Capital Budgeting Tools. Chapter 11. Capital Budgeting. Types of Capital Budgeting Projects. The Basics of Capital Budgeting: Evaluating Cash Flows

Transcription

1 Capital Budgeting Tools () Payback Period (a) Discounted Payback Period Chapter The Basics of Capital Budgeting: Evaluating s () Net Present Value (NPV) (a) Profitability Index (PI) () Internal Rate of Return (IRR) (a) Modified Internal Rate of Return (MIRR) (4) NPV Profiles Use to evaluate the merits of various Capital Budgeting projects Capital Budgeting Capital Budgeting (def): The budgeting of capital (long-term) expenditures. Entails the evaluation of projects and decision of which projects to accept. Types of Capital Budgeting Projects Types of projects: () replacement: due to normal wear and tear () replacement: to increase efficiency or reduce costs () expansion: enlarge current operations (4) expansion: new operations (5) regulation: for environmental or safety reasons

2 How are we going to evaluate projects? Base it on our risk and return concepts. Does the project give us ample return for its level of risk? Capital Budgeting Example 4 5 Assume a WACC = ra = % (discount rate) s Project A -$k +$5k +$5k +$5k s Project B -$k +$k +$k +$4k +$4k +$8k Payback Period Payback Period for Project A Payback Period (def) The number of years to get back the original investment -$k $5k $5k Cumulative -$k -$5k

3 Payback Period for Project B Payback Period for Project B Cumulative Therefore, Payback for project B is between and 4 years 4 -$k $k $k $4k $4k -$k -$8k -$6k -$k +$k yrs + (amount needed after years) (cash flow year 4) = + ( $k / $4k ) =.5 years Decision Rule for Payback Period Payback Period Advantages: If mutually exclusive (one or the other) choose lowest payback period. If not mutually exclusive (can choose both) then choose according to cutoff (below cutoff). Easy to understand. Emphases liquidity Disadvantages:. Ignores time value of money (TVM). Ignores cash flows after payback. Arbitrary cutoff 4. Biased against long-term projects and projects with R&D

4 Discounted Payback Period Discounted Payback Period To overcome disadvantage # use discounted payback period Project A (r=%) YR CF Disc CF Cuml CF -$ $5 $5 $5 -$. $45.45 $4. $7.57 -$. -$ $. +$4.4 Discounted Payback Period Discounted PaybackA = +./7.57 =.5 years Discounted PaybackB = 4 + 8/5 = 4.6 years Net Present Value (NPV) Definition: NPV is the present value of all future cash flows less the initial investment Based on TVM But, still ignores CFs after payback!!!!!

5 Net Present Value Net Present Value NPV A NPV B = PV(CFs) - Initial Investment = $4,4 - $, = $4,4 = PV(CFs) - Initial Investment = $4,758 - $, = $4,758 Decision Rule: If mutually exclusive (one or the other) choose highest NPV If not mutually exclusive (can choose both) then choose all with (+) NPV Problem with NPV Profitability Index (PI) Problem: () ignores size of initial investment example (r=%) Project C Project D Project C's -$k -$m -$m $k $65k $m $k $65k $m NPV $7,554 $8,99 $75,57 Solve by using Profitability Index PI = PV of cash inflows PV of cash outflows PI C = $7,55 / $, =.755 PI D = $,8,99 / $,, =.8

6 Profitability Index (PI) Decision Rule: If mutually exclusive (one or the other) choose highest PI greater than If not mutually exclusive (can choose both) then choose all with PI greater than Choose C - higher PI Internal Rate of Return (IRR) IRR (def) The discount rate that makes NPV=. Project A: IRR=.8% Project B: IRR=.8% Internal Rate of Return (IRR) Decision Rule: If mutually exclusive (one or the other) choose highest IRR If not mutually exclusive (can choose both) then choose all with IRR > cutoff (required rate of return) BUT, NPV says to choose B and IRR says to choose A NPV-IRR Conflict We get different answers because the magnitude of the cash flows and timing of the cash flows vary between the projects Problem: () IRR can give different decision than NPV due to different magnitude of cash flows or different timing of cash flows (unequal lives), () If sign of CF changes more than once can get multiple IRR's, and () assumes reinvestment rate = IRR Solve magnitude of cash flow problem and multiple IRR problem by using Modified Internal Rate of Return (MIRR) [note: still does not solve for different timing of cash flows]

7 Modified Internal Rate of Return (MIRR) Definition of MIRR The discount rate that makes the future value of all cash inflows equal the present value of all cash outflows. CF -$ $5 $5 $5 MIRR Project A PV of Cash Outflows -$ FV of Cash Inflows $6.5 $55. $5. Total -$ $65.5 MIRR NPV Profiles PV=-, FV=65.5, n=, i=mirr MIRR A = i = 8.9% MIRR B = i = 7.95% The solution to solving this NPV-IRR conflict Example Project C Project D -$k -$m $k $65k $k $65k

8 NPV Profiles Chart NPV at various discount rates:. Find NPV at i = %. Find IRR, the i where NPV = $. Calculate the crossover rate NPV Profiles. NPV C = $, at i = % NPV D = $, at i = %. IRR C = 6.8% IRR D = 9.4% NPV Profiles. Calculate the crossover rate Calculate by taking the difference in Project CFs Example: Project D - Project C CF = -$9k; CF = +$55k; CF = +$55k i = crossover rate = 4.49% Problem Anchor Gaming Inc. is considering the following project. Anchor Gaming has a weighted average cost of capital of 4%. What is the payback period for this project? What is the discounted payback period for this project? What is the net present value (NPV) of this project? What is the profitability index (PI) of the project?

9 Problem Problem Anchor Project 4 -$5,, +$6,8, +$5,, +$4,, +$4,9, Calculate the NPV and IRR of the following cash flows for a project being analyzed by Intel Corp. Intel Corp. has an after-tax cost of debt of 7.5% and a weighted average cost of capital of 4.%. Problem Intel Project -$84,, +$8,, +$7,, +$45,,