Ch 9 Learning Goals

Ch 9 Learning Goals

1.Calculate, interpret, and evaluate:

payback period.

net present value (NPV).

internal rate of return (IRR).

2. Ranking conflicts.

Ch 9 Learning Goals3. The importance of risk in capital budgeting.

4. Methods of evaluating project risk.

5. Determination and use of risk-adjusted

discount rates (RADRs).

6. Capital rationing.

CB Evaluation TechniquesTechniques used to evaluate capital outlays

include:

Payback

Net present value (___________)

Internal rate of return (___________)

CB Evaluation Techniques • Not all evaluation techniques are equally valid. The

best rely on:

– Cash Flows (rather than accounting values)

– Time value of money

• Techniques that do these two things are _________

_________________________________________

(DCF) methods (called “sophisticated” in your text).

Payback Period• The payback method measures how many years it

takes to recover the initial investment.

• The maximum acceptable payback period is

determined by management.

• Decision rule: accept if the payback period is _______

___________________________ the maximum

acceptable payback period.

Pros and Cons of Payback Periods• Payback is simple, intuitive, and considers cash flows

rather than accounting profits.

• Payback is widely used by large firms to evaluate

small projects and by small firms to evaluate most

projects.

• It is also used to supplement other methods such as

NPV and IRR.

Pros and Cons of Payback Periods• Weaknesses of Payback:

– Does not consider all CFs

– Does not consider TVOM

– The appropriate payback period is

__________________________ determined

It is not a ___________________ method (it is

unsophisticated)

Pros and Cons of Payback Periods

Net Present Value (NPV)

• Net Present Value (NPV). Net Present Value is found by subtracting the initial investment from the present value of the after-tax inflows.

Decision Criteria

If NPV > 0, _______________ the project

If NPV < 0, _______________ the project

If NPV = 0, indifferent

• The Internal Rate of Return (IRR) is defined as the discount rate that causes NPV to _____________ ________________.

• The IRR measures the annual percentage return on funds invested in the project.

Internal Rate of Return (IRR)

• To interpret IRR, we compare it to “k,” the required return, or “cost of capital” for the project.

Decision Criteria

If IRR > k, __________________ the project

If IRR < k, __________________ the project

If IRR = k, indifferent

Internal Rate of Return (IRR)

Capital Budgeting Techniques

• NPV and IRR are both _____________ (sophisticated) methods of evaluating capital budgeting projects. They are not interchangeable, however.

Conflicting Rankings

• A ranking conflict exists if:– Project A has higher NPV than Project B

but:

– Project B has higher IRR than A

• Mutually exclusive projects should be ranked by __________ (not IRR) when a ranking conflict occurs.

Which Approach is Best?• On a theoretical basis, NPV is better than IRR:

– NPV assumes that cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR,

– A project with non-conventional cash flows might have zero or multiple IRRs.

• Despite that, more firms use the IRR because of management preference for rates of return.

Risk in Capital Budgeting

• Different projects have different levels of risk.

Analysis of the project must consider that risk

(acceptance of the project affects the firm’s

future ____________________).

Approaches for Dealing with Risk

• Techniques for evaluating risk of a capital budgeting project include:– Scenario analysis– Sensitivity analysis– Simulation– Decision trees

Approaches for Dealing with Risk

• Each of the techniques considered gives insight into project risk, but none of them provide a _________________.

• Ultimately, the decision is based on a combination of analysis and judgment.

Assessing Project Risk: Scenario Analysis

• Scenario analysis involves identifying 3 or more possible outcomes. Normally, the probability of each outcome is also estimated.

Approaches for Dealing with Risk

• Once the risk level is determined, it is incorporated into the analysis by either:– Adjusting cash flows, or– Adjusting the required return to get the risk

adjusted discount rate (______________)

_______________ is more often used in practice.

Risk-Adjusted Discount Rates• The risk-adjusted discount rate is the rate of return

that must be earned on a project to compensate for the additional risk.

• The higher the risk of a project, the ______________ the RADR – and thus the __________________ a project’s NPV.

Approaches for Dealing with Risk

• CAPM could be used to determine a project’s RADR. However, most firms use project characteristics to classify projects as low, average, or high risk.

Risk Adjusted Discount Rates

• Examples of Project Classification– Low risk: replacement existing assets without

adding capacity or changing technology– Average risk: expanding capacity without changing

products or technology– High risk: changing product line or technology

Capital Rationing• Capital rationing exists if a firm lacks sufficient

financing to undertake all acceptable projects.

• The firm should adopt the set of projects that provides

highest ___________________________.