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Alternative Investment Rules and Capital Budgeting Analysis
Capital budgeting is the planning for purchases of assets whose returns
are expected to continue beyond one year.
Common Models
• There are several common models used in evaluating capital budgeting decisions:– Net present value – Payback period– Average accounting return– Internal rate of return– Profitability index
Defining Project Type
• Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system. – RANK all alternatives and select the best one.
• Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.– Must exceed a MINIMUM acceptance criteria.
The Net Present Value (NPV) Rule
• Net Present Value (NPV) = Total PV of future CF’s + Initial Investment
• Estimating NPV:– 1. Estimate future cash flows: how much? and when?
– 2. Estimate discount rate
– 3. Estimate initial costs
• Minimum Acceptance Criteria: Accept if NPV > 0• Ranking Criteria: Choose the highest NPV
Good Attributes of the NPV Rule
• 1. Uses cash flows
• 2. Uses ALL cash flows of the project
• 3. Discounts ALL cash flows properly
The Payback Period Rule
• How long does it take the project to “pay back” its initial investment?
• Payback Period = # of years to recover initial costs.
• Minimum Acceptance Criteria: set by management. Project must “pay back” within a certain period.
• Ranking Criteria: set by management.
Disadvantages of Payback Rule
• Ignores the time value of money.• Ignores CF after payback period.• Biased against long-term projects.• Payback period may not exist or there may
be multiple payback periods.• Requires an arbitrary acceptance criteria.• A project accepted based on the payback
criteria may not have a positive NPV.
Advantages of Payback Rule
• Easy to understand
• Biased toward liquidity
The Average Accounting Return (AAR) Rule
• AAR = Average NI / Average Book Value of Investment
• Minimum Acceptance Criteria: set by management.
• Ranking Criteria: set by management.
Disadvantages of AAR Rule
• Ignores the time value of money
• Uses an arbitrary benchmark cutoff rate
• Based on book values, not cash flows and market values
Advantages of AAR Rule
• The accounting information is usually available
• Easy to calculate
The Internal Rate of Return (IRR) Rule
• The IRR is the discount rate that sets the NPV to zero.
• Minimum Acceptance Criteria: Accept if the IRR > required return.
• Ranking Criteria: Select alternative with the highest IRR.
Disadvantages of IRR Rule
• Does not distinguish between investing and financing.
• IRR may not exist, or there may be multiple IRR’s
• Problems with mutually exclusive investments– borrowing or lending?– multiple (or no) rates of return– mutually exclusive projects: scale and timing
Advantages of IRR Rule
• Easy to understand and communicate
Problem # 1: Borrowing or LendingCf(0) Cf(1) Cf(2) Cf(3) IRR NPV @ 10%
+1000 -500 -500 -500 23.4% -243.43
This project represents the borrower’s side of a loan. Thus, as the discount rate increases, the NPV of the project increases.
23% r
NPV
Problem # 2: Multiple Rates of Return
NPV @
Cf(0) Cf(1) Cf(2) IRR 10%
-4,000 25,000 -25,000 25% -1,934
& 400%
NPV
r400%25%
Note: It is alsopossible there isno IRR.
Mutually Exclusive Projects: Problem # 1-- The Scale Problem
NPV
Cf(0) Cf(1) IRR @ 10%
Project 1 -100 200 100% $82
Project 2 -1000 1500 50% $323.6
Do not compare the IRR’s of mutually exclusive projects.
Mutually Exclusive Projects: Problem #2-- Timing Problem
Cf(0) Cf(1) Cf(2) Cf(3)
A: -$10,000 $10,000 $1,000 $1,000
B: -$10,000 $1,000 $1,000 $12,000
NPV NPV NPV
@ 0% @10% @15% IRR
A: $2,000 $669 $109 16.04%
B: $4,000 $751 -$484 12.94%
NPV & IRR for Timing Problem
-4000
-3000
-2000
-1000
0
1000
2000
3000
4000
5000
0 10 20 30 40
rNP
V
When interest rates are low, Project B has the higher NPV. When interest rates are high,Project A has the higher NPV.
Project B
Project ACrossoverRate
The Profitability Index (PI) Rule
• PI = Total Present Value of future CF’s / Initial Investment
• Minimum Acceptance Criteria: Accept if PI > 1
• Ranking Criteria: Select alternative with highest PI
Disadvantages of PI Rule
• Problems with mutually exclusive investments
Advantages of PI Rule
• May be useful when available investment funds are limited
• Easy to understand and communicate
• Correct decision when evaluating independent projects
Example: Investment Rules
Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
Example of Investment Rules: NPV, IRR, PI
Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
Example of Investment Rules: Payback Period
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150
Payback Period (cont’d)
Payback period for project B = 2 years
Payback period for project A = 1 or 3 years?
Relationship Between NPV and IRR
Discount rate NPV for A NPV for B-10% -87.52 234.77
0% 0.00 150.0020% 59.26 47.9240% 59.48 -8.6060% 42.19 -43.0780% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
NPV Profiles
-150
-100
-50
0
50
100
150
200
250
300
-10 0 20 40 60 80 100 120
r
NP
V
Project A
Project B
CrossoverRate
NPV & Capital Budgeting
Four basic steps for project valuation:1. Generate proposals.
