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7/30/2019 Lecture+5+ +Capital+Budgeting
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Capital budget is an out line of planned investment
in fixed assets and
CAPITAL BUDGETING is the process of analyzing
projects and deciding which ones to include in the
various capital budgets.
PROJECT CLASSIFICATIONSAnalysing projects can be expensive.
For certain types of projects, a relatively detailed
analysis may be required, for others simple
procedures may be used.Firms therefore categorize projects and analyse
the categories differently.
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1. Replacement: Maintenance of business
consists of expenditures to replace worn-out or
damaged equipment used in the production ofprofitable products.
Maintenance decisions are made without going
through an elaborate decision process.
2. Replacement: Cost reduction.
This category includes expenditures to replace
serviceable but obsolete equipment. The purpose is to
lower the cost of labour, materials and other inputssuch as electricity. These decisions are discretionary
and a fairly detailed analysis is generally required.
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3. Expansion of existing products or markets:
These include expenditures to increase output of
existing products, or to expand retail outlets ordistribution facilities in markets now being
served.
Decisions here are more complex on the basisthat they require an explicit forecast of growth in
demand.
More detailed analysis are required to avoidmistakes
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4. Expansion into new products or markets
- These involve investment to produce a new product
or to expand into a new geographic area not currentlybeing served.
- These are projects which involve strategic decisions
that could change the fundamental nature of the
business
- They require expenditure of large sums of money with
delayed paybacks
- A detailed analysis is required- Financial decisions are made at the very top by the
Board of Directors as part of the strategic plan.
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5. Safety and ,or environmental projects
- These involve expenditures to comply withgovernment safety standards, labour agreements, or
insurance policy terms.
-These expenditures are called mandatory
investments and often non-revenue producingprojects
- Handling of these projects depend on their size
- Smaller ones may handled like category one
described above.
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6. Other
These may include office buildings, parking
lots, executive aircrafts etc. the handling ofsuch projects varies among companies.
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Steps
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.3. Determine k = WACC for project.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >WACC.
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EVALUATING STEPS INVOLED IN CAPITAL
BUDGETING ANALYSIS.
First determine the cost of the project-Management estimates the expected cash
flows from the project, including the salvage
value of the asset at the end of the expectedproject life.
-- The riskiness of the projected cash flows
must be estimated. This requires information
about the probability distribution (riskiness)
of the cash flows
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Steps continued
- Given the projects riskiness, management determinesthe cost of capital at which the cash flows are
discounted.
- The expected cash inflows are discounted to obtain
an estimate of the assets value.
- Lastly, the present value of the expected cash inflows
is compared with the initial or required outlay. If the PV
of cash flows exceeds the cost, the project is accepted.Otherwise it is rejected. Alternatively, if the projects IRR
exceeds the cost of capital, the project is accepted
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Normal Cash Flow Project:Cost (negative CF) followed by a series of positive
cash inflows.One change of signs.
Nonnormal Cash Flow Project
Two or more changes of signs.
Most common: Cost (negative CF), then string of
positive CFs, then cost to close project.
Nuclear power plant, strip mine.
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Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
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CAPITAL BUDGETING DECISION RULES
Five main methods are used in rankingprojects and to decide whether or not the
project should be accepted for inclusion in
the capital budget.
They include
- Payback
- Discounted payback
- Net Present Value (NPV)-Internal Rate of Returns (IRR)
-Profitability Index
- Modified Internal Rate of Return (MIRR) 13
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We will use table 1 for projects S & L to illustrate each
of the methods.
We assume both projects are equally riskyThe cash flows CFt; are expected values
They have been adjusted to reflect taxes, depreciation
and salvage values
Many projects require investments in both fixed
assets and working capital. So the investment outlays
shown as CF0 include the necessary changes in net
operating working capital.We assume that all cash flows occur at the end of the
designated year.
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YEAR PROJECT
(S)
PROJECT
(L)
0 (1000) (1000)
1 500 100
2 400 3003 300 400
4 100 600
TABLE 1: EXPECTED AFTER-TAX NET CASH
FLOWS, CFt
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Independent and mutually exclusive
projects?
