1. Copyright © 1999 Addison Wesley Longman 1 Chapter 10: Capital Budgeting: Introduction and Techniques Part III Foundations of Corporate Finance Copyright © 1999 Addison Wesley Longman

2. Capital Budgeting: Introduction and Techniques 10 CHAPTER Copyright © 1999 Addison Wesley Longman

3. 3 Chapter 10: Capital Budgeting: Introduction and Techniques Objectives 1.Learn to use TVM in investment analysis 2.Develop project evaluation models

4. Copyright © 1999 Addison Wesley Longman 4 Chapter 10: Capital Budgeting: Introduction and Techniques The Capital Budgeting Process The Process for analyzing potential investments

5. Copyright © 1999 Addison Wesley Longman 5 Chapter 10: Capital Budgeting: Introduction and Techniques Define the projects –1.replace worn-equipment –2.replace outdated equipment –3.increase current capacity –4.expand product offerings –5.miscellaneous a.safety b.environmental c. cosmetics

6. Copyright © 1999 Addison Wesley Longman 6 Chapter 10: Capital Budgeting: Introduction and Techniques Cash Flow Estimations –1.cash flow time lines –2.cash flow riskiness

7. Copyright © 1999 Addison Wesley Longman 7 Chapter 10: Capital Budgeting: Introduction and Techniques Determine Project Feasibility 1.independent projects –The decision to implement the project is determined independently of all other projects. –a.accept if increase firm wealth –b.reject if reduces firm wealth

8. Copyright © 1999 Addison Wesley Longman 8 Chapter 10: Capital Budgeting: Introduction and Techniques  mutually exclusive projects The decision to implement a project depends upon its feasibility as compared to other projects - a.accept project that increases firm wealth the most - b.reject all projects that reduce firm wealth

9. Copyright © 1999 Addison Wesley Longman 9 Chapter 10: Capital Budgeting: Introduction and Techniques DECISION CRITERIA –1.net present value (NPV) –2.payback rule –3.discounted payback rule –4.internal rate of return (IRR) –5.modified internal rate of return (MIRR) –6.profitability index

10. Copyright © 1999 Addison Wesley Longman 10 Chapter 10: Capital Budgeting: Introduction and Techniques Net Present Value (NPV) The sum of the present value of all positive and negative cash flows. –YearCF’sDscting.DCF’s –0-$200/1.10 0 =-$200 –1 $70 /1.10 1 = $64 –2 $90 /1.10 2 = $74 –3 $100/1.10 3 = $75 –4 $125/1.10 4 = $85 NPV = $98

11. Copyright © 1999 Addison Wesley Longman 11 Chapter 10: Capital Budgeting: Introduction and Techniques Using the calculator - HP 10B –1.clear the memory: [  ] [CLEAR ALL] –2.for CF 0, enter [200] [+/-] [CF j ] –3.for CF 1, enter [70] [CF j ] –4.repeat step 3 until all cash flows are entered –5.for the discount rate, enter [10] [I/YR] –6.to calculate NPV, enter [  ] [NPV]

12. Copyright © 1999 Addison Wesley Longman 12 Chapter 10: Capital Budgeting: Introduction and Techniques TI BA II PLUS –1.clear the memory: [CF] [2nd] [CLR Work] –2.CF 0 : [CF] [200] [+/-] [ENTER] [  ] –3.CF 1 : [70] [ENTER] [  ] [1] [ENTER] [  ] –4.repeat step 3 until all cash flows are entered –5.to enter discount rate: [NPV] [10] [ENTER] [  ]

13. Copyright © 1999 Addison Wesley Longman 13 Chapter 10: Capital Budgeting: Introduction and Techniques Decision Criteria a. independent: accept if NPV > 0 b.mutually exclusive: accept highest (+) NPV

14. Copyright © 1999 Addison Wesley Longman 14 Chapter 10: Capital Budgeting: Introduction and Techniques FIGURE 10.1 NPV Profile

15. Copyright © 1999 Addison Wesley Longman 15 Chapter 10: Capital Budgeting: Introduction and Techniques FIGURE 10.2 IRR Ranking Problem

16. Copyright © 1999 Addison Wesley Longman 16 Chapter 10: Capital Budgeting: Introduction and Techniques Payback Rule –The expected number of years until recovery of original investment.

17. Copyright © 1999 Addison Wesley Longman 17 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation Project Cash Flows YearCF’s Cumulative 0-$200-$200 1 $70-$130 2 $90 -$40 3 $100 $60 4 $125 $185 (balance at beginning of next year) Payback = 2 + ($40 /$100) (year before full recovery)(cash flow during next year)

18. Copyright © 1999 Addison Wesley Longman 18 Chapter 10: Capital Budgeting: Introduction and Techniques problems with payback –a.ignores the time value of money –b.ignores cash flows received after payback period benefits of payback –a.measures projects liquidity – (high PB => low liquidity)

19. Copyright © 1999 Addison Wesley Longman 19 Chapter 10: Capital Budgeting: Introduction and Techniques Discounted Payback Rule The expected number of years until the discounted cash flows equals the initial investment.

20. Copyright © 1999 Addison Wesley Longman 20 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation Project Cash Flows, assume discount rate of 10% YearCF’sDscting.DCF’sCum. DCF’s 0-$200/1.10 0 =-$200-$200 1 $70/1.10 1 = $64-$136 2 $90/1.10 2 = $74 -$62 3 $100/1.10 3 = $75 $13 4 $125/1.10 4 = $85 $98 (balance at beginning of next year) Payback = 2 + ($62/ $75) (year before full recovery) (DCF during next year)

21. Copyright © 1999 Addison Wesley Longman 21 Chapter 10: Capital Budgeting: Introduction and Techniques Problems with discounted payback –a.may reject positive NPV investments –b.ignores cash flows received after payback period

22. Copyright © 1999 Addison Wesley Longman 22 Chapter 10: Capital Budgeting: Introduction and Techniques Internal Rate of Return  The discount rate that provides an NPV of zero.  PV of inflows = PV of outflows

23. Copyright © 1999 Addison Wesley Longman 23 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation YearCF’sDscting.DCF’s 0-$200/1.? 0 = -$200 1 $70/1.? 1 = $? 2 $90/1.? 2 = $? 3 $100/1.? 3 = $? 4 $125/1.? 4 = $? NPV = $0 Calculation done by trial and error without calculator.

