1. Chapter 9 Investment Decision Rules and Capital Budgeting

2. What is Capital Budgeting Definition- Capital budgeting is a process of allocating limited resources among the best investment opportunities.

3. Methods of Investment Rules for Capital Budgeting Net Present Value The Payback Rule The Discounted Payback The Internal Rate of Return The Profitability Index

4. Good Decision Criteria We need to ask ourselves the following questions when evaluating decision criteria –Does the decision rule adjust for the time value of money? –Does the decision rule adjust for risk? –Does the decision rule provide information on whether we are creating value for the firm?

5. Net Present Value The present value of future cash flows discounted at the cost of capital, r, minus the present value of the investment outlays. CF=Cash Flows R= Cost of Capital- Cost of Funds C 0 = Initial Cost (investment)

6. Rationale for the NPV Method NPV= PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

7. Computing NPV for the Project Project cost= $165,000, CF 1 =$63120 CF 2 =$70800, CF 3 = $91,080 cost of capital R=12%. What is the NPV? Using the formulas: –NPV = 63,120/(1.12) + 70,800/(1.12) 2 + 91,080/(1.12) 3 – 165,000 = $12,627.42 Using the calculator: –CF 0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; I/YR = 12; CPT NPV = $12,627.42 Do we accept or reject the project ?

8. Net Present Value A. ANNUITY CASH FLOWS B. UNEVEN SERIES CASH FLOWS

9. Cash Flows for two projects: L and M 108060 0123 10% L’s CFs: -100.00 702050 0123 10% M’s CFs: -100.00

10. What’s Project L’s NPV? 108060 0123 10% Project L: -100.00 9.09 49.59 60.11 NPV M = $19.98. 18.79 = NPV L

11. Calculator Solution Enter in CFLO for L: -100 10 60 80 10 CF 0 CF 1 NPV CF 2 CF 3 I = 18.78 = NPV L

12. Independent versus Mutually Exclusive Projects If Projects L and M are: Independent: if the cash flows of one are unaffected by the acceptance of the other, accept both projects. Since M & L are independent, accept both; NPV > 0. Mutually exclusive: if the cash flows of one can be adversely impacted by the acceptance of the other. Accept the one with highest NPV. Accept M because NPV M > NPV L.

13. Calculating NPVs with a Spreadsheet Spreadsheets are an excellent way to compute NPVs, especially when you have to compute the cash flows as well. Using the NPV function –The first component is the required return entered as a decimal –The second component is the range of cash flows beginning with year 1 –Subtract the initial investment after computing the NPV

14. Internal Rate of Return This is the most important alternative to NPV. It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. It is often used in practice and is intuitively appealing

15. Internal Rate of Return Definition: IRR is a discount rate at which the NPV = 0. That is, Uneven series of CF: If the cash flows are uneven series, then, we need to solve for IRR based on equation shown below:

16. IRR – Decision Rule Decision Rule: Accept the project if the IRR is greater than the required return (cost of capital).

17. 40 0123 -100 IRR = 9.70%. 3 -100 40 0 9.70% NI/YRPVPMTFV INPUTS OUTPUT Computing IRR

18. If you do not have a financial calculator, then this becomes a trial-and-error process or using excel.

19. Rationale for the IRR Method If IRR > R, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns. Example: R = 12%, IRR = 16.13%. So this project adds extra return to shareholders.

20. NPV Profile For trial-and-error IRR = 16.13%

21. What’s L’s IRR? 108060 0123 IRR = ? -100.00 PV 3 PV 2 PV 1 0 = NPV IRR L = 18.13%. IRR M = 23.56%.

22. Decisions on Projects M and L per IRR If M and L are independent, accept both: IRR M > R and IRR L > R. If M and L are mutually exclusive, accept M because IRR M > IRR L.

23. Advantages of IRR Knowing a return is intuitively appealing It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task

24. Payback Period How long does it take to get the initial cost back in a nominal sense? Computation –Estimate the cash flows –Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Rule – Accept if the payback period is less than some preset limit

25. Computing Payback For The Project Assume we will accept the project if it pays back within two years. –Year 1: 165,000 – 63,120 = 101,880 still to recover –Year 2: 101,880 – 70,800 = 31,080 still to recover –Year 3: 31,080 – 91,080 = -60,000 project pays back during year 3 –Payback = 2 years + 31,080/91,080 = 2.34 years Do we accept or reject the project?

26. Advantages and Disadvantages of Payback Advantages –Easy to understand –Adjusts for uncertainty of later cash flows –Biased towards liquidity Disadvantages –Ignores the time value of money –Requires an arbitrary cutoff point –Ignores cash flows beyond the cutoff date –Biased against long- term projects, such as research and development, and new projects

27. NPV vs. IRR NPV and IRR will generally give us the same decision Exceptions –Non-conventional cash flows – cash flow signs change more than once –Mutually exclusive projects Initial investments are substantially different Timing of cash flows is substantially different

28. Another Example – Nonconventional Cash Flows Suppose an investment will cost $90,000 initially and will generate the following cash flows: –Year 1: 132,000 –Year 2: 100,000 –Year 3: -150,000 The required return is 15%. Should we accept or reject the project?

