Capital Budgeting1 Select investments which increase value of firm Maximize wealth of shareholders Important to firm’s long-term success  Substantial cost  Cash flows over long time period Big Picture…

Capital Budgeting2 Steps in evaluating capital assets Determine cost of asset Estimate incremental cash flows  Very difficult but…  Very important… Determine decision criteria Apply decision criteria Compare actual results to projected

Capital Budgeting3 Capital Budgeting Decision Criteria Should you sign Shaq O’ Squeal to a four-year contract for $100 million???

Capital Budgeting4 Capital Budgeting Decision Criteria Determine cost Estimate incremental cash flows  Increase in revenue  Increase in expenses

Capital Budgeting5 Capital Budgeting Decision Criteria Payback period NPV Profitability index IRR

Capital Budgeting6 Payback Period How long until we get our money back???

Capital Budgeting7 Payback Period ShaqHackMac mil101 mil10 mil mil010 mil mil070 mil mil0510 mil 170 mil101 mil600 mil

Capital Budgeting8 Payback Period Payback: length of time to get $$$ back Rule: accept investments that payback before required period

Capital Budgeting9 Payback Period Advantages:  Easy to calculate and understand Useful for small investments  Favors investments with quick returns

Capital Budgeting10 Payback Period Disadvantages:  Future cash flows not discounted Since favors quick returns, not huge problem  Ignores cash flows after payback Coal mine: negative cash flows at end  Must select cutoff period Three or four years reasonable 20 years, probably not

Capital Budgeting11 Net Present Value NPV: PV of cash flow – Cost of Investment Rule: accept investments with a positive NPV

Capital Budgeting12 Net Present Value

Capital Budgeting13 Net Present Value Advantages:  If assumptions correct, increases value of firm  Discounts future cash flows

Capital Budgeting14 Net Present Value Disadvantages:  Determining proper discount rate Should it be adjusted for riskiness of each project’s cash flows??? Set too high, pass up acceptable projects  Buyer with lower discount rate will pay highest price Set too low, decrease wealth of firm  Ignores relative cost of investments Project A: cost $1 million; NPV $20 Project B: cost $50; NPV $19 In an efficient market, should projects have huge positive NPVs???

Capital Budgeting15 Profitability Index PI: PV Cash Flows / Cost Rule: accept investments with a PI above 1.0

Capital Budgeting16 Profitability Index

Capital Budgeting17 Profitability Index Advantages:  Comparing alternative investments  Discounts future cash flows Disadvantages:  Favors lower cost investments

Capital Budgeting18 Internal Rate of Return IRR: Discount rate where NPV = 0 Rule: accept investments with an IRR above required return

Capital Budgeting19 IRR

Capital Budgeting20 IRR Advantages:  Most often used criteria in capital budgeting  Not required to select a discount rate  Does discount future cash flows

Capital Budgeting21 IRR Disadvantages:  Assumes can reinvest cash flows at IRR NPV assumes reinvest at required rate return NPV assumption more logical  Favors short-term investments Difficult to achieve high IRR on distant cash flows

Capital Budgeting22 Calculating IRR Spend $10,000 today and receive $17,182 in 8 years Spend $10,000 today and receive $1,993 at the end of the next 10 years Spend $10,000 today and receive $2,000 in year 1; $5,000 in year 2 and $8,000 in year 3 (all at end of year)