Capital Budgeting Techniques: Certainty & Risk Chapter 9 Capital Budgeting Techniques: Certainty & Risk

Learning Goals Calculate, interpret, and evaluate the payback period. Apply net present value (NPV) and internal rate of return (IRR). Use net present value profiles to compare NPV and IRR techniques. Discuss two additional considerations in capital budgeting – recognizing real options and choosing projects under capital rationing. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Learning Goals (cont.) 5. Recognize sensitivity analysis and scenario analysis, decision trees, and simulation as behavioral approaches for dealing with project risk, and the unique risks that multinational companies face. 6. Understand the calculation and practical aspects of risk-adjusted discount rates (RADRs). Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Capital Budgeting Techniques Chapter Problem Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Capital Budgeting Techniques (cont.) Table 9.1 Capital Expenditure Data for Bennett Company Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Capital Budgeting Techniques (cont.) Figure 9.1 Bennett Company’s Projects A and B Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Payback Period The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. The maximum acceptable payback period is determined by management. If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Pros and Cons of Payback Periods The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. It is simple, intuitive, and considers cash flows rather than accounting profits. It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Pros and Cons of Payback Periods (cont.) One major weakness of the payback method is that the appropriate payback period is a subjectively determined number. It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value. Thus, payback fails to fully consider the time value of money. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Pros and Cons of Payback Periods (cont.) Table 9.2 Relevant Cash Flows and Payback Periods for DeYarman Enterprises’ Projects Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Pros and Cons of Payback Periods (cont.) Table 9.3 Calculation of the Payback Period for Rashid Company’s Two Alternative Investment Projects Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Net Present Value (NPV) Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Net Present Value (NPV) (cont.) Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Net Present Value (NPV) (cont.) Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 9.2 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Net Present Value (NPV) (cont.) Figure 9.2 Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Net Present Value (NPV) (cont.) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Net Present Value (NPV) (cont.) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Internal Rate of Return (IRR) (cont.) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return. Decision Criteria If IRR > cost of capital, accept the project If IRR < cost of capital, reject the project If IRR = cost of capital, technically indifferent Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Figure 9.3 Calculation of IRRs for Bennett Company’s Capital Expenditure Alternatives Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Internal Rate of Return (IRR) (cont.) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Net Present Value Profiles NPV Profiles are graphs that depict project NPVs for various discount rates and provide an excellent means of making comparisons between projects. To prepare NPV profiles for Bennett Company’s projects A and B, the first step is to develop a number of discount rate-NPV coordinates and then graph them as shown in the following table and figure. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Net Present Value Profiles (cont.) Table 9.4 Discount Rate–NPV Coordinates for Projects A and B Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Net Present Value Profiles (cont.) Figure 9.4 NPV Profiles Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Conflicting Rankings Conflicting rankings between two or more projects using NPV and IRR sometimes occurs because of differences in the timing and magnitude of cash flows. This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project. NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Conflicting Rankings (cont.) Bennett Company’s projects A and B were found to have conflicting rankings at the firm’s 10% cost of capital as depicted in Figure 9.4. If we review the project’s cash inflow pattern as presented in Table 9.1 and Figure 9.1, we see that although the projects require similar investments, they have dissimilar cash flow patterns. Table 9.5 on the following slide indicates that project B, which has higher early-year cash inflows than project A, would be preferred over project A at higher discount rates. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Conflicting Rankings (cont.) Table 9.5 Preferences Associated with Extreme Discount Rates and Dissimilar Cash Inflow Patterns Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Which Approach is Better? On a purely theoretical basis, NPV is the better approach because: NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR. Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Recognizing Real Options Real options are opportunities that are embedded in capital projects that enable managers to alter their cash flows and risk in a way that affects project acceptability (NPV). Real options are also sometimes referred to as strategic options. Some of the more common types of real options are described in the table on the following slide. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Recognizing Real Options (cont.) Table 9.6 Major Types of Real Options Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Recognizing Real Options (cont.) NPVstrategic = NPVtraditional + Value of Real Options Assume that a strategic analysis of Bennett Company’s projects A and B (see Table 10.1) finds no real options embedded in Project A but two real options embedded in B: During it’s first two years, B would have downtime that results in unused production capacity that could be used to perform contract manufacturing; Project B’s computerized control system could control two other machines, thereby reducing labor costs. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Recognizing Real Options (cont.) Bennett’s management estimated the NPV of the contract manufacturing option to be $1,500 and the NPV of the computer control sharing option to be $2,000. Furthermore, they felt there was a 60% chance that the contract manufacturing option would be exercised and a 30% chance that the computer control sharing option would be exercised. Value of Real Options for B = (60% x $1,500) + (30% x $2,000) $900 + $600 = $1,500 NPVstrategic = $10,924 + $1,500 = $12,424 NPVA = $12,424; NPVB = $11,071; Now choose A over B. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Capital Rationing Firm’s often operate under conditions of capital rationing—they have more acceptable independent projects than they can fund. In theory, capital rationing should not exist—firms should accept all projects that have positive NPVs. However, research has found that management internally imposes capital expenditure constraints to avoid what it deems to be “excessive” levels of new financing, particularly debt. Thus, the objective of capital rationing is to select the group of projects within the firm’s budget that provides the highest overall NPV or IRR. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Capital Rationing Tate Company, a fast growing plastics company with a cost of capital of 10%, is confronted with six projects competing for its fixed budget of $250,000. The initial investment and IRR for each project are shown below: Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Capital Rationing: IRR Approach Figure 9.5 Investment Opportunities Schedule Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Capital Rationing: NPV Approach Table 9.7 Rankings for Tate Company Projects Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Introduction to Risk in Capital Budgeting Thus far in our exploration of capital budgeting, all projects were assumed to be equally risky. The acceptance of any project would not alter the firm’s overall risk. In actuality, these situations are rare—project cash flows typically have different levels of risk and the acceptance of a project does affect the firm’s overall risk. This chapter will focus on how to handle risk. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Behavioral Approaches for Dealing with Risk In the context of the capital budgeting projects discussed in this chapter, risk results almost entirely from the uncertainty about future cash inflows, because the initial cash outflow is generally known. These risks result from a variety of factors including uncertainty about future revenues, expenditures and taxes. Therefore, to asses the risk of a potential project, the analyst needs to evaluate the riskiness of the cash inflows. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Behavioral Approaches for Dealing with Risk: Scenario Analysis Scenario analysis is a behavioral approach similar to sensitivity analysis but is broader in scope. This method evaluates the impact on the firm’s return of simultaneous changes in a number of variables, such as cash inflows, outflows, and the cost of capital. NPV is then calculated under each different set of variable assumptions. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Behavioral Approaches for Dealing with Risk: Scenario Analsis Treadwell Tire, a tire retailer with a 10% cost of capital, is considering investing in either of two mutually exclusive projects, A and B. Each requires a $10,000 initial investment, and both are expected to provide equal annual cash inflows over their 15-year lives. For either project to be acceptable, NPV must be greater than zero. We can solve for CF using the following: The risk of Treadwell Tire Company’s investments can be evaluated using scenario analysis as shown in Table 9.8 on the following slide. For this example, assume that the financial manager made pessimistic, most likely, and optimistic estimates of the cash inflows for each project. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Behavioral Approaches for Dealing with Risk: Risk and Cash Inflows (cont.) Table 9.8 Scenario Analysis of Treadwell’s Projects A and B Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Behavioral Approaches for Dealing with Risk: Decision Trees Figure 9.6 Decision Tree for NPV Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Behavioral Approaches for Dealing with Risk: Simulation Simulation is a statistically-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes. Figure 9.7 presents a flowchart of the simulation of the NPV of a project. The use of computers has made the use of simulation economically feasible, and the resulting output provides an excellent basis for decision-making. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Behavioral Approaches for Dealing with Risk: Decision Trees Figure 9.7 NPV Simulation Copyright © 2009 Pearson Prentice Hall. All rights reserved.

