Description
includes topics like pay back method, accounting rate of return, internal rate of return, net present value, steps to capital budgeting.
The Basics of Capital Budgeting
Click to edit Master subtitle style
10-1
What is capital budgeting?
?Analysis of potential additions to fixed
assets. ?Long-term decisions; involve large expenditures. ?Very important to firm’s future.
Examples:
?Expansion ?Replacement ?Buy or lease ?Choice of equipment ?Capital expenditure
Problems:
?Demand for capital-how much money needed for
expenditure ?Supply of capital – internal and external ?Capital rationing – selection of the projects
Types of capital
?Debt ?Preference share ?Equity capital ?Retained earnings
WACC: weighted average cost of capital
methods
?Pay back method ?Accounting rate of return ?Internal rate of return ?Net present value
Steps to capital budgeting
1. 2. 3. 4. 5.
Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC.
What is the difference between independent and mutually exclusive projects?
?Independent projects – if the cash flows of
one are unaffected by the acceptance of the other. ?Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.
What is the difference between normal and nonnormal cash flow streams?
?Normal cash flow stream – Cost (negative
CF) followed by a series of positive cash inflows. One change of signs. ?Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.
What is the payback period?
?The number of years required to recover a project’s
cost, or “How long does it take to get our money back?” ?Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.
Calculating payback
Project L CFt 100 Cumulative PaybackL years Project S CFt 20 Cumulative PaybackS years
0 -100 -100 1 10 -90 2 60 -30
2.4
3 80
0
50
=
2
0
+
1
30 / 80 1.6
2
= 2.375
3
-100 -100
70 -30
100 50 0 20
40
=
1
+
30 / 50
= 1.6
Strengths and weaknesses of payback
?Strengths ? Provides an indication of a project’s risk and liquidity. ? Easy to calculate and understand. ?Weaknesses ? Ignores the time value of money. ? Ignores CFs occurring after the payback period.
Discounted payback period
?Uses discounted cash flows rather than raw CFs.
0 CFt -100 80 of CFt PV -100 49.59 Cumulative -100 18.79 Disc PaybackL= = 2 years
10%
1 10 9.09 -90.91
2 60
2.7 3
60.11
-41.32 / 60.11 = 2.7
+ 41.32
Accounting rate of return
?= estimated net profits/ capital employed . 100 ?Average investment =( initial investment + scrap
value) / 2 ?Limitation : does not look at time value of money
Net Present Value (NPV)
?Sum of the PVs of all cash inflows and
outflows of a project:
What is Project L’s NPV?
Year CFt PV of CFt 0 -100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPVL = $18.79 NPVS = $19.98
Rationale for the NPV method
NPV = PV of inflows – Cost = Net gain in wealth ?If projects are independent, accept if the project NPV > 0. ?If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. ?In this example, would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent.
Internal Rate of Return (IRR)
?IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:
Normally NPV METHOD and IRR method gives the same result
How is a project’s IRR similar to a bond’s YTM?
?They are the same thing. ?Think of a bond as a project. The YTM on
the bond would be the IRR of the “bond” project. ?EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20.
?
Solve for IRR = YTM = 7.08%, the annual return for this project/bond.
Rationale for the IRR method
?If IRR > WACC, the project’s rate of return is
greater than its costs. There is some return left over to boost stockholders’ returns.
IRR Acceptance Criteria
?If IRR > k, accept project. ?If IRR < k, reject project. ?If projects are independent, accept both
projects, as both IRR > k = 10%. ?If projects are mutually exclusive, accept S, because IRRs > IRRL.
NPV Profiles
?A graphical representation of project NPVs at
various different costs of capital. k 0 5 10 15 20 NPVL NPVS $50 $40 33 29 19 20 7 12 (4) 5
Comparing the NPV and IRR methods
?If projects are independent, the two
methods always lead to the same accept/reject decisions. ?IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment. Without modification, IRR does not account for changing discount rates, so it's just not adequate for longer-term projects with discount rates that are expected to vary.
Comparisons :
proposals Initial inv Annual cash flow Life in years
1 2 3 4 5
60,000 88,000 2150 20,500 4,25,000
12000 22,500 1,500 4500 2,25000
15 22 3 10 20
Pay back method
Pay back period = Initial investment/annual cash flow 5 3.9 1.4 4.6 1.9
1 2 3 4 5
60,000/12,000 88,00/22500 21,50/1500 2,5000/4500 4,25000/2,25000
Accounting rate
proposal Initial Annual investment cash flow Life in years Annual Net profits Rate of depreciatio return n
1 2 3 4 5
60,000 88,000 2150 20,500 4,25000
12000 22,500 1500 4500 2,25000
15 22 3 10 20
4000 4000 717 2050 21,250
8000 18,500 783 2450 203750
26.67 42 72.84 23.9 95.88
NPV
proposal Initial Annual life inv cash low 1 60,00 12,000 15 0 2 88,00 22,500 22 0 3 2150 1500 3 5 425,000 2,25000 20 4 20,50 4500 10 0
Pv(10% Pv )
npvi
7.7688 93225.61.55 8.8919 200,06 2.27 7.75 2.5918 3887.7 1.81 8.6466 1945485 4.56 6.3213 28445. 1.39 8
DCF
?Discounted cash flows or internal rate of return may
sometimes give different results
?All methods do not give the same interpretation
methods Proposal 1 2 3 4 5
payback rank 5 3 1 4 2
accounting DCF ranks 4 3 2 5 1 ranks 4 3 2 5 1
NPV ranks 4 2 3 5 1
doc_753223562.pptx
includes topics like pay back method, accounting rate of return, internal rate of return, net present value, steps to capital budgeting.
