Capital Budgeting Techniques

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Capital Budgeting Techniques

• The Investment Detective

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What are these projects????
Mutually Exclusive
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A First Inspection

• Problems with this naive ranking
• Ignores time value of money

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The Payback Period

• The time you must wait before recouping your
  original investment.
• For our purposes we will concentrate on the
  closest year

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Example Projects 18
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Our Projects
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Problems with Payback

• Ignores the time value of money
• Ignores payments after the payback period
• Which is better????

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In Fairness

• Simple to calculate
• Provides a rough estimate of investment risk.
• PB is a measure of liquidity
• The longer it takes to recoup our investment the
  the greater the risk
• Near term cash flow estimates are more reliable
  than long term estimates
• Especially in volatile industries

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Accounting Rate of Return (ARR)

• Also called Average ROI

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Our Projects

• Problems
• Again ignores the TVM
• Which projects are best?
• Project 6?

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The Net Present Value NPV

• Where,
• CFt expected cash flow in year t
• WACC is the weighted average cost of capital or
  opportunity cost

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Example Project 7

• Remember that projects 7 8 are mutually
  exclusive
• Whats that mean?
• We must rank

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The Rational for NPV

• Payback Method
• Indicates whether a project repays invested
  capital
• NPV Method
• Indicates whether a project repays invested
  capital
• Indicates whether a project provides a sufficient
  return on invested capital
• Discount rate WACC Opportunity Cost

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The Interpretation

• Positive NPV
• Project generates an excess return
• Who gets the excess return
• Shareholders
• NPV represents the change in shareholder wealth
• Represents the value created
• Share price should increase
• Negative NPV
• Cash flows are not sufficient
• Project destroys value
• Share price should fall
• Zero NPV?

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• Which project is better? Why?

• What about the differing lives

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Our Projects
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The Benefit-Cost Ratio (Profitability Index)

• Popular cost-benefit analysis

• What does this mean?
• Project returns less than it costs
• Negative NPV

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Our Projects
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The Pros and Cons

• Accept independent projects with a BCR gt1
• Accept only projects with positive NPVs
• Measures a projects bang-for-the-buck
• Rank Mutually exclusive projects
• Useful in ranking projects under capital
  rationing
• Also gives some indication of project risk
• What is our safety margin
• BCR 1.20
• BCR 1.02

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Internal Rate of Return (IRR)

• IRR is the discount rate such that
• PV(inflows) PV(outflows)

• The most popular yard stick

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• Example Project 1

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• How do you solve?
• Calculator, Spreadsheet model
• Trial and error
• Remember NPV(7) 165 _at_ 10
• To achieve a NPV 0
• The discount rate must be higher

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165
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99
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IRR 15.3
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• What does this mean?
• Project 7
• IRR 15.3
• The project 7 investment is economically
  equivalent to an investment yielding 15.3
  annually

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Our Projects
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Comments on IRR

• Measures a projects expected rate of return
• Average compound rate of return
• Decision Rule
• Accept projects with IRRgtWACC
• Cost of capital
• Rank projects by IRR (Mutually Exclusive)

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NPV and IRR
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Interpretation

• From the NPV profile
• At high discount rates project 7 is better
• You receive your cash flows sooner
• At low discount rates project 8 is better
• You receive more cash flows in the future
• Future cash flows are not penalized as much

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Comparisons of NPV and IRR

• For Independent Projects
• IRR and NPV lead to the same decision
• Accept if IRR gt WACC
• Accept if NPV gt0
• For Mutually Exclusive Projects
• Scale Problems WACC 12

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• Timing of Cash Flows

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Cause of Conflict

• Cause

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Multiple IRRs

• Generally whenever we have future outflows we can
  expect to find multiple IRRs

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So Why is IRR so Popular

• Intuitive appeal of talking about projects in
  terms of returns
• Project 7 has a NPV of 165 at a 10 cost of
  capital
• Project 7 yields a return of 15.3
• May provide some perspective on project risk
• WACC 10
• IRR(7) 15.3
• IRR(8) 11.4

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Projects 78 revisited

• Remember that the projects are mutually exclusive

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• How do you handle the different lives
• Will the project be continued?
• Replacement Chain
• Create a chain of replacements of equal lives
• In this case it would last 35 years
• Equivalent annual annuity
• What is the equivalent annuity with the same PV
  as the NPV
• Splitting the NPV into equal annual payments
• Compare projects based on what they produce per
  year.

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Equivalent Annual Annuity EAA

• NPV(7) 165
• Project has a 5 year life
• What annuity has a 165 present value

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• Which projects should we choose?
• No capital limit
• 1,3,4,5,6,7 (1.2million)
• What about Capital Rationing?

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Final Comments

• What have we glossed over?
• Risk we assumed all projects had equivalent
  risk
• WACC 10
• Cash flow calculations
• Where do they come from
• Capital Rationing

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The End