International Risk Considerations Exchange rate risk is the risk that an unexpected change in the exchange rate will reduce NPV of a project’s cash flows. In the short term, much of this risk can be hedged by using financial instruments such as foreign currency futures and options. Long-term exchange rate risk can best be minimized by financing the project in whole or in part in the local currency. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

International Risk Considerations (cont.) Political risk is much harder to protect against once a project is implemented. A foreign government can block repatriation of profits and even seize the firm’s assets. Accounting for these risks can be accomplished by adjusting the rate used to discount cash flows—or better—by adjusting the project’s cash flows. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

International Risk Considerations (cont.) Since a great deal of cross-border trade among MNCs takes place between subsidiaries, it is also important to determine the net incremental impact of a project’s cash flows overall. As a result, it is important to approach international capital projects from a strategic viewpoint rather than from a strictly financial perspective. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates Risk-adjusted discount rates are rates of return that must be earned on given projects to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s share price. The higher the risk of a project, the higher the RADR—and thus the lower a project’s NPV. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates: Review of CAPM Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates: Applying RADRs Bennett Company wishes to apply the Risk-Adjusted Discount Rate (RADR) approach to determine whether to implement Project A or B. In addition to the data presented earlier, Bennett’s management assigned a “risk index” of 1.6 to project A and 1.0 to project B as indicated in the following table. The required rates of return associated with these indexes are then applied as the discount rates to the two projects to determine NPV. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates: Applying RADRs (cont.) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates: Applying RADRs (cont.) Figure 9.8 Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives Using RADRs Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates: Applying RADRs (cont.) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates: Applying RADRs (cont.) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates: RADRs in Practice Table 9.9 Bennett Company’s Risk Classes and RADRs Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Table 9.10 Summary of Key Formulas/Definitions and Decision Criteria for Capital Budgeting Techniques Copyright © 2009 Pearson Prentice Hall. All rights reserved.