Cap Bud Techniques

8/9/2019 Cap Bud Techniques

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A Comparison of Capital Budgeting Techniques

With definitions and exemplifications


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Capital budgetingCapital budgeting

Cost/benefit analysis:Cost/benefit analysis:

Estimating the value of investment projectsEstimating the value of investment projects

Making informed choicesMaking informed choices


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Capital Budgeting Techniques

A collection of methods allowing the manager to choose among a

variety of investment projects.


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P

roblem

Value, rank and select investment projects


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Exemplification

Project : Project : Project :

R q ir r t 7.7% 3% 6%

r 1: $400 $100 $5,200

r 2 $1,250 $200 $4,000

r 3 $900 $150 $1,000

r 4 $3,000 $100 $200

r 5 $1,000 $50 $100

I iti l C st $5,045 $490.67 $9,687.23


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Clarifications

Re uired rate: a fair discount rate given each projects risk


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MethodsMethods

Average Accounting ReturnAverage Accounting Return PaybackPayback

Discounted paybackDiscounted payback Internal Rate ofReturnInternal Rate ofReturn Modified Internal Rate ofReturnModified Internal Rate ofReturn Net Present ValueNet Present Value Profitability IndexProfitability Index


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Average Accounting Return

AAR is the ratio of the Average Net Income to the Average Book Value.

Decision rule

Take the project ifAAR is greater than some target ratio set by accountants.

Disadvantages

It has too many flaws, don't ever use it.


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P

ayback period

PB is the time it takes to recover the initial cost of theinvestment


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Payback period

Decision rule

Take the project with the shortest payback period

Disadvantages

Ignores time value of money Ignores risk

Ignores cash inflows beyond the cutoff point


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Payback period

In our example:

project C: . years

project B: . years

projectA: . years

All three projects are viable


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Discounted payback period

DPB is the time it takes to recover the initial cost of the investment

PB uses nominal CF DPB uses discounted CF


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Discounted payback period

Decision rule

Take the project with the shortest discounted payback period.

Disadvantages

DPB ignores cash inflows beyond the cutoff point


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Internal Rate of Return

IRR is the discount rate that makes the present value of theproject e ual to its initial cost.


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Decision rule

Take the project If the IRR exceeds the re uired rate of return

Disadvantages

Reinvestment rate assumption is unrealistic Multiple IRR

IRR cannot rank mutually exclusive projects


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Internal Rate of Return Calculation

Set: Initial cost = PV(project)$5,045 = $400/(1+r) +$1,250/(1+r)2 +$900/(+r)3 +$3,000/(1+r)4 +$1,000/(1+r)5

r = .


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IRR(A) =

IRR(B) =IRR(C) = .

Only A andB are viable


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Modified Internal Rate of Return

MIRR is the discount rate that makes the future value of the projecte ual to its initial cost.

MIRRrequires a reinvestment rate.


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Modified Internal Rate of Return

Decision rule

Take the project if MIRR is larger than the re uired rate.

Disadvantages

MIRR cannot rank mutually exclusive projects.


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MIRR calculation

Project A

Set FV(at ) = , (1+MIRR)

MIRR =


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MIRR calculation

MIRR(A) =

MIRR(B) = .

MIRR(C) =



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NPV

Net Present Value is the difference between the present value of aproject and its initial cost

NPV = PV - Initial cost


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NPV

Decision rule

If NPV is positive, take the project.

Disadvantages

Very complex analysis, too many variables to forecast


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NPV:Corollary

Required Rate = IRR NPV = 0

and vice-versa.


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NPV calculation

projectA:

PV =$400/(1.077) +$1,250/(1.077)2 +$900/(1.077)3 +$3,000/(1.077)4 +$1,000/(1.077)5

PV=$5,089.36

NPV= Present value - Initial Cost

NPV = , . - , = .


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NPV calculation

NPV(A)= +$44.

NPV(B)= +$64.17

NPV(C)= -$148.81


B is better because it adds more value


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The Profitability Index

The profitability index is the ratio of project PV to initial cost

PI = PV/Initial cost


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The Profitability Index

Decision rule

Take the project if PI > 1

Disadvantages

PI cannot rank mutually exclusive projects.


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PI calculation

Project A:

PI(A) = PV(A)/Initial cost = , 89. 6/$5, 45

PI(A) = 1. 88


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PI Calculation

PI(A) = 1. 88

PI(B) = 1.131

PI(C) = .9846



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Why cant PI rank the projects?

Exemplification

P r o j e c t x P r o j e c t y

P r e s e n t a l e $ 2 5 ,0 0 0 ,0 0 0 $ 3 ,0 0 0

In i t ia l c o s t $ 2 4 ,0 0 0 ,0 0 0 $ 1 ,0 0 0

P I 1 .0 4 2 3

N P $ 1 ,0 0 0 ,0 0 0 $ 2 ,0 0 0


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Answer

NPV rules.

Always.


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Important side note

In project valuation, measures of absolute wealth are moreappropriate than measures of relative efficiency.


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j j j

i 7.7% % %

$5, 5 $490. 7 $9,6 7.2

l $5,089. 6 $554.84 9,5 8.42

F l (5% $7,075.45 $67 .45 $12,363.5

i 3.83 3.41 2.49 *

i 4.94 3.76 * N/A

IRR 8%* 8%* 5%

MIRR 7%* 6.54%* 5%

N l $44.36* $64.17* ($148.81

i ili i x 1.0088* 1.131* 0.9846

Documents

Cap Bud Techniques