1. Capital Budgeting Techniques: Certainty & Risk
Chapter 9
Capital Budgeting Techniques: Certainty & Risk

2. Learning Goals Calculate, interpret, and evaluate the payback period.
Apply net present value (NPV) and internal rate of return (IRR).
Use net present value profiles to compare NPV and IRR techniques.
Discuss two additional considerations in capital budgeting – recognizing real options and choosing projects under capital rationing.
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3. Learning Goals (cont.)
5. Recognize sensitivity analysis and scenario analysis, decision trees, and simulation as behavioral approaches for dealing with project risk, and the unique risks that multinational companies face.
6. Understand the calculation and practical aspects of risk-adjusted discount rates (RADRs).
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4. Capital Budgeting Techniques
Chapter Problem
Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1.
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5. Capital Budgeting Techniques (cont.)
Table 9.1 Capital Expenditure Data for Bennett Company
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6. Capital Budgeting Techniques (cont.)
Figure 9.1 Bennett Company’s
Projects A and B
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7. Payback Period
The payback method simply measures how long (in years and/or months) it takes to recover the initial investment.
The maximum acceptable payback period is determined by management.
If the payback period is less than the maximum acceptable payback period, accept the project.
If the payback period is greater than the maximum acceptable payback period, reject the project.
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8. Pros and Cons of Payback Periods
The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects.
It is simple, intuitive, and considers cash flows rather than accounting profits.
It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.
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9. Pros and Cons of Payback Periods (cont.)
One major weakness of the payback method is that the appropriate payback period is a subjectively determined number.
It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value.
Thus, payback fails to fully consider the time value of money.
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10. Pros and Cons of Payback Periods (cont.)
Table 9.2 Relevant Cash Flows and Payback Periods for DeYarman Enterprises’ Projects
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11. Pros and Cons of Payback Periods (cont.)
Table 9.3 Calculation of the Payback Period for Rashid Company’s Two Alternative Investment Projects
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12. Net Present Value (NPV)
Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.
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13. Net Present Value (NPV) (cont.)
Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
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14. Net Present Value (NPV) (cont.)
Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 9.2
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15. Net Present Value (NPV) (cont.)
Figure 9.2 Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives
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16. Net Present Value (NPV) (cont.)
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17. Net Present Value (NPV) (cont.)
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18. Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows.
The IRR is the project’s intrinsic rate of return.
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19. Internal Rate of Return (IRR) (cont.)
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows.
The IRR is the project’s intrinsic rate of return.
Decision Criteria
If IRR > cost of capital, accept the project
If IRR < cost of capital, reject the project
If IRR = cost of capital, technically indifferent
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20. Figure 9.3 Calculation of IRRs for Bennett Company’s Capital Expenditure Alternatives
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21. Internal Rate of Return (IRR) (cont.)
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22. Net Present Value Profiles
NPV Profiles are graphs that depict project NPVs for various discount rates and provide an excellent means of making comparisons between projects.
To prepare NPV profiles for Bennett Company’s projects A and B, the first step is to develop a number of discount rate-NPV coordinates and then graph them as shown in the following table and figure.
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23. Net Present Value Profiles (cont.)
Table 9.4 Discount Rate–NPV Coordinates for Projects A and B
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24. Net Present Value Profiles (cont.)
Figure 9.4 NPV Profiles
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25. Conflicting Rankings
Conflicting rankings between two or more projects using NPV and IRR sometimes occurs because of differences in the timing and magnitude of cash flows.
This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project.
NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.
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26. Conflicting Rankings (cont.)
Bennett Company’s projects A and B were found to have conflicting rankings at the firm’s 10% cost of capital as depicted in Figure If we review the project’s cash inflow pattern as presented in Table 9.1 and Figure 9.1, we see that although the projects require similar investments, they have dissimilar cash flow patterns. Table 9.5 on the following slide indicates that project B, which has higher early-year cash inflows than project A, would be preferred over project A at higher discount rates.
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27. Conflicting Rankings (cont.)
Table 9.5 Preferences Associated with Extreme Discount Rates and Dissimilar Cash Inflow Patterns
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28. Which Approach is Better?
On a purely theoretical basis, NPV is the better approach because:
NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR,
Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR.
Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return.
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29. Recognizing Real Options
Real options are opportunities that are embedded in capital projects that enable managers to alter their cash flows and risk in a way that affects project acceptability (NPV).
Real options are also sometimes referred to as strategic options.
Some of the more common types of real options are described in the table on the following slide.
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30. Recognizing Real Options (cont.)
Table 9.6 Major Types of Real Options
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31. Recognizing Real Options (cont.)
NPVstrategic = NPVtraditional + Value of Real Options
Assume that a strategic analysis of Bennett Company’s projects A and B (see Table 10.1) finds no real options embedded in Project A but two real options embedded in B:
During it’s first two years, B would have downtime that results in unused production capacity that could be used to perform contract manufacturing;
Project B’s computerized control system could control two other machines, thereby reducing labor costs.
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32. Recognizing Real Options (cont.)
Bennett’s management estimated the NPV of the contract manufacturing option to be $1,500 and the NPV of the computer control sharing option to be $2,000. Furthermore, they felt there was a 60% chance that the contract manufacturing option would be exercised and a 30% chance that the computer control sharing option would be exercised.
Value of Real Options for B = (60% x $1,500) + (30% x $2,000)
$900 + $600 = $1,500
NPVstrategic = $10,924 + $1,500 = $12,424
NPVA = $12,424; NPVB = $11,071; Now choose A over B.
