1. Chapter 10 - Capital Budgeting

2. A major part of the financial management of the firm
Capital Budgeting
A major part of the financial management of the firm
Kinds Of Spending In Business
Short term - to support day to day operations
Long term - to support long lived equipment and projects
Long term money and the things acquired with it are both called capital
Capital Budgeting
Planning and Justifying How Capital Dollars Are Spent On Long Term Projects
Provides methods for evaluating whether projects make financial sense and for choosing among them

3. Capital Budgeting
Capital budgeting involves planning and justifying large expenditures on long-term projects
Projects can be classified as:
Replacement – low risk
Expansion – moderate risk
New venture – high risk

4. Characteristics of Business Projects
Project Types and Risk
Capital projects have increasing risk according to whether they are replacements, expansions or new ventures
Stand-Alone and Mutually Exclusive Projects
Stand-alone project has no competing alternatives
Mutually exclusive projects involve selecting one project from among two or more alternatives

5. Characteristics of Business Projects
Project Cash Flows
Reduce projects to a series of cash flows:
C0 $(50,000)
C1 (10,000)
C ,000
C ,000
C ,000
C ,000
Business projects: early cash outflows and later inflows
C0 is the Initial Outlay and usually required to get started

6. Characteristics of Business Projects
The Cost of Capital
The average rate a firm pays investors for use of its long term money
Firms raise money from two sources: debt and equity

7. Capital Budgeting Techniques
Payback Period
How many years to recover initial cost
Net Present Value
Present value of inflows less outflows
Internal Rate of Return
Project’s return on investment
Profitability Index
Ratio of present value of inflows to outflows

8. Capital Budgeting Techniques Payback
Payback period is the time it takes to recover early cash outflows
Shorter paybacks are better
Payback Decision Rules
Stand-alone projects
Mutually Exclusive Projects
Weaknesses of the Payback Method
Ignores time value of money
Ignores cash flows after payback period

9. Concept Connection Example 10-1 Payback Period
Payback period is easily visualized by the cumulative cash flows

10. Example 10-2: Weakness of the Payback Technique
Use the payback period technique to choose between mutually exclusive projects A and B.
Project A’s payback is 3 years as its initial outlay is fully recovered in that time. Project B doesn’t fully recover until sometime in the 4th year. Thus, according to the payback method, Project A is better than B. But project B is clearly better because of the large inflows in the last two years

11. NET PRESENT VALUE (NPV)
The present value of future cash flows is what counts
when making decisions based on value.
The Net Present Value of all of a project's cash flows is its expected contribution
to the firm's value and shareholder wealth
PVs are taken at k, the cost of capital
Calculate NPV using
NPV = C0 + C1[PVFk,1] + C2[PVFk,2] + · · · + Cn[PVFk,n]
Outflows are Ci with negative values and tend to occur first
NPV: Difference between the present values of positives and negatives
Projects with positive NPVs increase the firm’s value
Projects with negative NPVs decrease the firm’s value

12. Net Present Value (NPV)
NPV and Shareholder Wealth
A project’s NPV is the net effect that it is expected to have on the firm’s value
To maximize shareholder wealth, select the capital spending program with the highest NPV

13. Net Present Value (NPV)
Decision Rules
Stand-alone Projects
NPV > 0  accept
NPV < 0  reject
Mutually Exclusive Projects
NPVA > NPVB  choose Project A over B

14. Concept Connection Example 10-3 Net Present Value (NPV)
Project Alpha has the following cash flows. If the firm considering Alpha has a cost of capital of 12%, should the project be undertaken?

15. Concept Connection Example 10-3 Net Present Value (NPV)
The NPV is found by summing the present value of the cash flows when discounted at the firm’s cost of capital.
Since Alpha’s NPV<0, it should not be undertaken.

16. Internal Rate of Return (IRR)
A project’s IRR is the return it generates on the investment of its cash outflows
For example, if a project has the following cash flows
The “price” of receiving
the inflows
The IRR is the interest rate at which the present value of the three inflows just equals the $5,000 outflow

17. Defining IRR Through the NPV Equation
At the IRR the PVs of project inflows and
outflows are equal, so NPV = 0
Set NPV=0 and substitute IRR for k
0 = C0 + C1[PVFIRR,1] + C2[PVFIRR,2] + · · + Cn[PVFIRR,n]
IRR is the solution to this equation for a given set of Ci
Requires an iterative approach if the Ci are irregular

18. Internal Rate of Return (IRR)
Decision Rules
Stand-alone Projects
If IRR > cost of capital (k)  accept
If IRR < cost of capital (k)  reject
Mutually Exclusive Projects
IRRA > IRRB  choose Project A over Project B

19. Internal Rate of Return (IRR)
Calculating IRRs
Finding IRRs usually requires an iterative, trial-and-error technique
Guess at the project’s IRR
Calculate the project’s NPV using this interest rate
If NPV = zero, guessed interest rate is the project’s IRR
If NPV > 0, try a higher interest rate
If NPV < 0, try a lower interest rate

20. Concept Connection Example 10-5 IRR – Iterative Procedure
Find the IRR for the following series of cash flows:
If the firm’s cost of capital is 8%, is the project a good idea? What if the cost of capital is 10%?

