Topic3_CapitalBudgeting

8/10/2019 Topic3_CapitalBudgeting

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FINS1613: Business FinanceSemester 2, 2014

Topic: Capital Budgeting I


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Contact Details

Emma Jincheng Zhang (Weeks 5-7) [email protected] Rm 302Consultation hours: Monday 9-11am
mailto:[email protected]:[email protected]


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Outline

1. Introduction to capital budgetinga. Independent and mutually exclusive projects

2. Investment decision rulesa. Net present value (NPV)

b. Payback rulec. Average accounting return (AAR)d. Internal rate of return (IRR)e. Modified internal rate of return (MIRR)f. Profitability index (PI)

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1. Introduction to capitalbudgeting

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Role of the financial manager

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It is the role of the financial manager to make someimportant decisionsCapital budgeting (investment decision)

What long-term investments should the firm take on?

Capital structure (financing decision)Where will we get the long-term financing to pay for the investment?Working capital management

How will we manage the everyday financial activities of the firm?


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Capital budgeting decision criteria

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We need to ask ourselves the following questions whenevaluating decision criteria:Does the decision rule adjust for the time value of money?Does the decision rule adjust for risk?

Does the decision rule provide information on whether we arecreating value for the firm?


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Independent projects

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What are independent projects?Independent Projects are investments that have no impact oneach others cash flows. This means that the company decides to accept or reject eachproject and that decision will have no impact on whether

another project is accepted or rejected.The firm could accept one or more projects or it could rejectthem all.


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Mutually exclusive projects

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What are mutually exclusive projects?Mutually exclusive projects are investments in which acceptingone project requires reject of all other options.This may be due to financial constraints or limitations toavailable assets.Projects need to be ranked in order to determine which toundertake.


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An example of two mutually exclusive projects is:A company has a piece of land and it is debating either buildingan office block on the land or building a warehouse.It cannot use the same piece of land for two different things atthe same time.These are mutually exclusive projects.


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A second example of two mutually exclusive projects is:A company has a fixed budget of $20,000 for investment thisyear. The firm is considering two projects. The first will take$15,000 to establish and the second project will require$18,000.

Clearly, only one project can be carried out this year so theyare mutually exclusive.


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2. Investment Decision Rules

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Net Present Value

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Net present value (NPV): The difference between aninvestments market value and its initial investment.Steps in calculating the NPV:

Step 1: Estimate the expected future cash

flows.Step 2: Estimate the required return for projectsof this risk level.

Step 3: Find the present value of the cash flows

and subtract the initial investment toarrive at the net present value.NPV Rule: An investment should be accepted if the netpresent value is positive and rejected if it is negative


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Net Present Value

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1 =

C t: Cash flows from the project. These cash flows areusually inflows (positive).C0: Initial cost of the project. This is usually an outflow

(negative)r: the discount rate for the project


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Net Present Value

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Cash inflows:Receipts from sale of goods and servicesReceipts from sale of physical assets

Cash outflows:

Expenditure on materials, labour, and indirect expenses formanufacturingSelling and administrativeInventory and taxes


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Net Present Value Decision Rule

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If NPV is positive, accept the project NPV > 0 means:

project is expected to add value to the firmproject will increase the wealth of the owners

NPV is a direct measure of how well this project willachieve the goal of increasing shareholder wealth.

NPV represents the net gain in shareholder wealth


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Example: Net Present Value

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You are looking at a new project and have estimated thefollowing cash flows and net income:

The average book value is $72,000Your required return for assets of this risk is 12%

We will use this project for all investment decision rules.

Year Cash Flow Net Income

0 -165,000

1 63,120 13,6202 70,800 3,300

3 91,080 29,100


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Example: Net Present Value

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1

=

63,1201.12 70,8001.12 91,0801.12165,000 = $12,627.41

t = 0 t = 1 t = 2

$63,120

t = 3

$70,800 $91,080-$165,000


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Analysing the NPV rule

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Meets all desirable criteriaConsiders all cash flowsConsiders time value of moneyAdjusts for risk

Can rank mutually exclusive projectsNPV method is consistent with the companys objectiveof maximising shareholders wealth. Dominant method; always prevails


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Payback rule

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Payback Period: The amount of time required for aninvestment to generate net cash flows sufficient torecover its initial cost (investment).Steps in calculating the payback period:

Step 1: Estimate the expected future cashflows.Step 2: Subtract the future cash flows from the initialcost until initial investment is recovered.

Payback Rule: Accept if the payback period is less thansome predetermined limit.


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Example: Payback rule

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2 2,, 2.34

Do we accept or reject the project?Depends on the companys predetermined limit.

