capital budgeting march 2013

8/13/2019 Capital Budgeting March 2013

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Chapter 9

Capital-Budgeting Decision Criteria

Foundations of Finance

MBA SMS UOFK 2013 Prof.Abdelgadir


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Concepts and Learning Objectives

Be able to compute payback and discountedpayback and understand their shortcomings

Understand accounting rates of return andtheir shortcomings

Be able to compute the internal rate of returnand understand its strengths and

weaknesses

Be able to compute the net present value andunderstand why it is the best decision

criterionMBA SMS UOFK 2013 Prof.Abdelgadir


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Capital Budgeting

Investments in fixed assets

An approach to source and evaluateprofitable projects

Evaluating the profitability of projects

Often choosing between one or moreprojects


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Decision-making Criteria

in Capital Budgeting

How do we decide if a capital investment

project should be accepted or rejected? The ideal evaluation method should:

a) include all cash flows that occur during the

life of the project,b) consider the time value of money, and

c) incorporate the required rate of return on

the project.MBA SMS UOFK 2013 Prof.Abdelgadir


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Good Decision Criteria

We need to ask ourselves the followingquestions when evaluating capital budgetingdecision rules:

1. Does the decision rule adjust for the time valueof money?

2. Does the decision rule adjust for risk?3. Does the decision rule provide information on

whether we are creating value for the firm?



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Techniques of capital budgeting

The Payback Rule

The Discounted Payback

Net Present Value The Profitability Index

The Internal Rate of Return

The Average Accounting Return



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1-Payback Period

How long does it take to get the initial costback in a nominal sense?

Computation Estimate the cash flows

Subtract the future cash flows from the initial costuntil the initial investment has been recovered

Decision RuleAccept i f the paybackper iod is less than som e preset l im it


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Payback Period: example 1

How long will it take for the projectto generate enough cash to pay for

itself?

Payback period = 3.33 years

0 1 2 3 4 5 86 7

(500) 150 150 150 150 150 150 150 150



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Payback: Example2

ProjectProject A

2700015000investment

44N

7500

7500

7500

18000

5000

5000

5000

5000

OCF

1

2

3

4


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Advantages and Disadvantages of Payback

Advantages

Easy to understand

Adjusts for uncertainty of

later cash flows Biased towards liquidity

Disadvantages

Ignores the time value ofmoney

Requires an arbitrarycutoff point

Ignores cash flowsbeyond the cutoff date

Biased against long-termprojects, such asresearch anddevelopment, and newprojects


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Drawbacks of Payback Period

Does not consider all of the projects

cash flows.

This project is clearly unprofitable, but

we would accept it based on a 4-year

payback criterion!

0 1 2 3 4 58

67

(500) 150 150 150 150 150 150 150 150



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2- Discounted Payback Period

Compute the present value of each cash flowand then determine how long it takes topayback on a discounted basis

Compare to a specified required period

Decision Rule - Accept the project i f i t paysback on a discounted basis w i th in the

speci f ied t ime



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Discounted Payback: example 1

0 1 2 3 4 5

(500) 250 250 250 250 250

Discounted

Year Cash Flow CF (14%)0 -500 -500.00

1 250 219.30 1 year

280.702 250 192.37 2 years

88.33

3 250 168.74 .52 yearsMBA SMS UOFK 2013 Prof.Abdelgadir


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Discounted payback: Example2

A project costs 13000 and has an

economic life of 4 years. The annual

operating cash flows are:7000, 7500, 8000

and 8500 respectively.

Required:

If the discount rate 12% what will be the

discounted payback period for this

project?MBA SMS UOFK 2013 Prof.Abdelgadir


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Advantages and Disadvantages of Discounted

Payback

Advantages

Includes time value ofmoney

Easy to understand Does not accept negative

estimated NPVinvestments when allfuture cash flows are

positive Biased towards liquidity

Disadvantages

May reject positive NPVinvestments

Requires an arbitrarycutoff point

Ignores cash flowsbeyond the cutoff point

Biased against long-termprojects, such as R&Dand new products



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3- Net Present Value

The difference between the market value of aproject and its cost

How much value is created from undertaking an

investment? Steps in calculating NPV:

1. Estimate the expected future cash flows.

2. Estimate the required return for projects of this risk level.

3. Find the present value of the cash flows.

4. Subtract the initial investment from the total present valueof future cash flows to get NPV


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NPV = the total PV of the annual netcash flows - the initial outlay.

NPV = - IO

FCFt

(1 + k) t

n

t=1

3- Net Present Value



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NPVDecision Rule

If the NPV is pos it ive, accept the project

If you have to select one pro ject out o f

many p rojects accept the one w ith the

highest posi t ive NPV

A positive NPV means that the project isexpected to add value to the firm and willtherefore increase the wealth of the owners.


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NPV Example

The initial investment = $ 165000

Discount Rate 12%


year cash flows

1 63,120

2 70,8003 91,080


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Computing NPV for the Project

Using the formulas:

NPV = 63,120 /(1.12) + 70,800 /(1.12)2+ 91,080/(1.12)3165,000 = 12,627.42

Using the calculator: CF0= -165,000; C01 = 63,120; F01 = 1; C02 =

70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I =12; CPT NPV = 12,627.42

Do we accept o r reject the project?


