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Attribution Non-Commercial (BY-NC)

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Capital

Capital Budgeting

Budgeting

Techniques

Techniques

© 2001 Prentice-Hall, Inc.

Fundamentals of Financial Management, 11/e

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

Carroll College, Waukesha, WI

What

What is

is

Capital

Capital Budgeting?

Budgeting?

analyzing, and selecting

investment projects whose

returns (cash flows) are

expected to extend beyond

one year.

What is capital budgeting?

◆ Analysis of potential additions

to fixed assets.

◆ Long-termdecisions; involve

large expenditures.

◆ Very important to firm’s future.

The

The Capital

Capital

Budgeting

Budgeting Process

Process

◆ Generate investment proposals

consistent with the firm’s strategic

objectives.

◆ Estimate after-tax incremental

operating cash flows for the investment

projects.

◆ Evaluate project incremental cash

flows.

Steps to capital budgeting

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.

3. Determine the appropriate cost of

capital.

4. Find NPV and/or IRR.

5. Accept if NPV > 0

Project

Project Evaluation:

Evaluation:

Alternative

Alternative Methods

Methods

◆ Internal Rate of Return (IRR)

◆ Net Present Value (NPV)

◆ Profitability Index (PI)

Proposed

Proposed Project

Project Data

Data

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.

Independent Project

◆ For this project, assume that it is

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.

Payback

Payback Period

Period (PBP)

(PBP)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

required for the cumulative

expected cash flows from an

investment project to equal

the initial cash outflow.

Payback

Payback Solution

Solution (#1)

(#1)

0 1 2 3 (a) 4 5

10 K 22 K 37 K (c) 47 K 54 K

Cumulative

Inflows PBP =a+(b-c)/d

= 3 + (40 - 37) / 10

= 3 + (3) / 10

= 3.3 Years

Payback

Payback Solution

Solution (#2)

(#2)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

-40 K -30 K -18 K -3 K 7K 14 K

Cumulative Years

Cash Flows

Note: Take absolute value of last

negative cumulative cash flow value.

PBP

PBP Acceptance

Acceptance Criterion

Criterion

The management of Basket Wonders

has set a maximum PBP of 3.5

years for projects of this type.

Should this project be accepted?

initial cash outlay in less than 3.5

years. [3.3 Years < 3.5 Year Max.]

PBP

PBP Strengths

Strengths

and

and Weaknesses

Weaknesses

Strengths: Weaknesses:

◆Easy to use and ◆ Does not account

understand for TVM

◆Can be used as a ◆ Does not consider

measure of liquidity cash flows beyond

◆Easier to forecast the PBP

ST than LT flows ◆ Cutoff period is

subjective

Internal

Internal Rate

Rate of

of Return

Return (IRR)

(IRR)

present value of the future net cash

flows from an investment project with

the project’s initial cash outflow.

ICO = + +...+

(1+IRR) (1+IRR)2

1

(1+IRR)n

IRR

IRR Solution

Solution

+ +

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

$15,000 $10,000 $7,000

+ +

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

discounted cash flows to equal $40,000.

IRR

IRR Solution

Solution (Try

(Try 10%)

10%)

$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!!]

IRR

IRR Solution

Solution (Try

(Try 15%)

15%)

$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!!]

IRR

IRR Solution

Solution (Interpolate)

(Interpolate)

.10 $41,444

X $1,444

.05 IRR $40,000 $4,603

.15 $36,841

X $1,444

.05 = $4,603

IRR

IRR Solution

Solution (Interpolate)

(Interpolate)

.10 $41,444

X $1,444

.05 IRR $40,000 $4,603

.15 $36,841

X $1,444

.05 = $4,603

IRR

IRR Solution

Solution (Interpolate)

(Interpolate)

.10 $41,444

X $1,444

.05 IRR $40,000 $4,603

.15 $36,841

X = ($1,444)(0.05) X = .0157

$4,603

IRR = .10 + .0157 = .1157 or 11.57%

IRR

IRR Acceptance

Acceptance Criterion

Criterion

The management of Basket Wonders

has determined that the hurdle rate

is 13% for projects of this type.

Should this project be accepted?

each dollar invested in this project at

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

IRR

IRR Strengths

Strengths

and

and Weaknesses

Weaknesses

Strengths: Weaknesses:

◆ Accounts for ◆ Assumes all cash

TVM flows reinvested at

the IRR

◆ Considers all

cash flows ◆ Difficulties with

project rankings and

◆ Less

subjectivity Multiple IRRs

Net

Net Present

Present Value

Value (NPV)

(NPV)

investment project’s net cash

flows minus the project’s initial

cash outflow.

NPV = + +...+ - ICO

(1+k)1 (1+k)2 (1+k)n

NPV

NPV Solution

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

4 + 5 - $40,000

(1.13) (1.13)

NPV

NPV Solution

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

NPV

NPV Acceptance

Acceptance Criterion

Criterion

The management of Basket Wonders

has determined that the required

rate is 13% for projects of this type.

Should this project be accepted?

that the project is reducing shareholder

wealth. [Reject as NPV < 0 ]

NPV

NPV Strengths

Strengths

and

and Weaknesses

Weaknesses

Strengths: Weaknesses:

◆ Cash flows ◆ May not include

assumed to be managerial

reinvested at the options embedded

hurdle rate. in the project. See

Chapter 14.

◆ Accounts for TVM.

◆ Considers all

cash flows.

Profitability

Profitability Index

Index (PI)

(PI)

a project’s future net cash flows to

the project’s initial cash outflow.

CF1 CF2 CFn

PI = + +...+ ICO

(1+k)1 (1+k)2 (1+k)n

<< OR >>

PI = 1 + [ NPV / ICO ]

PI

PI Acceptance

Acceptance Criterion

Criterion

PI = $38,572 / $40,000

= .9643 (Method #1, 13-33)

means that the project is not profitable.

[Reject as PI < 1.00 ]

PI

PI Strengths

Strengths

and

and Weaknesses

Weaknesses

Strengths: Weaknesses:

◆ Same as NPV ◆ Same as NPV

◆ Allows ◆ Provides only

comparison of relative profitability

different scale ◆ Potential Ranking

projects Problems

Evaluation Summary

Method Project Comparison Decision

PBP 3.3 3.5 Accept

IRR 11.47% 13% Reject

NPV -$1,424 $0 Reject

PI .96 1.00 Reject

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