Unformatted text preview: 1 0 ower Point Presentation designed by Dr. Sylvia C. Hudgins for Finance 323 at ODU Capital Budgeting Concepts 2 Capital Budgeting  deciding which projects
Capital
add value to the firm.
add
Basic components of capital budgeting
Basic
decisions.
decisions.
Estimate future expected cash flows
Evaluate project based on evaluation method
Classify Projects
Mutually Exclusive  accept ONE project
Independent  accept ALL profitable projects Capital Budgeting Concepts 3 Cash Flows Initial Cash Outlay  amount of capital spent to get
Initial
project going.
project If spend $10 million to build new plant then the Initial
If
Outlay (IO) = $10 million
Outlay
CF00 = Cash Flow time 0 = 10 million
CF = Cash Flow time 0 = 10 million
Annual Cash Inflows
Cash inflows from the project CFnn = Sales  Costs
CF = Sales Costs 4 Capital Budgeting Methods: Payback Period
How long does it take to get the initial cost
How
back in a nominal sense?
back
Computation
Estimate the cash flows
Subtract the future cash flows from the
initial cost until the initial investment has
been recovered
Decision Rule – Accept if the payback
Decision
period is less than some preset limit
period 5 Capital Budgeting Methods
Payback Period Number of years needed to recover your initial
Number
outlay.
outlay.
Time
0
1
2
3
4 0 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 1 (10,000)
3,500
Cumulative CF 6,500 2 3,500
3,000 3 3,500
+500 4 3,500 Payback = 2 + (3000/3500)= 2.86 years 6 Capital Budgeting Methods
Payback Period Number of years needed to recover your initial
Number
outlay.
outlay.
Time
0
1
2
3
4 0 Evaluation:
Company sets maximum
acceptable payback. If
Max PB = 3 years,
accept project A and
reject project B PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 1 (10,000)
500
Cumulative CF 9,500 2 500
9,000 3 4,600
4,400 Payback = 3 + (4400/10000)=3.44 years 4 10,000
+5,600 7 Advantages and Disadvantages of Payback
Advantages
Easy to understand
Biased towards
liquidity Disadvantages
Ignores the time
value of money
Ignores cash flows
beyond the cutoff
date
Biased against
longterm projects,
such as research
and development,
and new projects Capital Budgeting Methods: NPV 8 The difference between the market value of
The
a project and its cost
project
How much value is created from
How
undertaking an investment?
undertaking
The first step is to estimate the
expected future cash flows.
The second step is to estimate the
required return for projects of this risk
level.
The third step is to find the present
value of the cash flows and subtract the
initial investment. Capital Budgeting Methods 9 Net Present Value Present Value of all costs and benefits of a project. Concept is similar to Intrinsic Value of a security but
Concept
subtracts cost of project.
subtracts
NPV = PV of Inflows  Initial Outlay
NPV = PV of Inflows Initial Outlay NPV = CF1
(1+ R ) + CF2
+ CF3 3+···+ CFn n–
(1+ R )2 (1+ R )
(1+ R) IO 10 Capital Budgeting Methods
Net Present Value Time
0
1
2
3
4 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 R=10%
0 1 (10,000) 500 455
413
3,456
6,830
$11,154 2 500 3 4,600 4 10,000 $10,000
(1.10) 4 11 Capital Budgeting Methods
Net Present Value Time
0
1
2
3
4 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 R=10%
0 1 (10,000) 500 2 500 3 4,600 455
PV Benefits > PV Costs
413
$11,154 > $ 10,000
3,456
6,830
$11,154
$1,153.95 = NPV 4 10,000 NPV > $0
$1,153.95 > $0 12 Financial Calculator
Capital Budgeting Solutions Additional Keys used to
Additional
enter Cash Flows and
compute the Net Present
Value (NPV)
Value
Time
0
1
2
3
4 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 13 Capital Budgeting Methods
Net Present Value
Time
0
1
2
3
4 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 R=10%
0 1 2
(10,000) 3,500 3,500 NPV =
= 3 3,500 4 3,500 3,500
(1+ .1 ) 3,500
3,500
3,500
+ (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 –
1
1
3,500( .10 .10(1+.10)4)  10,000 = 11,095 – 10,000 = $1,094.53
$1,094.53 10,000 14 Financial Calculator Capital Budgeting Solutions Additional Keys used to
Additional
enter Cash Flows and
compute the Net Present
Value (NPV)
Value Time
0
1
2
3
4 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 Capital Budgeting Methods 15 NPV Decision Rules If projects are independent then
If
accept all projects with NPV ≥ 0. If projects are mutually exclusive,
If
accept higher with NPV ≥ 0. ACCEPT A & B
ACCEPT B only A positive NPV means that the project is expected
positive
to add value to the firm and will therefore
increase the wealth of the owners.
increase
Since our goal is to increase owner wealth, NPV is
Since
a direct measure of how well this project will
meet our goal.
meet 16 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 A
(10,000.)
