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Capital Budgeting Project Selection

Methods

4 Methods in Chapter 9:
Payback
Net Present Value
Profitability Index
Internal Rate of Return

Characteristics of a Good Project


Selection Method

Considers all project cash flows


(from NICO through DCF)
Adjusts cash flows for timing
(finds PV of future cash flows)
Incorporates firms cost of capital
(uses MCC in analysis)

Payback Method

Determine how long (# years) it takes to


recover NICO from OCFs
Compare payback period to company
determined standard
No universal guidelines
Payback method fails to meet any of
the criteria for good selection method

Net Present Value

Find the PV of the OCFs and the DCF


using the firms MCC
Subtract NICO from the sum of the PVs
Result is NPV
If NPV > 0, accept project
If NPV < 0, reject project

Profitability Index

Find the PV of the OCFs and the DCF


using the firms MCC
Divide the sum of the PVs by NICO
Result is PI
If PI > 1.0, accept project
If PI < 1.0, reject project

Internal Rate of Return

Solving for unknown interest rate


Looking for rate that makes the PV of
the OCFs and the DCF equal to NICO
If IRR > MCC, accept project
If IRR < MCC, reject project

Incorporating Risk into the Capital


Budgeting Process

What can go wrong with incremental


cash flow estimates?
NICO can be larger than expected
OCFs and DCF can be smaller than
expected
Useful life can be shorter than expected

Options for Incorporating Risk

Scenario Analysis
Sensitivity Analysis
Risk Adjusted Discount Rates

Scenario Analysis

Set up different scenarios for the


projects cash flows
Best Case: Lowest NICO, Highest
OCFs and DCF, longest life
Worst Case: Highest NICO, Lowest
OCFs and DCF, shortest life
Most Likely Case: Cash flows fall in
between Best and Worst Cases

Sensitivity Analysis

What if analysis
Change one variable by a certain %.
Hold other variables constant.
Recalculate NPV, PI, or IRR. Look at %
change in NPV, PI, or IRR.
Identifies which variables have biggest
impact on success/failure of project

Risk Adjusted Discount Rates


(RADR)

Average risk projects should be


evaluated using MCC
Average risk means projects similar to
what company has done in the past
MCC represents investors required
rates of return based on what the firm
currently does

Above Average Risk Projects

When firm undertakes new kind of work,


investors want higher rates of return to
compensate for increased risk
Use MCC + extra points for projects
that are different from what firm usually
does

Purpose of RADR

The higher the risk of a project, the higher the


discount rate used to evaluate the project
The higher the discount rate, the lower the PV
of future cash flows
The lower the PV, the harder it will be to cover
NICO
Higher risk projects have to meet a tougher
standard

Example of RADR

Risk Class 1 = Replacement projects.


Use MCC.
Risk Class 2 = Expansion projects.
Use MCC + 3 points.
Risk Class 3 = New projects.
Use MCC + 5 points.