Capital Budgeting Processes And Techniques Professor XXXXX Course Name / Number

The Capital Budgeting Decision Process The Capital Budgeting Process involves three basic steps: Generating long-term investment proposals Reviewing, analyzing, and selecting from the proposals that have been generated Implementing and monitoring the proposals that have been selected Managers should separate investment and financing decisions

Capital Budgeting Decision Techniques Payback period: most commonly used Accounting rate of return (ARR): focuses on project’s impact on accounting profits Net present value (NPV): best technique theoretically Internal rate of return (IRR): widely used with strong intuitive appeal Profitability index (PI): related to NPV

A Capital Budgeting Process Should: Account for the time value of money Account for risk Focus on cash flow Rank competing projects appropriately Lead to investment decisions that maximize shareholders’ wealth

Entropica Investment Entropica is a provider of magnetic resonance imaging devices Entropica evaluating two investment proposals Construction of completely new manufacturing plant Refurbishing an existing plant Construction ($ millions) Refurbishing ($ millions) $850 Year 5 inflow $740 Year 4 inflow $400 Year 3 inflow $250 Year 2 inflow $100 Year 1 inflow -$1,200 Initial outlay $48 Year 5 inflow $47 Year 4 inflow $41 Year 3 inflow $30 Year 2 inflow $22 Year 1 inflow -$75 Initial outlay

Management determines maximum acceptable payback period The payback period is the amount of time required for the firm to recover its initial investment If the project’s payback period is less than the maximum acceptable payback period, accept the project If the project’s payback period is greater than the maximum acceptable payback period, reject the project Management determines maximum acceptable payback period

Calculating Payback Periods For Entropica Projects Management selects a 3-year payback period Construction project has initial outflow of -$1,200 million But cash inflows over first 3 years only $750 million Entropica would reject construction project based on payback Refurbishing project has initial outflow of -$75 million Cash inflows over first 3 years cumulate to $93 million Project recovers initial outflow middle of year 3 Entropica would accept the project

Pros And Cons Of Payback Method Advantages of payback method: Computational simplicity Easy to understand Focus on cash flow Disadvantages of payback method: Does not account properly for time value of money Does not account properly for risk Cutoff period is arbitrary Does not lead to value-maximizing decisions

Discounted Payback Period Discounted payback accounts for time value Apply discount rate to cash flows during payback period Still ignores cash flows after payback period Entropica uses a 16% discount rate Reject -- Accept / reject $67.53 $528.26 Cumulative PV $26.27 $256.26 0.6407 PV Year 3 inflow $22.29 $185.79 0.7432 PV Year 2 inflow $18.97 $86.21 0.8621 PV Year 1 inflow Refurbishing project ($million) Construction project ($million) PV Factors (16%) Item

Accounting Rate Of Return (ARR) Can be computed from available accounting data Need only profits after taxes and depreciation Accounting ROR = Average profits after taxes  Average investment Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows Average profits after taxes Average annual operating cash inflows Average annual depreciation = - ARR uses accounting numbers, not cash flows; no time value of money

Net Present Value The present value of a project’s cash inflows and outflows Discounting cash flows accounts for the time value of money Choosing the appropriate discount rate accounts for risk Accept projects if NPV > 0

Net Present Value A key input in NPV analysis is the discount rate r represents the minimum return that the project must earn to satisfy investors r varies with the risk of the firm and/or the risk of the project

Calculating NPVs For Entropica’s Projects Assuming Entropica uses 16% discount rate, NPVs are: Construction project: NPV = $141.65 million Refurbishing project: NPV = $41.43 million Should Entropica invest in one project or both?

