Description
capital budgeting in economics and also gives steps in capital budgeting. What is the difference between independent and mutually exclusive projects. What is the difference between normal and non-normal cash flow streams? What is NPV and IRR, limitations of IRR.
THE BASICS OF CAPITAL BUDGETING
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
Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine the appropriate cost of capital. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.
1.
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 Cumulative
0
-100 -100
1
10 -90
2
60 -30
2.4
100 0
3
80
50
PaybackL
Project S CFt Cumulative PaybackS
= 2 =
0 -100 -100
+
1
30 / 80 1.6
2
= 2.375 years
3 20 40
70 -30
100 50 0 20
= 1 =
+
30 / 50
= 1.6 years
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 PV of CFt Cumulative -100 -100 -100 2 +
10%
1 10 9.09 -90.91
2 60 49.59 -41.32
2.7 3
80 60.11 18.79 = 2.7 years
Disc PaybackL = =
41.32 / 60.11
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:
CFt NPV ? ? t t ?0 ( 1 ? k )
n
What is Project L’s NPV?
Year 0 1 2 3 CFt -100 10 60 80 NPVL = PV of CFt -$100 9.09 49.59 60.11 $18.79
NPVS = $19.98
Rationale for the NPV method
= 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. NPV
Internal Rate of Return (IRR)
? IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:
CFt 0?? ( 1 ? IRR ) t t ?0
n
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 $50 33 19 7 (4)
NPVS $40 29 20 12 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 Life in investme cash flow years nt Annual deprecia tion Net profits Rate of return
1
60,000
12000
15
4000
8000
26.67
2
3 4 5
88,000
2150 20,500 4,25000
22,500
1500 4500 2,25000
22
3 10 20
4000
717 2050 21,250
18,500
783 2450 203750
42
72.84 23.9 95.88
NPV
proposal 1 2 3 4 Initial inv 60,000 88,000 2150 20,500 Annual cash low 12,000 22,500 1500 4500 life 15 22 3 10 Pv(10%) 7.7688 8.8919 2.5918 6.3213 Pv 93225.6 npvi 1.55
200,067.7 2.27 5 3887.7 28445.8 1.81 1.39
5
425,000 2,25000
20
8.6466
1945485
4.56
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
payback
rank 5 3 1
accountin g
ranks 4 3 2
DCF
ranks 4 3 2
NPV
ranks 4 2 3
4
5
4
2
5
1
5
1
5
1
doc_579613465.pptx
capital budgeting in economics and also gives steps in capital budgeting. What is the difference between independent and mutually exclusive projects. What is the difference between normal and non-normal cash flow streams? What is NPV and IRR, limitations of IRR.
THE BASICS OF CAPITAL BUDGETING
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
Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine the appropriate cost of capital. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.
1.
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 Cumulative
0
-100 -100
1
10 -90
2
60 -30
2.4
100 0
3
80
50
PaybackL
Project S CFt Cumulative PaybackS
= 2 =
0 -100 -100
+
1
30 / 80 1.6
2
= 2.375 years
3 20 40
70 -30
100 50 0 20
= 1 =
+
30 / 50
= 1.6 years
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 PV of CFt Cumulative -100 -100 -100 2 +
10%
1 10 9.09 -90.91
2 60 49.59 -41.32
2.7 3
80 60.11 18.79 = 2.7 years
Disc PaybackL = =
41.32 / 60.11
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:
CFt NPV ? ? t t ?0 ( 1 ? k )
n
What is Project L’s NPV?
Year 0 1 2 3 CFt -100 10 60 80 NPVL = PV of CFt -$100 9.09 49.59 60.11 $18.79
NPVS = $19.98
Rationale for the NPV method
= 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. NPV
Internal Rate of Return (IRR)
? IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:
CFt 0?? ( 1 ? IRR ) t t ?0
n
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 $50 33 19 7 (4)
NPVS $40 29 20 12 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 Life in investme cash flow years nt Annual deprecia tion Net profits Rate of return
1
60,000
12000
15
4000
8000
26.67
2
3 4 5
88,000
2150 20,500 4,25000
22,500
1500 4500 2,25000
22
3 10 20
4000
717 2050 21,250
18,500
783 2450 203750
42
72.84 23.9 95.88
NPV
proposal 1 2 3 4 Initial inv 60,000 88,000 2150 20,500 Annual cash low 12,000 22,500 1500 4500 life 15 22 3 10 Pv(10%) 7.7688 8.8919 2.5918 6.3213 Pv 93225.6 npvi 1.55
200,067.7 2.27 5 3887.7 28445.8 1.81 1.39
5
425,000 2,25000
20
8.6466
1945485
4.56
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
payback
rank 5 3 1
accountin g
ranks 4 3 2
DCF
ranks 4 3 2
NPV
ranks 4 2 3
4
5
4
2
5
1
5
1
5
1
doc_579613465.pptx