Principles of Managerial Finance Brief Edition

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Principles of Managerial FinanceBrief Edition

• Chapter 10

Capital Budgeting Techniques Certainty and Risk
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Learning Objectives

• Calculate, interpret, and evaluate the payback
  period.
• Apply net present value (NPV) and internal rate
  of return (IRR) to relevant cash flows to choose
  acceptable capital expenditures.
• Use net present value profiles to compare, from
  both theoretical and practical viewpoints, net
  present value and internal rate of return
  techniques in light of conflicting rankings.

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Learning Objectives

• Discuss the two basic approaches - IRR and NPV -
  for choosing under conditions of capital
  rationing.
• Recognize sensitivity and scenario analysis,
  decision trees, and simulation as behavioral
  approaches for dealing with project risk, and the
  unique risks facing multinational corporations.
• Understand the calculation, differing approaches,
  and practical aspects of certainty equivalents
  (CEs) and risk-adjusted discount rates (RADRs).

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Techniques that Ignore the Time Value of Money

• Payback. The payback method simply measures how
  long (in years and/or months) it takes to recover
  the initial investment.
• But payback has two major weaknesses
• First, it fails to consider the importance of the
  time value of money.
• Second, it fails to consider cash flows that
  occur after the pre-set payback period.

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Techniques that Ignore the Time Value of Money

• Payback Weakness Failure to consider the time
  value of money (pattern of cash flows).

But which is preferred?
Payback is the same!
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Techniques that Ignore the Time Value of Money

• Payback Weakness Failure to consider all
  relevant cash flows.

But look at the total cash flows for Project 1!
Payback says pick Project 2!
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Time Value Techniques

• Net Present Value (NPV). Net Present Value is
  found by subtracting the present value of the
  after-tax outflows from the present value of the
  after-tax inflows.

Decision Criteria If NPV gt 0, accept the
project If NPV lt 0, reject the project If NPV
0, indifferent
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Time Value Techniques
Net Present Value
Recall the Net Incremental Cash Flows for East
Coast Drydock from Chapter 9
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Time Value Techniques
Net Present Value
With a 15 discount rate, we would keep the
existing hoist
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Time Value Techniques
Net Present Value
In fact, even with a discount rate of 0, we
would keep the existing hoist since it has the
highest NPV.
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Time Value Techniques
Net Present Value
Recall that the before tax operating cash inflows
for Drydock in Chapter 9 were as follows
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Time Value Techniques
Net Present Value
What if -- because of a measurement error -- the
cash inflows for A and B were double those
initially estimated as shown below
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Time Value Techniques
Net Present Value
Recalculating the NPV at a discount rate of 15,
we get
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Time Value Techniques
Net Present Value
With the new numbers, we can now see that Hoist B
should be used to replace the existing hoist.
This will maximize NPV and ultimately,
shareholder value.
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Time Value Techniques
Profitability Index

• The profitability index which is also sometimes
  called the benefit/cost ratio, is the ratio of
  the present value of the inflows to the present
  value of the outflows.

PI PV Inflows PV Outflows
Decision Criteria If PI gt 1, accept the
project If PI lt 1, reject the project If PI 1,
indifferent
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Time Value Techniques
Profitability Index
Returning to the last East Coast Drydock example,
we get
Choose Hoist A since PIA gt PIB
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Time Value Techniques
Internal Rate of Return

• The IRR is the discount rate that will equate the
  present value of the outflows with the present
  value of the inflows
• The IRR is the projects intrinsic rate of
  return.

Decision Criteria If IRR gt k, accept the
project If IRR lt k, reject the project If IRR
k, indifferent
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Time Value Techniques
Internal Rate of Return
Note that both replacement projects provide a
return in excess of the cost of capital of 15.
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Time Value Techniques
Internal Rate of Return
What if the cost of capital were 42.19?
Notice that the IRR discount rate and that NPV
0
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Time Value Techniques
Net Present Value Profile
The NPV Profile shows how a projects value
changes with changes in the discount rate.
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Time Value Techniques
Net Present Value Profile
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Problems with Discounted Cash Flow Techniques
Conflicting Rankings for Mutually Exclusive
Projects
Mutually exclusive projects compete in some way
with the same resources. A firm can pick one, or
the other, but not both.
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Problems with Discounted Cash Flow Techniques
Conflicting Rankings for Mutually Exclusive
Projects
Mutually exclusive projects compete in some way
with the same resources. A firm can pick one, or
the other, but not both.
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Problems with Discounted Cash Flow Techniques
Conflicting Rankings for Mutually Exclusive
Projects
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Problems with Discounted Cash Flow Techniques
Conflicting Rankings for Mutually Exclusive
Projects

