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Capital Chapter Budgeting Decision Criteria and Risk Analysis
Copyright 2007 Thomson South-Western
Introduction
This
chapter looks at capital budgeting decision models. It discusses and illustrates their relative strengths and weeknesses. It examines the evaluation of the flexibility of the project on the basis of the cash flow estimated
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Chapter Objectives
Know
and apply capital budgeting evaluation methods Know the merits and limitations of the capital budgeting evaluation methods Understand how to account for and evaluate differences in riskiness of projects Understand the effects of inflation
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Firms Cost of Capital
Defined
as the cost of the funds supplied to it known as
Also
Required rate of return Hurdle rate
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How Projects are Classified
Independent
Acceptance or rejection does not directly eliminate other projects
Mutually
exclusive
Acceptance of one project precludes the acceptance of alternative proposals
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Availability of Funds
Funds
constraint - firms have acceptable projects whose total initial cost is greater than the total funds the firm has available to invest in capital projects rationing - setting limits on capital expenditures; results in some special capital budgeting problems
Capital
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Capital Budgeting Criteria
Net
present value ( NPV ) rate of return ( IRR ) index ( PI )
Internal
Profitability
Payback
period ( PB )
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Net Present Value
PV
of the stream of future CFs from a project minus the projects net investment
n NPV = NCF t x PVIF k , t NINV t =1 n NCFt NPV = NINV (w/PVIF tables) t = 1 (1 + k )t
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NPV Decision Rule
A
project should be
Accepted if its net present value is greater than or equal to zero Rejected if its net present value is less than zero
NPV
0 acceptable exclusive investments
Mutually
Select the project with the largest NPV
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Advantages and Disadvantages of the NPV Method
Advantages
Consistent with shareholder wealth maximization Considers both magnitude and timing of cash flows Indicates whether a proposed project will yield the investors required rate of return
Disadvantage
Many people find it difficult to work with a dollar return rather than a percentage return
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NVP Profiles
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IRR
Rate
of discount that equates the PV of net cash flows of a project with the PV of the NINV
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(w/PVIF tables)
IRR
Restated as
The internal rate of return is the discount rate that yields a present value of net cash flows equal to the net investment.
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IRR Decision Rule
A
project whose IRR is greater than or equal to the firms cost of capital should be accepted. A project IRR whose is less than the firms cost of capital should be rejected. IRR k acceptable Mutually exclusive projects
Accept the project with the highest IRR k
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Advantages and Disadvantages
Advantages
People feel more comfortable with IRR Considers both the magnitude and the timing of cash flows
Disadvantage
Multiple internal rates of return with unconventional cash flows
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NPV Versus IRR
Reinvestment
assumption
NPV reinvested at k IRR reinvested at r Can lead to conflicts in ranking of mutually exclusive projects Crossover
NPV
is superior to IRR when choosing among mutually exclusive investments
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NPV v. IRR for Mutually Exclusive Alternatives
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Profitability Index (Benefit-Cost Ratio)
Ratio
of the PV of expected cash flows over the life of the project to the NINV
NCF (1 + k )t t =1 PI = NINV
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n
Profitability Index Decision Rule
1 acceptable Mutually exclusive investments
PI
Conflicts may arise between NPV and PI When alternative projects require significantly different NINVs Final decision based on other factors Capital rationing
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Payback Period
Number
of years for the cumulative net cash flows from a project to equal the initial cash outlay
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Payback Decision Rule
to a specified maximum period Accept
PB
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Advantages and Disadvantages
Advantages
Measure of risk and liquidity Useful for evaluating small projects
Disadvantages
Ignores the time value of money Ignores cash flows after the payback period Objective not consistent with shareholder wealth maximization 22
Adjusting for Risk
When
project risk is significantly different Risk adjusted discount rate Risk classes
Below-average Average Above-average
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Risk Analysis
Sensitivity
Analysis (What-if Analysis)
Critical variables Sensitive analysis Spreadsheets
Simulation
analysis
Probability distribution Interaction among variables Considerable time and effort
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Illustrative Sensitivity Curves
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Illustration of the Simulation Approach
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Illustration of the Simulation Approach
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Illustration of the Simulation Approach
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Real Options in Capital Projects
Investment
timing
Growth
options
option
Evaluate additional information
Abandonment
Research programs, expand a small plant, or strategic acquisition
Design-in
option
Reduce downside risk
options
Input/output flexibility options or expansion options
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Inflation and Capital Budgeting Analysis
Discount
rate or the cost of capital used in evaluating project net cash flows incorporates an inflation premium
not adjusting the cash flows for inflation may lead to incorrect decision.
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