After Studying Chapter 13 you should be able to Understand the payback period PBP method of project evaluation and selection including its a calculation b acceptance criterion c advantages and disadvantages and d focus on liquidity rather than profitability ID: 1028829
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1. Chapter 13Capital Budgeting Techniques
2. After Studying Chapter 13, you should be able to:Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability.Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and profitability index (PI).Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. Define, construct, and interpret a graph called an “NPV profile.”Understand why ranking project proposals on the basis of IRR, NPV, and PI methods “may” lead to conflicts in rankings. Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or PI rankings.Understand how “sensitivity analysis” allows us to challenge the single-point input estimates used in traditional capital budgeting analysis.Explain the role and process of project monitoring, including “progress reviews” and “post-completion audits.”
3. Capital Budgeting Techniques Project Evaluation and Selection Potential Difficulties Capital Rationing Project Monitoring Post-Completion Audit
4. Project Evaluation: Alternative MethodsSimple Method Payback Period (PBP)Discounted Cash Flow (DCF) Method Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI)Refer to the additional PowerPoint slides and the Excel spreadsheet “VW13E-13b.xlsx” for computer-based solutions.
5. Proposed Project DataJulie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.
6. Payback Period (PBP)PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.0 1 2 3 4 5 –40 K 10 K 12 K 15 K 10 K 7 K
7. Payback PeriodYearCash FlowsCumulative Inflows0(40,000)--------110,00010,000212,00022,000315,00037,000410,00047,00057,00054,000
8. Payback Period Solution(#1)1) 40,000 – 37,000 = 3,0002) 3,000 / 10,000 = 0.33) 0.3 x 12 = 3.64) 0.6 x 30 = 18The payback period is 3 years and 3 monthes and 18 days
9. (c)10 K 22 K 37 K 47 K 54 KPayback Solution (#2) Another MethodPBP = a + ( b – c ) / d = 3 + (40 – 37) / 10 = 3 + (3) / 10 = 3.3 Years0 1 2 3 4 5 –40 K 10 K 12 K 15 K 10 K 7 KCumulativeInflows(a)(-b)(d)
10. Payback Solution (#3)PBP = 3 + ( 3K ) / 10K = 3.3 YearsNote: Take absolute value of last negative cumulative cash flow value.CumulativeCash Flows –40 K 10 K 12 K 15 K 10 K 7 K0 1 2 3 4 5–40 K –30 K –18 K –3 K 7 K 14 K
11. PBP Acceptance CriterionYes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.]The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type.Should this project be accepted?
12. Payback Period (Equal Cash Inflow)If we assume for the same example the cash outflow is $40,000 and the inflow will be $15,000 each year, what is the payback period?
13. Payback Period (PBP)(Solution)Payback period = Cash outflow/ Annual Cash inflow$40,000 / 15,000 = 2.670.67 x 12 = 8.040.04 x 30 = 1.2The (PBP) is 2 years and 8 month
14. PBP Strengths and WeaknessesStrengths: Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flowsWeaknesses: Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective
15. Internal Rate of Return (IRR)IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow (ICO).CF1 CF2 CFn (1 + IRR)1 (1 + IRR)2 (1 + IRR)n+ . . . ++ICO =
16. $15,000 $10,000 $7,000 IRR Solution$10,000 $12,000(1+IRR)1 (1+IRR)2Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000.++++$40,000 =(1+IRR)3 (1+IRR)4 (1+IRR)5
17. IRR Solution (Try 10%)$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5) $40,000 = $10,000(0.909) + $12,000(0.826) + $15,000(0.751) + $10,000(0.683) + $ 7,000(0.621)$40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 = $41,444 [Rate is too low!!]
18. IRR Solution (Try 10% )YearNet Cash FlowsPVIF 10%Present Value110,0000.9099,090212,0000.8269,912315,0000.75111,265410,0000.6836,83057,0000.6214,347Total Present Value41,444
19. IRR Solution (Try 15%)$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5) $40,000 = $10,000(0.870) + $12,000(0.756) + $15,000(0.658) + $10,000(0.572) + $ 7,000(0.497)$40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 = $36,841 [Rate is too high!!]
