© 2003 McGraw-Hill Ryerson Limited 12 Chapter The Capital Budgeting Decision McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by P Chua April 5, 2005 Based on Slides by: Terry Fegarty, Carol Edwards, Lawrence J. Gitman, and Sean Hennessey

© 2003 McGraw-Hill Ryerson Limited Chapter 12 - Outline  What is Capital Budgeting?  Stages in Capital Budgeting Process  Decision-making Criteria in Capital Budgeting  Capital Budgeting Selection Strategies  Methods of Evaluating Investment Proposals  Payback Period  Net Present Value (NPV)  Profitability Index  Internal Rate of Return (IRR)  Capital Rationing  NPV vs IRR  Summary and Conclusions PPT 12-2

© 2003 McGraw-Hill Ryerson Limited What is Capital Budgeting?  Capital Budgeting is the process of evaluating and selecting long-term investment projects that achieve the goal of owner wealth maximization.  The purposes of Capital Budgeting Projects include: to expand, replace, or renew fixed assets over a long period.  Examples of Capital Budgeting projects:  buying a new computer system,  expanding the production capacity of an existing plant or  modernizing its operations. PPT 12-3

© 2003 McGraw-Hill Ryerson Limited What is Capital Budgeting?  Capital Budgeting requires intensive planning. Once a Capital budgeting decision is made, it sets a strategic direction that is difficult to change.  Because capital budgeting decisions involve a firm’s commitment of sizable financial resources to a project on a long-term basis, it is extremely important that a firm makes the right decision.  A wrong decision can lead to huge financial distress and even bankruptcy for a firm.

© 2003 McGraw-Hill Ryerson Limited What is Capital Budgeting?  The longer the time horizon associated with a capital expenditure, the greater the uncertainty.  Areas of uncertainty include:  Annual outflows and inflows  Product life  Economic conditions  Cost of capital  Technological change PPT 12-3

© 2003 McGraw-Hill Ryerson Limited Stages in Capital Budgeting Process 1. Finding Projects 2. Estimating the incremental cash flows associated with projects 3. Evaluating and selecting projects 4. Implementing and monitoring projects

© 2003 McGraw-Hill Ryerson Limited Decision-making Criteria in Capital Budgeting  The Ideal Evaluation Method:  considers the time value of money,  focuses on resultant cash flows,  uses a firm’s cost of capital as the discount rate to evaluate a project.

© 2003 McGraw-Hill Ryerson Limited Earnings before amortization and taxes (EBAT).... $20,000 Amortization (non-cash expense) ,000 Earnings before taxes ,000 Taxes (50%) ,500 Earnings aftertaxes ,500 Amortization ,000 Cash flow $12,500 Alternative method of cash flow calculation EBAT $20,000 Taxes ,500 Cash flow $12,500 PPT 12-5 Converting Accounting Flow to Cash Flow

© 2003 McGraw-Hill Ryerson Limited Methods of Evaluating Investment Proposals  Payback Period (PP)  Net Present Value (NPV)  Profitability Index (PI)  Internal Rate of Return (IRR) PPT 12-7

© 2003 McGraw-Hill Ryerson Limited NetCash Inflows (of a $10,000 investment) YearInvestment AInvestment B 1 $5,000 $1,500 25,0002,000 32,0002,500 45,000 55,000 cost of capital = 10% PPT Project Data

© 2003 McGraw-Hill Ryerson Limited Payback Period Payback Period (PP):  computes the amount of time required to recover the initial investment  a cutoff period is established for comparison Accept/Reject Decision:  if PP < cutoff period, accept the project  if PP > cutoff period, reject the project PPT 12-9

© 2003 McGraw-Hill Ryerson Limited Payback Period Advantages:  Easy to understand and use  Places premium on liquidity  Emphasizes the shorter time-horizon Disadvantages:  ignores inflows after the cutoff period  fails to consider the time value of money  fails to consider any required rate of return

© 2003 McGraw-Hill Ryerson Limited Net Present Value Net Present Value (NPV):  the present value of the cash inflows minus the present value of the cash outflows  the future cash flows are discounted back over the life of the investment  the basic discount rate is usually the firm’s cost of capital (WACC, assuming similar risk) Accept/Reject Decision:  if NPV > 0, accept the project  if NPV < 0, reject the project PPT 12-11

© 2003 McGraw-Hill Ryerson Limited Profitability Index (PI) Profitability Index (PI):  is computed by dividing the present value of inflows by the present value of outflows. Accept/Reject Decision:  if PI > 1, accept the project  if PI < 1, reject the project

© 2003 McGraw-Hill Ryerson Limited Internal Rate of Return Internal Rate of Return (IRR):  Is the Rate of Return that equates the initial cash outflow (cost) with the future cash inflows (benefits)  is the discount rate where the cash outflows equal the cash inflows (or NPV = 0), that is, IRR is simply the discount rate at which the NPV of the project equals zero. Accept/Reject Decision:  if IRR > cost of capital, accept the project  if IRR < cost of capital, reject the project PPT 12-12

© 2003 McGraw-Hill Ryerson Limited Investment AInvestment BSelection Payback period....2 years3.8 yearsQuickest payback: Investment A Net present value... $177 $1,413Highest net present value: Investment B Internal rate of return 11.18%14.33%Highest yield: Investment B Profitability Index Highest relative profitability: Investment B PPT Capital budgeting results

© 2003 McGraw-Hill Ryerson Limited Capital Budgeting – Selection Strategies  Independent Projects vs. Mutually Exclusive Projects as investment opportunities.  Unlimited Funds vs. Capital Rationing to funding considerations.  Accept/Reject Approach vs. Ranking Approach to project selection.