Projects are:
independent, if the cash flows of one are
unaffected by the acceptance of the other.
mutually exclusive, if the cash flows ofone can be adversely impacted by the
acceptance of the other.
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PAYBACK PERIOD
Defined as the expected number years required to
recover the original investment(calculate the payback period for projects S & L).Paybacks = year before full recovery + unrecovered cost at start of
year/Cash flow during year
= 2 + 100/300 = 2.33 yearsCalculate payback for project L
NB . The shorter the payback period the better
If the firm required payback period of 3 years S is
accepted and L rejected
If both projects are mutually exclusive, S would be
ranked over L since S has lower payback period
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Strengths of Payback:
1. Provides an indication of a projects risk andliquidity.
2. Easy to calculate and understand.
Weaknesses of Payback:
1. Ignores the time value of money
2. Ignores CFs occurring after the payback
period.
3. Biased against long-term projects, such as
research and development, and new projects
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Discounted Payback
- Variant of the regular payback period
-Similar to the regular payback period except that the
expected cash flows are discounted by the projects
cost of capital.
-The discounted payback period is therefore definedas the number of years required to recover the
investment from discounted net cash flows.
- Discounted payback for projects S = 2.95 years
-Discounted payback for project L = 3.88 years.-(to be done in class)
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Advantages and disadvantages of the discounted
payback period
Advantages1. Includes time value of money
2. Easy to understand
3. Does not accept negative estimated NPV investments
4. Biased towards liquidity
5. It shows the breakeven year after covering debt and equity(capital) costs
Disadvantages
1. May reject positive NPV investments
2. Requires an arbitrary cutoff point3. Ignores cash flows beyond the cutoff date
4. Biased against long-term projects such as research and
development, and new projects
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.
10t
t
n
t k
CFNPV
NPV: Sum of the PVs of inflows andoutflows.
Cost often is CF0 and is negative.
.CFk1
CFNPV
0t
tn
1t
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Whats Project Ss NPV?
500 100400
0 1 2 410%
Project S:
-1000
454.55
330.58
68.30
78.82 = NPVS22
3
300
225.39
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Whats Project Ls NPV?
100 600300
0 1 2 410%
Project S:
-1000
90.9
247.93
409.81
49.18 = NPVL23
3
400
300.53
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Rationale for the NPV Method
- NPV of zero means that the projects cash flows are
exactly sufficient to repay the investment capital and
to provide the required rate of return on that capital.
If a project has a positive NPV, then it is generating
more cash than is needed to service its debt and to
provide the required returns to shareholders, this
excess cash accrues solely to the stockholders.Projects with positive NPV improve stockholders
wealth by the NPV.
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Rationale for the NPV Method
NPV = PV inflows - Cost= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutuallyexclusive projects on basis ofhigher NPV. Adds most value.
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Using NPV method, which project(s)
should be accepted?
If Projects S and L are mutually
exclusive, accept S because NPVs >NPVL .
If S & L are independent, accept
both; NPV > 0.
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The Profitability Index (PI)
Minimum Acceptance Criteria: Accept if PI > 1
Ranking Criteria: Select alternative with highest PI
InvestentInitial
FlowsCashFutureofPVTotalPI
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The Profitability Index
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds
are limited
Easy to understand and communicate
Correct decision when evaluating independentprojects
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INTERTNAL RATE OF RETURN (IRR)
IRR is defined as the discount rate that
equates the present value of a projects
expected cash inflows to the present value of
the projects cost.
PV (inflows) = PV (investment costs)Or the rate that forces the NPV to equal zero
Calculate the IRR for projects L and S
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Internal Rate of Return: IRR
0 1 3 4
CF0 CF1 CF3 CF4Cost Inflows
IRR is the discount rate that forcesPV inflows = cost. This is the same
as forcing NPV = 0.
30
2
CF2
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.NPVk1
CFt
t
n
0t
.0IRR1CF
t
t
n
0t
NPV: Enter k, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
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Whats Project Ss IRR?
500 100400
0 1 2 4IRR = ?
