335 Chap 11 Capital Budgeting Basics

8/11/2019 335 Chap 11 Capital Budgeting Basics

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Chapter 11: The Basics of Capital Budgeting

I. What is Capital Budgeting?

The process of determining what capital projects to accept

Project Classificationis the starting point for determining the appropriate discount rate

Replacement to maintain current operationsReplacement to reduce costsExpansion of existing products or markets

Expansion into new products or markets

Pure research & development (example: pharmaceutical firms)

Exploration (example: energ firms)

!afet and "or environmental (government mandated) projects

II. Decision Criteria

What are the major investment decision criteria?

#et Present $alue % #P$

nternal Rate of Return % RR

'odified nternal Rate of Return % 'RR

Paack Period % Paack

iscounted Paack Period * iscounted Paack

Profitailit ndex % P

What are they used for?

To evaluate the cash flows from capital investment projects

To make the accept or reject decision

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. The !"# $ule:

1. Why Is !et "resent #alue the Best Decision Criteria?

% t considers the time value of money(T$')1 a dollar toda is worth more than adollar in the future

% t considers all cash flows during the project2s entire life

% #P$ lets ou know exactl how much value is eing added the project

% 3ou can set the appropriate re4uire rate of return (discount rate or hurdle rate)depending on a project2s risk

%. Calculating !et "resent #alue &!"#:

#P$ 5/+6 7 /+0 7 /+8 7 999 7 /+t(0 7 r)0 (0 7 r)8 (0 7 r)t

'. The !"# decision &accept/reject( rule:

% Acceptthe project (investment) if #P$ ;ero

% Rejectthe project if #P$ < ;ero

). What does a positive !"# mean?

% ThePVof cash inflows PVof cash outflows

% The value of the compan is eing increased the amount of #P$

% The project meets the re4uired rate of return1and then some



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!"# *+ample 1:

= friend asks ou to invest >86.666 and promises to pa ou >8?.666 at the end of 8ears9 3our re4uired rate of return is 0-@9 o ou take the offerA

#P$ 5/+6 7 /+8(0 7 r)8

#P$ 5 %86.666 7 8?.666 5 %86.666 7 0B.??6090- 8

!"# , -')/ 0ou should reject your friends offer2

C f this were a capital investment project. acceptance would reducethe value of the

compan >,D6

C =cceptance of the project would not increasethe value of the compan >?.666

The ke variale here is the re4uired rate of return (or discount rate)9

The re4uired rate of return (RRR) is:

C The hurdle rate

C The cost of capital (funds)

C The est rate of return the compan could expect on other projects of similar risk

!ote:

n a competitive market. positive #P$ projects are considered rare and re4uire diligenteffort to uncover

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B. The "ay9ac $ule:

Time period re4uired for a project to generate enough cash inflows to recover the initialcost9

The "ay9ac decision &accept/reject( rule:

% Acceptif paack period < maximum acceptale paack period9% Rejectif paack period maximum acceptale paack period9

dvantages

% Eas to understand: the shorter the paack period. the etter% Guick indicator of the liquidity riskof the project (how long funds will e tied up)

Disadvantages

% gnores time value of mone% gnores cash flows eond acceptale paack date% =cceptale paack date is usuall an aritrar cutoff point9 Risk is not

4uantified in a re4uired rate of return9 The li4uidit risk is simpl a Hrule ofthumI

"roject 3:

6 0 8 , DF%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F

#et /+ %0.666 -66 D66 ,66 066/umulative %0.666 %-66 %066 866 ,66

#/+

Paack 5 ears efore 7 uncovered cost at end of ear full recover #/+ during following ear

5 8 7 066",665 89,, ears

If accepta9le pay9ac period is %.'' or more years; you accept project 3

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C. The Discounted "ay9ac $ule:

Time period re4uired for a project to generate enough discountedcash inflows to recoverthe initial cost9

The Discounted "ay9ac decision &accept/reject( rule:

% Acceptif discountedpaack period < maximum acceptale paack period9% Rejectif discountedpaack period maximum acceptale paack period9

dvantages

% Eas to understand: the shorter the paack period. the etter% Guick indicator of the liquidity riskof the project (how long funds will e tied up)% oes consider the time value of mone

Disadvantages

% gnores cash flows eond acceptale paack date% =cceptale paack date is usuall an aritrar cutoff point9

"roject 3: ssume a 1/ percent discount rate

6 0 8 , DF%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F

#et /+ %0.666 -66 D66 ,66 066P$#/+ %0.666 D-D ,,0 88- ?J/umulative %0.666 %-D? %80- 06P$#/+

Paack 5 ears efore 7 uncovered cost at end of ear

full recover #/+ during following ear

5 8 7 80-"88-5 89B? ears

If accepta9le pay9ac period is %.8< or more years; you accept project 3

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D. Internal $ate of $eturn

The RR is similar to a ond2s ield to maturit9 t is the rate that makes the present valueof cash inflows (/+) e4ual to the present value of cash outflows (/K+)9 Thus. it is therate of return that results in a ;ero #P$ when it is used as the discount rate9

