Chapter 9 Capital Budgeting Decision Criteria

1、,Chapter 9Capital Budgeting Decision Criteria, 1998 South-Western College PublishingSlide 1,Capital Expenditure A cash outlay expected to generate a flow of future cash benefits for more than a year - Capital Budgeting The process of planning for purchases of assets whose returns are expected to con

2、tinue beyond a year Cost of Capital The cost of capital is defined as the cost of funds supplied to a firm. It represents the required rate of return a firm must earn on its investment.,Slide 2,Capital Expenditure Decisions,Expand an existing product line Working capital Merger and acquisition Educa

3、tion and training,Slide 3,Enter a new line of business Replacement of an old machine Advertising campaign R and D,Cost of Capital,Firms overall cost of funds Investors required rate of return Provides a basis for evaluating capital investment projects,Slide 4,How Are Projects Classified,Independent

4、Acceptance or rejection has no effect on other projects Example: Install a new computer system and upgrading some production equipment Mutually Exclusive (OR) Acceptance of one automatically rejects the others. Example: Building a factory in Macon or McDonough Contingent (AND) Acceptance is dependen

5、t upon the selection of another Example: Installing a new management information system may first require purchase of suitable hardware (computers).,Slide 5,Capital Rationing,Most companies have a limited amount of dollars available for investment Funds constraint,Slide 6,Capital Budgeting Problems,

6、All projects may not be known at one time Changing markets, technology, and corporate strategies can make current projects obsolete and make new ones profitable Estimates of CFs have varying degrees of uncertainty,Slide 8,Capital Budgeting Process,Step 1 Generating proposals Step 2 Estimating CFs St

7、ep 3 Evaluating alternatives and selecting projects Step 4 Reviewing prior decisions,Slide 9,Capital Budgeting Criteria,Net present value ( NPV ) Internal rate of return ( IRR ) Profitability index ( PI ) Payback period ( PB ), 1998 South-Western College PublishingSlide 2,Work on problem 1.,NPV,PV o

8、f the stream of future CFs from a project minus the projects net investment NPV = PVNCF PVNINV PVNCF : is present value of all cash flow excluding investment. PVNINV : is present value of all investments. (should investment be made in different years, then calculate the present value of investment m

9、ade in different years.) Note: You can also compute NPV by just computing present value of all cash flows including investments. When the discount rate is zero, NPV is the sum of cash flows (including investment), 1998 South-Western College PublishingSlide 3,Work on problem 1,NPVCharacteristics, 199

10、8 South-Western College PublishingSlide 4,NPV 0 acceptable above-normal profits Considers the time value of money Absolute measure of wealth Positive NPVs increase owners wealth Negative NPVs decrease owners wealth,IRR,Rate of discount that equates the PV of net cash flows of a project with the PV o

11、f the NINV PVNCF = PVNINV To compute IRR, simply compute i or IRR in your calculating after you input all the cash flows., 1998 South-Western College PublishingSlide 6,Work on problem 1,IRRCharacteristics,IRR k acceptable Considers the time value of money Unusual CF pattern can result in multiple ra

12、tes of return CFs contain more than one sign change If the NPV If NPV 0, then IRR k (work on problem 1), 1998 South-Western College PublishingSlide 7,PI,Ratio of the PV of future cash flows over the life of the project to the NINV PI = PVNCF / PVNINV Note : NPV = PVNCF - PVNINV Therefore, PVNCF = PV

13、NINV + NPV Also, PVNIV = PVNCF-NPV Or, we can also say, PI = 1 + NPV / PVNINV (Work on problem 1), 1998 South-Western College PublishingSlide 8,PI characteristics,PI 1 acceptable Considers the time value of money CFs reinvested at k Relative measure showing wealth increase per dollar of investment I

14、n the case of mutually exclusive projects and with fund constraints, NPV and PI are likely to yield conflicting decisions when the projects are significantly different in size In the case of independent projects and no fund constraints, NPV, IRR and PI would give identical accept / reject decision.,

15、 1998 South-Western College PublishingSlide 9,Payback Method Number of years for the cumulative net cash flows from a project to equal the initial cash outlay When you have equal cash flows, PB = Net Investment / Annual Cash Flow Note : Three variables : PB, NI and ACF. Given any two variables, you

16、should be able to determine the third variable. When net CFs are unequal, interpolation is required Work on problem 1, 1998 South-Western College PublishingSlide 10,PB Characteristics Simple Provides a measure of project liquidity Not a true measure of profitability Ignores CFs after the payback per

17、iod Ignores the time value of money,i.John and Jane company is considering the following two projects: Assume Cash flows are even distributed during the year. Project 1Project 2 YearCash FlowCash Flow 0-$165 ? 1 70 70 2 50 80 3 60 80 4 70 60 The two projects have the same payback. What is Project 2s

18、 internal rate of return IRR. Assume ka = 8%, compute PI and NPV? i.IRR, payback, and missing cash flow Step 1:Find Project 1s payback: Project 1 Cumulative YearCash FlowCash Flow 0-165 1 70 70 2 50 120. 3 60 165 (45 out of 60) 4 70 PaybackProject 1 = 2 + $45/$60 = 2.75 years.,Step 2:Calculate Proje

19、ct 2s initial outlay, given its payback = 2.75 years: 70 + 80 + (0.75 *80) = 210 Step 3:Calculate Project 2s IRR: Enter the following data in the calculator: 210 +/- CF, 70 CF, 80 CF, 80 CF, 60 CF, a) Comp NPV = 31.01 b) Comp IRR = 14.59% c)PI = 1 + (NPV / Inv) = 1 + (31.01/210) = 1.15,Ex: Assume investment is $100,000 in year 0. The firm will receive $20,000 at the end of year 1, $30,000 at the end of year 2, and increase by 10% from there on. What is the payback period. YearCash FlowCumulativeCF still CF received needed 1$20,000$20,000 100K-20K = 80K $30,