-1000
PV4
PV2PV1
0 = NPV
IRRS = 14.5%.
300
3
PV3
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Whats Project Ls IRR?
100 600300
0 1 2 4IRR = ?
-1000
PV4
PV2PV1
0 = NPV
IRRL = 11.8%.
400
3
PV3
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90 1,09090
0 1 2 10IRR = ?
Q. How is a projects IRRrelated to a bonds YTM?
A. They are the same thing.A bonds YTM is the IRR
if you invest in the bond.
-1,134.2
IRR = 7.08%
...
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Rationale for the IRR Method
Rationale for the IRR Method
The IRR is special because
It is the projects expected rate of return
If the IRR exceeds the cost of the funds used to
finance the project, a surplus remains after
paying for the capital, and this surplus accrues
to the firms stockholdersUndertaking a project whose IRR exceeds its
cost of capital increases stockholders wealth.
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Rationale for the IRR Method
If IRR > WACC, then the projects
rate of return is greater than itscost-- some return is left over toboost stockholders returns.
Example: WACC = 10%, IRR = 15%.Profitable.
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IRR Acceptance Criteria
If IRR > k, accept project.
If IRR < k, reject project.
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Decisions on Projects S and L per IRR
If S and L are independent, accept both.
IRRs > k = 10%.
If S and L are mutually exclusive, accept Sbecause IRRS > IRRL .
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Construct NPV Profiles
Enter CFs in CFLO and find NPVL and
NPVS at different discount rates:
k0
5
1015
20
NPVL
400
206.18
49.18(80.14)
NPVS
300
180.42
78.82(8.33)
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-100
0
100
200
300
400
60
5 7.2
NPV ($)
Discount Rate (%)
IRRL = 11.8%
IRRS = 14.5%
Crossover
Point = 7.2%
k
0
5
10
15
20
NPVL
400
206.5
49.18
(80.14)
(4)
NPVS
300
180.42
78.82
(8.33)
5
S
L
.
.
...
.
.
. .
..
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NPV and IRR always lead to the same accept/rejectdecision for independent projects:
k > IRR
and NPV < 0.Reject.
NPV ($)
k (%)IRR
IRR > k
and NPV > 0Accept.
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Mutually Exclusive Projects
k 7.2 k
NPV
%
IRRS
IRRL
L
S
k < 7.2: NPVL> NPVS , IRRS > IRRL
CONFLICT
k > 7.2: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
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To Find the Crossover Rate
1. Find cash flow differences between the projects.See data at beginning of the case.
2. Enter these differences in CFLO register, then
press IRR. Crossover rate = 7.2%,3. Can subtract S from L or vice versa, but better to
have first CF negative.
4. If profiles dont cross, one project dominates the
other.
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Two Reasons NPV Profiles Cross
1. Size (scale) differences. Smallerproject frees up funds at t = 0 for
investment. The higher the opportunitycost, the more valuable these funds, sohigh k favors small projects.
2. Timing differences. Project with fasterpayback provides more CF in earlyyears for reinvestment. If k is high,early CF especially good, NPVS > NPVL.
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Reinvestment Rate Assumptions
NPV assumes reinvest at k (opportunitycost of capital).
IRR assumes reinvest at IRR. Reinvest at opportunity cost, k, is more
realistic, so NPV method is best. NPVshould be used to choose betweenmutually exclusive projects.
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Managers like rates--prefer IRR toNPV comparisons. Can we give
them a better IRR?
Yes, MIRR is the discount rate which
causes the PV of a projects terminalvalue (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.
Thus, MIRR assumes cash inflows arereinvested at WACC.
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MIRR = 16.5%
10.0 80.060.0
0 1 2 310%
66.012.1
158.1
MIRR for Project L (k = 10%)
-100.0
10%
10%
TV inflows-100.0
PV outflowsMIRRL = 16.5%
$100 = $158.1(1+MIRRL)
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Why use MIRR versus IRR?
MIRR correctly assumes reinvestmentat opportunity cost = WACC. MIRRalso avoids the problem of multipleIRRs.
Managers like rate of return
comparisons, and MIRR is better forthis than IRR.
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