Capital Budgeting Capital Budgeting The process by which a business

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1 Capital Budgeting 1 Capital Budgeting The process by which a business chooses which investments to make in capital equipment 2 Capital Investments Money markets: Short term Capital markets: Long term Capital investments: Long term Capital budgeting: Long term 3 1

2 Capital Investments Expensive [ Big ticket ] Difficult to reverse Define the nature of the firm s lines of business for many years [Hopefully] add value to the firm 4 Some capital investments are very routine. Repair and update existing capital equipment Replacement of existing equipment 5 Other capital investments are very strategic. Expansion of existing product lines New: Products Markets Technology 6 2

3 Still other capital projects can be motivated by miscellaneous reasons that may not even be cost effective Regulatory or other mandate Other (parking, aircraft, luxury offices) 7 Summary of Types Renewal: repair and update Replacement Expansion Regulatory & other 8 Capital Budgeting The process of choosing optimal capital investments Those projects that add the most value to a firm Some of the most important decisions a firm can make 9 3

4 Relationship of Capital Investments Independent projects Mutually-exclusive projects Contingent projects 10 Independent Projects Investments whose CFs are unrelated All acceptable investments which are independent will be made, since their CFs are unrelated. Accepting/rejecting one has no bearing on choice of the other. 11 Mutually-Exclusive Projects They all serve the same function, so only one will be chosen. Only the single most attractive of the acceptable investments will be chosen. 12 4

5 Contingent Projects Regardless of how attractive, these investments will only be made if a related project is also accepted. 13 Capital-Budgeting Tools Payback period Net present value (NPV NPV) Internal RoR (IRR) 14 Payback Period 15 5

6 Payback Period A tool for evaluating projects that calculates the length of time required to recover an investment s costs Payback cutoff point (e.g., 3 years) < cutoff: Accept the proposal > cutoff: Reject the proposal 16 (Payback) = Payback Period Years before full cost recovery + (Remaining unrecovered cost) (Next year s CF) 17 Advantages of Payback Period Easy to understand even even for someone w/ no finance background Useful if liquidity is critical for the company 18 6

7 Disadvantages of Payback Period Does not account for TVM Uses arbitrary cutoff point Ignores CFs beyond cutoff point Biased against L-T projects with delayed benefits 19 Discounted Payback Period Same as simple payback period, except that all CFs are discounted to their PVs. 20 Net Present Value (NPV NPV) 21 7

8 NPV A tool for evaluating projects that calculates the difference between the PVs of all cash inflows and outflows 22 The Steps of NPV Calculate all CFs Determine the discount rate (the required RoR or hurdle rate) Applying the hurdle rate, calculate the NPV. Make a decision 23 Decision Rule w/ NPV If NPV < $0,, reject it. If NPV > $0,, it is attractive. Accept all independent proposals. Accept the most attractive of mutually exclusive. Accept appropriate contingent proposals. 24 8

9 Cash-Flow Registry Use your CF registry!!!!! Although the TVM registry can be used, it is very cumbersome if there are more than 4 or 5 CFs. And, you MUST use the CF registry for most IRR calculations!!!! 25 Internal Rate of Return (IRR IRR) 26 IRR The discount rate that sets the PV of all cash inflows equal to the PV of all cash outflows PV Cash OFs = PV NPV = 0 PV Cash Ifs 27 9

10 Calculating the IRR (Rule 1) If the cash inflows are an annuity,, the TVM registry can be used. (Rule 2) If the CFs are uneven, you must use your CF registry!!!! (Rule 3) If you forget Rule 2: then you must use your CF registry!!!! 28 IRR Decision Rule If IRR < hurdle rate,, the project is unattractive--reject. reject. If IRR > hurdle rate,, the project is attractive. Make the appropriate independent, ME or contingent decision. 29 IRR vs. NPV IRR will usually lead to the same investment decision as does NPV. Always with independent projects 30 10

11 When Do NPV & IRR Differ? Some mutually exclusive projects with unconventional CFs: Very erratic CFs Future CFs w/ both (+) & (-) CFs 31 Conflict Between NPV & IRR If there is conflict, choose the NPV recommendation. The NPV measures the project s contribution to the firm s value

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