20. IRR Solution (Try 15%)YearNet Cash FlowsPVIF 15%Present Value110,0000.8708,700212,0000.7569,072315,0000.6589,870410,0000.5725,72057,0000.4973,479Total Present Value36,841
21. 0.10 $41,444 0.05 IRR $40,000 $4,603 0.15 $36,841 X $1,444 0.05 $4,603IRR Solution (Interpolate)$1,444X=
22. 0.10 $41,444 0.05 IRR $40,000 $4,603 0.15 $36,841 X $1,444 0.05 $4,603IRR Solution (Interpolate)$1,444X=
23. 0.10 $41,444 0.05 IRR $40,000 $4,603 0.15 $36,841 ($1,444)(0.05) $4,603 IRR Solution (Interpolate)$1,444XX =X = 0.0157IRR = 0.10 + 0.0157 = 0.1157 or 11.57%
24. IRR Acceptance Criterion No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR < required Rate ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted?
25. IRRs on the Calculator We will use the cash flow registry to solve the IRR for this problem quickly and accurately!
26. Actual IRR Solution Using Your Financial CalculatorSteps in the ProcessStep 1: Press CF keyStep 2: Press 2nd CLR Work keysStep 3: For CF0 Press -40000 Enter keysStep 4: For C01 Press 10000 Enter keysStep 5: For F01 Press 1 Enter keysStep 6: For C02 Press 12000 Enter keysStep 7: For F02 Press 1 Enter keysStep 8: For C03 Press 15000 Enter keysStep 9: For F03 Press 1 Enter keys
27. Actual IRR Solution Using Your Financial CalculatorSteps in the Process (Part II)Step 10:For C04 Press 10000 Enter keysStep 11:For F04 Press 1 Enter keysStep 12:For C05 Press 7000 Enter keysStep 13:For F05 Press 1 Enter keysStep 14: Press keysStep 15: Press IRR keyStep 16: Press CPT keyResult: Internal Rate of Return = 11.47%
28. IRR Strengths and Weaknesses Strengths: Accounts for TVM Considers all cash flows Less subjectivityWeaknesses: Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs
29. Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow (ICO).CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n+ . . . ++- ICONPV =
30. Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%.$10,000 $7,000 NPV Solution$10,000 $12,000 $15,000 (1.13)1 (1.13)2 (1.13)3 +++- $40,000(1.13)4 (1.13)5NPV =+
31. NPV SolutionNPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $ 7,000(PVIF13%,5) – $40,000NPV = $10,000(0.885) + $12,000(0.783) + $15,000(0.693) + $10,000(0.613) + $ 7,000(0.543) – $40,000NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 – $40,000 = - $1,428
32. NPV Solution (Another Method)YearCash FlowsPVIF 13%Present Value110,0000.8858,850212,0000.7839,396315,0000.69310,396410,0000.6136,13057,0000.5433,801Total PV38,573Cash outflow40,000Net PV(1,427)
33. NPV Acceptance Criterion No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ]The management of Basket Wonders has determined that the required rate is 13% for projects of this type.Should this project be accepted?
34. NPV on the Calculator We will use the cash flow registry to solve the NPV for this problem quickly and accurately!Hint: If you have not cleared the cash flows from your calculator, then you may skip to Step 15.
35. Actual NPV Solution Using Your Financial CalculatorSteps in the ProcessStep 1: Press CF keyStep 2: Press 2nd CLR Work keysStep 3: For CF0 Press -40000 Enter keysStep 4: For C01 Press 10000 Enter keysStep 5: For F01 Press 1 Enter keysStep 6: For C02 Press 12000 Enter keysStep 7: For F02 Press 1 Enter keysStep 8: For C03 Press 15000 Enter keysStep 9: For F03 Press 1 Enter keys
36. Steps in the Process (Part II)Step 10:For C04 Press 10000 Enter keysStep 11:For F04 Press 1 Enter keysStep 12:For C05 Press 7000 Enter keysStep 13:For F05 Press 1 Enter keysStep 14: Press keysStep 15: Press NPV keyStep 16: For I=, Enter 13 Enter keysStep 17: Press CPT keyResult: Net Present Value = -$1,424.42Actual NPV Solution Using Your Financial Calculator
37. NPV Strengths and Weaknesses Strengths: Cash flows assumed to be reinvested at the required rate. Accounts for TVM. Considers all cash flows.Weaknesses: May not include managerial options embedded in the project. See Chapter 14.
