lecture 9 investment
DESCRIPTION
ffffTRANSCRIPT
1
Capital Budgeting Decision Investment Valuation Criteria
2
Capital Budgeting Decision
What is capital budgeting?
NPV rule for making investment decisions
Other alternative investment criteria
Payback period (traditional and discounted)
Internal rate of return
Profitability index and capital rationing
Deciding on projects with different lives
Investment criteria in corporate practice
3
What is capital budgeting?
Capital budgeting deals with the analysis of potential additions to firm’s fixed assets
These are long-term decisions that generally involve large expenditures and are typically quite difficult to reverse
Capital budgeting is very important for a firm’s future
4
Capital budgeting process
Idea development
Collection of data
Accounting, finance,
engineering
Project analysis
Decision making
Results
Reevaluation
5
What is a project?
Any of the following decisions would qualify as projects:
Major strategic decisions to enter a new area of business or new markets
Acquisitions of other firms
Decisions on new ventures with existing business or markets
Decisions that may change the way existing ventures and projects are run
Decisions on how best to deliver a service that is necessary for the business to run smoothly
6
Types of projects
Independent projects
Mutually exclusive projects
Expansion projects
Existing products / markets
New products / markets
Replacement projects
Maintenance of business
Cost reduction
Research & development projects
Other projects (safety / environmental projects)
7
NPV rule illustrated – a reminder
Assume you have the following information on Project X:
Initial outlay -$1,100
Required return = 10%
Annual cash revenues and expenses are as follows:
Year Revenues Expenses
1 $1,000 $500
2 2,000 1,000 Draw a time line and compute the NPV of project X
8
NPV rule concluded
0 1 2
Initial outlay ($1,100)
Revenues $1,000 Expenses 500
Cash flow $500
Revenues $2,000 Expenses 1,000
Cash flow $1,000
– $1,100.00
+454.55
+826.45
+$181.00 NPV
1 $500 x 1.10
1 $1,000 x 1.102
9
Foundations of the NPV rule
Why does NPV work? And what does “work” mean?
A “firm” is created when security holders supply the funds to acquire assets that will be used to produce and sell goods and services
The market value of the firm is based on the free cash flows it is expected to generate
Thus, “good” projects are those which increase firm value “good” projects are those projects that have
positive NPVs
Moral:
INVEST ONLY IN PROJECTS WITH POSITIVE NPVs
10
Why do we like NPV that much?
NPV uses cash flows, and not other accounting artificial constructs
NPV uses all the cash flows generated by the project during its life
NPV discounts the cash flows properly, since it takes into account TVM
Payback Period
Payback Period (PB): The length of time it takes to recover the original costs (of the project) from expected cash flows.
Rationale: The sooner investment costs are recovered, the better.
Process: Simply add up the expected cash flows until they equal (or exceed) the original investment. The number of years it take to do this is the payback period.
Note: no discounting of cash flows is required
PB =
Number of years before
full recovery of
original investment
Uncovered cost at start
of full-recovery year
Total cash flow during
full-recovery year
+
Cash Flow
Cumulative
Net CF
1,500
-1,500
800
500
1,200
-300
-3,000
-3,000
300
800
PB 0 1 2 3 4
Example: Find the payback period for a project which has the following cash flows
= PB 2 + 300/800 = 2.375 years
Full-recovery year
Payback Period
Payback Period
Decision Rules:
PP = payback period
MDPP = maximum desired payback period
Independent Projects:
PP MDPP - Accept
PP > MDPP - Reject
Mutually Exclusive Projects:
Select the project with the fastest payback, assuming PP MDPP.
14
Pitfalls in using the payback period
Which project would you choose from the followings, given a 2 years payback?
Project C0 C1 C2 C3 Payback period
A -2,000 500 500 5000 3
B -2,000 500 1800 0 2
C -2,000 1800 500 0 2
15
Pitfalls in using the payback period
Project C0 C1 C2 C3 Payback period
NPV @ 10%
A -2,000 500 500 5000 3 +2,624
B -2,000 500 1800 0 2 -58
C -2,000 1800 500 0 2 +50
16
Pitfalls in using the payback period By using payback period:
You may select projects that are not acceptable under NPV rule look at project B
You won’t consider the timing of cash flows within the payback period compare project B and
project C
You won’t consider the payments after the payback period compare project A and project C
You can’t compare projects that have no initial investment
Arbitrary standard for payback period
17
Use of payback period
PB is often used when making relatively small decisions
PB ensures liquidity
Nevertheless, as a decision grows in importance, the NPV becomes the order of the day
Discounted Payback Period
Similar to Payback Period Method
Expected future cash flows are discounted by the project’s cost of capital
Thus the discounted payback period is defined as the number of years required to recover the investment from discounted net cash flows.
