Chapter 9

Investment In Long-Term Assets

Chapter Objectives Difficulty in finding profitable projects Use capital budget techniques to evaluate new projects Dollar limitation on capital budgeting Project rankings Ethical considerations in capital budgeting Trends in capital budgeting International markets and new capital budgeting projects

Capital Budgeting Evaluating the profitability of projects Often choosing between one or more projects

R & D Typically, a firm has a research & development department that searches for ways of improving existing products or finding new projects.

Capital Budgeting Payback Period Net Present Value Profitability Index Internal Rate of Return Capital Rationing

Payback Period Number of years needed to recover the initial cash outlay of a project

Payback Period Example: Project with an initial cash outlay of $10,000 Free Cash Flows of $2,500 per year for 6 years YearCash FlowBalance $10,000 1$2,500$7,500 2$2,500$5,000 3$2,500$2,500 4$2, Payback is 4 years

Payback Period Ignores Time Value of Money Ignores cash flows beyond payback period

Net Present Value or NPV Present value of the free cash flows less the initial outlay Gives a measurement of the net value of a project in today’s dollars If NPV > 0, accept If NPV < 0, reject

NPV Example: Project cost $10,000 Cash flows$2,500 a year for 6 years Required rate of return10% PV of 2,500, 6 years, 10% is $10,888 NPV of the project = $10,888 - $10,000 = $ 888

NPV Examines cash flows, not profits Recognizes time value of money By accepting only positive NPV projects, increases value of the firm

Profitability Index Benefit-cost ratio Ratio of the present value of the future free cash flows to the initial outlay Generates same results as NPV PI = PV FCF/ Initial outlay PI > 1 = accept PI < 1 reject

Profitability Index Example: Purchase$10,000 Cash flows $ 2,500 6 years Required rate of return 10% PV of the cash flows $10,888 PI = 10,888/10,000 = 1.088

NPV and PI When the present value of a project’s cash flows are greater than the initial cash outlay, the project NPV will be positive. PI will also be greater than 1. NPV and PI will always yield the same decision

Internal Rate of Return or IRR Discount rate that equates the present value of a project’s cash flows with the project’s initial cash outlay If IRR > Required rate of return, accept IF IRR < Required rate of return, reject

IRR and NPV If NPV is positive, IRR will be greater than the required rate of return If NPV is negative, IRR will be less than required rate of return If NPV = 0, IRR is the required rate of return.

IRR Purchase$10,000 Cash flows $2,5006 years Discount rateNPV 8% 1,557 10% % % IRR is between 12% and 13% True IRR 12.97% via financial calculator

Capital Rationing Limit on the dollar size of the capital budget Often a firm may select a set of projects with the highest NPV– subject to the capital constraint May preclude accepting the highest ranked project in terms of PI or IRR

Ranking Problems Size Disparity Time Disparity Unequal Life

Popularity of Capital Budgeting Techniques Percent of Firms Using Each Method usedPrimarySecondaryTotal MethodMethodFirms IRR88%11%99% NPV63%22%85% Payback24%59%83% PI15%18%33%