1. Chapter 10: The Basics Of Capital Budgeting

2. 2 The Basics Of Capital Budgeting :

3. 3 Chapter Outline:  Introduction.  Capital Budgeting Decision Rules:  Payback Period.  Discounted payback Period.  Net Present Value (NPV).  Internal Rate of Return (IRR).  Profitability Index (PI).

4. 4 Capital Budgeting:  The process of planning expenditures on assets whose cash flows are expected to extend beyond one year.

5. 5 Capital Budgeting:  Analysis of potential additions to fixed assets.  Long-term decisions; involve large expenditures.  Very important to firm’s future.

6. 6 Steps to Capital Budgeting: 1. Estimate Cash Flow (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine the appropriate cost of capital. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.

7. 7 Payback Period:  The number of years required to recover a project’s cost, or “How long does it take to get our money back?”

8. 8 Calculating Payback: Payback L = 2 + / = 2.375 years CF t -100 10 60 100 Cumulative -100 -90 0 50 012 3 = 2.4 3080 -30 Project L Payback S = 1 + / = 1.6 years CF t -100 70 100 20 Cumulative -100 0 20 40 012 3 = 1.6 3050 -30 Project S

9. 9 Example :  Initial investment is $5,000  Positive cash flow each year  Year 1 -- $1,500  Year 2 -- $2,500  Year 3 -- $3,000  Year 4 -- $4,500  Year 5 -- $5,500  Payback in 2 and 1/3 rd years…ignore years 4 and 5 cash flows

10. 10 Strengths and Weaknesses of Payback:  Strengths  Easy to calculate and understand.  Initial cash flows most important  Good for small dollar investments  Weaknesses  Ignores the time value of money.  Ignores CFs occurring after the payback period.

11. 11 Discounted Payback Period:  Attempt to correct one flaw of Payback Period…time value of money  Discount cash flow to present and see if the discount cash flow are sufficient to cover initial cost within cutoff time period  Careful in consistency  Discounting means cash flow at end of period  Appropriate discount rate for cash flow

12. 12 Discounted payback period:  Uses discounted cash flows rather than raw CFs. Disc Payback L = 2 + / = 2.7 years CF t -100 10 60 80 Cumulative -100 -90.91 18.79 012 3 = 2.7 60.11 -41.32 PV of CF t -100 9.09 49.59 41.3260.11 10%

13. 13 Net Present Value (NPV):  Correction to discounted cash flow  Includes all cash flow in decision  Changes decision (go vs. no-go) to dollars, not arbitrary cutoff period  Need all cash flow  Need appropriate discount rate

14. 14 Net Present Value (NPV):  NPV = PV of inflows minus Cost = Net gain in wealth.  Acceptance of a project with a NPV > 0 will add value to the firm.  Decision Rule:  Accept if NPV >0,  Reject if NPV < 0

15. 15 Net Present Value (NPV):  Sum of the PVs of all cash inflows and outflows of a project:

16. 16 Net Present Value (NPV):  Sum of the PVs of all cash inflows and outflows of a project:

17. 17 Calculating the NPV: Year CF t PV of CF t 0-100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPV L = $18.79 NPV S = $19.98

18. 18 Net Present Value (NPV):  The Decision Model  Incorporates risk and return  Incorporates time value of money  Incorporates all cash flow

19. 19 NPV Profile and Shareholder Wealth:

20. 20 Internal Rate of Return (IRR):  Model closely resembles NPV but…  Finding the discount rate (Internal Rate) that implies an NPV of zero  Internal rate used to accept or reject project  If IRR > Cost of Capital, accept  If IRR < Cost of Capital, reject  Very popular model as “managers” like the single return variable when evaluating projects

21. 21 Internal Rate of Return (IRR):

22. 22 Calculating the IRR:

23. 23 Comparing the NPV and IRR methods:  If projects are independent, the two methods always lead to the same accept/reject decisions.  If projects are mutually exclusive …  If k > crossover point, the two methods lead to the same decision and there is no conflict.  If k < crossover point, the two methods lead to different accept/reject decisions.

24. 24 Profitability Index (PI):  Close to NPV as we calculate present value of future positive cash flows (present value of benefits) and initial cash flow (present value of costs)  PI = (NPV + Initial cost) / Initial Cost  Answer is modified return  Choosing between two different projects?  Higher PI is best choice…  Careful, cannot scale projects up and down

25. 25 Profitability Index (PI):  Modified version of NPV  Decision Criteria  PI > 1.0, accept project  PI < 1.0, reject project

26. 26 Methods to generate, review, analyze, select, and implement long-term investment proposals:  Payback Period  Discounted payback period  Net Present Value (NPV)  Internal rate of return (IRR)  Profitability index (PI) Capital Budgeting:

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