© 2003 McGraw-Hill Ryerson Limited Capital Rationing  Occurs when a limit is set on the amount of funds available to a firm for investment.  Firm must rank investments based on their NPVs  Those with positive NPVs greater than the cost of capital are accepted until all funds are exhausted PPT 12-17

© 2003 McGraw-Hill Ryerson Limited CapitalA$2,000,000$400,000 rationingB2,000, ,000 solutionC1,000,000$5,000, ,000 D1,000,000100,000 Best E800,0006,800,000 40,000 solution F800,000(30,000.) Net TotalPresent ProjectInvestmentInvestmentValue PPT Capital Rationing

© 2003 McGraw-Hill Ryerson Limited NPV – most reliable measure  Payback period is the least reliable measure of project acceptability. NPV, PI and IRR are more reliable measure.  In case of conflict among NPV, PI and IRR, NPV should prevail. NPV has proven to be the only reliable measure of a project’s acceptability.  So, remember:  NPV is the only measure which always gives the correct decision when evaluating projects.  Only NPV measures the amount by which a project would increase the value of the firm.

© 2003 McGraw-Hill Ryerson Limited  High IRR for a project does not necessarily mean a high NPV.  Calculate the IRR and NPV for the projects below: Cash Flows in Dollars Project:C 0 C 1 IRR 6% J K Both projects have the same IRR … but Project J contributes more to the value of the firm.. Obviously, you should prefer Project J! 50% + $ % - $41.5 Pitfalls of IRR

© 2003 McGraw-Hill Ryerson Limited Lending vs Borrowing  Project J involves lending $100 at 50% interest.  Project K involves borrowing $100 at 50% interest.  Which option should you choose?  Remember:  When you lend money, you want a high rate of return.  When you borrow money, you want a low rate of return.. Pitfalls of IRR

© 2003 McGraw-Hill Ryerson Limited  IRR can mislead you when choosing among mutually exclusive projects.  Calculate the IRR and NPV for the following projects: Cash Flows in Dollars Project:C 0 C 1 C 2 C 3 IRR 6% H I Project H has a higher IRR … but Project I contributes more to the value of the firm.. Obviously, you should prefer Project I! 14.29% $ % $70.60 Pitfalls of IRR

© 2003 McGraw-Hill Ryerson Limited  Other Pitfalls with IRR  Some projects will generate multiple internal rates of return.  Here is an example. Cash Flow ,528 -1,528 -1, ,000 9,167 1, ,000 -7, NPV 0 0 How should you evaluate a project in cases like this?. You should calculate NPV! Pitfalls of IRR

© 2003 McGraw-Hill Ryerson Limited  Other Pitfalls with IRR  Some projects have no internal rate of return.  For example, there is no IRR for a project that has cash flows of +$1,000 in year 0, -$3,000 in year 1, and +$2,500 in year 2.  If you don’t believe this, try plotting NPV for different discount rates. How should you evaluate a project in cases like this?. You should calculate NPV! Pitfalls of IRR

© 2003 McGraw-Hill Ryerson Limited Net Present Value Profile Net Present Value Profile:  The NPV profile is the relationship between the NPV of a project and the discount rate used to calculate that NPV. Since the IRR is the discount rate that makes a project’s NPV zero, the NPV profile also identifies a project’s IRR.  a graph of the NPV of a project at different discount rates shows the NPV at 3 different points:  a zero discount rate  the normal discount rate (or cost of capital)  the IRR  allows an easy way to visualize whether or not an investment should be undertaken PPT 12-19

© 2003 McGraw-Hill Ryerson Limited 6,000 4,000 2,000 0 Net present value ($) 5%10%15%20%25% IRR B = 14.33% IRR A = 11.16% Discount rate (percent) Investment B Investment A PPT Net present value Profile B B A A

© 2003 McGraw-Hill Ryerson Limited Net Cash Inflows (of a $10,000 investment) Year Investment BInvestment C 1 $1,500 $9, ,000 3, ,500 1, , ,000 cost of capital = 10% Net present value profile with crossover

© 2003 McGraw-Hill Ryerson Limited 6,000 4,000 2,000 0 Net present value ($) 5% 10% 15% 20%25% IRR C = 22.49% IRR B = 14.33% Discount rate (percent) Crossover point Investment C Investment B Investment C Investmen t B PPT Net present value profile with crossover B B C C

© 2003 McGraw-Hill Ryerson Limited Net present value profile with crossover  Cross-Over Rate is the discount rate where NPV profiles of two (or more) projects intersect, meaning that they are equal.  When this occurs ranking projects will have different results depending on what discount rate is used. A rate below the Cross-Over Rate will produce one ranking, a rate above it will produce another ranking.

© 2003 McGraw-Hill Ryerson Limited Summary and Conclusions  A capital budgeting decision involves planning cash flows for a long-term investment  Several methods are used to analyze investment proposals: payback, net present value, internal rate of return, and profitability index  The net present value method, in particular, considers the amount and timing of cash flows  The analysis is based upon estimates of incremental cash flows aftertax that will result from the investment PPT 12-30