8-1 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Chapter 8: Capital Budgeting Techniques Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida

8-2 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. n The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year. n Analysis of potential additions to fixed assets. n Long-term decisions; involve large expenditures. n Very important to firm’s future. What is Capital Budgeting?

8-3 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Generating Ideas for Capital Projects 4 A firm’s growth and its ability to remain competitive depend on a constant flow of ideas for new products, ways to make existing products better, and ways to produce output at a lower cost. 4 Procedures must be established for evaluating the worth of such projects.

8-4 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Project Classifications èReplacement Decisions: èReplacement Decisions: whether to purchase capital assets to take the place of existing assets to maintain or improve existing operations. èExpansion Decisions: èExpansion Decisions: whether to purchase capital projects and add them to existing assets to increase existing operations. èIndependent Projects: èIndependent Projects: Projects whose cash flows are not affected by decisions made about other projects. èMutually Exclusive Projects: èMutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted.

8-5 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Similarities between Capital Budgeting and Asset Valuation 1 Determine the cost, or purchase price, of the asset. 2 Estimate the cash flows expected from the project. 3 Assess the riskiness of cash flows. 4 Compute the present value of the expected cash flows to obtain as estimate of the asset’s value to the firm. 5 Compare the present value of the future expected cash flows with the initial investment. Uses same steps as in general asset valuation

8-6 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Net Cash Flows for Project S and Project L ^

8-7 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is the Payback Period? The length of time before the original cost of an investment is recovered from the expected cash flows or... How long it takes to get our money back. PB = Number of years before full recovery of original investment Uncovered cost at start of full-recovery year Total cash flow during full-recovery year ( () ) Payback = +

8-8 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Payback Period for Project S Net Cash Flow Cumulative Net CF = Payback S /800 = years 1,500 -1, , , PB S 01234

8-9 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Payback Period for Project L Net Cash Flow Cumulative Net CF = Payback L /1,500 = 3.3 years ,600 1, , ,000 1,500 1,100 PB L 01234

8-10 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Strengths of Payback: Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses of Payback: Ignores the TVM. Ignores CFs occurring after the payback period. Strengths an Weaknesses of Payback:

8-11 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Net Present Value: Sum of the PVs of Inflows and Outflows Cost often is CF 0 and is negative ^ ^ ^

8-12 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. k = 10% 1, ,200(3,000) 1, What is Project S’s NPV? NPV S =

8-13 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. k = 10% (3,000) What is Project L’s NPV? NPV L =

8-14 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Calculator Solution, NPV for L : Enter in CFLO for L: -3, ,300 1,500 CF 0 CF 1 NPV CF 2 CF 3 I = = NPV L CF 4

8-15 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Rationale for the NPV method: NPV= PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

8-16 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. n If Projects S and L are mutually exclusive, accept S because NPV s > NPV L n If S & L are independent, accept both; NPV > 0 Using NPV method, which project(s) should be accepted?

8-17 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Internal Rate of Return: IRR 0123 CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows = cost This is the same as forcing NPV = 0

8-18 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. NPV: Enter k, solve for NPV. IRR: Enter NPV = 0, solve for IRR. Calculating IRR

8-19 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is Project S’s IRR? IRR = ? 1, ,200(3,000) NPV S = IRR S = 13.1% Enter CFs in CF register, then press IRR: Sum of PVs for CF 1-4 = 3,000 0

8-20 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. What is Project L’s IRR? IRR = ? (3,000) NPV L = Enter CFs in CF register, then press IRR: IRR L = 11.4% Sum of PVs for CF 1-4 = 3,000 0

8-21 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. How is a Project’s IRR Related to a Bond’s YTM? They are the same thing. A bond’s YTM is the IRR if you invest in the bond IRR = ? IRR = 7.08% (use TVM or CF register)

8-22 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Rationale for the IRR Method: If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns. Example: WACC = 10%, IRR = 15%. Profitable.

8-23 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. n If IRR > k, accept project. n If IRR < k, reject project. IRR acceptance criteria:

8-24 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Decisions on our Projects S and L per IRR: n If S and L are independent, accept both. IRRs > k = 10%. n If S and L are mutually exclusive, accept S because IRR S > IRR L.

8-25 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Construct NPV Profiles Enter CFs in CFLO and find NPV L and NPV S at several discount rates: k NPV L (4) NPV S

8-26 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. NPV ($) Discount Rate (%) IRR L = 16.1% IRR S = 23.6% Crossover Point = 8.7% k NPV L (4) NPV S S L NPV Profiles for Project S and Project L

8-27 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. NPV and IRR always lead to the same accept/reject decision for independent projects: k > IRR and NPV < 0. Reject. NPV ($) k (%) IRR IRR > k and NPV > 0 Accept.

8-28 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Mutually Exclusive Projects 8.7 NPV % IRR s IRR L S k NPV S, IRR S > IRR L CONFLICT k> 8.7: NPV S > NPV L, IRR S > IRR L NO CONFLICT

8-29 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. To Find the Crossover Rate: 1. Find cash flow differences between the projects. See data at beginning of the case. 2. Enter these differences in CF register, then press IRR. Crossover rate = 8.68, rounded to 8.7%. 3. Can subtract S from L or vice versa, but better to have first CF negative. 4. If profiles don’t cross, one project dominates the other.

8-30 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Two Reasons NPV Profiles Cross: 1) Size (scale) differences. 1) Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opp. cost, the more valuable these funds, so high k favors small projects. 2) Timing differences. 2) Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPV S > NPV L.

8-31 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Reinvestment Rate Assumptions n NPV assumes reinvest at k. n IRR assumes reinvest at IRR. n Reinvest at opp. cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

8-32 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. End of Chapter 8 Capital Budgeting Techniques