Post on 15-Dec-2015
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FINANCE 7311FINANCE 7311
CAPITAL BUDETING
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OutlineOutline
Projects
Investment Criteria
NPV v. IRR
Sources of NPV
Project Cash Flow Checklist
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ProjectsProjectsA project is any potential real investment
opportunityDistinguish real from financial
Mutually Exclusive - can do only oneIndependent - decision about one does not
affect decision w/r/t the others
Replacement - special case
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Investment CriteriaInvestment Criteria
Investment criteria are the rules by which we decide whether or not to accept a particular project; consider the following:
Year Project A Project B
0 (10,000) (10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
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Accounting Rate of ReturnAccounting Rate of Return
ARR = Avg. Income / Avg. Investment
Uses Income rather than Cash Flow
Ignores Time Value of Money
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PaybackPayback
Years needed to recover initial investment
To Find: Calculate where cumulative cash flows become positive
Project A: 2 1/6 yearsProject B: 2 6/7 years
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Problems with PaybackProblems with Payback
Ignores Time Value of MoneyCan use Discounted Payback; Why?
Ignores CF’s after paybackTo see: Assume Project B’s cash flow in
year 4 is 1,000,000; how does this affect payback
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Net Present ValueNet Present Value
This rule is always consistent with maximizing the value of the firm
Economically, take all projects for which benefits > costs (in PV dollars)
Mathematically, sum the present values of all the cash flows
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Net Present ValueNet Present Value
CFR
CFn
ii
iNPV0
1 )1(
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NPV exampleNPV exampleYear Project A Project B
0 (10,000) (10,000)
1 5,804 3.125
2 2,392 2.790
3 2,135 2,491
4 636 2,224
967 630
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRR - That rate which causes NPV to = 0.
0 iCFi
(1IRR)i1
n
0CF
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IRRIRR
Independent Projects - select all projects for which IRR > Cost of Capital
Mutually Exclusive - select project with highest IRR
Use ‘well-designed’ spreadsheet
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Comparison of NPV & IRRComparison of NPV & IRR
Business people are accustomed to thinking in rates of return, so does it matter which of NPV or IRR we use?
Independent - the two rules are equivalent
NPV > 0 <==> IRR > Cost of Capital
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Comparison of NPV & IRRComparison of NPV & IRR
Mutually Exclusive Projects - can get different answers
NPV Profile for Example
Reinvestment Assumption
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NPV v. IRR ExampleNPV v. IRR Example
Project 1: (100,000) 125,000Project 2: 1,000 2,000
NPV IRRProject 1 13,636 25%Project 2 818 100%
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NPV v. IRR, cont.NPV v. IRR, cont.
IRR ==> Do Project 2NPV ==> Do Project 1
Problem: Reinvestment AssumptionWhat are you going to do with the other
$99,000?
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Profitability IndexProfitability IndexPV Cash Inflows / PV Cash OutflowsIndependent: Choose all with PI > 1Mutually Exclusive: Choose highest PI
Project 1: 1.136 Project 2: 1.818
May be useful for capital rationing
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Other Real OptionsOther Real Options
Option to ExpandOption to AbandonStrategic Options
Excluding biases NPV downDecision Tree: Capital Budgeting should be
dynamic, not static
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Source of NPVSource of NPV
Market Opportunities - ‘deviations from equilibrium’
Economies of Scale Cost Advantages Product differentiation Distribution Advantage Regulatory Protection
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Relevant Cash FlowsRelevant Cash Flows
We can always write: EBIT + Depreciation - Taxes (t x EBIT) = Operating Cash Flow - ∆ NWC - Capital Spending = FCF
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Cash FlowsCash Flows
1. Focus on Cash Flows; not accounting #’s Depreciation Not a cash flow Affects Cash Flow through depreciation Capital spending Capitalized for accounting purposes Cash outflow for finance purposes
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Project Cash FlowsProject Cash Flows
2 Focus on Incremental Cash Flows “What is different if project is accepted?”
Sunk Costs - those costs which have been incurred and are not affected by project decision
Opportunity Cost - highest value use of an asset if not used in project
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Project CF’s, cont.Project CF’s, cont.3 Externalities - less obvious costs/benefits
which should be included in analysis
4 Change in NWC - often a cash outflow initially and cash inflow at end
5 Cash flows should be after tax ∆Rev/Exp x (1-t) Depreciation x t6 Do not include interest as a cash flow
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Project CF’s, cont.Project CF’s, cont. Replacement problem - should you keep an
existing asset, or replace it with a new one
∆ in Cash Flows Net of tax proceeds from disposal of
existing asset