1 Capital Budgeting Techniques © 2007 Thomson/South-Western

2 Essentials of How do firms make decisions about whether to invest in costly, long-lived assets? How does a firm make a choice between two acceptable investments when only one can be purchased? How are different capital budgeting techniques related? Which capital budgeting methods do firms actually use?

3 What is Capital Budgeting? The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year Analysis of potential additions to fixed assets Long-term decisions; involve large expenditures Very important to firm’s future

4 Generating Ideas for Capital Projects A firm’s growth and its ability to remain competitive depend on a constant flow of ideas for new products, ways to make existing products better, and ways to produce output at a lower cost. Procedures must be established for evaluating the worth of such projects.

5 Project Classifications Replacement Decisions: whether to purchase capital assets to take the place of existing assets to maintain or improve existing operations Expansion Decisions: whether to purchase capital projects and add them to existing assets to increase existing operations Independent Projects: Projects whose cash flows are not affected by decisions made about other projects Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted

6 Determine the cost, or purchase price, of the asset. Estimate the cash flows expected from the project. Assess the riskiness of cash flows. Compute the present value of the expected cash flows to obtain as estimate of the asset’s value to the firm. Compare the present value of the future expected cash flows with the initial investment. Similarities between Capital Budgeting and Asset Valuation

7 1,500 1, ,300 1,500 ^ Net CashFlows, CF t r edpAExctefte-Tax Year(T)ProjectSPro tL 0$(3,000)$( 0) Net Cash Flows for Project S and Project L

8 The length of time before the original cost of an investment is recovered from the expected cash flows or... How long it takes to get our money back. What is the Payback Period?

9 Payback Period for Project S = Payback S /800 = years Net Cash Flow Cumulative Net CF 1,500 -1, , , PB S 01234

10 = Payback L /1,500 = 3.3 years Net Cash Flow Cumulative Net CF ,600 1, , ,000 1,500 1,100 PB L Payback Period for Project L

11 Strengths of Payback: Provides an indication of a project’s risk and liquidity Easy to calculate and understand Weaknesses of Payback: Ignores TVM Ignores CFs occurring after the payback period Strengths and Weaknesses of Payback:

12 Cost is CF 0 and is generally negative. ^ ^ Net Present Value: Sum of the PVs of Inflows and Outflows ^

13 What is Project S’s NPV? r = 10% 1, ,200(3,000) 1, NPV S =

14 What is Project L’s NPV? r = 10% (3,000) NPV L =

15 NPV L = = NPV L Enter in CF for L: I -3, ,300 1,500 10% CF 0 CF 1 CF 2 CF 3 CF 4 Calculator Solution, NPV for L

16 Rationale for the NPV method: NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Which adds most value?

17 Using NPV method, which project(s) should be accepted? If Projects S and L are mutually exclusive, accept S because NPVS > NPVL. If S & L are independent, accept both; NPV > 0.

CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. Internal Rate of Return: IRR

19 NPV: Enter r, solve for NPV. IRR: Enter NPV = 0, solve for IRR. Calculating IRR

20 Enter CFs in CF register, then press IRR: NPV S = IRR S = 13.1% 0 (3,000) IRR = ? Sum of PVs for CF 1-4 = 3,000 1, , What is Project S’s IRR?

21 NPV L = Enter CFs in CF register, then press IRR: IRR L = 11.4% 0 IRR = ? Sum of PVs for CF 1-4 = 3,000 (3,000) What is Project L’s IRR?

22 They are the same thing. A bond’s YTM is the IRR if you invest in the bond IRR = ? IRR = 7.08% (use TVM or CF register) How is a Project’s IRR Related to a Bond’s YTM?

23 If IRR (project’s rate of return) > the firm’s required rate of return, r, then some return is left over to boost stockholders’ returns. Example: r = 10%, IRR = 15%. Profitable. Rationale for the IRR Method

24 IRR Acceptance Criteria If IRR > r, accept project. If IRR < r, reject project.

25 Decisions on Projects S and L per IRR If S and L are independent, accept both. IRRs > r = 10%. If S and L are mutually exclusive, accept S because IRR S > IRR L.

26 Enter CFs in your calculator and find NPV L and NPV S at several discount rates (r): r NPV L 1, (259) (566) NPV S ( 91) (309) Construct NPV Profiles

27 k NPV L 1, (259) (566) NPV S ( 91) (309) IRR L = 11.4% IRR S = 13.1% Crossover Point = 8.1% Project L Project S NPV Profiles for Project S and Project L

28 IRR < r and NPV < 0. Reject. NPV ($) r (%) IRR IRR > r and NPV > 0 Accept. NPV and IRR always lead to the same accept/reject decision for independent projects

29 Mutually Exclusive Projects r NPV S, IRR L < IRR S CONFLICT r > 8.1: NPV S > NPV L, IRR S > IRR L NO CONFLICT 8.1 NPV % IRR s IRR L S L

30 1. Find cash flow differences between the projects. See data at beginning of the case. 2. Enter these differences in CF register, then press IRR. Crossover rate = 8.11, rounded to 8.1%. 3. Can subtract S from L or vice versa. 4. If profiles don’t cross, one project dominates the other. To Find the Crossover Rate:

31 Two Reasons NPV Profiles Cross: 1) Size (scale) differences. 1) Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects. 2) Timing differences. 2) Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPV S > NPV L.

32 Reinvestment Rate Assumptions NPV assumes reinvest at r. IRR assumes reinvest at IRR. Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

33 Modified Internal Rate of Return A better indicator of relative profitability Better for use in capital budgeting

34 Chapter 9 Essentials How do firms make decisions about whether to invest in costly, long-lived assets? Firms use decision-making methods that are based on fundamental valuation concepts How does a firm make a choice between two acceptable investments when only one can be purchased? The decision should be consistent with the goal of maximizing the value of the firm

35 Chapter 9 Essentials How are different capital budgeting techniques related? All techniques except traditional payback period (PB) are based on time value of money Which capital budgeting methods do firms actually use? Most firms rely heavily on NPV and IRR to make investment decisions