#P$ 5 /+6 7 /+0 7 /+8 7 999 7 /+t(0 7 r)0 (0 7 r)8 (0 7 r)t

6 5 /+6 7 /+0 7 /+8 7 999 7 /+t(0 7 RR) 0 (0 7 RR) 8 (0 7 RR)t

I$$ Decision $ule

% Acceptthe project if RR re42d rate of return (discount rate)% Rejectthe project if RR < re42d rate of return (discount rate)

dvantages

% /onsiders T$'% /onsiders all cash flows% Eas to understand

Disadvantages

% 'a use unreasonale discount rate% /an conflict with #P$ if projects are mutually exclusive

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I$$ *+amples:

I$$ for "roject 3

6 0 8 , D"roject 3 F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F %0.666 -66 D66 ,66 066

6 5 %0666 7 -66 7 D66 7 ,66 7 066(07rr) 0 (07rr) 8 (07rr) , (07rr)D

3olve for the I$$. That is the discount rate that solves this e4uation and makes the

answer (#P$) e4ual to ;ero9

RR for Project ! 5 0D9DB@

I$$ for "roject 4

6 0 8 , D"roject 4 F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%%F %0.666 066 ,66 D66 -66

6 5 %0666 7 066 7 ,66 7 D66 7 -66(07rr) 0 (07rr) 8 (07rr) , (07rr)D

I$$ for "roject 4, 8.%6=

The RR is the most popular method. after #P$. for evaluating cash flows and is almostas good9

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"ro9lems 5ith I$$:

There are prolems with using RR rather than #P$ with ou are choosing etweenmutually exclusive projects:

% Independentprojects: Mhen evaluating multiple projects and an. none. or all ofthem can e accepted9 =cceptance of an project has no earing on the acceptanceor rejection of another9

% utually exclusiveprojects: Mhen evaluating multiple projects and onl one cane accepted9 =cceptance of one project means rejection of the other(s)9

There is never a conflict etween RR and #P$ criterion when evaluating independentprojects9 Nut when choosing etween mutuall exclusive projects. the RR choice ma

conflict with the #P$ choice under certain conditions9

The Scale Problem: = potential conflict exists when there are significant differences inthe si;e of the cash flows9 =n example would e if comparing a project with a >066.666initial investment (/K+) with another project with a >0.666.666 initial investment9

The Timing Problem: = potential conflict exists when the timing of the cash flows fortwo projects are radicall different9 This can result in a conflict etween the #P$ choiceand the RR choice at low discount rates9

Multiple IRRs: Projects with non!normal "non!conventional#cash flows ma havemultiple RRs9 = normal(or conventional) cash flow is a cash outflow at the eginningof a project. followed cash inflows thereafter9

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The !"# "rofile: !"# graphed against the discount rate

Recall the #P$ & RR acceptance rules:

#P$: Acceptthe project if #P$ ;eroRR: Acceptthe project if RR RRR

#P$/ash +lows%0666

>,66 -66 D66 ,66

066RR

6 r90DDB

=n project with a positive #P$ will also have an RR that exceeds the discount rate(re4uired rate of return)9

#P$ Profiles forMutually ExclusiveProjects:

#P$ /ash +lows= N

Project N %06.666 %06.66606.666 0.6660.666 0.666 0.666 08.666

/rossover rateProject =

r



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*+ample: I$$ vs !"# for >utual *+clusive "rojects

/ash +lows= N

%06.666 %06.66606.666 0.666 0.666 0.666 0.666 08.666

RR for = OOOOOOOOOOOOO RR for N is OOOOOOOOOOO

#P$ at 6@ OOOOOOOOOOOO #P$ at 6@ OOOOOOOOOOOO

#P$ at 06@ OOOOOOOOOOO #P$ at 06@ OOOOOOOOOOO

#P$ at 0-@ OOOOOOOOOOO #P$ at 0-@ OOOOOOOOOOO

Mhich project is acceptale if the are independentA MhA

Mhich project is acceptale if the are mutuall exclusiveA MhA

*. >odified Internal $ate of $eturn

% Acceptthe project if 'RR re42d rate of return (discount rate)% Rejectthe project if 'RR < re42d rate of return (discount rate)

dvantage: 4ets you decide the reinvestment rate2

/ost 5 Terminal $alueT(0 7 'RR)T

iven: /ost. T$!olve: 'RR



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. "rofita9ility Inde+ &"I(

"I , &"# of Cash Inflo5s(@&"# of Cash Autflo5s(

The P is the ratio of the P$ of the project2s cash inflows to the P$ of the project2s cashoutflows9

"I for "roject 3

P$/+! 5 -66 7 D66 7 ,66 7 066 5 0.6LJ9J8 (07906)0 (07906)8 (07906), (07906)D

P$/K+! 5 0.666

P! 5 0.6LJ9J8"0.666 5 096LJJ8

"I Decision $ule

% Accept if P 0966% Rejectif P < 0966

dvantages

% /onsiders T$'% /onsiders all cash flows% Qses reasonale discount rate% Qseful when faced with capital rationing9

Disadvantages

% /annot distinguish projects of vastl different scale% 'a conflict with #P$ when evaluating mutuall exclusive projects



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"rofita9ility Inde+ vs !"# forMutually Exclusive"rojects

6 0 F%%%%%%%%%%%%%%%%%%%%%F

Cash lo5s

Project = %>06 >0-Project N %>0.666 >0.8-6

= N#P$ at 906 > ,9?D >0,?9,?P at 906 09,?D 090,?

=ccording to #P$. ou choose N9

=ccording to P. ou choose =9

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335 Chap 11 Capital Budgeting Basics