38. Net Present Value ProfileDiscount Rate (%)0 3 6 9 12 15IRRNPV@13%Sum of CF’sPlot NPV for eachdiscount rate.Three of these points are easy now!Net Present Value$000s151050-4
39. Creating NPV Profiles Using the Calculator Hint: As long as you do not “clear” the cash flows from the registry, simply start at Step 15 and enter a different discount rate. Each resulting NPV will provide a “point” for your NPV Profile!
40. Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow.CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n+ . . . ++ICOPI =Method #1:
41. PI Acceptance Criterion No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI < 1.00 ] PI = $38,573 / $40,000 = .9643 (Method #1, previous slide)Should this project be accepted?
42. PI Strengths and Weaknesses Strengths: Same as NPV Allows comparison of different scale projectsWeaknesses: Same as NPV Provides only relative profitability Potential Ranking Problems
43. Evaluation SummaryBasket Wonders Independent Project
44. Project Evaluation: Remember Chapter 12 ‘New Asset’ project?We will start with the cash flows of the project and also calculate the cumulative cash flow values.We can use Excel functions / approaches to calculate each of the following methods from the above cash flows.
45. Independent ProjectIndependent – A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.
46. Other Project RelationshipsMutually Exclusive – A project whose acceptance precludes the acceptance of one or more alternative projects. Dependent – A project whose acceptance depends on the acceptance of one or more other projects.
47. Potential Problems Under Mutual ExclusivityA. Scale of InvestmentB. Cash-flow PatternC. Project Life Ranking of project proposals may create contradictory results.
48. A. Scale Differences Compare a small (S) and a large (L) project.NET CASH FLOWSProject S Project LEND OF YEAR 0 -$100 -$100,000 1 0 0 2 $400 $156,250
49. A. Scale DifferencesCalculate the PBP, IRR, NPV@10%, and PI@10%.Which project is preferred? Why?Project IRR NPV PI S 100% $ 231 3.31 L 25% $29,132 1.29
50. A. Scale DifferencesRefer to VW13E-13b.xlsx on the ‘Scale’ tab.Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘Scale’ tab.
51. B. Cash Flow PatternLet us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project.NET CASH FLOWSProject D Project IEND OF YEAR 0 -$1,200 -$1,200 1 1,000 100 2 500 600 3 100 1,080
52. D 23% $198 1.17 I 17% $198 1.17Cash Flow Pattern Calculate the IRR, NPV@10%, and PI@10%.Which project is preferred? Project IRR NPV PI?
53. Examine NPV ProfilesDiscount Rate (%)0 5 10 15 20 25-200 0 200 400 600IRRNPV@10%Plot NPV for eachproject at variousdiscount rates.Net Present Value ($)Project IProject D
54. Fisher’s Rate of IntersectionDiscount Rate ($)0 5 10 15 20 25-200 0 200 400 600Net Present Value ($)At k<10%, I is best!Fisher’s Rate ofIntersectionAt k>10%, D is best!
55. B. Cash Flow PatternRefer to VW13E-13b.xlsx on the ‘Pattern’ tab.Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘Pattern’ tab.
56. C. Project Life Differences Let us compare a long life (X) project and a short life (Y) project.NET CASH FLOWSProject X Project YEND OF YEAR 0 -$1,000 -$1,000 1 0 2,000 2 0 0 3 3,375 0
57. X 50% $1,536 2.54 Y 100% $ 818 1.82Project Life DifferencesCalculate the PBP, IRR, NPV@10%, and PI@10%.Which project is preferred? Why? Project IRR NPV PI?
