Topic Four - Capital Budgeting

Topic Four - Capital Budgeting - Topic 4 Capital Budgeting...

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Topic 4: Capital Budgeting Craig Mellare University of Sydney
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This Lecture Nature of capital budgeting Review of the project evaluation techniques Justification of NPV technique Issues in applying NPV technique including which cashflows to discount the impact of taxation the impact of inflation
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Capital Budgeting definition process of deciding on the optimum use of the scarce resources of a corporation Process forecast costs/benefits apply investment evaluation technique make decision on basis of quantitative analysis qualitative factors
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Investment Evaluation Techniques NPV IRR Payback Accounting Rate of Return
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NPV Technique Underlying Assumption take on project if increases ‘wealth of owners’ Consider the following Opportunities: Company invests $100m in project paying $106m Company pays dividend of $100m, which investors can re-invest at 7% Q: What is the optimum decision?
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NPV Technique (cont’d) Definition Net Present Value p =Present Value p -Cost p increase in wealth of owner from taking on project Decision Rule Accept project if NPV > 0 Reject project if NPV < 0
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Example Apply NPV rule to project requiring $100m outlay, returning $106m in 1 year when opportunity cost of capital is 7%. Present Value of project = $106m/(1.07) = $99m Cost of Project = $100m Net Present Value = -$1m => reject project Why Optimum to Reject?
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Strengths of NPV Rule Makes decision which maximises wealth of shareholders takes into account time value of money takes into account all cashflows
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Internal Rate of Return Rule (IRR) Definition rate of return which makes NPV of project 0 Σ (F t )/(1+irr) t - C 0 = 0 implicit rate of return generated by a project taking into account the time value of money Decision Rule Accept Project if irr > Required rate of return
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Example Apply IRR to project requiring $100m outlay, returning $106m in 1 year when opportunity cost of capital is 7%. ($106/(1+irr) - $100= 0 irr = 6% Since IRR < Cost of Capital => reject
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Strengths of IRR Summarises project information into 1 number Simple number, easily understood Most popular method for project evaluation BUT at least 4 pitfalls ...
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Pitfall 1. Solving for IRR with more than 3 cashflows Example Year 0 1 2 3 4 Cashflow $-2 $-1 $2 $-1 $4
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Pitfall 1. Solving for IRR with more than 3 cashflows Example Year 0 1 2 3 4 Cashflow $-2 $-1
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