lecture9 NPV

Chap. 10KMPLECTURE 9Capital budgeting techniques and practice1.Discuss the difficulty of finding profitable projects incompetitive markets and the importance of the search.2.Determine whether a new project should be accepted orrejected using the payback period, net present value, the profitability index, and the internal rate of return.3.Explain how the capital-budgeting decision processchanges when a dollar limit is placed on the capitalbudget.4.Discuss the problems encountered inproject ranking.5.Explain the importance of ethicalconsiderations in capital-budgetingdecisions.6.Discuss the trends in the use of differentcapital-budgeting criteria.Slide Contents•Capital Budgeting•Capital Budgeting Decision Criteria •Capital Rationing•Ranking Problems•Ethics in Capital Budgeting •Capital Budgeting Practices1. Capital Budgeting •Meaning: The process of decision making with respect to investments in fixed assets—that is, should a proposed project be accepted or rejected.•It is easier to “evaluate”profitable projects than to “find them”Source of Ideas for projects •Within the Firm: Typically, a firm has a research & development (R&D) department that searches for ways of improving existing products or finding new projects.•Other sources: Other employees, Competition, Suppliers, Customers.2. Capital BudgetingDecision Criteria•The Payback Period•Net Present Value•Profitability Index•Internal Rate of Return2.1 The Payback Period •Meaning: Number of years needed to recover theinitial cash outlay of a capital budgeting project.•Decision Rule: Project feasible or desirable if the payback period is less than or equal to the firm’s maximum desired payback period. In general, shorter payback period is preferred while comparing two projects.Payback Period ExampleExample: Project with an initial cash outlay of $20,000 with following free cash flows for 5 years.Payback is 4 years.YEAR CASH FLOWBALANCE 1$ 8,000($ 12,000)24,000( 8,000)33,000( 5,000)45,0000510,00012,000Trade-offs •Benefits:–Uses cash flows rather than accounting profits–Easy to compute and understand–Useful for firms that have capital constraints •Drawbacks:–Ignores the time value of money and–Does not consider cash flows beyond the paybackperiod.Discounted Payback Period •The discounted payback period is similar to the traditional payback period except that it uses discounted free cash flows rather than actual undiscounted cash flows.•The discounted payback period is defined as the number of years needed to recover the initial cash outlay from the discounted free cash flows.Table 10-2•Table 10-2 shows thedifference betweentraditional payback anddiscounted paybackmethods.•With undiscounted freecash flows,the payback period isonly 2 yearswhile with discountedfree cash flows (at 17%),the discounted paybackperiod is 3.07 years.2.2 Net Present Value (NPV)•Meaning: NPV is equal to the present value of all future free cash flows less the investment’s initial outlay. It measures the net value of a project in today’s dollars.NPV Example•Example: Project with an initial cash outlay of $60,000 with following free cash flows for 5 years.Year FCF Year FCFInitial outlay–60,000313,0001–25,000412,0002–24,000511,000•The firm has a 15% required rate of return.•PV of FCF= $60,764•Subtracting the initial cash outlay of $60,000 leaves an NPV of $764.•Since NPV> 0, project is feasibleNPV in Excel®•Input cash flows for initial outlay and free cash inflows in cells A1 to A6.•In cell A7 type the following formula:=A1+npv(.15,a2:a6)•Excel will give the NPV= $764NPV Trade-offs •Benefits–Considers cash flows, not profits–Considers all cash flows–Recognizes time value of money•Drawbacks–Requires detailed long-term forecast of cash flows •NPV is considered to be the most theoretically correct criterion for evaluating capital budgeting projects.2.3 Profitability Index (PI)(Benefit-Cost ratio) •Meaning: PI is the ratio of the present value of the future free cash flows (FCF) to the initial outlay. It yields the sameaccept/reject decision as NPV.PI= PV of FCF/Initial outlayProfitability Index•Decision Rule:PI≥1 = accept;PI< 1 = reject• A firm with a 10% required rate of return is considering investing in a new machine with an expected life of six years. The initial cash outlay is $50,000.FCF PVF@10%PVInitialOutlay–$50,0001.000–$50,000 Year 115,0000.90913,636 Year 28,0000.8266,612 Year 310,0000.7517,513 Year 412,0000.6838,196 Year 514,0000.6218,693 Year 616,0000.5649,032PI= ($13,636 + $6,612+$7,513 + $8,196 + $8,693+ $9,032) / $50,000= $53,682/$50,000= 1.0736Project’s PI is greater than 1. Therefore, accept.NPV and PI•When the present value of a project’s free cash inflows are greater than the initial cash outlay, the project NPV will be positive. PI will also be greater than 1.