2. Capital Budgeting Arguing for your project

3.  Capital budgeting  CFO receives proposals from divisions  Projects described by cash flows

4. Arguing means applying measures  Net present value is the right measure.  Many smart people use the wrong ones.  Alternative ways to the same end.

5. Uses of measures  Project acceptance  Mutually exclusive alternatives.

6. Capital Budgeting Techniques  Kim, Crick, and Kim, Management Accounting  Nov. 1986, p. 49-52

7. Survey of use of measures by corporations

8. Make no mistake NNPV is the right measure always. OOthers work sometimes. NNPV measures value to owners, their wealth.

9. Objectives of a good measure  Value cash flows.  Respond to the market.

10. NPV’s merits  Values cash flows as the market does.  Responsive because the discount rate is the current market rate.  Measures increase in shareholder value.

11. Payback period is  The time required for undiscounted cash flows to add up to the initial investment.  e.g., build a Wendy’s if it “pays for itself” in two years or less.

12. Payback merits  Based on cash flows

13. Payback defects  No market response. When r is high, payback period should be shorter.  Subtracts time-t dollars from time-0 dollars, a cardinal sin.  Ignores cash flow after payback.  Ignores timing during payback.

14. Defects are not necessarily fatal  Repeated, similar investments.  Stable financial conditions.

15. The well-informed capital budgeter knows  When to accept payback period as a measure.  When it is likely to fail.

16. Accounting rate of return  Doesn’t value cash flows  No market response  Ignores market values  Scaling problems: melons or malls

17. Merits of accounting r.o.r.  Easily understood.  Sometimes okay in stable markets.  Smart application can overcome defects.

18. Internal rate of return  Definition: IRR is the discount rate that makes NPV = 0 That is, IRR is the r such that

19. Internal rate of return  Definition: IRR is the discount rate that makes NPV(r) = 0.  NPV(r) is a function.  RWJ Figures 6.4 and 6.5.

20. Project

21. Figure 6.4: NPV(r)=0 at r=23.37% NPV r 100 NPV(r) NPV(.1) = 48.68520.1 IRR =23.37 48.685

22. Figure 6.4  NPV (r) = 0 at r = 23.37%

23. Applications of IRR measure  Hurdle rate = market rate  Project acceptance: Accept a project if IRR > hurdle rate.  Mutually exclusive projects: Take the one with the highest IRR (> hurdle rate)????? Don’t rely on it.

24. Project acceptance:  NPV and IRR give the same conclusion when...  Cash flows have one sign change.  In the example: IRR = 23.37% > hurdle = 10% for an investment project.  IRR = 23.37% < hurdle rate = 30% for a financing or “borrowing from nature” project.

25. Merits  Uses cash flows.  Responds to the market when the hurdle rate changes

26. Objective  Learn to recognize the times when NPV and IRR are the same.  and also the problems with IRR

27. Defects of IRR -- project acceptance  Lending to nature or borrowing from her?  Multiple IRR's may occur.

28. Financing (borrowing from nature)  Seek IRR < hurdle rate  Same as NPV > 0

29. Multiple IRR's

30. IRR’s at r = 1 and r = 2  100% per decade = 7.17735% per year.  200% per decade = 11.61232% per year.

31. IRR’s at r=1 and r=2. NPV r 100% 200%

32. Descartes’ Rule  The number of internal rates of return is no more than the number of sign changes.

33. Defects of IRR -- mutually exclusive projects  Ignores market values.  Scale problems -- melons or malls.

34. Typical hour exam question  What is the scale problem in using IRR to choose between mutually exclusive projects?

35. Scale problem in IRR One canyon, one dam.

36. Sketch of answer  The smaller dam has the higher IRR.  The big dam has higher value.  The big dam extends consumption possibility of owners more than the little dam does.  It is wrong to take the higher IRR in this case.

37. Scale problems in IRR

38. More answer  Consider the project of replacing the little dam by the big dam.  Cash flows are -900, +1300.  IRR of the project is 4/9 =.4444 >.1  NPV is 281.8181…  So replace the little dam.  Capital budgeting jiu jitsu.

39. r NPV 50%100% 100 500 Big dam Little dam IRR

40. Big dam, little dam NPV NPV of the big dam NPV of the small dam 500 100.5 1 r r* For hurdle rates below r*, the big dam is preferred. r* =.4444...