Capital Budgeting Arguing for your project
Capital budgeting CFO receives proposals from divisions Projects described by cash flows
Arguing means applying measures Net present value is the right measure. Many smart people use the wrong ones. Alternative ways to the same end.
Uses of measures Project acceptance Mutually exclusive alternatives.
Capital Budgeting Techniques Kim, Crick, and Kim, Management Accounting Nov. 1986, p
Survey of use of measures by corporations
Make no mistake NNPV is the right measure always. OOthers work sometimes. NNPV measures value to owners, their wealth.
Objectives of a good measure Value cash flows. Respond to the market.
NPV’s merits Values cash flows as the market does. Responsive because the discount rate is the current market rate. Measures increase in shareholder value.
Payback period is The time required for undiscounted cash flows to add up to the initial investment. e.g., build a Wendy’s if it “pays for itself” in two years or less.
Payback merits Based on cash flows
Payback defects No market response. When r is high, payback period should be shorter. Subtracts time-t dollars from time-0 dollars, a cardinal sin. Ignores cash flow after payback. Ignores timing during payback.
Defects are not necessarily fatal Repeated, similar investments. Stable financial conditions.
The well-informed capital budgeter knows When to accept payback period as a measure. When it is likely to fail.
Accounting rate of return Doesn’t value cash flows No market response Ignores market values Scaling problems: melons or malls
Merits of accounting r.o.r. Easily understood. Sometimes okay in stable markets. Smart application can overcome defects.
Internal rate of return Definition: IRR is the discount rate that makes NPV = 0 That is, IRR is the r such that
Internal rate of return Definition: IRR is the discount rate that makes NPV(r) = 0. NPV(r) is a function. RWJ Figures 6.4 and 6.5.
Project
Figure 6.4: NPV(r)=0 at r=23.37% NPV r 100 NPV(r) NPV(.1) = IRR =
Figure 6.4 NPV (r) = 0 at r = 23.37%
Applications of IRR measure Hurdle rate = market rate Project acceptance: Accept a project if IRR > hurdle rate. Mutually exclusive projects: Take the one with the highest IRR (> hurdle rate)????? Don’t rely on it.
Project acceptance: NPV and IRR give the same conclusion when... Cash flows have one sign change. In the example: IRR = 23.37% > hurdle = 10% for an investment project. IRR = 23.37% < hurdle rate = 30% for a financing or “borrowing from nature” project.
Merits Uses cash flows. Responds to the market when the hurdle rate changes
Objective Learn to recognize the times when NPV and IRR are the same. and also the problems with IRR
Defects of IRR -- project acceptance Lending to nature or borrowing from her? Multiple IRR's may occur.
Financing (borrowing from nature) Seek IRR < hurdle rate Same as NPV > 0
Multiple IRR's
IRR’s at r = 1 and r = 2 100% per decade = % per year. 200% per decade = % per year.
IRR’s at r=1 and r=2. NPV r 100% 200%
Descartes’ Rule The number of internal rates of return is no more than the number of sign changes.
Defects of IRR -- mutually exclusive projects Ignores market values. Scale problems -- melons or malls.
Typical hour exam question What is the scale problem in using IRR to choose between mutually exclusive projects?
Scale problem in IRR One canyon, one dam.
Sketch of answer The smaller dam has the higher IRR. The big dam has higher value. The big dam extends consumption possibility of owners more than the little dam does. It is wrong to take the higher IRR in this case.
Scale problems in IRR
More answer Consider the project of replacing the little dam by the big dam. Cash flows are -900, IRR of the project is 4/9 =.4444 >.1 NPV is … So replace the little dam. Capital budgeting jiu jitsu.
r NPV 50%100% Big dam Little dam IRR
Big dam, little dam NPV NPV of the big dam NPV of the small dam r r* For hurdle rates below r*, the big dam is preferred. r* =