Principles of Managerial Finance 9th Edition Chapter 9 Capital Budgeting Techniques

Learning Objectives Understand the role of capital budgeting techniques in the capital budgeting process. Calculate, interpret, and evaluate the payback period. Calculate, interpret, and evaluate the net present value (NPV). Calculate, interpret, and evaluate the internal rate of return (IRR).

Learning Objectives Use the net present value profiles to compare net present value and internal rate of return techniques. Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach.

Techniques that Ignore the Time Value of Money Payback. The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. But payback has two major weaknesses: First, it fails to consider the importance of the time value of money. Second, it fails to consider cash flows that occur after the pre-set payback period.

Techniques that Ignore the Time Value of Money But which is preferred? Payback is the same! Payback Weakness: Failure to consider the time value of money (pattern of cash flows).

Techniques that Ignore the Time Value of Money Payback Weakness: Failure to consider all relevant cash flows. But look at the total cash flows for Project 1! Payback says pick Project 2!

Time Value Techniques Net Present Value (NPV). Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, indifferent

Time Value Techniques Net Present Value Recall the Net Incremental Cash Flows for East Coast Drydock from Chapter 8

Time Value Techniques With a 15% discount rate, we would keep the existing hoist Net Present Value

Time Value Techniques In fact, even with a discount rate of 0%, we would keep the existing hoist since it has the highest NPV. Net Present Value

Time Value Techniques Recall that the before tax operating cash inflows for Drydock in Chapter 9 were as follows: Net Present Value

Time Value Techniques What if -- because of a measurement error -- the cash inflows for A and B were double those initially estimated as shown below: Net Present Value

Time Value Techniques Recalculating the NPV at a discount rate of 15%, we get: Net Present Value The Excel function for computing NPV is =NPV(int rate, data range) 此資料由第 一期計算， 財務計算機 則由第零期 計算

Time Value Techniques With the new numbers, we can now see that Hoist B should be used to replace the existing hoist. This will maximize NPV and ultimately, shareholder value. Net Present Value

The IRR is the discount rate that will equate the present value of the outflows with the present value of the inflows: The IRR is the project’s intrinsic rate of return. Decision Criteria If IRR > k, accept the project If IRR < k, reject the project If IRR = k, indifferent Time Value Techniques Internal Rate of Return

Note that both replacement projects provide a return in excess of the cost of capital of 15%. Time Value Techniques Internal Rate of Return The Excel function for computing IRR is =IRR(data range) 此資料由第零期計算， 財務計算機也由第零期 計算 無法計算 其 IRR

Time Value Techniques Internal Rate of Return What if the cost of capital were 42.19%? Notice that for Hoist B, IRR = the discount rate and that NPV = 0

IRR 的應用 元智大學提供教職員優惠的年金保險，參加人員每年 將依個人服務年資由學校補助一萬五仟元（服務十年 以上）、一萬元（服務六至九年）及伍仟元（服務五 年以下）。根據該保險經紀人公司的試算結果，去計 算該項年金保險的內部報酬率： 假設現年三十九歲女性教職員，本校服務年資兩年， 首欄的數字為連續十年繳納年金保險費 ( 扣除掉 5% 的 單利以及學校提撥的金額 ) ，於第十八年時全數領出； 次欄的數字為連續十年繳納年金保險費 ( 扣除掉 5% 的 單利以及學校提撥的金額 ) ，於第十九年時全數領 出。兩者用 EXCEL 計算出來的內部報酬率 (IRR) 都是 6% ，遠高於現行市場上任何的定存利率。

The NPV Profile shows how a project’s value changes with changes in the discount rate. Time Value Techniques Net Present Value Profile

Time Value Techniques Net Present Value Profile 47.63% 42.19% 只有當 K 大於 這點時， NPV 與 IRR 的決策 是一致的

The profitability index which is also sometimes called the benefit/cost ratio, is the ratio of the present value of the inflows to the present value of the outflows. Time Value Techniques Profitability Index Decision Criteria If PI > 1, accept the project If PI < 1, reject the project If PI = 1, indifferent PI = PV Inflows PV Outflows

Time Value Techniques Profitability Index Returning to the last East Coast Drydock example, we get: Choose Hoist A since PI A > PI B Double A 和 B 的 cash flow 後

Problems with Discounted Cash Flow Techniques Mutually exclusive projects compete in some way with the same resources. A firm can pick one, or the other, but not both. Conflicting Rankings for Mutually Exclusive Projects

Mutually exclusive projects compete in some way with the same resources. A firm can pick one, or the other, but not both. Problems with Discounted Cash Flow Techniques Conflicting Rankings for Mutually Exclusive Projects

Problems with Discounted Cash Flow Techniques Conflicting Rankings for Mutually Exclusive Projects 36% 兩個 project 的 IRR 皆為 36% 亦即 NPV=0 時的 K 皆為 36% 若 AB 為 mutually exclusive ，則當 k<36% 時，選 A 當 k>36% 時，都不要 若 AB 為 Independent ，當 k<36% ， 2 者都選 當 k>36% ，都不要 e f g NPV A B If k<e If e<k<f If k>f k(%)

Interdependent projects are those that influence the value of others. In general terms, if there are two interdependent projects, then three appraisals are required: –Project A –Project B –And Project A plus B Problems with Discounted Cash Flow Techniques Conflicting Rankings for Mutually Exclusive Projects 如：兩家鄰近的購物中心

Summary If projects are mutually exclusive and not subject to capital rationing, the project with the higher NPV should be selected. If the projects are independent, and there is no capital restriction, both should be chosen if they have positive NPVs. In the presence of capital restrictions, the project with the higher NPV should be selected. Problems with Discounted Cash Flow Techniques

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基本上： greater the difference between the magnitude and timing of cash inflows, the greater the likelihood of conflicting rankings between NPV and IRR. 理論上：用 NPV ，不要用 IRR 。因為 (1)NPV 假設 intermediate cash flows are reinvested at cost of capital ， IRR 則假設 intermediate cash flows are reinvested at IRR 。 NPV 法的假 設較為合理且保守。 (2)non-conventional cash flow 常會有多 重或零個 IRR 的解 實務上：業界仍偏好 IRR 若期初投資一樣的話 WHY? 因為晚期的 Cash flow 會 被高折現率 severely penalized in present value terms.