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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 long-term 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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This note was uploaded on 01/28/2012 for the course ACCT 303 taught by Professor Staff during the Spring '08 term at CSU Bakersfield.

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