize a base-case to compare the impact of

individual variable changes

E.g., Change forecasted sales units to see

impact on the projects NPV

Post-Completion Audit

Post-completion Audit

A formal comparison of the actual costs and

benefits of a project with original estimates.

13-57

Let us assume the following cash flow

pattern for a project for Years 0 to 4:

-$100 +$100 +$900 -$1,000

How many potential IRRs could this

project have?

Two!! There are as many potential

IRRs as there are sign changes.

13-58

* Refer to Appendix A

Net Present Value

($000s)

75

50

25

0

-100

13-59

Multiple IRRs at

k = 12.95% and 191.15%

40

80

120

160

Discount Rate (%)

200

Hint: Your calculator

will only find ONE

IRR even if there

are multiple IRRs. It

will give you the

lowest IRR. In this

case, 12.95%.

13-60

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