CAPITAL BUDGETING (A Short Review)

CAPITAL BUDGETING Recall that one reason money has a time value is because of the opportunity to invest in productive assets We investigate the firm’s decision to invest in productive assets

Capital Budgeting (cont.) Consider a firm with the following projects: Project Initial Outlay NCF/yr Life A B C D E

Capital Budgeting (cont.) Firm cost of capital is 10% There are a number of ways to evaluate these projects (1) Payback Period –PP = time to recover initial outlay –PP A = /350 = 2 6/7 yrs –PP B = 500/150 = 3 1/3 yrs PP C = 3 ¾ –PP D = 4 PP E = 4

Capital Budgeting (cont.) Problems with PP: (1) Not consider CFs after PP (2) Not consider timing of CFs (2) Net Present Value Method (NPV) –Addresses both problems of PP –NPV = PV Cash Inflows – PV Cash Outflows

Capital Budgeting (cont.) NPV (cont.) Decision Rule: if NPV > 0 Accept if NPV < 0 Reject if NPV = 0 Indifferent NPV A = 350 A 4,.10 – NPV B = NPV C = 8.2 NPV D = -41.8

Capital Budgeting (cont.) NPV E = RANK: B-A-E-C-D Reject D only

Capital Budgeting (cont.) (3) Internal Rate of Return (IRR) –The IRR is the discount rate of a project which sets the NPV equal to zero. –Intuitively: it represents a breakeven rate of return of the project –The IRR is the return on the project if the cash flows can be reinvested at the IRR rate

Capital Budgeting (cont.) IRR Decision Rule: If IRR > k accept If IRR < k reject If IRR = k indifferent Where k is some required return (cost of capital) or some “hurdle rate”

Capital Budgeting (cont.) IRR (cont.) IRR for projects in general cannot be found analytically, but can only be found numerically (e.g. use “f*” function in Excel) For our project A: want NPV =0 or 350 A 4,r – 1000 = 0 r =.15 or 15%

Capital Budgeting (cont.) IRRs Project IRR A.15 B.20 if use k =.10 then accept all projects C.1025 except D D.08 E.21 Note: NPV and IRR rankings are different

Capital Budgeting (cont.) RANKINGS NPV IRR B E Rankings are A B different, but E A same accept/ C C reject D D

Capital Budgeting NPV is superior to IRR Method for the following reasons: (1) Reinvestment rate assumption (2) Multiple Internal Rates of Return (3) Scale Differences

Capital Budgeting (cont.) Multiple IRRs Ex Year CF assume can borrow at 10% NPV = /1.1 –10000/1.21= IRR =.25 and 4 or 25% and 400%

Capital Budgeting (cont.) Scale Differences –Consider 2 projects with CFs as follows: Year A I 0 CF1 CF2 B I 0 /M CF1/M CF2/M Where M is some large # (e.g. 1 Billion) NPV A = NPV B x M A is much better than B But IRRs are the same!

Capital Budgeting (cont.) (4) Profitability Index (PI) benefit-cost ratio PI = PV of Future CFs/Initial Investment PI A = /1000 = 1.11 That is, get 11cents on the $ in PV terms Project A B C D E

Capital Budgeting (cont.) PI Decision Rule: – if PI > 1 accept –If PI < 1 reject –If PI = 1 indifferent If projects are INDEPENDENT, then PI and NPV give same results. However, if they are mutually exclusive or there is capital rationing then differences may arise. NPV will always give correct result if used properly.