29. NPV Profile IRR = 10.11% and 42.66%

30. Summary of Decision Rules The NPV is positive at a required return of 15%, so you should Accept If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject You need to recognize that there are non- conventional cash flows and look at the NPV profile

31. IRR and Mutually Exclusive Projects Mutually exclusive projects –If you choose one, you can’t choose the other –Example: You can choose to be in the classroom or work, but not both Intuitively, you would use the following decision rules: –NPV – choose the project with the higher NPV –IRR – choose the project with the higher IRR

32. Example With Mutually Exclusive Projects PeriodProject A Project B 0-500-400 1325 2 200 IRR19.43%22.17% NPV64.0560.74 The required return for both projects is 10%. Which project should you accept and why?

33. NPV Profiles IRR for A = 19.43% IRR for B = 22.17%

34. Two Reasons NPV Profiles Cross Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high WACC favors small projects. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF especially good, NPV A > NPV B.

35. Reinvestment Rate Assumptions NPV assumes reinvest at WACC (opportunity cost of capital). IRR assumes reinvest at IRR. Reinvest at opportunity cost, R, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

36. Modified Internal Rate of Return (MIRR) MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at R. Thus, MIRR assumes cash inflows are reinvested at the cost of capital R.

37. Modified IRR This method overcomes the reinvestment rate deficiency inherent in the regular IRR.

38. Conflicts Between NPV and IRR NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV IRR is unreliable in the following situations –Non-conventional cash flows –Mutually exclusive projects

39. Profitability Index Measures the benefit per unit cost, based on the time value of money. It is the ratio of the present value of cash flows divided by the initial outflow. A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value This measure can be very useful in situations in which we have limited capital.

40. Example- Profitability Index with Capital Constraint Problem: Your division at NetIT, a large networking company, has put together a project proposal to develop a new home networking router. The expected NPV of the project is $17.7 million, and the project will require $50 initial cost. NetIT has devoted only $190 million for its investments and is unable to raise additional funds to take all of its investment opportunities shown on the right- side Table. How should NetIT prioritize these projects? Which projects should be selected? ProjectNPVInitial CostPI Router$17.70$50.001.354 A$22.70$47.001.483 B$8.10$44.001.184 C$14.00$40.001.350 D$11.50$61.001.189 E$20.60$58.001.355 F$12.90$32.001.403 Total $107.50$332.00

41. Example- Profitability Index with Capital Constraint Solution: The goal is to maximize the total NPV we can create with $190 millions (at most). We can use PI to sort out the basket of projects that would create the highest total NPV for the Company. Table on the right side shows the ranking of the projects based on their PI. Ranking based on PI ProjectNPVInitial CostPI A22.7471.483 F12.9321.403 E20.6581.355 Router17.7501.354 C14401.350 D11.5611.189 B8.1441.184

42. Example- Profitability Index with Capital Constraint Evaluate To maximize NPV within the constraint of $190 million capital, NetIT should choose the first four projects on the list. There is no other combination of projects that will create more value without using more capital than we have. This ranking also shows us exactly what the capital constraint costs us—this capital constraint forces NetIT to forgo three otherwise valuable projects (C, D, and B) with a total NPV of $33.6 million. Selected Investments ProjectNPVInitial CostPI A22.7471.483 F12.9321.403 E20.6581.355 Router17.7501.354 73.9187

43. Advantages and Disadvantages of Profitability Index Advantages –Closely related to NPV, generally leading to identical decisions –Easy to understand and communicate –May be useful when available investment funds are limited Disadvantages –May lead to incorrect decisions in comparisons of mutually exclusive investments

44. Unequal Lives Projects There are two methods for the adjustment of unequal lives projects: Equivalent Annual Annuity (EAA) Adjusted Net Present Value (ANPV)

45. Summary of Investment Decision Rule DECISION CRITERIA 1.NPV>0, IRR>R, PI>1,Accept 2.NPV<0, IRR<R, PI<1,Reject 3.NPV=0, IRR=R, PI=1,Accept

46. Capital Budgeting In Practice We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is a commonly used secondary investment criteria

47. Summary – Discounted Cash Flow Criteria Net present value –Difference between market value and cost –Take the project if the NPV is positive –Has no serious problems –Preferred decision criterion Internal rate of return –Discount rate that makes NPV = 0 –Take the project if the IRR is greater than required return –Same decision as NPV with conventional cash flows –IRR is unreliable with non-conventional cash flows or mutually exclusive projects Profitability Index –Benefit-cost ratio –Take investment if PI > 1 –Cannot be used to rank mutually exclusive projects –May be use to rank projects in the presence of capital rationing

48. Summary – Payback Criteria Payback period –Length of time until initial investment is recovered –Take the project if it pays back in some specified period –Doesn’t account for time value of money and there is an arbitrary cutoff period Discounted payback period –Length of time until initial investment is recovered on a discounted basis –Take the project if it pays back in some specified period –There is an arbitrary cutoff period