Year Cash Flow Cumulative Cash Flow0 -165,000 -165,000

1 63,120 -101,880

2 70,800 -31,080

3 91,080 60,000


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Example: Payback rule

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Your companys payback period is 2 years. According tothe payback rule, which of the following projects will youaccept?

Year A B C D E

0 -$100 -$200 -$200 -$200 -$50

1 30 40 40 100 100

2 40 20 20 100 -50,000,000

3 50 10 10 -200

4 60 130 200Payback period 2.6 Never 4 2 or 4 0.5


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Analysing the payback rule

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Advantages

Easy to understand Adjusts for uncertainty of

later cash flows Biased towards liquidity

Disadvantages

Ignores the time value ofmoney

Requires an arbitrarycut-off point Ignores cash flows

beyond the cut-off date Biased against long-term

projects, such as researchand development, andnew projects


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Average Accounting Return

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Many different definitions for average accountingreturn (AAR).

In your textbook: Average book value depends on how the asset isdepreciated.

Requires a target cut-off rateDecision rule: Accept the project if the AAR is greaterthan target rate.


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Example: Average Accounting Return

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Sample project data:

Average book value = $72 000Required average accounting return = 25%

Average net income:($13 620 + 3300 + 29 100) / 3 = $15 340AAR = $15 340 / 72 000 = 0.213 = 21.3%Do we accept or reject the project?

Year Cash Flow Net Income

0 -165,000

1 63,120 13,620

2 70,800 3,300

3 91,080 29,100


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Analysing AAR

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Advantages Easy to calculate Needed information

usually available

Disadvantages Not a true rate of

return Time value of money

ignored Uses an arbitrary

benchmark cut-off rate Based on accounting

net income and bookvalues, not cash flowsand market values


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Internal Rate of Return

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Most important alternative to NPVWidely used in practiceIntuitively appealingBased entirely on the estimated cash flowsIndependent of interest rates


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Internal Rate of Return

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Internal Rate of Return (IRR): the discount rate thatmakes the NPV equal to 0.

0 1=

Decision rule: Accept the project if the IRR is greaterthan the required return. Finding the IRR often involves trial and error.


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Example: IRR

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Sample project data:

To solve for the IRR:

0 165,00063,1201

70,8001

91,0801

Using trial and error, IRR = 16.132%

Year Cash Flow

0 -165,000

1 63,120

2 70,800

3 91,080


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Example: IRR

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The NPV of the project at various discount rates:

To calculate the NPV at a discount rate of 4%: 165,00063,1201.04 70,8001.04 91,0801.04 $42,121 We can plot the NPV profile (next slide).

Discount rate NPV

0% $60,000

4% $42,121

8% $26,446

12% $12,627

16% $380.83

20% -$10,525


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Example: IRR

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-20,000-10,000

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

Discount Rate

N P V


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NPV and IRR

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The NPV and IRR rules always lead to identical decisionsif:1. Cash flows are conventional

Conventional cash flows: First cash flow (the initial investment) isnegative and all the rest are positive

2. The project is independentThe decision to accept or reject this project does not affect thedecision to accept or reject any other.

Whenever there is a conflict between NPV and anotherdecision rule, you should always use NPV.


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Non-conventional cash flows: Multiple IRRs

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It is possible for a project to have more than one IRRvalue.This happens in situations when there is a large cashoutflow at the beginning of the project and then

another large outflow at some later time.This makes it difficult to use the IRR methodology as itis not possible to know which IRR result should beused.


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Example: Multiple IRRs

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0 1 2 IRR (%)Project X -$100 $230 -$132 ??

General equation:

0 100+ + At 10%:

1002301.10

1321.10 0

At 20%:

1002301.201321.20 0


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Example: Multiple IRRs

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-2500

-1500

-500

500

0 5 10 15 20 25 30 35

Discount rate (%)

N e

t P r e s e n

t V

a l u e

( $ )


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Example: Mutually Exclusive Investments

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Consider a Projects A and B with the following cash flows:

Year Project A Project B

0 -1,000 -1,500

1 400 599

2 500 400

3 150 600

4 200 350

5 400 400


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Example: Mutually Exclusive Investments

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The NPV of the project at various discount rates:

Discount rate Project A NPV Project B NPV

0% $650.00 $849.00

4% $479.97 $607.13

8% $337.35 $403.3612% $216.58 $230.17

16% $113.41 $81.79

20% $24.56 -$46.29

24% -$52.53 -$157.61


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Mutually Exclusive Investments

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-400

-200

0

200

400

600

800

1000

0% 5% 10% 15% 20% 25%

N P V

( $ )

Discount rate

Project A Project B

IRR Project B(18.49%)

