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Capital Budgeting 1
Capital Budgeting
Select investments which increase value of firm
Maximize wealth of shareholders Important to firm’s long-term success
Substantial costCash flows over long time period
BigPicture…
Capital Budgeting 2
Steps in evaluating capital assets Determine cost of asset Estimate incremental cash flows
Very difficult but…Very important…
Determine decision criteria Apply decision criteria Compare actual results to projected
Capital Budgeting 3
Capital Budgeting Decision Criteria Should you sign Shaq O’ Squeal to a four-
year contract for $100 million???
Capital Budgeting 4
Capital Budgeting Decision Criteria Determine cost Estimate incremental cash flows
Increase in revenue Increase in expenses
Capital Budgeting 7
Payback Period
Shaq Hack Mac
2005 30 mil 101 mil 10 mil
2006 40 mil 0 10 mil
2007 40 mil 0 70 mil
2008 70 mil 0 510 mil
170 mil 101 mil 600 mil
Capital Budgeting 8
Payback Period
Payback: length of time to get $$$ back
Rule: accept investments that payback before required period
Capital Budgeting 9
Payback Period
Advantages: Easy to calculate and understand
Useful for small investmentsFavors investments with quick returns
Capital Budgeting 10
Payback Period
Disadvantages: Future cash flows not discounted
Since favors quick returns, not huge problem Ignores cash flows after payback
Coal mine: negative cash flows at endMust select cutoff period
Three or four years reasonable 20 years, probably not
Capital Budgeting 11
Net Present Value
NPV: PV of cash flow – Cost of Investment
Rule: accept investments with a positive NPV
Capital Budgeting 12
Net Present Value
Shaq Mac Hack
2005 30$ 101$ 10$
2006 40$ 10$
2007 40$ 70$
2008 70$ 510$
Total 180$ 101$ 600$
Cost 100$ 100$ 100$
Discount Rate 12% 12% 12%
PV Cash Flows $131.63 $90.18 $390.84
NPV $31.63 ($9.82) $290.84
Capital Budgeting 13
Net Present Value
Advantages: If assumptions correct, increases value
of firmDiscounts future cash flows
Capital Budgeting 14
Net Present Value
Disadvantages:Determining proper discount rate
Should it be adjusted for riskiness of each project’s cash flows???
Set too high, pass up acceptable projects Buyer with lower discount rate will pay highest price
Set too low, decrease wealth of firm Ignores relative cost of investments
Project A: cost $1 million; NPV $20 Project B: cost $50; NPV $19
In an efficient market, should projects have huge positive
NPVs???
Capital Budgeting 15
Profitability Index
PI: PV Cash Flows / Cost Rule: accept investments with a PI
above 1.0
Capital Budgeting 16
Profitability Index
Shaq Mac Hack
2005 30$ 101$ 10$
2006 40$ 10$
2007 40$ 70$
2008 70$ 510$
Total 180$ 101$ 600$
Cost 100$ 100$ 350$
Discount Rate 12% 12% 12%
PV Cash Flows $131.63 $90.18 $390.84
NPV $31.63 ($9.82) $40.84
PI 1.32 0.90 1.12
Capital Budgeting 17
Profitability Index
Advantages:Comparing alternative investmentsDiscounts future cash flows
Disadvantages:Favors lower cost investments
Capital Budgeting 18
Internal Rate of Return
IRR: Discount rate where NPV = 0
Rule: accept investments with an IRR above required return
Capital Budgeting 19
IRR
Shaq Shaq Shaq
Cost (100)$ (100)$ (100)$
2005 30$ 30$ 30$
2006 40$ 40$ 40$
2007 40$ 40$ 40$
2008 70$ 70$ 70$
Total 180$ 180$ 180$
Discount Rate 12% 20% 30%
PV Cash Flows $131.63 $109.68 $89.46
NPV $31.63 $9.68 ($10.54)
IRR 24.39% 24.39% 24.39%
Capital Budgeting 20
IRR
Advantages:Most often used criteria in capital
budgetingNot required to select a discount rateDoes discount future cash flows
Capital Budgeting 21
IRR
Disadvantages:Assumes can reinvest cash flows at IRR
NPV assumes reinvest at required rate return
NPV assumption more logicalFavors short-term investments
Difficult to achieve high IRR on distant cash flows