• Interdependent projects are those that influence
  the value of others.
• In general terms, if there are two interdependent
  projects, then three appraisals are required
• Project A
• Project B
• And Project A plus B

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Problems with Discounted Cash Flow Techniques
Summary

• If projects are mutually exclusive and not
  subject to capital rationing, the project with
  the higher NPV should be selected.
• If the projects are independent, and there is no
  capital restriction, both should be chosen if
  they have positive NPVs.
• In the presence of capital restrictions, the
  project with the higher NPV should be selected.

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Capital Rationing
Example
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Capital Rationing
IRR Approach
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Capital Rationing
IRR Approach
Assume the firms cost of capital is 10 and
has a maximum of 250,000 available for
investment. Ranking the projects according to
IRR, the optimal set of projects for Gould is
B, C, and E.
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Capital Rationing
NPV Approach
If we ration capital using the NPV approach and
maintain the rankings provided by IRR, the
total PV of inflows and NPV would be 336,000 and
106,000 respectively.
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Capital Rationing
NPV Approach
However, if we rank them such that NPV is
maximized, then we can use our entire budget
and raise the PV of inflows and NPV to 357,000
and 107,000 respectively.
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Behavioral Approaches for Dealing with Risk
Sensitivity Analysis
Treadwell Tire has a 10 cost of capital and is
considering investing in one of two mutually
exclusive projects A or B. Each project has a
10,000 initial cost and a useful life of 15
years. As financial manager, you have provided
pessimistic, most-likely, and optimistic
estimates of the equal annual cash inflows for
each project as shown in the following table.
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Behavioral Approaches for Dealing with Risk
Sensitivity Analysis
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Behavioral Approaches for Dealing with Risk
Decision Trees
Convoy Inc., a manufacturer of picture frames,
wishes to choose between two equally risky
projects, I and J. Project I requires an
initial investment of 120,000, an expected PV of
inflows of 130,000, and expected NPV of 10,000.
Project J, calculated in a similar fashion, has
an expected NPV of 15,000.
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Behavioral Approaches for Dealing with Risk
Decision Trees
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Behavioral Approaches for Dealing with Risk
Decision Trees
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Risk-Adjustment Techniques
Certainty Equivalents
Blano Company is currently evaluating two
projects, A and B. The firms cost of capital
is 10 and the initial investment and operating
cash flows are shown on the following slide.
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Risk-Adjustment Techniques
Certainty Equivalents
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Risk-Adjustment Techniques
Certainty Equivalents
Assume that it is determined that Project A is
actually more risky than B. To adjust for this
risk, you decide to apply certainty equivalents
(CEs) to the cash flows, where CEs represent the
percentage of the cash flows that you would be
satisfied to receive for certain rather than the
original (possible) cash flows.
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Risk-Adjustment Techniques
Certainty Equivalents
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Risk-Adjustment Techniques
Certainty Equivalents
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Risk-Adjustment Techniques
Risk-Adjusted Discount Rates
Blano also wishes to apply the Risk-Adjusted
Discount Rate (RADR) approach to determine
whether to implement Project A or B. To do so,
Blano has developed the following Risk Index to
assist them in their endeavor.
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Risk-Adjustment Techniques
Risk-Adjusted Discount Rates
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Risk-Adjustment Techniques
Risk-Adjusted Discount Rates
Project B has been assigned a Risk Index Value of
1.0 (average risk) with a RADR of 11, and
Project A has been assigned a Risk Index Value of
1.6 (above average risk) with a RADR of 14.
These rates are then applied as the discount
rates to the two projects to determine NPV as
shown on the following slide.
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Risk-Adjustment Techniques
Risk-Adjusted Discount Rates
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Risk-Adjustment Techniques
Risk-Adjusted Discount Rates