Practical financial managment 7e LASHER chapter 10

Chapter 10 - Capital Budgeting


Capital Budgeting
A major part of the financial management of the firm
Kinds Of Spending In Business
Short term - to support day to day operations
Long term - to support long lived equipment and projects

Long term money and the things acquired with it are both called capital

Capital Budgeting
Planning and Justifying How Capital Dollars Are Spent On Long
Term Projects

Provides methods for evaluating whether projects make financial
sense and for choosing among them


Capital Budgeting
Capital budgeting involves planning and
justifying large expenditures on longterm projects
– Projects can be classified as:
Replacement

– low risk

Expansion

– moderate risk

New venture – high risk

3


Characteristics of Business Projects
Project Types and Risk
– Capital projects have increasing risk according to
whether they are replacements, expansions or new
ventures
Stand-Alone and Mutually Exclusive Projects
– Stand-alone project has no competing alternatives
– Mutually exclusive projects involve selecting one
project from among two or more alternatives

4


Characteristics of Business Projects
Project Cash Flows
– Reduce projects to a series of cash flows:
C0 $(50,000)
C1

(10,000)

C2

15,000

C3

15,000

C4

15,000

C5

5,000

– Business projects: early cash outflows and later inflows
– C0 is the Initial Outlay and usually required to get started
5


Characteristics of Business Projects
The Cost of Capital
– The average rate a firm pays investors for
use of its long term money
Firms raise money from two sources: debt and
equity

6


Capital Budgeting Techniques
Payback Period
– How many years to recover initial cost

Net Present Value
– Present value of inflows less outflows
Internal Rate of Return
– Project’s return on investment
Profitability Index
– Ratio of present value of inflows to outflows
7


Capital Budgeting Techniques
Payback
Payback period is the time it takes to recover early cash
outflows
– Shorter paybacks are better
Payback Decision Rules
– Stand-alone projects
– Mutually Exclusive Projects
Weaknesses of the Payback Method
– Ignores time value of money
– Ignores cash flows after payback period
8


Concept Connection Example 10-1
Payback Period
Payback period is easily visualized by the cumulative cash flows

9

Example 10-2: Weakness of the
Payback Technique
Use the payback period technique to choose between mutually
exclusive projects A and B.

Project A’s payback is 3 years as its initial outlay is fully recovered
in that time. Project B doesn’t fully recover until sometime in the
4th year. Thus, according to the payback method, Project A is
better than B. But project B is clearly better because of the large
inflows in the last two years
10


NET PRESENT VALUE (NPV)
The present value of future cash flows is what counts
when making decisions based on value.
The Net Present Value of all of a project's cash flows is its expected contribution
to the firm's value and shareholder wealth
PVs are taken at k, the cost of capital

NPV = C0 +

C

1 +

C

2

(1+ k ) (1+k )2

+... +

Cn

(1+ k )n

Calculate NPV using
NPV = C0 + C1[PVFk,1] + C2[PVFk,2] + · · · + Cn[PVFk,n]
Outflows are Ci with negative values and tend to occur first
NPV: Difference between the present values of positives and negatives
Projects with positive NPVs increase the firm’s value
Projects with negative NPVs decrease the firm’s value


Net Present Value (NPV)
NPV and Shareholder Wealth
– A project’s NPV is the net effect that it is
expected to have on the firm’s value
– To maximize shareholder wealth, select the
capital spending program with the highest
NPV

12


Net Present Value (NPV)
Decision Rules
– Stand-alone Projects

NPV > 0 ⇒ accept
NPV < 0 ⇒ reject

– Mutually Exclusive Projects
NPVA > NPVB ⇒ choose Project A over B
13


Concept Connection Example 10-3
Net Present Value (NPV)
Project Alpha has the following cash flows.
If the firm considering Alpha has a cost of
capital of 12%, should the project be
undertaken?