21. Example 10-5 IRR – Iterative Procedure
Start by guessing IRR = 12% and calculate NPV.
NPV = C0 + C1[PVFk,1] + C2[PVFk,2] + · · · + Cn[PVFk,n]
NPV = -5, ,000[PVF12,1] + 2,000[PVF12,2] + 3,000[PVF12,3]
NPV = -5, ,000[.8929] + 2,000[.7972] + 3,000[.7118]
NPV = -5, , ,135.40
NPV = -$377.30
Since NPV<0, the project’s IRR must be < 12%.

22. Figure 10-1 NPV Profile
A project’s NPV profile is a graph of its NPV vs. the cost of capital. It crosses the horizontal axis at the IRR.

23. Concept Connection Example 10-5 IRR – Iterative Procedure
We’ll try a different, lower interest rate, say 10%. At 10%, the project’s NPV is ($184). Since the NPV is still less than zero, we need to try a still lower interest rate, say 9%. The following table lists the project’s NPV at different interest rates.
Interest Rate Guess
Calculated NPV
12%
($377)
Since NPV becomes positive somewhere between 8% and 9%, the project’s IRR must be between 8% and 9%. If the firm’s cost of capital is 8%, the project is marginal. If the firm’s cost of capital is 10%, the project is not a good idea. 10
($184) 9
($83) 8
$22 7
$130

24. Techniques: Internal Rate of Return (IRR)
Technical Problems with IRR
Multiple Solutions
Unusual projects can have more than one IRR
The number of positive IRRs to a project depends on the number of sign reversals to the project’s cash flows
The Reinvestment Assumption
IRR method implicitly assumes cash inflows will be reinvested at the project’s IRR

25. Comparing IRR and NPV
NPV and IRR do not always select the same project in mutually exclusive decisions
A conflict can arise if NPV profiles cross in the first quadrant
In the event of a conflict The selection of the NPV method is preferred

26. Figure 10-2 Projects for Which IRR and NPV Can Give Different Solutions
At a cost of capital of k1, Project A is better than Project B, while at k2 the opposite is true.

27. PROJECTS WITH A SINGLE OUTFLOW AND REGULAR INFLOWS
Many projects are characterized by an initial outflow and a series of equal, regular inflows:
PV of annuity formula makes the pattern easy to work with
NPV: NPV = C0 + C [PVFAk,n]
IRR: = C0 + C [PVFAIRR,n]

28. Example 10-6 – Regular Cash Inflows
Find the NPV and IRR for the following project if the cost of capital is 12%.
C C C C3
($5,000) $2, $2, $2,000
Solution: For NPV
NPV = C0 + C[PVFAk,n]
= -$5,000 + $2,000[PVFA12,3]
= -$5,000 + $2,000(2.4018)
= -$196.40
For IRR
0 = C0 + C[PVFAIRR,n]
= -$5,000 + $2,000[PVFAIRR,3]
PVFAIRR,3 = $5,000 / $2,000 =
From which IRR is between 9% and 10%

29. Profitability Index (PI)
Is a variation on the NPV method
A ratio of the present value of a project’s inflows to the present value of a project’s outflows
Projects are acceptable if PI>1

30. Profitability Index (PI)
Also known as the benefit/cost ratio
Positive future cash flows are the benefit
Negative initial outlay is the cost

31. Profitability Index (PI)
Decision Rules
Stand-alone Projects
If PI > 1.0  accept
If PI < 1.0  reject
Mutually Exclusive Projects
PIA > PIB choose Project A over Project B
Comparison with NPV
With mutually exclusive projects the two methods may not lead to the same choices

32. Comparing Projects with Unequal Lives
If a significant difference exists between mutually exclusive projects’ lives, a direct comparison is meaningless
The problem arises due to the NPV method
Longer lived projects almost always have higher NPVs

33. Comparing Projects with Unequal Lives
Two solutions exist
Replacement Chain Method
Extends projects until a common time horizon is reached
Equivalent Annual Annuity (EAA) Method
Replaces each project with an equivalent perpetuity that equates to the project’s original NPV

34. Concept Connection Example 10-8 Replacement Chain
The IRR method argues for undertaking the Short-Lived Project while the NPV method argues for the Long-Lived Project. We’ll correct for the unequal life problem by using both the Replacement Chain Method and the EAA Method. Both methods will lead to the same decision.
Thus, choosing the Long-Lived Project is a better decision than choosing the Short-Lived Project twice.

35. Concept Connection Example 10-8 Replacement Chain
Which of the two following mutually exclusive projects should a firm purchase?

36. Concept Connection Example 10-9 Equivalent Annual Annuity (EAA)
The EAA Method equates each project’s original NPV to an equivalent annual annuity. For the Short-Lived Project the EAA is $ (the equivalent of receiving $ spread out over 3 years at 8%); while the Long-Lived Project has an EAA of $ (the equivalent of receiving $ spread out over 6 years at 8%).

37. Concept Connection Example 10-9 Equivalent Annual Annuity (EAA)
Because the Long-Lived Project has the higher EAA, it should be chosen. This is the same decision reached by the Replacement Chain Method.

38. Capital Rationing
Used when capital funds for new projects are limited
Generally rank projects in descending order of IRR and cut off at the cost of capital
However this doesn’t always make the best use of capital so a complex mathematical process called constrained maximization can be used

39. Figure 10-6 Capital Rationing