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Capital Budgeting Chapter 13
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Capital Budgeting uThe process of planning investments in assets whose cash flows are expected to extend beyond one year
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Importance of Capital Budgeting uLong term impact uTiming uSubstantial expenditures for which funds must be raised (either internally, externally, or both)
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Project Classifications uReplacement decisions F decisions to determine whether to purchase capital assets to take the place of existing assets to maintain existing operations
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Project Classifications uExpansion decisions F decisions to determine whether to purchase capital projects and add them to existing assets to increase existing operations
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uIndependent projects F projects whose cash flows are not affected by the acceptance or rejection of other projects Project Classifications
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uMutually exclusive projects F a set of projects where the acceptance of one project means the others cannot be accepted Project Classifications
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Steps in the Valuation Process u1. Determine the cost, or purchase price, of the asset u2. Estimate the cash flows expected from the asset u3. Evaluate the riskiness of the projected cash flows to determine the appropriate rate of return to use for computing the present value of the estimated cash flows u4. Compute the present value of the expected cash flows u5. Compare the present value of the expected cash inflows with the initial investment, or cost, required to acquire the asset
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Cash Flow Estimation uCash is different from accounting profits uCount cash flows after taxes uOnly incremental cash flows are relevant to the accept/reject decision F the change in a firm’s net cash flow attributable to an investment project
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Problems in Cash Flow Estimation u1. Sunk costs F already incurred and cannot be recovered u2. Opportunity costs F return on the best alternative use of an asset u3. Externalities F the effect accepting a project will have on the cash flows in other areas of the firm
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Problems in Cash Flow Estimation u4. Shipping and Installation F the depreciable basis for an asset includes the purchase price plus shipping and installation u5. Depreciation F depreciation is a non-cash expense affecting taxable income, thus taxes u6. Inflation F expected inflation should be built into the expected cash flows
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Identifying Incremental (Relevant) Cash Flows uCash flows that occur only at the start of the project’s life uCash flows that continue throughout a project’s life uCash flows that occur only at the end, or termination of the project
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^ Identifying Incremental (Relevant) Cash Flows uInitial investment outlay F includes the incremental cash flows associated with a project that occur only at the start of a project’s life, CF 0
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Identifying Incremental (Relevant) Cash Flows uIncremental operating cash flow F changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes of the asset
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Incremental Operating Cash Flow
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Identifying Incremental (Relevant) Cash Flows uTerminal cash flow F the net cash flow that occurs at the end of the life of a project, including the cash flows associated with: v 1. final disposal of the project v 2. returning the firm’s operations to where they were before the project was accepted
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Cash Flow Estimation and the Evaluation Process uExpansion projects F initial investment outlays required F estimate the cash flows once production begins F terminal cash flow
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Cash Flow Estimation and the Evaluation Process uReplacement analysis F must consider cash flow from old asset and new asset in decision F cash flows from the new asset take the place of cash flows from the old asset
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Capital Budgeting Evaluation Techniques u1. Payback u2. Net present value (NPV) u3. Internal rate of return (IRR)
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Payback uPayback period is the length of time before the original cost of an investment is recovered from the expected cash flows
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Net Present Value uNPV is a method of evaluating capital investment proposals by finding the present value of future net cash flows, discounted at the rate of return required by the firm uOne of two discounted cash flow (DCF) techniques using time value of money that we will cover
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Net Present Value
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Discounted Payback uDiscounted payback is the length of time it takes for a project’s discounted cash flows to repay the initial cost of the investment
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Internal Rate of Return uIRR is the discount rate that forces the PV of a project’s expected cash flows to equal its initial cost uSimilar to the YTM on a bond
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Comparison of the NPV and IRR Methods uNPV profile is a graph (curve) showing the relationship between a project’s NPV and various discount rates (required rates of return) uIRR is at the point where the NPV profile crosses the X axis
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NPVs and the Required Rate of Return uCrossover rate F the discount rate at which the NPV profiles of two projects cross and, thus, at which the project’s NPVs are equal
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Independent Projects uNPV and IRR will both lead to the same decision F if a project’s NPV is positive, its IRR will exceed k, while if NPV is negative, k will exceed the IRR
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Mutually Exclusive Projects uIf NPV profiles cross, NPV and IRR decisions may conflict depending on discount rate selected F project size differences F timing differences v reinvestment rate may not match IRR uNPV method is preferred
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Multiple IRRs uA project can have two or more IRRs F unconventional cash flow pattern v large outflow during or at the end of its life F NPV profile is required
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Conclusions on the Capital Budgeting Decision Methods uPayback and discounted payback indicate risk and liquidity of a project uNPV gives a direct measure of the dollar benefit to the shareholders uIRR provides information about a project’s “safety margin” uIRR reinvestment assumption may be unrealistic uWatch out for multiple IRRs
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Incorporating Risk in Capital Budgeting Analysis uStand-alone risk F the risk an asset would have if it were a firm’s only asset F measured by the variability of the asset’s expected returns
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Incorporating Risk in Capital Budgeting Analysis uScenario analysis F a risk analysis technique in which “good” and “bad” sets of financial circumstances are compared with a most likely, or best- case situation
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Incorporating Risk in Capital Budgeting Analysis uWorst-case scenario F an analysis in which all of the input variables are set at their worst reasonably forecasted values
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Incorporating Risk in Capital Budgeting Analysis uBest-case scenario F an analysis in which all of the input variables are set at their best reasonably forecasted values
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Incorporating Risk in Capital Budgeting Analysis uBase case F an analysis in which all of the input variables are set at their most likely values
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Incorporating Risk in Capital Budgeting Analysis uCorporate (within-firm) risk F risk not considering the effects of stockholders’ diversification F measured by a project’s effect on the firm’s earnings variability
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Incorporating Risk in Capital Budgeting Analysis uBeta (market) risk F that part of a project’s risk that cannot be eliminated by diversification F measured by the project’s beta coefficient
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Corporate (Within-Firm) Risk uDiversification (risk reduction) F as long as assets are not perfectly positively correlated some diversification can be achieved F adding projects can help reduce corporate risk
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Beta (or Market) Risk uProject required rate of return, k proj F the risk adjusted required rate of return for an individual project F k proj = k RF + (k M - k RF ) proj
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Beta (or Market) Risk uPure play method F estimating beta of a project using firms whose only business is the product in question to approximate its own project’s beta
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How Project Risk is Considered in Capital Budgeting Decisions uRisk-adjusted discount rate F required rate of return that applies to a particularly risky stream of income F equal to the risk-free rate of interest plus a risk premium appropriate for the level of risk attached to a particular project’s income stream
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Capital Rationing uA situation in which a constraint is placed on the total size of the firm’s capital investment
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Multinational Capital Budgeting uRepatriation of earnings F process of sending cash flows from a foreign subsidiary back to the parent company
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uExchange rate risk F uncertainty associated with the price at which the currency from one country can be converted into the currency of another country Multinational Capital Budgeting
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uPolitical risk F the risk of expropriation of a foreign subsidiary’s assets by the host country, or of unanticipated restrictions on cash flows to the parent company
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End of Chapter 13 Capital Budgeting
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