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Calculating NPVs with a Spreadsheet

Spreadsheets are an excellent way tocompute NPVs, especially when you have tocompute the cash flows as well.

Using the NPV function The first component is the required return entered

as a decimal

The second component is the range of cash flows

beginning with year 1 Subtract the initial investment after computing the

NPV



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Advantages & Disadvantages

of NPV

Includes the time valueof money.

Easy to understand

Includes all cash flows It accounts for risk of

cash flows

Assumes a single ratethrough the life of theproject.

Ignores the size of theproject.


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4- Profitability Index

Measures the benefit per unit cost, based onthe time value of money

A profitability index of 1.1 implies that forevery $1 of investment, we create anadditional $0.10 in value

This measure can be very useful in situations

in which we have limited capital


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Profi tabi l i ty I ndex

PI = IOFCFt

(1 + k)

n

t=1

t

NPV = - IOFCFt

(1 + k) t

n

t=1



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Profitability index

It is the ratio of present value of OCF to the present value ofthe cost of the project. The decision Rule:

1- We accept the project if PI > 1.

2- We reject the project if PI < 1.

4- If we have to select one of two mutually exclusive projectswe select the one with the highest PI.

5- If the projects are independent we select all projects thathave PIs more than 1 provided that we have enough.

In general the project with PI > 1 will have positive NPV.

In most cases if we accept under NPV we will accept it underPI.


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Profitability Index

A firm with a 10% required rate of return is

considering investing in a new machinewith an expected life of six years. Theinitial cash outlay is $50,000.


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Profitability Index

FCF PVF @ 10% PV

Initial

Outlay

-$50,000 1.000 -$50,000

Year 1 15,000 0.909 13,635

Year 2 8,000 0.826 6,608

Year 3 10,000 0.751 7,510

Year 4 12,000 0.683 8,196

Year 5 14,000 0.621 8,694

Year 6 16,000 0.564 9,024MBA SMS UOFK 2013 Prof.Abdelgadir


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Profitability Index

PI = ($13,635 + $6,608+$7,510 + $8,196 + $8,694+ $9,024) / $50,000

=$53,667/$50,000

= 1.0733

Project PI > 1

Therefore, accept.



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Advantages and Disadvantages of Profitability

Index

Advantages

Closely related to NPV,generally leading toidentical decisions

Easy to understand andcommunicate

May be useful whenavailable investment

funds are limited

Disadvantages

May lead to incorrectdecisions in comparisonsof mutually exclusiveinvestments



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5- Internal Rate of Return

This is the most important alternative to NPV

It is often used in practice and is intuitivelyappealing

It is based entirely on the estimated cash flows andis independent of interest rates found elsewhere

Definition: IRR is the return that makes the NPV = 0

Decision Rule: Accept the project i f the IRR isgreater than th e requ ired return



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Internal Rate of Return (IRR)

NPV = - IOFCFt

(1 + k)

t

n

t=1

n

t=1

IRR: = IOFCFt(1 + IRR) t



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IRR: Example 1

A project costs 100 and has one year as an

economic life. At the end of that year it

will generate 110. What is the IRR for this

project?



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NPV Example 2

The initial investment = $ 165000

Discount Rate 12%

year cash flows

1 63,120

2 70,8003 91,080



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Computing IRR For The Project

If you do not have a financial calculator, thenthis becomes a trial and error process

Calculator

Enter the cash flows as you did with NPV

Press IRR and then CPT

IRR = 16.13% > 12% required return



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NPV Profile For The Project

-20,000

-10,000

0

10,000

20,000

30,00040,000

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

NPV

IRR = 16.13%



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Calculating IRRs With A Spreadsheet

You start with the cash flows the same asyou did for the NPV

You use the IRR function

You first enter your range of cash flows,beginning with the initial cash flow

You can enter a guess, but it is not necessary

The default format is a whole percentyou willnormally want to increase the decimal places to atleast two



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Advantages of IRR

Knowing a return is intuitively appealing

It is a simple way to communicate the valueof a project to someone who doesnt know all

the estimation details

If the IRR is high enough, you may not needto estimate a required return, which is often a

difficult task


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6- Average Accounting Return

average net income

average book value

average net income= Total Net Income

No. of years

average book value:= (Beginning investment + ending investment)

2

Need to have a target cutoff rate Decision Rule: Accept the pro ject i f the AAR is

g reater than a preset rate.


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Project Example Information

You are looking at a new project and youhave estimated the following cash flows:

Year 1: 13,620

Year 2: 3,300

Year 3: 29,100

Average Book Value = 72,000



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Computing AAR For The Project

Assume we require an average accountingreturn of 25%

Average Net Income:

(13,620 + 3,300 + 29,100) / 3 = 15,340

AAR = 15,340 / 72,000 = .213 = 21.3%



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Advantages and Disadvantages of AAR

Advantages

Easy to calculate

Needed information will

usually be available

Disadvantages

Not a true rate of return;time value of money isignored

Uses an arbitrarybenchmark cutoff rate

Based on accounting netincome and book values,

not cash flows andmarket values


capital budgeting march 2013

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