The Basics of Capital Budgeting
Click to edit Master subtitle style
10-1
What is capital budgeting?
?Analysis of potential additions to fixed
assets. ?Long-term decisions; involve large expenditures. ?Very important to firm’s future.
Examples:
?Expansion ?Replacement ?Buy or lease ?Choice of equipment ?Capital expenditure
Problems:
?Demand for capital-how much money needed for
expenditure ?Supply of capital – internal and external ?Capital rationing – selection of the projects
Types of capital
?Debt ?Preference share ?Equity capital ?Retained earnings
WACC: weighted average cost of capital
methods
?Pay back method ?Accounting rate of return ?Internal rate of return ?Net present value
Steps to capital budgeting
1. 2. 3. 4. 5.
Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC.
What is the difference between independent and mutually exclusive projects?
?Independent projects – if the cash flows of
one are unaffected by the acceptance of the other. ?Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.
What is the difference between normal and nonnormal cash flow streams?
?Normal cash flow stream – Cost (negative
CF) followed by a series of positive cash inflows. One change of signs. ?Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.
What is the payback period?
?The number of years required to recover a project’s
cost, or “How long does it take to get our money back?” ?Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.
Calculating payback
Project L CFt 100 Cumulative PaybackL years Project S CFt 20 Cumulative PaybackS years
0 -100 -100 1 10 -90 2 60 -30
2.4
3 80
0
50
=
2
0
+
1
30 / 80 1.6
2
= 2.375
3
-100 -100
70 -30
100 50 0 20
40
=
1
+
30 / 50
= 1.6
Strengths and weaknesses of payback
?Strengths ? Provides an indication of a project’s risk and liquidity. ? Easy to calculate and understand. ?Weaknesses ? Ignores the time value of money. ? Ignores CFs occurring after the payback period.
Discounted payback period
?Uses discounted cash flows rather than raw CFs.
0 CFt -100 80 of CFt PV -100 49.59 Cumulative -100 18.79 Disc PaybackL= = 2 years
10%
1 10 9.09 -90.91
2 60
2.7 3
60.11
-41.32 / 60.11 = 2.7
+ 41.32
Accounting rate of return
?= estimated net profits/ capital employed . 100 ?Average investment =( initial investment + scrap
value) / 2 ?Limitation : does not look at time value of money
Net Present Value (NPV)
?Sum of the PVs of all cash inflows and
outflows of a project:
What is Project L’s NPV?
Year CFt PV of CFt 0 -100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPVL = $18.79 NPVS = $19.98
Rationale for the NPV method
NPV = PV of inflows – Cost = Net gain in wealth ?If projects are independent, accept if the project NPV > 0. ?If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. ?In this example, would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent.
Internal Rate of Return (IRR)
?IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:
Normally NPV METHOD and IRR method gives the same result
How is a project’s IRR similar to a bond’s YTM?
?They are the same thing. ?Think of a bond as a project. The YTM on
the bond would be the IRR of the “bond” project. ?EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20.
?
Solve for IRR = YTM = 7.08%, the annual return for this project/bond.
Rationale for the IRR method
?If IRR > WACC, the project’s rate of return is
greater than its costs. There is some return left over to boost stockholders’ returns.
IRR Acceptance Criteria
?If IRR > k, accept project. ?If IRR < k, reject project. ?If projects are independent, accept both
projects, as both IRR > k = 10%. ?If projects are mutually exclusive, accept S, because IRRs > IRRL.
NPV Profiles
?A graphical representation of project NPVs at
various different costs of capital. k 0 5 10 15 20 NPVL NPVS $50 $40 33 29 19 20 7 12 (4) 5
Comparing the NPV and IRR methods
?If projects are independent, the two
methods always lead to the same accept/reject decisions. ?IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment. Without modification, IRR does not account for changing discount rates, so it's just not adequate for longer-term projects with discount rates that are expected to vary.
Comparisons :
proposals Initial inv Annual cash flow Life in years
1 2 3 4 5
60,000 88,000 2150 20,500 4,25,000
12000 22,500 1,500 4500 2,25000
15 22 3 10 20
Pay back method
Pay back period = Initial investment/annual cash flow 5 3.9 1.4 4.6 1.9
1 2 3 4 5
60,000/12,000 88,00/22500 21,50/1500 2,5000/4500 4,25000/2,25000
Accounting rate
proposal Initial Annual investment cash flow Life in years Annual Net profits Rate of depreciatio return n
1 2 3 4 5
60,000 88,000 2150 20,500 4,25000
12000 22,500 1500 4500 2,25000
15 22 3 10 20
4000 4000 717 2050 21,250
8000 18,500 783 2450 203750
26.67 42 72.84 23.9 95.88
NPV
proposal Initial Annual life inv cash low 1 60,00 12,000 15 0 2 88,00 22,500 22 0 3 2150 1500 3 5 425,000 2,25000 20 4 20,50 4500 10 0
Pv(10% Pv )
npvi
7.7688 93225.61.55 8.8919 200,06 2.27 7.75 2.5918 3887.7 1.81 8.6466 1945485 4.56 6.3213 28445. 1.39 8
DCF
?Discounted cash flows or internal rate of return may
sometimes give different results
?All methods do not give the same interpretation
methods Proposal 1 2 3 4 5
payback rank 5 3 1 4 2
accounting DCF ranks 4 3 2 5 1 ranks 4 3 2 5 1
NPV ranks 4 2 3 5 1
doc_753223562.pptx