58. C. Project Life DifferencesRemember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘Life’ tab.
59. Another Way to Look at Things1. Adjust cash flows to a common terminal year if project “Y” will NOT be replaced. Compound Project Y, Year 1 @10% for 2 years.Year 0 1 2 3CF –$1,000 $0 $0 $2,420 Results: IRR* = 34.26% NPV = $818*Lower IRR from adjusted cash-flow stream. X is still Best.
60. Replacing Projects with Identical Projects2. Use Replacement Chain Approach (Appendix B) when project “Y” will be replaced.0 1 2 3–$1,000 $2,000 –1,000 $2,000 –1,000 $2,000–$1,000 $1,000 $1,000 $2,000Results: IRR = 100% NPV* = $2,238.17*Higher NPV, but the same IRR. Y is Best.
61. C. Project Life DifferencesRemember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘Life2’ tab.
62. Capital RationingCapital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.Example: Julie Miller must determine what investment opportunities to undertake for Basket Wonders (BW). She is limited to a maximum expenditure of $32,500 only for this capital budgeting period.
63. Available Projects for BW Project ICO IRR NPV PI A $ 500 18% $ 50 1.10 B 5,000 25 6,500 2.30 C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 E 12,500 26 500 1.04 F 15,000 28 21,000 2.40 G 17,500 19 7,500 1.43 H 25,000 15 6,000 1.24
64. Choosing by IRRs for BW Project ICO IRR NPV PI C $ 5,000 37% $ 5,500 2.10 F 15,000 28 21,000 2.40 E 12,500 26 500 1.04 B 5,000 25 6,500 2.30 Projects C, F, and E have the three largest IRRs.The resulting increase in shareholder wealth is $27,000 with a $32,500 outlay.
65. Choosing by NPVs for BW Project ICO IRR NPV PI F $15,000 28% $21,000 2.40 G 17,500 19 7,500 1.43 B 5,000 25 6,500 2.30 Projects F and G have the two largest NPVs.The resulting increase in shareholder wealth is $28,500 with a $32,500 outlay.
66. Choosing by PIs for BW Project ICO IRR NPV PI F $15,000 28% $21,000 2.40 B 5,000 25 6,500 2.30 C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 G 17,500 19 7,500 1.43Projects F, B, C, and D have the four largest PIs.The resulting increase in shareholder wealth is $38,000 with a $32,500 outlay.
67. Summary of Comparison Method Projects Accepted Value Added PI F, B, C, and D $38,000 NPV F and G $28,500 IRR C, F, and E $27,000PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period.
68. Single-Point Estimate and Sensitivity AnalysisAllows us to change from “single-point” (i.e., revenue, installation cost, salvage, etc.) estimates to a “what if” analysisUtilize a “base-case” to compare the impact of individual variable changesE.g., Change forecasted sales units to see impact on the project’s NPV Sensitivity Analysis: A type of “what-if” uncertainty analysis in which variables or assumptions are changed from a base case in order to determine their impact on a project’s measured results (such as NPV or IRR).
69. Post-Completion AuditPost-completion AuditA formal comparison of the actual costs and benefits of a project with original estimates. Identify any project weaknesses Develop a possible set of corrective actions Provide appropriate feedbackResult: Making better future decisions!
70. Multiple IRR Problem* Two!! There are as many potential IRRs as there are sign changes.Let us assume the following cash flow pattern for a project for Years 0 to 4:–$100 +$100 +$900 –$1,000How many potential IRRs could this project have?* Refer to Appendix A
71. NPV Profile – Multiple IRRsDiscount Rate (%)0 40 80 120 160 200Net Present Value($000s)Multiple IRRs atk = 12.95% and 191.15%7550250–100
72. NPV Profile – Multiple IRRs Hint: Your calculator will only find ONE IRR – even if there are multiple IRRs. It will give you the lowest IRR. In this case, 12.95%.