24. Copyright © 1999 Addison Wesley Longman 24 Chapter 10: Capital Budgeting: Introduction and Techniques Using the calculator HP 10B –1.clear the memory: [  ] [CLEAR ALL] –2.for CF 0, enter [200] [+/-] [CF j ] –3.for CF 1, enter [70] [CF j ] –4.repeat step 3 until all cash flows are entered –5.to calculate IRR, enter [  ] [IRR/YR] –6.answer = 29%

25. Copyright © 1999 Addison Wesley Longman 25 Chapter 10: Capital Budgeting: Introduction and Techniques TI BA II PLUS –1.clear the memory: [CF] [2nd] [CLR Work] –2.CF 0 : [CF] [200] [+/-] [ENTER] [  ] –3.CF 1 : [70] [ENTER] [  ] [1] [ENTER] [  ] –4.repeat step 3 until all cash flows are entered – 5.to calculate IRR: [IRR] [CPT] –6.answer = 29%

26. Copyright © 1999 Addison Wesley Longman 26 Chapter 10: Capital Budgeting: Introduction and Techniques Decision criteria –a.independent: 1.provides same result as NPV 2.accept if IRR > RRR (cost of capital) –b.mutually exclusive: 1.may provide different results from NPV 2.use NPV results

27. Copyright © 1999 Addison Wesley Longman 27 Chapter 10: Capital Budgeting: Introduction and Techniques Problems with IRR a.provides multiple IRRs when CF signs change more than once b.assumes reinvestment rate equals IRR c.may provide incorrect results for mutually exclusive projects

28. Copyright © 1999 Addison Wesley Longman 28 Chapter 10: Capital Budgeting: Introduction and Techniques FIGURE 10.3 Multiple IRRs

29. Copyright © 1999 Addison Wesley Longman 29 Chapter 10: Capital Budgeting: Introduction and Techniques Benefits of IRR a. easy to understand b. generally provides results consistent with NPV c. business executives prefer 3 to 1 over NPV

30. Copyright © 1999 Addison Wesley Longman 30 Chapter 10: Capital Budgeting: Introduction and Techniques Modified Internal Rate of Return (MIRR)  The discount rate that makes the future value of cash inflows equal the present value of cash outflows.  PV of cash outflows = FV of cash inflows  The future value of cash inflows and present value of cash outflows is found using the RRR (cost of capital).

31. Copyright © 1999 Addison Wesley Longman 31 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation step 1:obtain present value of cash outflows and future value of cash inflows using cost of capital

32. Copyright © 1999 Addison Wesley Longman 32 Chapter 10: Capital Budgeting: Introduction and Techniques Year CF’sOutflow PV’s Inflow FV’s 0 -$200/1.10 0 = -$200 1 $70*1.10 3 = $93 2 $90*1.10 2 = $109 3 $100*1.10 1 = $110 4 $125*1.10 0 = $125 Total =-$200 $437

33. Copyright © 1999 Addison Wesley Longman 33 Chapter 10: Capital Budgeting: Introduction and Techniques step 2:use calculator to determine rate which equates present value of cash outflows to future value of cash inflows N =4 I/YR=?=21.58% PV=-$200 PMT= $0 FV= $437

34. Copyright © 1999 Addison Wesley Longman 34 Chapter 10: Capital Budgeting: Introduction and Techniques Benefits a.assumes cash flows from project are reinvested at the cost of capital b.eliminates multiple IRR problem c. provides results consistent with NPV

35. Copyright © 1999 Addison Wesley Longman 35 Chapter 10: Capital Budgeting: Introduction and Techniques F.Profitability Index  (a.k.a.: benefit cost ratio)  Measures the projects profitability per dollar of investment.

36. Copyright © 1999 Addison Wesley Longman 36 Chapter 10: Capital Budgeting: Introduction and Techniques Calculation PI = PV of benefits / PV of costs assuming a 10% discount rate Year CF’s Outflow PV’sInflow PV’s 0-$200-$200 1 $70 $64 2 $90 $74 3 $100 $75 4 $125 $85 Totals$200 $298 PI=$298 / $200 = 1.49

37. Copyright © 1999 Addison Wesley Longman 37 Chapter 10: Capital Budgeting: Introduction and Techniques Decision criteria a. independent: accept if PI > 1 b. mutually exclusive: accept highest PI

38. Copyright © 1999 Addison Wesley Longman 38 Chapter 10: Capital Budgeting: Introduction and Techniques Compared to NPV and IRR a. provides same results for independent projects b. can have conflicting results for mutually exclusive projects with significantly different sized cash flows

39. Copyright © 1999 Addison Wesley Longman 39 Chapter 10: Capital Budgeting: Introduction and Techniques SYNTHESIZING THE PROCEDURES

40. Copyright © 1999 Addison Wesley Longman 40 Chapter 10: Capital Budgeting: Introduction and Techniques Each method provides information  1.NPV provides a direct measure of the increase in shareholder wealth  2.Payback methods provide measures of liquidity  3.IRR methods provide measures of safety margins in easy to understand terms  4.Profitability indexes provide safety margin measures and the profitability per dollar of investment