1. 1 Chap 9 – Capital Budgeting Key Sections: Explain Payback period, NPV and IRR Evaluate advantages, disadvantages of each and determine project acceptability Compute payback, NPV and IRR (with projects with irregular cash flows) Understand capital rationing and disparities

2. 2 Budgeting Criteria Capital Budgeting – decision process relative to investing in fixed assets or other long-term investments in a new product or line of business. Focuses on after-tax cash flows resulting from a project. Should it be undertaken? –Compare returns relative to costs Criteria: NPV, IRR and payback period

3. 3 Payback Period How many years to recover the initial outlay? Does it meet the minimum period? Main weakness – ignores TVM –But we could PV each cash flow to show TVM Problems: period is arbitrary and ignores later cash flows Advantages: understandable, early cash flows more certain

4. 4 Net Present Value NPV’s of inflows less NPV’s of outflows Measures net value in today’s dollars Criteria: If NPV > 0.0 accept but –If NPV less than zero, reject Rationale: Discount rate used at least equals cost of capital; if you can’t cover costs, you are destroying shareholder value

5. 5 NPV Illustration @ 10% YearCF PVIFPV 1 12,000.909 10,908 2 13,000.826 10,738 3 14,000.751 10,574 4 15,000.683 10,245 PV of inflows 42,465 Initial out -35,0001.000-35,000 NPV+ 7,465

6. 6 More on NPV Depends on accuracy of cash flow projected Advantages: deals with CF and timing; costs and benefits logically compared Disadvantages: need detailed, long-term cash forecasts Theoretically correct – measures project’s impact; authors prefer.

7. 7 Internal Rate of Return What rate of return does the project earn? How does it compare to our cost of capital? Definition: IRR is the discount rate that produces an NPV of zero What rate does the project earn on the IO? –(Use calculators, not tables) Criteria: if over the required rate, accept

8. 8 NPV and IRR

9. 9 Problems with IRR Can’t handle later cash outflows NPV assumes all cash flows reinvested at discount rate (required rate of return) IRR assumes cash flows are reinvested at IRR (perhaps unrealistically) Authors believe NPV is better (but industry doesn’t agree)

10. 10 NPV Profile – Page 271 Discount RateProject’s NPV 5%$24,367 10 8,207 130 15 -4,952 20-15,798

11. 11 Summary Technique Measure Accept if Payback periodTimeSooner than Maximum NPVDollars> 0 IRRDisc rate> C of C

12. 12 Capital Rationing Dollar limit placed on capital spending Management sees it can’t profitably do all even if NPV positive and IRR>RR Why: adverse market conditions, lack of qualified managers and intangibles –Related to economy, interest rates, stock prices, credit availability Effect negative but depends on severity

13. 13 Example: $1,000 Limit ProjectCostNPV A$200$280 B 200 260 C 800 560 D 300 90 Projects A and C have highest total NPV within the $1,000 spending limit

14. 14 Capital Rationing

15. 15 Project Rankings Mutually exclusive projects perform same task –Accepting one requires rejection of other Conflicting rankings may occur –One is caused by size disparity –Not responsible for time disparity

16. 16 Size Disparity On your land, you can make a parking lot ($10,000 cost, earns $10,000/yr forever) OR Build building (costs $20 mil sold year later for $24 mil) IRRNPV @15% Parking lot 100% $66,666 Building 20% $869,565 IRR independent of size, NPV better here

17. 17 Methods Used by Companies As shown in Table 9-11, more use IRR (on either primary or secondary basis) than use NPV. Why? With computers, no more difficult to calculate.A rate may be easier to put in perspective than a dollar NPV

18. 18 Capital Budgeting Practices T9-11

19. 19 Major Points Payback emphasizes risk and liquidity NPV shows profitability and dollar benefits IRR indicates safety margin measured by returns Quantitative measures useful but not a substitute for sound judgment –Why are returns so high? What will comp do?