14


Concept Connection Example 10-3
Net Present Value (NPV)
The NPV is found by summing the present value of the
cash flows when discounted at the firm’s cost of capital.
NPVAlpha = 5,000 + (11,.000
+ 2 , 000 + 3, 000
12 ) 1 ( 1.12 ) 2 ( 1.12 ) 3
= $5,000 + $1,000(.8929) + $2,000(.7972) + $3,000(.7118 )
= $5,000 + $829.90 + $1,594.40 + $2135.40
= $5,000 + $4,622.70
= ($377.30)

Since Alpha’s
NPV<0, it should
not be
undertaken.
15


Internal Rate of Return (IRR)
A project’s IRR is the return it generates on the investment of its
cash outflows
– For example, if a project has the following cash flows

The “price” of receiving
the inflows

The IRR is the interest rate at which the present value of the three
inflows just equals the $5,000 outflow

16


Defining IRR Through the NPV Equation
At the IRR the PVs of project inflows and
outflows are equal, so NPV = 0
NPV = C0 +

C

1 +

C

2

(1+ k ) (1+ k )2

+ ... +

Cn

(1+ k )n

Set NPV=0 and substitute IRR for k

0 = C0 +

C1

(1 + IRR )

+

C2
(1 + IRR )

2

+ ...+

Cn

(1 + IRR )n

0 = C0 + C1[PVFIRR,1] + C2[PVFIRR,2] + · · + Cn[PVFIRR,n]
IRR is the solution to this equation for a given set of C i
Requires an iterative approach if the Ci are irregular


Internal Rate of Return (IRR)
Decision Rules
– Stand-alone Projects
If IRR > cost of capital (k) ⇒ accept
If IRR < cost of capital (k) ⇒ reject

– Mutually Exclusive Projects
IRRA > IRRB ⇒ choose Project A over Project B
18


Internal Rate of Return (IRR)
Calculating IRRs
– Finding IRRs usually requires an iterative, trialand-error technique
Guess at the project’s IRR
Calculate the project’s NPV using this interest rate
– If NPV = zero, guessed interest rate is the project’s IRR
– If NPV > 0, try a higher interest rate
– If NPV < 0, try a lower interest rate

19

Concept Connection Example 10-5
IRR – Iterative Procedure
Find the IRR for the following series of cash
flows:

If the firm’s cost of capital is 8%, is the project
a good idea? What if the cost of capital is 10%?

20


Example 10-5
IRR – Iterative Procedure
Start by guessing IRR = 12% and calculate NPV.
NPV = C0 + C1[PVFk,1] + C2[PVFk,2] + · · · + Cn[PVFk,n]
NPV = -5,000 + 1,000[PVF12,1] + 2,000[PVF12,2] +
3,000[PVF12,3]
NPV = -5,000 + 1,000[.8929] + 2,000[.7972] + 3,000[.7118]
NPV = -5,000 + 892.90 + 1,594.4 + 2,135.40
NPV = -$377.30
Since NPV<0,
the project’s IRR
must be < 12%.

21


Figure 10-1 NPV Profile
A project’s NPV profile is a graph of its NPV vs. the cost
of capital. It crosses the horizontal axis at the IRR.

22


Concept Connection Example 10-5
IRR – Iterative Procedure
We’ll try a different, lower interest rate, say 10%. At 10%, the project’s
NPV is ($184). Since the NPV is still less than zero, we need to try a still
lower interest rate, say 9%. The following table lists the project’s NPV at
different interest rates.
Interest Rate
Guess

Calculated
NPV

12%

($377)

10

($184)

9

($83)

8

$22

7

$130

Since NPV becomes positive
somewhere between 8% and
9%, the project’s IRR must be
between 8% and 9%. If the
firm’s cost of capital is 8%, the
project is marginal. If the
firm’s cost of capital is 10%,
the project is not a good idea.

23


Techniques: Internal Rate of Return
(IRR)
Technical Problems with IRR
– Multiple Solutions
Unusual projects can have more than one IRR
The number of positive IRRs to a project depends
on the number of sign reversals to the project’s
cash flows

– The Reinvestment Assumption
IRR method implicitly assumes cash inflows will be
reinvested at the project’s IRR

24


Comparing IRR and NPV
NPV and IRR do not always select the same project in
mutually exclusive decisions
A conflict can arise if NPV profiles cross in the first
quadrant
In the event of a conflict The selection of the NPV
method is preferred

25