•NPV and PI will always yield the same decision.2.4 Internal Rateof Return (IRR)•Meaning: IRR is the discount rate that equates the present value of a project’s future net cash flows with the project’s initial cash outlay.•Internal Rate of Return•Decision Rule:–If IRR≥Required Rate of Return, accept –If IRR< Required Rate of Return, rejectFigure 10-1IRR and NPV•If NPV is positive, IRR will be greater than the required rate of return•If NPV is negative, IRR will be less than required rate of return•If NPV= 0, IRR is the required rate of return.IRR Example•Initial Outlay:$3,817•Cash flows: Yr.1=$1,000, Yr. 2=$2,000,Yr. 3=$3,000Discount rate NPV15%$4,35620%$3,95822%$3,817•IRR is 22%because the NPV equals the initial cash outlay at that rate.IRR in Excel®•IRR can be easily computed in Excel®•In the previous example, input cash outflow and three year cash inflows in cells A1:A4•In cell A5 input “=IRR(a1:a4)”•Excel®will give the IRR= 22%Multiple IRR s• A normal cash flow pattern for project is negative initial outlay followed by positive cash flows (–, +, +, + …)•However, if the cash flow pattern is not normal (such as –, +, –) there can be more than one IRRs.•Figure 10-2 is based on cash flows of:–1,600; +10,000; –10,000 in years 0,1, 2Figure 10-2Modified IRR•Primary drawback of the IRR relative to the net present value is the reinvestment rate assumption made by the internal rate of return. Modified IRR allows the decision maker to directly specify the appropriate reinvestment rate.•Modified IRR •Accept if MIRR ≥required rate of return •Reject if MIRR < required rate of return•Project having a 3 year life and a required rate of return of 10% with the following cash flows:FCF’s FCF’sInitial–$6,000Year 2$3,000OutlayYear 12,000Year 34,000•Step 1: Determine the PV of the project’s cash outflows. $6,000 is already at present.•Step 2: Determine the terminal value of the project’s free cash flows. To do this use the project’s required rate of return to calculate the FV of the project’s three cash flows of the project’s cash outflows. They turn out to be $2,420 + $3,300 + $4,000 = $9,720 for the terminal value•Step 3: Determine the discount rate that equates to the PV of the terminal valueand the PV of the project’s cash outflows. MIRR= 17.446%.It is greater than required rate of return so Accept.MIRR in Excel®= MIRR(values, finance rate, reinvestment rate)where values is simply the range of cells where the cash flows are stored, and k is entered for both the finance rate and the reinvestment rate.3. Capital Rationing •Meaning: Capital rationing refers to situation where there is a limit on the dollar size of thecapital budget. This may be due to:(a) temporarily adverse conditions in the market;(b) shortage of qualified personnel to direct newprojects; and/or(c) other factors such as not willing to take onexcess debt to finance new projects.Capital Rationing•How to select? Select a set of projects with the highest NPV—subject to the capital constraint. Using NPV may preclude accepting the highest ranked project in terms of PI or IRR.Figure 10-4Table 10-74. Ranking MutuallyExclusive Projects•Size Disparity•Time Disparity•Unequal Life4.1 Size Disparity•This occurs when we examine mutually exclusive projects of unequal size.•Example: Consider the following cash flows for one-year Project A and B, with required rates of return of 10%.–Initial Outlay: A = $200; B = $1,500–Inflow:A = $300; B = $1,900Table 10-8Ranking ProblemRanking Conflict:–Using NPV , Project B is better;–Using PI and IRR , Project A is better.27%50%IRR 1.151.36PI227.2872.73NPVProject B Project ARanking Problem•Which technique to use to select the project?•Use NPV whenever there is size disparity. If there is no capital rationing, project with the largest NPV will be selected. When capital rationing exists, select set of projects with the largest NPV.•Time Disparity problem arises because of differing reinvestment assumptions made by the NPV and IRR decision criteria.•How are Cash flows reinvested?–According to NPV: Required rate of return–According to IRR: IRR•Example: Consider two projects, A and B, with initial outlay of $1,000, cost of capital of 10%, and following cash flows in years 1, 2, and 3:•A: $100$200$2,000•B: $650$650$650Table 10-9Time Disparity Problem•Ranking Conflict:–Using NPV or PI , A is better–Using IRR , B is better•Which technique to use to select the superior project?–Use NPV43%35%IRR1.6161.759PI 616.45758.83NPV Project B Project A4.3 Unequal Lives Problem •This occurs when we are comparing twomutually exclusive projects with different lifespans.•To compare projects, we compute the Equivalent Annual Annuity (EAA)Unequal Lives Problem •Example: If you have two projects, A and B, with equal investment of $1,000, requiredrate of return of 10%, and following cash flows in years 1-3 (for project A) and 1-6(for project B)•Project A = $500 each in years 1-3•Project B = $300 each in years 1-6。