Cross-over pointNPVA = NPV B

(13.14%)

IRR Project A(21.22%)


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Analysing the IRR

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Advantages Knowing a return is

intuitively appealing It is a simple way to

communicate the value of aproject to someone whodoesnt know all theestimation details

If the IRR is high enough,

you may not need toestimate a required return,which is often a difficulttask

Disadvantages Can produce multiple

answers Cannot rank mutually

exclusive projects


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Modified IRR

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Controls for some problems with IRRThree methods:1.Discounting approach = Discount future outflows to present

and add to CF 02. Reinvestment approach = Compound all CFs except the

first one forward to end3. Combination approach = Discount outflows to present;

compound inflows to endMIRR will be unique number for each method

Discount (finance) /compound (reinvestment) rateexternally supplied


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Example: Discounting approach

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Discounting approach: Discount all negative cash flows to

the present and add to the initial cost.Solving for the MIRR:

Time 0: -$60 + (-$100/1.20 2) = -129.44Time 1: +$155Time 2: $0

MIRR is 19.75%

0 1 2Project X -$60 $155 -$100

Adjusted cash flows -$129.44 $155 0


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Example: Reinvestment approach

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Reinvestment approach: Compound all CFs except the

first one to the end of the projects life and calculate IRR.Solving for the MIRR:

Time 0: -$60Time 1: $0Time 2: -$100 + ($155 1.20) = $86

MIRR is 19.72%

0 1 2Project X -$60 $155 -$100

Adjusted cash flows -$60 0 $86


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Example: Combination approach

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Combination approach: Negative cash flows discounted

back to the present, positive cash flows compounded tothe end of the project.Solving for the MIRR:

Time 0: -$60 + (-$100/1.20 2) = -$129.44Time 1: $0Time 2: $155 1.20 = $186

MIRR is 19.87%

0 1 2Project X -$60 $155 -$100

Adjusted cash flows -$129.44 0 $186


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MIRR vs. IRR

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Different opinions about MIRR and IRR.MIRR avoids the multiple IRR problem.Managers like rate of return comparisons, and MIRR isbetter for this than IRR.

Problem with MIRR: different ways to calculate with noevidence of the best method.Interpreting a MIRR is not obvious.


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Profitability Index

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Profitability index: The present value of an investmentsfuture cash flows divided by its initial cost.

Measures the value created per dollar invested (bang for thebuck). E.g. A profitability index of 1.1 implies that for every $1 ofinvestment, we create an additional $0.10 in value.

This measure can be very useful in situations where wehave limited capital.

Decision Rule (Independent projects): Accept the projectif PI > 1.0.


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Example: Profitability index

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What is the profitability index for the following set of cashflows if the relevant discount rate is 10%? Should we acceptthe project?

13,5001.10 8,5001.105,5001.10$20,000 1.171We should accept the project because PI > 1.0.

Year Cash Flow

0 -$20,000

1 13,5002 8,500

3 5,500


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What if the discount rate is 22%?

13,5001.228,5001.225,5001.22$20,000

0.990

We should reject the project because PI < 1.0.


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47

Consider two mutually exclusive projects with thefollowing cash flows:

The required return is 11%.

According to the PI rule, which project will you choose?According to the NPV rule, which project will youchoose?

Year Project A Project B

0 -$45,000 -$20,000

1 17,000 6,000

2 20,000 13,000

3 24,000 9,000


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48

According to the PI rule, which project will you choose?

According to the PI rule, we choose Project B.

( )17,0001.11 20,0001.11 24,0001.1145,000 1.091

( )6,0001.1113,0001.11 9,0001.1120,000 1.127


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According to the NPV rule, which project will you choose?

According to the NPV rule, we choose Project A.

The profitability index does not consider the scale of theproject. Project A is approximately double the size of projectB.

17,0001.1120,0001.11

24,0001.1145,000 $4,096.36

6,0001.1113,0001.11 9,0001.1120,000 $2,537.22


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Analysing the Profitability index

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Advantages

Closely related toNPV, generally

leading to identicaldecisions Easy to understand

and communicate

May be useful whenavailable investmentfunds are limited

Disadvantages

May lead to incorrectdecisions in

comparisons ofmutually exclusiveinvestment


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Project Evaluation Methods

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Method Percentage Accounting Rate of Return 20.29Profitability Index 11.87Internal Rate of Return 75.61Net Present Value 74.93Payback Period 56.74Source: Graham & Harvey (2001)


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Tutorial QuestionsTextbook (Chapter 8)

Critical Thinking and Concepts Review8.3 8.4 8.5 8.7

Questions and Problems2 4 10 11 12 13 18 21 24 25

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Topic3_CapitalBudgeting