Ch 9 Learning Goals 1.Calculate, interpret, and evaluate: payback period. net present value (NPV). internal rate of return (IRR). 2. Ranking conflicts.

Ch 9 Learning Goals 3. The importance of risk in capital budgeting. 4. Methods of evaluating project risk. 5. Determination and use of risk-adjusted discount rates (RADRs). 6. Capital rationing.

CB Evaluation Techniques Techniques used to evaluate capital outlays include: Payback Net present value (___________) Internal rate of return (___________)

CB Evaluation Techniques Not all evaluation techniques are equally valid. The best rely on: Cash Flows (rather than accounting values) Time value of money Techniques that do these two things are _________ _________________________________________ (DCF) methods (called “sophisticated” in your text).

Payback Period The payback method measures how many years it takes to recover the initial investment. The maximum acceptable payback period is determined by management. Decision rule: accept if the payback period is _______ ___________________________ the maximum acceptable payback period.

Pros and Cons of Payback Periods Payback is simple, intuitive, and considers cash flows rather than accounting profits. Payback is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. It is also used to supplement other methods such as NPV and IRR.

Pros and Cons of Payback Periods Weaknesses of Payback: Does not consider all CFs Does not consider TVOM The appropriate payback period is __________________________ determined It is not a ___________________ method (it is unsophisticated)

Pros and Cons of Payback Periods

Net Present Value (NPV) Net Present Value (NPV). Net Present Value is found by subtracting the initial investment from the present value of the after-tax inflows. Decision Criteria If NPV > 0, _______________ the project If NPV < 0, _______________ the project If NPV = 0, indifferent

Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is defined as the discount rate that causes NPV to _____________ ________________. The IRR measures the annual percentage return on funds invested in the project.

Internal Rate of Return (IRR) To interpret IRR, we compare it to “k,” the required return, or “cost of capital” for the project. Decision Criteria If IRR > k, __________________ the project If IRR < k, __________________ the project If IRR = k, indifferent

Capital Budgeting Techniques NPV and IRR are both _____________ (sophisticated) methods of evaluating capital budgeting projects. They are not interchangeable, however.

Conflicting Rankings A ranking conflict exists if: Project A has higher NPV than Project B but: Project B has higher IRR than A Mutually exclusive projects should be ranked by __________ (not IRR) when a ranking conflict occurs.

Which Approach is Best? On a theoretical basis, NPV is better than IRR: NPV assumes that cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, A project with non-conventional cash flows might have zero or multiple IRRs. Despite that, more firms use the IRR because of management preference for rates of return.

Risk in Capital Budgeting Different projects have different levels of risk. Analysis of the project must consider that risk (acceptance of the project affects the firm’s future ____________________).

Approaches for Dealing with Risk Techniques for evaluating risk of a capital budgeting project include: Scenario analysis Sensitivity analysis Simulation Decision trees

Approaches for Dealing with Risk Each of the techniques considered gives insight into project risk, but none of them provide a _________________. Ultimately, the decision is based on a combination of analysis and judgment.

Assessing Project Risk: Scenario Analysis Scenario analysis involves identifying 3 or more possible outcomes. Normally, the probability of each outcome is also estimated.

Approaches for Dealing with Risk Once the risk level is determined, it is incorporated into the analysis by either: Adjusting cash flows, or Adjusting the required return to get the risk adjusted discount rate (______________) _______________ is more often used in practice.

Risk-Adjusted Discount Rates The risk-adjusted discount rate is the rate of return that must be earned on a project to compensate for the additional risk. The higher the risk of a project, the ______________ the RADR – and thus the __________________ a project’s NPV.

Approaches for Dealing with Risk CAPM could be used to determine a project’s RADR. However, most firms use project characteristics to classify projects as low, average, or high risk.

Risk Adjusted Discount Rates Examples of Project Classification Low risk: replacement existing assets without adding capacity or changing technology Average risk: expanding capacity without changing products or technology High risk: changing product line or technology

Capital Rationing Capital rationing exists if a firm lacks sufficient financing to undertake all acceptable projects. The firm should adopt the set of projects that provides highest ___________________________.