DPB =
Number of years before
full recovery of
original investment
Uncovered cost at start
of full-recovery year
Total discounted cash flow during
full-recovery year
+
Cash Flow
Cumulative
Net Discounted CF
1,500
-1,636
800
-44
1,200
-645
-3,000
-3,000
300
161
PB 0 1 2 3 4
Example: Find the discounted payback period for a project which has the following cash flows
= DPB 3 + 44/161 = 3.273 years
Full-recovery year
Discounted Payback Period
r =10%
20
Discounted payback period
Although recognizes TVM, it has the same problems as the traditional payback period
Is suitable to be used in case of investments made in risky markets.
21
Internal rate of return
IRR tries to find a single number that summarizes the merits of a project
This number does not depend on the interest rate that prevails in the capital market
The number is intrinsic to the project and only depends on the cash flows of the project and their timing
Internal Rate of Return (IRR)
Definition:
The discount rate for what the PV of a project’s expected cash flows is equal with the initial cost (NPV = 0)
nt
tn
t IRR
TV
IRR
CFI
111
0
Internal Rate of Return (IRR)
Decision Rules:
Independent Projects:
IRR opportunity cost of capital - Accept
IRR < opportunity cost of capital - Reject
Mutually Exclusive Projects:
Select the project with the highest IRR, assuming IRR opportunity cost of capital.
24
Internal rate of return illustrated
Find r such that NPV = 0
Year 0 1 2 3
Cash flow -200 50 100 150
32r1
150
r)(1
100
r1
502000
IRR isr this19.44%r
25
NPV profile
-60,00
-40,00
-20,00
0,00
20,00
40,00
60,00
80,00
100,00
1 5 9 13 17 21 25 29
Discount rate (%)
NP
V
IRR = 19.44%
26
Trial and error for IRR
Trial and error Discount rates NPV
0% $100
5% 68
10% 41
15% 18
20% -2 IRR is just under 20%
19.44%
!!! In order to estimate IRR for the project you analyze, you can use Excel IRR function by selecting the column/row of the cash flows (inflows or outflows) the investment generates including the initial cost.
1,500 800 1,200 -3,000 300
0 1 2 3 4
Example: What is the IRR of a project with the following cash flows?
3000 = 1,500 + 1,200 + 800 + 300 (1+IRR) (1+IRR)2 (1+IRR)3 (1+IRR)4 NPV = 0 = -3000 + 1,500 + 1,200 + 800 + 300 (1+IRR) (1+IRR)2 (1+IRR)3 (1+IRR)4 Answer: IRR= 13.114% (Excel function IRR)
Internal Rate of Return (IRR)
28
Pitfalls with the IRR approach
Pitfall 1: IRR assumes funds can be invested each year at the same rate of return (IRR)
Pitfall 2: Make no distinction between investing or financing projects
Pitfall 3: A project can have multiple rates of return
Pitfall 4: The scale problem
Pitfall 5: The timing problem
Solution to pitfall 1: Modified Internal Rate of Return (MIRR)
It is basically the same as the IRR, except it assumes that the revenue (cash flows) from the project are reinvested back into the company, and are compounded by the company's cost of capital, but are not directly invested back into the project from which they came.
MIRR assumes that the revenue is not invested back into the same project, but is put back into the general "money fund" for the company, where it earns interest. We don't know exactly how much interest it will earn, so we use the company's cost of capital as a good guess.
30
Profitability index
PI Rule for independent projects:
Accept project if PI 0
Reject project if PI < 0
Look at this!
investment theofcost Initial
investment theof NPVindexity Profitabil
NPV 0 PI 0 IRR discount rate ACCEPT PROJECT
NPV < 0 PI < 0 IRR < discount rate REJECT PROJECT
31
Problems with PI
Making decisions with PI for mutually exclusive projects
Cash flows
PV @ 12%
PI
NPV @ 12% Project C0 C1 C2
1 -20 70 10 70.5 2.53 50.5
2 -10 15 40 45.3 3.53 35.3
Same problems as in the case of scale problem form IRR decide using NPV
32
Capital rationing
Suppose the projects above are independent, but you have only $25 mil. to invest. Which project(s) do you choose?
USE PROFITABILITY INDEX
Cash flows
PV @ 12%
PI
NPV @ 12% Project C0 C1 C2
1 -20 70 10 70.5 2.53 50.5
2 -10 15 40 45.3 3.53 35.3
3 -10 -5 60 43.4 3.34 33.4
33
Capital rationing
Two types of capital rationing: Soft rationing provisional limits adopted by
management as an aid to financial control
Hard rationing the firm is unable to raise the money she desires
Profitability index does not work if funds are also limited beyond the initial time period and projects are not divisible use linear programming
34
Investment criteria in practice
Capital budgeting technique
Percentage always or
almost always use
Average score
Scale is 4(always) or 0(never)
Overall Large
firms
Small
firms
Internal rate of return 76 3.09 3.41 2.87
Net present value 75 3.08 3.42 2.83
Payback period 57 2.53 2.25 2.72
Discounted payback period 29 1.56 1.55 1.58
Profitability index 12 0.83 0.75 0.88
Source: Graham & Campbell (2001) – „Theory and practice of corporate finance”