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©2012 McGraw-Hill Ryerson Limited 1 of 45 Learning Objectives 1.Define capital budgeting decisions as long-run investment decisions. (LO1) 2.Explain that.

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Presentation on theme: "©2012 McGraw-Hill Ryerson Limited 1 of 45 Learning Objectives 1.Define capital budgeting decisions as long-run investment decisions. (LO1) 2.Explain that."— Presentation transcript:

1 ©2012 McGraw-Hill Ryerson Limited 1 of 45 Learning Objectives 1.Define capital budgeting decisions as long-run investment decisions. (LO1) 2.Explain that cash flows rather than accounting earnings are evaluated in the capital budgeting decision. (LO2) 3.Evaluate investments by the average accounting return, the payback period, the internal rate of return, the net present value and the profitability index. (LO3)

2 ©2012 McGraw-Hill Ryerson Limited 2 of 45 5 Methods of Evaluating Investment Proposals Average Accounting Return (AAR) Payback Period (PB) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI) LO3

3 ©2012 McGraw-Hill Ryerson Limited 3 of 45 Average Accounting Return (AAR) AAR = Average Earnings Aftertax Average Book Value of Investment Advantage:Relatively easy to calculate Disadvantages: Uses accounting earnings, not cash flows Ignores the timing of the earnings Uses book value, not market value of investment Does not suggest an objective evaluation yardstick LO3

4 ©2012 McGraw-Hill Ryerson Limited 4 of 45 Payback Period  computes the amount of time required to recoup the initial investment  a cutoff period is arbitrarily established Advantages: –easy to use (“quick and dirty” approach) –emphasizes liquidity –one measure of the risk of an investment Disadvantages: –ignores inflows after the cutoff period and –fails to consider the time value of money –does not have an objective yardstick –not a good measures of risk LO3

5 ©2012 McGraw-Hill Ryerson Limited 5 of 45 Net Present Value Net Present Value (NPV): –the present value of the cash inflows minus the present value of the cash outflows –the future cash flows are discounted back over the life of the investment –the basic discount rate is usually the firm’s cost of capital (WACC) (assuming similar risk) LO3

6 ©2012 McGraw-Hill Ryerson Limited 6 of 45 Internal Rate of Return Yield on an investment or a rate of return Discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits) Discount rate where the cash outflows equal the cash inflows (or NPV = 0) LO3

7 ©2012 McGraw-Hill Ryerson Limited 7 of 45 Profitability Index P.I. = Present value of the inflows Present value of the outflows  an alternative presentation of the NPV method  used to compare investments of different sizes especially in a capital rationing situation LO3

8 ©2012 McGraw-Hill Ryerson Limited 8 of 45 Table 12-3 Investment alternatives Capital Budgeting: An Example LO3

9 ©2012 McGraw-Hill Ryerson Limited 9 of 45 Evaluating These 2 Investments Payback Period : Investment A: $5,000 + $5,000 = $10,000 (2 years) Investment B: $1,500 + $2,000 + $2,500 + $4,000 ( = 0.8 of $5,000) = $10,000 (3.8 years) Net Present Value: Investment A: $5,000 $5,000 $2,000 0 1 2 3 |----------------|-----------------|-------------------| PV = -$10,000 n = 3 %i = 10% Using the NPV function in a financial calculator: CF 0 = -10000; C01 = 5000; F01 = 2; C02 = 2000; F02 = 1; I = 10; Compute NPV = 180.32 LO3

10 ©2012 McGraw-Hill Ryerson Limited 10 of 45 Evaluating These 2 Investments Net Present Value: Investment B: $1,500 $2,000 $2,500 $5,000 $5,000 0 1 2 3 4 5 |---------------|---------------|---------------|----------------|---------------| PV= -$10,000 n = 5 i% = 10 Using the NPV function in a financial calculator: CF 0 = -10000; C01 = 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; I = 10; Compute NPV = 1414.49 LO3

11 ©2012 McGraw-Hill Ryerson Limited 11 of 45 Evaluating These 2 Investments Internal Rate of Return: Investment A: Investment B: Profitability Index: Investment A: PI = $10,180/$10,000 = 1.0180 Investment B: PI = $11,414/$10,000 = 1.1414 Using the IRR function in a financial calculator: CF 0 = -10000; C01 = 5000; F01 = 2; C02 = 2000; F02 = 1; Compute IRR = 11.16(%) Using the IRR function in a financial calculator: CF 0 = -10000; C01 = 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; Compute IRR = 14.33 (%) LO3

12 ©2012 McGraw-Hill Ryerson Limited 12 of 45 Table 12-4 Capital budgeting results LO3 Investment A Investment BSelection Payback period2 years3.8 yearsQuickest payback: investment A Net present value$180$1,414Highest net present value: investment B Internal rate of return 11.16%14.33%Highest yield: investment B Profitability Index1.01801.1414Highest relative profitability: investment B

13 ©2012 McGraw-Hill Ryerson Limited 13 of 45 Accept/Reject Decision Payback Method (PB): – if PB period < cutoff period, accept the project – if PB period > cutoff period, reject the project Internal Rate of Return (IRR): – if IRR > cost of capital, accept the project – if IRR < cost of capital, reject the project Net Present Value (NPV): – if NPV > 0, accept the project – if NPV < 0, reject the project Profitability Index (PI): – if PI > 1, accept the project – if PI < 1, reject the project LO3

14 ©2012 McGraw-Hill Ryerson Limited 14 of 45 Comparing Methods PI is a variation of NPV method. IRR and NPV methods are superior to PB and AAR methods, because – IRR and NPV evaluate all the resultant cash flows – they employ the time value of money – they have an objective yardstick – the cost of capital IRR method has some flaws: – inconsistency with NPV for some mutually exclusive projects – discounting considerations – multiple IRRs NPV is the best methodology. LO3

15 ©2012 McGraw-Hill Ryerson Limited 15 of 45 Modified Internal Rate of Return The reinvestment assumption of the IRR method may be unrealistic. To remedy this flaw, the more realistic reinvestment assumption of the NPV method is combined with the IRR method, producing the modified internal rate of return (MIRR). MIRR is the discount rate that will equate the initial investment with the future value of inflows. Each of these inflows grows at the cost of capital. LO3

16 ©2012 McGraw-Hill Ryerson Limited 16 of 45 Modified Internal Rate of Return Cost of capital = 10% $6,000 FV = $7,260 $5,000 FV = $5,500 $2,850 FV = $2,850 0 1 2 3 FV = $15,610 PV = -$10,000 Using the PV function in a financial calculator N = 3; PV = -10000; PMT = 0; FV = $15,610; Compute I/Y = 16(%) MIRR = 16% LO3

17 ©2012 McGraw-Hill Ryerson Limited 17 of 45 Table 12-6 Multiple IRRs LO3 Cash Flow@20%@500% 0………………………………………..-1,528 1………………………………………..11,0009,1671,833 2………………………………………..-11,000-7,639-305 NPV…………………………………....00

18 ©2012 McGraw-Hill Ryerson Limited 18 of 45 Capital Rationing A limit or constraint on the amount of funds that can be invested Firm must rank investments based on their NPVs Those with positive NPVs are accepted until all funds are exhausted LO3

19 ©2012 McGraw-Hill Ryerson Limited 19 of 45 Table 12-7 Capital rationing LO3 ProjectInvestment Total Investment Net Present Value CapitalA$2,000,000$400,000 rationingB2,000,000380,000 solutionC1,000,000$5,000,000150,000 D1,000,000100,000 BestE800,0006,800,00040,000 solutionF800,000 (30,000)

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