2. Estimate cash flows.
3. Evaluate and select projects.
4. Review decisions.
Generating Proposals
• Projects may come from growth opportunities.
• Projects may come from cost reduction opportunities.
• Projects may be required to meet legal requirements or health and safety standards.
Estimating Cash Flows
• Cash Flows should be estimated on an incremental basis. Compare the cash flows with the project to cash flows without the project.
• Cash flows should be measured on an after-tax basis, except for government projects.
• Use cash flows - not accounting income.
Estimating Cash Flows
• “Let bygones be bygones” - ignore sunk costs.
• Remember opportunity costs of resources used.
• Consider side effects - are cash flows from other projects affected? Either up or down?
Example: Project Valuation
• Suppose a steel company is thinking of adding a new blast furnace to its operations. You have just completed a $1 million feasibility study and have found the following:
• Adding the blast furnace will result in $50 million in new sales each year and will save $100 million per year in expenses. However, the furnace will cost $10 million per year to operate.
Example - Continued• Suppose the furnace costs $1,000 million and uses
some parts from a (fully depreciated) retired furnace that could be sold for $30 million. The new furnace will last 10 years and has a salvage value of $200 million. The project will require $20 million of working capital over its 10-year life.
• The firm uses straight-line depreciation for tax purposes and pays 40% in corporate income taxes.
• Assume the cost of capital is 10%.
Example - Continued• Step One (“No Rules, Just Right”, i.e., it works
for me...): Initial Cash Flow.• $1,000 million capital expenditure• $20 million working capital• $30 million lost gain on sale of old furnace• But, would have paid taxes on gain of (.40*$30
million) = $12 million. Net gain if sold old furnace = $18 million
• Total initial cash flow = -$1,038 million• (Negative sign reflects cash outflow.)
Example - Continued• Step Two: Operating Cash Flows.• Change in Depreciation each year =
$1,000 million ÷ 10 = $100 million• Change in Revenue = $50 million • Change in Expenses = $10 million - $100 million
(savings) = -$90 • Change in Taxes = ($50 - (-$90) - $100) * .40 =
$16 million• CFi = ($50 - (-$90) - $100) - $16 + $100 = $124
million
Example - Continued• In Cash Flow Statement Format:
Revenues $50- Expenses -(-90)- Depreciation -100= EBT = $40- Taxes (.40) -16= EAT = $24+ Depreciation +100= Cash Flow = $124
Example - Continued
• Step Three: Project Termination Cash Flows.
• Salvage Value = $200 million
• Owe taxes of (.40 * $200 million) = $80 million
• Release of Working Capital = $20 million
• Total = $200 - $80 + $20 = $140 million
Example - Continued
• Step Four: Find NPV
• NPV = -$1,038 million + $124 million * (PVIFA10%, 9) + ($124 million + $140 million) * PVIF10%, 10)
• CF0 = -1,038, C01 = 124, F01 = 9, C02 = 264, F02 = 1, I% =10%
• NPV = -$222 million, IRR = 5.10%
Example - Continued
• Step Five: Make decision.
• Reject project since NPV is less than zero.
Additional Considerations
• Inflation
• Comparing Projects with Different Lives
Cash Flows and Inflation
• It is important to recognize the effects of inflation on cash flows.
• The Fisher equation says:• (1 + nominal rate of interest) = (1 + real
interest rate) * (1 + inflation rate)• Example: If the real interest rate is 5% and
inflation is 4%, the nominal rate of interest is 9.2% (1.05 x 1.04 = 1.092, or 9.2%)
Consistency
• The most important lesson in choosing the appropriate discount rate is to be consistent.
• Nominal cash flows must be discounted with the nominal interest rate.
• Real cash flows must be discounted with the real interest rate.
Projects with Different Lives - Replacement Chain Analysis
• Replacement chain analysis assumes that alternative projects can and will be repeated.
• Matching-cycle analysis finds a common multiple of both projects and finds NPV for project string, i.e., if one project last 2 years and the other lasts 3 years, compare NPVs if invest in the first project 3 times consecutively and the second project 2 times consecutively.
• Huh?
Projects with Different Lives - Replacement Chain Analysis
• Equivalent annual cost analysis finds the equal annual payments over the life of the project that have the same NPV as the true cash flows.
• Generally, easier to compute than matching-cycle analysis.
Example: Equivalent Annual Cost
Suppose we’re looking at the cost of two machines, A and B, r = 5%. (All cash outflows.)
Machine A Machine B
t=0 $15 million $20 million
t=1 $2 million $1 million
t=2 $2 million $1 million
t=3 $1 million
Example - Continued
• Project A lasts two years.
• Find the NPV of A = -$18.72 million.
• Find the equal annual amount that gives an NPV of -$18.72 million over 2 years.
• N=2, I=5, PV=-$18.72, FV=0 ==> PMT= $10.07 million
• Payments of $10.07 million gives same NPV as Machine A’s Cash Flows
Example - Continued
• Project B lasts 3 years and has NPV=-22.72• Find the equal annual amount that gives an
NPV of -$22.72 million over 3 years.• N=3, I=5, PV=-$22.72, FV=0 ==> PMT=
$8.34 million• Payments of $8.34 million gives same NPV
as Machine B’s Cash Flows• Choose Machine B - Lowest Cost
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