3,500
3,500
3,500
3,500 B
(10,000.)
500
500
4,600
10,000 Cost of Capital 5% 3,500 10% 15% 3,500 20% 3,500 3,500 T NPV(0%) = (1+ 0 ) + (1+ 0)2 + (1+ 0 )3 + (1+ 0)4 – 10,000
= $4,000 17 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 A
(10,000.)
3,500
3,500
3,500
3,500 B
(10,000.)
500
500
4,600
10,000 Cost of Capital 5% 10% 15% 20% NPV(5%) = 3,500 + 3,500 + 3,500 + 3,500 4– 10,000
2
3
(1+ .05 ) (1+ .05) = $2,410.83 (1+ .05 ) (1+ .05) T 18 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 A
(10,000.)
3,500
3,500
3,500
3,500 B
(10,000.)
500
500
4,600
10,000 Cost of Capital 5% 10% 15% 20% NPV(10%) = 3,500 + 3,500 + 3,500 + 3,500 4– 10,000
2
3
(1+ .10 ) (1+ .10) = $1,094.53 (1+ .10 ) (1+ .10) T 19 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 A
(10,000.)
3,500
3,500
3,500
3,500 B
(10,000.)
500
500
4,600
10,000 Cost of Capital 5% 10% 15% 20% NPV(15%) = 3,500 + 3,500 + 3,500 + 3,500 4– 10,000
2
3
(1+ .15 ) (1+ .15) = – $7.58 (1+ .15 ) (1+ .15) T 20 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 A
(10,000.)
3,500
3,500
3,500
3,500 B
(10,000.)
500
500
4,600
10,000 Cost of Capital 5% 10% 15% 20% NPV(20%) = 3,500 + 3,500 + 3,500 + 3,500 4– 10,000
2
3
(1+ .20 ) (1+ .20) = – $939.43 (1+ .20 ) (1+ .20) T 21 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 Cost of Capital 5% 10% 15% 20% Connect the Points A
(10,000.)
3,500
3,500
3,500
3,500 T B
(10,000.)
500
500
4,600
10,000 22 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 NPV(0%) = A
(10,000.)
3,500
3,500
3,500
3,500 B
(10,000.)
500
500
4,600
10,000 Cost of Capital 5% 10% 500
(1+ 0 ) = $5,600 15% + 500 (1+ 0)2 20% + 4,6003 + 10,000 – 10,000
4
(1+ 0 ) (1+ 0) T 23 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 NPV(5%) = A
(10,000.)
3,500
3,500
3,500
3,500 B
(10,000.)
500
500
4,600
10,000 Cost of Capital 5% 10% 15% 20% 500
+ 500 2 + 4,600 3 + 10,000 4 –
(1+.05) (1+.05) (1+ .05) (1+ .05) = $3,130.38 T 10,000 24 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 NPV(10%) = A
(10,000.)
3,500
3,500
3,500
3,500 B
(10,000.)
500
500
4,600
10,000 Cost of Capital 5% 10% 15% 20% 500
+ 500 2 + 4,600 3 + 10,000 4
(1+.10) (1+.10) (1+ .10) (1+ .10) = $1.153.95 T – 10,000 25 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V 3,000 0 NPV(15%) = A
(10,000.)
3,500
3,500
3,500
3,500 B
(10,000.)
500
500
4,600
10,000 Cost of Capital 5% 10% 15% 20% 500
+ 500 2 + 4,600 3 + 10,000 4 –
(1+.15) (1+.15) (1+ .15) (1+ .15) = –$445.04 T 10,000 26 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V Project B 3,000 0 A
(10,000.)
3,500
3,500
3,500
3,500 Cost of Capital 5% 10% 15% 20% Connect the Points T B
(10,000.)
500
500
4,600
10,000 27 Net Present Value Profile Graphs the Net Present Value of the project with
Graphs
different required rates
different
PROJEC
Time
0
1
2
3
4 6,000 N
P
V Project B 3,000 0 Cost of Capital 5% 10% 15% 20% A
(10,000.)
3,500
3,500
3,500
3,500 T B
(10,000.)
