Capital Budgeting Decision Rules

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Capital Budgeting Decision Rules

• What real investments should firms make?

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Alternative Rules in Use Today

• NPV
• IRR
• Profitability Index
• Payback Period
• Discounted Payback Period
• Accounting Rate of Return

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What Provides Good Decision-Making?

• Our work has shown that several criteria must be
  satisfied by any good decision rule
• The decision rule must be based on cash flow.
• The rule should incorporate all the incremental
  cash flows attributable to the project.
• The rule should discount cash flows appropriately
  taking into account the time value of money and
  properly adjusting for the risk inherent in the
  project. - Opportunity cost of capital.
• When forced to choose between projects, the
  choice should be governed by maximizing
  shareholder wealth given any relevant constraints.

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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.
• NPV based decision rule
• When evaluating independent projects, take those
  with positive NPVs, reject those with negative
  NPVs.
• When evaluating interdependent projects, take the
  feasible combination with the highest combined
  NPV.

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Lockheed Tri-Star

• As an example of the use of NPV analysis we will
  use the Lockheed Tri-Star case.
• To examine the decision to invest in the Tri-Star
  project, we first need to forecast the cash flows
  associated with the Tri-Star project for a volume
  of 210 planes.
• Then we can ask What is a valid estimate of the
  NPV of the Tri-Star project at a volume of 210
  planes as of 1967.

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Internal Rate of Return

• Definition The discount rate that sets the NPV
  of a project to zero (essentially project YTM) is
  the projects IRR.
• IRR asks What is the projects 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.

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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.
• Thats all you do to find IRR.

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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 0

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The Merit to the IRR Approach

• The IRR can be interpreted as the answer to the
  following question. Suppose that the initial
  investment is placed in a bank account instead of
  this project. What interest rate must the bank
  account pay in order that we may make withdrawals
  equal to the cash flows generated by the project?
• As with NPV, the IRR is also based on incremental
  cash flows, does not ignore any cash flows, and
  (by comparison to the appropriate discount rate,
  r) accounts for the time value of money and risk
  (the opportunity cost of capital).
• In short, it can be useful.

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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.

-100
230
-132
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Pitfalls of IRR cont

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Pitfalls of IRR cont
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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.
• Lets look at the cash flows, IRRs and NPVs.

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Mutually Exclusive Projects and IRR
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• At low discount rates, B is better. At high
  discount rates, project A is a better choice.
• 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.

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Summary of IRR vs. NPV

• IRR analysis can be misleading if you dont fully
  understand its limitations.
• For individual projects with a normal cash flow
  pattern 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 several changes in
  sign of the cash flows multiple IRRs exist. Must
  compute the NPVs to see what is appropriate
  decision rule.
• IRR can give conflicting signals relative to NPV
  when ranking projects.
• I recommend NPV analysis, using others as backup.

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Profitability Index

• Definition The present value of the cash flows
  that accrue after the initial outlay divided by
  the initial cash outlay.
• Rule Take any/only projects with a PIgt1.
• The PI does a benefit/cost (bang for the buck)
  analysis. When the PV of the future benefits is
  larger than the current cost PI gt 1. If this is
  true what is true of the NPV? Thus for
  independent projects the rules make exactly the
  same decision.

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PI and Mutually Exclusive Projects

• Example
• Project CF0 CF1 NPV _at_ 10 PI
• A -1,000 1,500 364
  1.36
• B -10,000 13,000 1,818
  1.18
• Since you can only take one and not both the NPV
  rule says B, the PI rule would suggest A. Which
  is right?
• The projects are mutually exclusive so the NPV of
  one is an opportunity cost to the other. We must
  take B in this respect A has a negative NPV.
• PI treats scale strangely. It measures the bang
  per buck invested. This is larger for A but
  since we invest more in B it will create more
  wealth for us.

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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?

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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 only virtue.
• At times the payback or discounted payback period
  may be valuable information but it is not often
  that this information alone makes for good
  decision-making.

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Average Accounting Return

• Definition The average net income after
  depreciation and taxes (before interest) divided
  by the average book value of the investment.
• Rule If the AAR is above some cutoff take the
  project.
• This is essentially a measure of return on assets
  (ROA).

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AAR

• Issues
• Doesnt use cash flows but rather accounting
  numbers.
• Ignores the time value of money.
• Does not adjust for risk.
• Uses an arbitrarily specified cutoff rate.
• Other than that its a beautiful decision-making
  tool.

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Applying the NPV Method

• While other approaches (particularly IRR) can be
  of use, I recommend NPV.
• The three steps to apply NPV
• Estimate the incremental cash flows (today).
• Select the appropriate discount rate to reflect
  current capital market conditions and risk.
• Compute the present value of the cash flows.
• For now, we will continue to assume that firms
  are all equity financed. To be continued

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Our Golden Rules

1. Cash flows are the concern.
2. Consider only incremental cash flows.
3. Dont forget induced changes in NWC.
4. Dont ignore opportunity costs.
5. Never, never, never neglect taxes.
6. Dont include financing costs in cash flow.
7. Treat inflation consistently.
8. Recognize project interactions.

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Incremental Cash Flow

• The incremental cash flow is the companys total
  free cash flow with the proposed project minus
  the companys total cash flow without the
  project.
• Some issues that arise
• Sunk costs. These are costs, related to the
  project, that have already been incurred.
• Opportunity costs. What else could be done?
• Capital expenditures versus depreciation expense.
• Side effects. Does the new project affect other
  cash flows of the firm?
• Taxes.
• Increased investment in working capital.

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Sunk Costs vs. Opportunity Costs

• Last year, you purchased a plot of land for 2.5
  million.
• Currently, its market value is 2.0 million.
• You are considering placing a new retail outlet
  on this land. How should the land cost be
  evaluated for purposes of projecting the cash
  flows that will become part of the NPV analysis?

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Side Effects

• A further difficulty in determining cash flows
  from a project comes from effects the proposed
  project may have on other parts of the firm. The
  most important side effect is called erosion.
  This is cash flow transferred from existing
  operations to the project.
• Chryslers introduction of the minivan.
• What if a competitor would introduce the new
  product if your company does not?

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Taxes

• Typically,
• Revenues are taxable when accrued.
• Expenses are deductible when accrued.
• Capital expenditures are not deductible, but
• depreciation can be deducted as it is accrued,
• tax depreciation can differ from that reported on
  financial statements.
• Sale of an asset for a price other than its tax
  basis (original price less accumulated tax
  depreciation) leads to a capital gain/loss with
  tax implications.

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Working Capital

• Increases in Net Working Capital should typically
  be viewed as requiring a net cash outflow.
• increases in inventory and/or the cash balance
  require actual uses of cash.
• increases in receivables mean that accrued
  revenues exceed actual cash collections.
• If you are basing your measure of cash flow on
  accrued revenues you need a correcting
  adjustment.
• If you are basing your measure of cash flow on
  cash revenues no adjustment is required.