Capital Budgeting Decision Rules - PowerPoint Presentation

Slide1

Capital Budgeting Decision RulesSlide2

NPV Analysis

The

recommended approach to any significant capital budgeting decision is NPV analysis.

NPV = PV of the incremental benefits – PV of the incremental costs.

When evaluating independent projects, take a project if and only if it has a positive NPV.

When evaluating interdependent projects, take the feasible combination with the highest total NPV.

The NPV rule appropriately accounts for the opportunity cost of capital and so ensures the project is more valuable than comparable alternatives available in the financial market.Slide3

Internal Rate of Return

Definition: The discount rate that sets the NPV of a project to zero

is

the project’s IRR.

Conceptually, IRR

asks: “What is the project’s rate of return?”

Standard Rule

: Accept a project if its IRR is greater than the appropriate market based discount rate, reject if it is less. Why does this make sense?

For independent projects with “normal cash flow patterns” IRR and NPV give the same conclusions.

IRR is completely internal to the project. To use the rule effectively we compare the IRR to a market rate.Slide4

IRR – “Normal” Cash Flow Pattern

Consider the following stream of cash flows:

Calculate the NPV at different discount rates until you find the discount rate where the NPV of this set of cash flows equals zero.

That’s all you do to find IRR.

0

1

2

3

-$1,000

$400

$400

$400Slide5

IRR – NPV Profile Diagram

Evaluate the NPV at various discount rates:

Rate

NPV

0 $200

10 -$5.3

20 -$157.4

At r = 9.7%,

NPV = 0Slide6

The Merit to the IRR Approach

The IRR

is

an approximation for the return generated over the life of a project on the initial investment.

As with NPV, the IRR is based on incremental cash flows, does not ignore any cash flows, and (by comparison to the appropriate discount rate, r) take proper account of the time value of money and risk.

In short, it can be useful.Slide7

Pitfalls of the IRR Approach

Multiple IRRs

There can be as many solutions to the IRR definition as there are changes of sign in the time ordered cash flow series.

Consider:

This can (and does) have two IRRs.

0

1

2

-$100

$230

-$132Slide8

Pitfalls of IRR cont…

Slide9

Pitfalls of IRR cont…Slide10

Pitfalls of IRR cont…

Mutually exclusive projects:

IRR can lead to incorrect conclusions about the

relative worth

of projects.

Ralph owns a warehouse he wants to fix up and use for

one

of two purposes:

Store toxic waste.

Store fresh produce.

Let’s look at the cash flows, IRRs and NPVs.Slide11

Mutually Exclusive Projects and IRRSlide12

At low discount rates, B is better. At high discount rates, A is better.

But A always has the higher IRR. A common mistake to make is choose A regardless of the discount rate.

Simply choosing the project with the larger IRR would be justified

only if

the project cash flows could be reinvested at the IRR instead of the actual market rate, r, for the life of the project.Slide13

Project Scale and the IRR

Because the IRR puts things in terms of a “rate” it may not tell you what interests you; which investment will create the most “wealth”.

Example:

Project

Investment

Time 1

IRR

NPV at 10%

A

-$1,000

+$1,500

50%

$363.64

B-$10,000

+$13,00030%$1,1818.18Slide14

Summary of IRR vs. NPV

IRR analysis can be misleading if you don’t fully understand its limitations.

For individual projects with normal cash flows NPV and IRR provide the same conclusion.

For projects with inflows followed by outlays, the decision rule for IRR must be reversed.

For Multi-period projects with

changes

in sign of the cash

flows,

multiple IRRs exist. Must compute the NPVs to see what

decision rule is appropriate.

IRR can give conflicting signals relative to NPV when ranking projects.

I recommend NPV analysis, using others as backup.Slide15

Payback Period Rule

Frequently used as a check on NPV analysis or by small firms or for small decisions.

Payback period is defined as the number of years before the cumulative cash inflows equal the initial outlay.

Provides a rough idea of how long invested capital is at risk.

Example

: A project has the following cash flows

Year 0 Year 1 Year 2 Year 3 Year 4

-$10,000 $5,000 $3,000 $2,000 $1,000

The payback period is 3 years. Is that good or bad?Slide16

Payback Period Rule

An adjustment to the payback period rule that is sometimes made is to discount the cash flows and calculate the discounted payback period.

This “new” rule continues to suffer from the problem of ignoring cash flows received after an arbitrary cutoff date.

If this is true, why mess up the simplicity of the rule? Simplicity is its one virtue.

At times the

discounted

payback period may be valuable information but it is not often that this information alone makes for good decision-making.Slide17

Economic Profit or EVA

EVA and Economic Profit

Economic Profit

The difference between revenue and the opportunity cost of all resources consumed in producing that revenue, including the opportunity cost of

capital

Economic Value Added (EVA)

The cash flows of a project minus a charge for the opportunity cost of capitalSlide18

Economic Profit or

EVA

EVA When Invested Capital is Constant

EVA in Period n

(when capital lasts forever

)

where

I

is the project’s capital,

Cn is the project’s cash flow

at time n, and r is the cost of capital. (r

× I ) is known as the capital chargeSlide19

Economic Profit or

EVA

EVA When Invested Capital is Constant

EVA Investment Rule

Accept any investment

for

which the present value (at the project’s cost of capital) of all future EVAs is positive.

When invested capital is constant, the EVA rule and the NPV rule will coincide.Slide20

Example

Problem

Ralph

has an investment opportunity which requires an upfront investment of $150 million.

The annual end-of-year cash flows of $14 million dollars are expected to last forever.

The firm’s cost of capital is 8%.

Compute the annual EVA and the present value of the project.Slide21

Example

Solution

EVA

each year is:

The present value of the EVA perpetuity is:Slide22

Economic Profit or

EVA

EVA When Invested Capital Changes

EVA in Period n

(when capital depreciates

)

Where

C

n is a project’s cash flow in time period

n, I

n – 1 is the project’s capital at time n –

1, and r is the cost of capitalWhen invested capital changes, the EVA rule and the NPV rule

continue to coincide.Slide23

Example

Ralph is considering an investment in a machine to manufacture rubber chickens.

It will generate revenues of $20,000 each year for 4 years and cost $60,000. The machine is expected to depreciate evenly over the 4 years.

The current interest rate is 5%

Should he invest in the machine?Slide24

Example

Using the NPV rule we have a cost of $60,000 and benefits that look like a 4 year annuity. The NPV is

Indicating that this is a valuable endeavor.Slide25

Example

For EVA we calculate

The present value of EVA is then:

Year

0

1

2

3

4

Capital

$60,000

$45,000

$30,000

$15,000

$0

Cash

Flow

$20,000

$20,000

$20,000$20,000

Capital Charge($3,000)($2,250)($1,500)

($750)Depreciation

($15,000)

($15,000)

($15,000)

($15,000)

EVA

n

$2,000

$2,750

$3,500

$4,250