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33. Capital Rationing
Firm’s often operate under conditions of capital rationing—they have more acceptable independent projects than they can fund.
In theory, capital rationing should not exist—firms should accept all projects that have positive NPVs.
However, research has found that management internally imposes capital expenditure constraints to avoid what it deems to be “excessive” levels of new financing, particularly debt.
Thus, the objective of capital rationing is to select the group of projects within the firm’s budget that provides the highest overall NPV or IRR.
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34. Capital Rationing
Tate Company, a fast growing plastics company with a cost of capital of 10%, is confronted with six projects competing for its fixed budget of $250,000. The initial investment and IRR for each project are shown below:
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35. Capital Rationing: IRR Approach
Figure 9.5 Investment Opportunities Schedule
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36. Capital Rationing: NPV Approach
Table 9.7 Rankings for Tate Company Projects
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37. Introduction to Risk in Capital Budgeting
Thus far in our exploration of capital budgeting, all projects were assumed to be equally risky.
The acceptance of any project would not alter the firm’s overall risk.
In actuality, these situations are rare—project cash flows typically have different levels of risk and the acceptance of a project does affect the firm’s overall risk.
This chapter will focus on how to handle risk.
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38. Behavioral Approaches for Dealing with Risk
In the context of the capital budgeting projects discussed in this chapter, risk results almost entirely from the uncertainty about future cash inflows, because the initial cash outflow is generally known.
These risks result from a variety of factors including uncertainty about future revenues, expenditures and taxes.
Therefore, to asses the risk of a potential project, the analyst needs to evaluate the riskiness of the cash inflows.
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39. Behavioral Approaches for Dealing with Risk: Scenario Analysis
Scenario analysis is a behavioral approach similar to sensitivity analysis but is broader in scope.
This method evaluates the impact on the firm’s return of simultaneous changes in a number of variables, such as cash inflows, outflows, and the cost of capital.
NPV is then calculated under each different set of variable assumptions.
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40. Behavioral Approaches for Dealing with Risk: Scenario Analsis
Treadwell Tire, a tire retailer with a 10% cost of capital, is considering investing in either of two mutually exclusive projects, A and B. Each requires a $10,000 initial investment, and both are expected to provide equal annual cash inflows over their 15-year lives. For either project to be acceptable, NPV must be greater than zero. We can solve for CF using the following:
The risk of Treadwell Tire Company’s investments can be evaluated using scenario analysis as shown in Table 9.8 on the following slide. For this example, assume that the financial manager made pessimistic, most likely, and optimistic estimates of the cash inflows for each project.
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41. Behavioral Approaches for Dealing with Risk: Risk and Cash Inflows (cont.)
Table 9.8 Scenario Analysis of Treadwell’s
Projects A and B
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42. Behavioral Approaches for Dealing with Risk: Decision Trees
Figure Decision Tree for NPV
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43. Behavioral Approaches for Dealing with Risk: Simulation
Simulation is a statistically-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.
Figure 9.7 presents a flowchart of the simulation of the NPV of a project.
The use of computers has made the use of simulation economically feasible, and the resulting output provides an excellent basis for decision-making.
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44. Behavioral Approaches for Dealing with Risk: Decision Trees
Figure 9.7 NPV Simulation
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45. International Risk Considerations
Exchange rate risk is the risk that an unexpected change in the exchange rate will reduce NPV of a project’s cash flows.
In the short term, much of this risk can be hedged by using financial instruments such as foreign currency futures and options.
Long-term exchange rate risk can best be minimized by financing the project in whole or in part in the local currency.
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46. International Risk Considerations (cont.)
Political risk is much harder to protect against once a project is implemented.
A foreign government can block repatriation of profits and even seize the firm’s assets.
Accounting for these risks can be accomplished by adjusting the rate used to discount cash flows—or better—by adjusting the project’s cash flows.
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47. International Risk Considerations (cont.)
Since a great deal of cross-border trade among MNCs takes place between subsidiaries, it is also important to determine the net incremental impact of a project’s cash flows overall.
As a result, it is important to approach international capital projects from a strategic viewpoint rather than from a strictly financial perspective.
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48. Risk-Adjusted Discount Rates
Risk-adjusted discount rates are rates of return that must be earned on given projects to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s share price.
The higher the risk of a project, the higher the RADR—and thus the lower a project’s NPV.
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49. Risk-Adjusted Discount Rates: Review of CAPM
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50. Risk-Adjusted Discount Rates: Applying RADRs
Bennett Company wishes to apply the Risk-Adjusted Discount Rate (RADR) approach to determine whether to implement Project A or B. In addition to the data presented earlier, Bennett’s management assigned a “risk index” of 1.6 to project A and 1.0 to project B as indicated in the following table. The required rates of return associated with these indexes are then applied as the discount rates to the two projects to determine NPV.
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51. Risk-Adjusted Discount Rates: Applying RADRs (cont.)
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52. Risk-Adjusted Discount Rates: Applying RADRs (cont.)
Figure 9.8 Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives Using RADRs
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53. Risk-Adjusted Discount Rates: Applying RADRs (cont.)
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54. Risk-Adjusted Discount Rates: Applying RADRs (cont.)
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55. Risk-Adjusted Discount Rates: RADRs in Practice
Table 9.9 Bennett Company’s Risk Classes and RADRs
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56. Table Summary of Key Formulas/Definitions and Decision Criteria for Capital Budgeting Techniques
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