cap budget [autosaved]
TRANSCRIPT
10-1
The Basics of Capital Budgeting
10-2
What is capital budgeting? Analysis of potential additions to
fixed assets. Long-term decisions; involve
large expenditures. Very important to firm’s future.
10-3
Examples:
Expansion Replacement Buy or lease Choice of equipment Capital expenditure
10-4
Problems:
Demand for capital-how much money needed for expenditure
Supply of capital – internal and external
Capital rationing – selection of the projects
10-5
Types of capital
Debt Preference share Equity capital Retained earningsWACC: weighted average cost of
capital
10-6
methods
Pay back method Accounting rate of return Internal rate of return Net present value
10-7
Steps to capital budgeting
1. 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.
10-8
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.
10-9
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.
10-10
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.
10-11
Calculating payback
PaybackL = 2 + / = 2.375 years
CFt -100 10 60 100Cumulative -100 -90 0 50
0 1 2 3
=
2.4
30 80
80
-30
Project L
PaybackS = 1 + / = 1.6 years
CFt -100 70 100 20Cumulative -100 0 20 40
0 1 2 3
=
1.6
30 50
50-30
Project S
10-12
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.
10-13
Discounted payback period
Uses discounted cash flows rather than raw CFs.
Disc PaybackL = 2 + / = 2.7 years
CFt -100 10 60 80
Cumulative -100 -90.91 18.79
0 1 2 3
=
2.7
60.11
-41.32
PV of CFt -100 9.09 49.59
41.32 60.11
10%
10-14
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
10-15
Net Present Value (NPV) Sum of the PVs of all cash inflows and
outflows of a project:
n
0tt
t
) k 1 (CF
NPV
10-16
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
10-17
Rationale for the NPV methodNPV = 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.
10-18
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
n
0tt
t
) IRR 1 (CF
0
10-19
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.
10-20
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.
10-21
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.
10-22
NPV Profiles A graphical representation of project
NPVs at various different costs of capital.
k NPVL NPVS
0 $50 $40 5 33 2910 19 2015 7 1220 (4) 5
10-23
Comparing the NPV and IRR methods
If projects are independent, the two methods always lead to the same accept/reject decisions.
If projects are mutually exclusive … If k > crossover point, the two
methods lead to the same decision and there is no conflict.
If k < crossover point, the two methods lead to different accept/reject decisions.
10-24
Comparisons :proposals Initial inv Annual cash
flowLife in years
1 60,000 12000 15
2 88,000 22,500 22
3 2150 1,500 3
4 20,500 4500 10
5 4,25,000 2,25000 20
10-25
Pay back methodPay back period =
Initial investment/annual cash flow
1 60,000/12,000 5
2 88,00/22500 3.9
3 21,50/1500 1.4
4 2,5000/4500 4.6
5 4,25000/2,25000 1.9
10-26
Accounting rate proposal
Initial investment
Annual cash flow
Life in years
Annual depreciation
Net profits
Rate of return
1 60,000 12000 15 4000 8000 26.67
2 88,000 22,500 22 4000 18,500 42
3 2150 1500 3 717 783 72.84
4 20,500 4500 10 2050 2450 23.9
5 4,25000
2,25000
20 21,250 203750 95.88
10-27
NPV
proposal
Initial inv
Annual cash low
life Pv(10%)
Pv npvi
1 60,000
12,000 15 7.7688 93225.6
1.55
2 88,000
22,500 22 8.8919 200,067.75
2.27
3 2150 1500 3 2.5918 3887.7 1.81
4 20,500
4500 10 6.3213 28445.8
1.39
5 425,000
2,25000
20 8.6466 1945485
4.56
10-28
DCF
Discounted cash flows or internal rate of return may sometimes give different results
10-29
All methods do not give the same interpretation
methods
payback
accounting
DCF NPV
Proposal rank ranks ranks ranks
1 5 4 4 4
2 3 3 3 2
3 1 2 2 3
4 4 5 5 5
5 2 1 1 1