500
500
4,600
10,000 28 Net Present Value Profile Compare NPV of the two projects for different
Compare
required rates
required
N
P
V Crossover point 6,000 Project B For any discount rate >
crossover point choose A 3,000 For any discount rate <
crossover point choose B Project A
Cost of Capital 0
5% 10% 15% 20% 29 Capital Budgeting Methods
Internal Rate of Return Measures the rate of return on a project
Definition:
The IRR is the discount rate in which NPV = 0
6,000 N
P
V Project B 3,000 NPV = $0
0 Cost of Capital 5% 10% 15% 20% Capital Budgeting Methods: IRR 30 This is the most important alternative to
This
NPV
NPV
It is often used in practice and is intuitively
It
appealing
appealing
It is based entirely on the estimated cash
It
flows and is independent of interest rates
found elsewhere
found Capital Budgeting Methods 31 Internal Rate of Return Determine the mathematical solution for IRR 0 = NPV =
IO = CF1
CF2
+
(1+ IRR ) (1+ IRR )2 CFn
+···+
–
n
(1+ IRR ) CF1
CF2
CFn
+
+···+
2
(1+ IRR ) (1+ IRR )
(1+ IRR )n Outflow = PV of Inflows
Solve for Discount Rates IO 32 Capital Budgeting Methods
Internal Rate of Return
For Project B
Cannot solve for IRR
directly, must use Trial &
Error 6,000 N
P
V Project B 3,000 IRRB ≈ 14%
0 Cost of Capital 5% 10% 15% 20% 10,000 = 500 + 500 2 + 4,600 3 + 10,000 4
(1+ IRR ) (1+ IRR ) (1+ IRR )
(1+ IRR )
TRY 14%
? 10,000 = ? 500
+ 500 2 + 4,600 3+ 10,0004
(1+ .14 ) (1+ .14)
(1+ .14 ) (1+ .14 ) 10,000 = 9,849 PV of Inflows too low, try lower rate 33 Capital Budgeting Methods
Internal Rate of Return
For Project B
Cannot solve for IRR
directly, must use Trial &
Error 6,000 N
P
V Project B 3,000 IRRB ≈ 14%
0 Cost of Capital 5% 10% 15% 20% 10,000 = 500 + 500 2 + 4,600 3 + 10,000 4
(1+ IRR ) (1+ IRR ) (1+ IRR )
(1+ IRR )
TRY 13%
? 10,000 = ? 500
+ 500 2 + 4,600 3+ 10,0004
(1+ .13 ) (1+ .13)
(1+ .13 ) (1+ .13 ) 10,000 = 10,155 13% < IRR < 14% 34 Capital Budgeting Methods
Internal Rate of Return
For Project B Time
0
1
2
3
4 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 Enter the Cash Flows into memory Compute IRR 0 (10,000) 1 500 2 3 500 4,600 4 10,000 35 Capital Budgeting Methods
Internal Rate of Return
For Project A Time
0
1
2
3
4 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 Enter the Cash Flows into memory Compute IRR 0 1 (10,000) 3,500 2 3,500 3 4 3,500 3,500 Capital Budgeting Methods 36 Decision Rule for Internal Rate of Return
Independent Projects
Accept Projects with
IRR ≥ required rate
Mutually Exclusive Projects
Accept project with highest
IRR ≥ required rate Advantage of IRR
Knowing a return is intuitively appealing
It is a simple way to communicate the value of a
It
project to someone who doesn’t know all the
estimation details
estimation 37 Capital Budgeting Methods
Profitability Index
Very Similar to Net Present Value PI = PV of Inflows = 1 +
Initial Outlay NPV
Initial Outlay Instead of Subtracting the Initial Outlay from the PV
of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.
Outlay PI = CF1
(1+ R) + CF2
(1+R )2 IO + CF3
+···+ CFn n
(1+R )3
(1+ R ) Capital Budgeting Methods: PI 38 Measures the benefit per unit cost, based
Measures
on the time value of money
on
A profitability index of 1.1 implies that for
profitability
every $1 of investment, we create an
additional $0.10 in value
This measure can be very useful in
situations where we have limited capital
situations 39 Capital Budgeting Methods
Profitability Index for Project B PI =
PI = 500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4 10,000
11,154
= 1.12
10,000 Time
0
1
2
3
4 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 40 Capital Budgeting Methods
Profitability Index for Project B PI =
PI = 500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4 10,000
11,154
= 1.12
10,000 Profitability Index for Project A PI =
PI = 1
3,500(.10 1
4
.10(1+.10) ) 10,000
11,095
= 1.11
10,000 Time
0
1
2
3
4 PROJECT
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000 Capital Budgeting Methods
Profitability Index Decision Rules Independent Projects Accept Project if PI ≥ 1 Mutually Exclusive Projects Accept Highest PI ≥ 1 Project 41 42 Advantages and Disadvantages of Profitability Index
Advantages
Disadvantages
Closely related to
May lead to
NPV, generally
incorrect decisions
leading to identical
in comparisons of
decisions
mutually exclusive
investments
Easy to understand
and communicate
May be useful when
available
investment funds
are limited Capital Budgeting In Practice 43 We should consider several investment criteria
We
when making decisions
when
NPV and IRR are the most commonly used
NPV
primary investment criteria
primary
Payback is a commonly used secondary
Payback
investment criteria
investment ...
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 Spring '08
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 Managerial Accounting, Net Present Value, capital budgeting methods, Capital Budgeting Solutions

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