Independent versus Mutually Exclusive Projects Independent projects – accepting/rejecting one project has no impact on the accept/reject decision for the other project Mutually exclusive projects – accepting one project implies rejecting another Both Entropica projects deal with production capacity If demand is high enough, projects may be independent If demand warrants only one investment, projects are mutually exclusive When ranking mutually exclusive projects, choose the project with highest NPV

Pros and Cons Of Using NPV As Decision Rule NPV is the “gold standard” of investment decision rules Key benefits of using NPV as decision rule Focuses on cash flows, not accounting earnings Makes appropriate adjustment for time value of money Can properly account for risk differences between projects Though best measure, NPV has some drawbacks Lacks the intuitive appeal of payback Doesn’t capture managerial flexibility (option value) well

Internal Rate of Return IRR found by computer/calculator or manually by trial and error Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project The IRR decision rule is: If IRR is greater than the cost of capital, accept the project If IRR is less than the cost of capital, reject the project

Calculating IRRs For Entropica’s Projects Entropica will accept all projects with at least 16% IRR: Construction project: IRR (rC) = 19.63% Refurbishing project: IRR (rR) = 34.54% Which project looks better if Entropica can invest only in one?

Advantages of IRR Properly adjusts for time value of money Uses cash flows rather than earnings Accounts for all cash flows Project IRR is a number with intuitive appeal

Disadvantages of IRR Three key problems encountered in using IRR: Lending versus borrowing? Multiple IRRs No real solutions IRR and NPV rankings do not always agree

Lending Versus Borrowing IRR can give incorrect answers for projects with non-standard cashflows Project 1: Invest $120 today, receive $170 in one year Project 2: Receive $120 today, pay back $170 in one year Project 1 amounts to lending; project 2 to borrowing Both projects have same IRR, but #1 obviously superior When borrowing, a low IRR is preferred on the loan.

Multiple IRRs NPV ($) NPV>0 IRR NPV>0 Discount rate NPV<0 NPV<0 IRR When project cash flows have multiple sign changes, there can be multiple IRRs With multiple IRRs, which do we compare with the cost of capital to accept/reject the project?

Sometimes projects do not have a real IRR solution No Real Solution Sometimes projects do not have a real IRR solution Modify Entropica’s construction project to include a large negative outflow (-$1,300 million) in year 6. There is no real number that will make NPV=0, so no real IRR. Project is a bad idea based on NPV. At r =16%, project has NPV= -$391.92 million, so reject!

Conflicts Between NPV and IRR NPV and IRR do not always agree when ranking competing projects The scale problem $41.34 mn 36.53% Refurbishing $141.65 mn 19.63% Construction NPV (16%) IRR Project Refurbishing project has higher IRR, but doesn’t increase shareholders’ wealth as much as construction project

The Timing Problem Long-term project NPV IRR = 15% Short-term project IRR = 17% Discount rate 13% 15% 17% The NPV of the long-term project is more sensitive to the discount rate than the NPV of the short-term project is Long-term project has higher NPV if the cost of capital is less than 13%. Short-term project has higher NPV if the cost of capital is greater than 13%

Reconciling NPV and IRR Timing and scale problems can cause NPV and IRR methods to rank projects differently In these cases, calculate the IRR of the incremental project Cash flows of large project minus cash flows of small project Cash flows of long-term project minus cash flows of short-term project If incremental project’s IRR exceeds the cost of capital Accept the larger project Accept the longer term project

Like IRR, PI suffers from the scale problem Profitability Index Calculated by dividing the PV of a project’s cash inflows by the PV of its outflows Decision rule: Accept projects with PI > 1.0, equal to NPV > 0 Both projects’ PI > 1.0, so both acceptable if independent 1.55 $75 mn $116.34 mn Refurbishing 1.12 $1.2 bn $1341.65 mn Construction PI Initial Outlay PV of CF (yrs1-5) Project Like IRR, PI suffers from the scale problem

Capital Budgeting Generating, reviewing, analyzing, selecting, and implementing long-term investment proposals Payback Period Discounted payback period Accounting rate of return Net Present Value (NPV) Internal rate of return (IRR) Profitability index (PI)