1. Capital Budgeting Techniques

2. What is Capital Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

3. Project Classifications Independent Projects: Independent Projects: Projects whose cash flows are not affected by decisions made about other projects. Mutually Exclusive Projects: Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted. e.g. buying computers of different brands. Dependent( contingent)projects: e.g. buying a new machine may force to extend the construction 3

4. Project Evaluation: Alternative Methods – Payback Period (PBP) – Net Present Value (NPV) – Internal Rate of Return (IRR) – Profitability Index (PI) – Payback Period (PBP) – Net Present Value (NPV) – Internal Rate of Return (IRR) – Profitability Index (PI)

5. 5 Net Cash Flows for Project S and Project L 1,500 1,200 800 300 400 900 1,300 1,500 ^ Net CashFlows, CF t r edpAExctefte-Tax Year(T)ProjectSPro tL 0 a $(3,000)$( 0) 1 2 3 4

6. What is the Payback Period? 6 The length of time before the original cost of an investment is recovered from the expected cash flows or... How long it takes to get our money back.

7. Payback Period for Project S 7 = Payback S 2 + 300/800 = 2.375 years Net Cash Flow Cumulative Net CF 1,500 -1,500 800 500 1,200 -300 -3,000 300 800 PB S 01234

8. Payback Period for Project L 8 = Payback L 3 + 400/1,500 = 3.3 years Net Cash Flow Cumulative Net CF 400 - 2,600 1,300 - 400 900 - 1,700 - 3,000 1,500 1,100 PB L 01234

9. Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. 9 CF 1 CF 2 CF n (1+k) 1 (1+k) 2 (1+k) n +... ++ ICO - ICO NPV =

10. Proposed Project Data Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000. 10

11. NPV Solution Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. 11 $10,000 $7,000 $10,000 $12,000 $15,000 (1.13) 1 (1.13) 2 (1.13) 3 ++ + $40,000 - $40,000 (1.13) 4 (1.13) 5 NPV NPV = +

12. NPV Solution NPV $40,000 NPV = $10,000(PVIF 13%,1 ) + $12,000(PVIF 13%,2 ) + $15,000(PVIF 13%,3 ) + $10,000(PVIF 13%,4 ) + $ 7,000(PVIF 13%,5 ) - $40,000 NPV $40,000 NPV = $10,000(.885) + $12,000(.783) + $15,000(.693) + $10,000(.613) + $ 7,000(.543) - $40,000 NPV $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000 $1,428 =- $1,428 12

13. NPV Acceptance Criterion Reject NPV0 No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted? 13

14. Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. CF 1 CF 2 CF n (1+IRR) 1 (1+IRR) 2 (1+IRR) n +... ++ ICO =

15. $15,000 $10,000 $7,000 IRR Solution $10,000 $12,000 (1+IRR) 1 (1+IRR) 2 Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000. ++ ++ $40,000 = (1+IRR) 3 (1+IRR) 4 (1+IRR) 5

16. IRR Solution (Try 10%) $40,000 $40,000 = $10,000(PVIF 10%,1 ) + $12,000(PVIF 10%,2 ) + $15,000(PVIF 10%,3 ) + $10,000(PVIF 10%,4 ) + $ 7,000(PVIF 10%,5 ) $40,000 $40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) + $ 7,000(.621) $40,000 $41,444[Rate is too low!!] $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 =$41,444[Rate is too low!!]

17. IRR Solution (Try 15%) $40,000 $40,000 = $10,000(PVIF 15%,1 ) + $12,000(PVIF 15%,2 ) + $15,000(PVIF 15%,3 ) + $10,000(PVIF 15%,4 ) + $ 7,000(PVIF 15%,5 ) $40,000 $40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) + $10,000(.572) + $ 7,000(.497) $40,000 $36,841[Rate is too high!!] $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 =$36,841[Rate is too high!!]

18. IRR Solution (Try 15%) NPV at Lower Rate (10%) NPV at Lower Rate (10%) NPV = PV - ICO NPV = PV - ICO NPV = $ 41,444 - $ 40,000 = $ 1,444 NPV = $ 41,444 - $ 40,000 = $ 1,444 NPV at Higher Rate (15%) NPV = PV - ICO NPV = PV - ICO NPV = $ 36,881 - $ 40,000 = $ - 3159 NPV = $ 36,881 - $ 40,000 = $ - 3159

19. IRR Solution IRR= LR + NPv L X (HR – LR) NPV L – NPv H 19

20. IRR Solution IRR= 10 + 1444 x (15 – 10) 1444 – (-3159) IRR= 10 + 1444 x 5 4603 IRR= 10 + 0.3137 x 5 IRR= 10+ 1.57 = 11.57% 20

21. PI = PV / ICO Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow.

22. PI Acceptance Criterion PI Reject PI 1.00 No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI < 1.00 ] PI PI = $38,572 / $40,000 =.9643 Should this project be accepted?

23. Assignment Calculate NPV,PBP,IRR and PI for the following projects. Which project should be selected.(discount rate =13%)

24. YearsProject AProject B 0$ 28,000$ 20,000 180005000 280005000 380006000 480006000 580007000 680007000 780007000