Capital%20Budgeting%20Decision%20Rules

1
Capital Budgeting Decision Rules

• What real investments should firms make?

2
Alternative Rules in Use Today

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

3
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.

4
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.

5
Lockheed Tri-Star Key Points

• Pre-production costs estimated at 900 million
  incurred between 1967 and 1971.
• Total of 210 planes delivered from 1972-1977
• Revenues of 16 million per unit, 25 of revenue
  received 2 years in advance of delivery.
• Production costs of 14 million (at 210 units
  could decline to 12.5 million at 300) from
  1971-1976.
• Discount rate of 10 per year.

6
Tri-Star Cash Flows

• 210 planes (1972-1977)
• Planes per year 210/635
• Production Costs (1971-1976)
• 35(14M)490M per year
• Dont forget the preproduction costs of 900M
• Revenues (1970-1977)
• Total Revenues 35(16M)560M per year
• Deposits0.25(560M)140M (2 yrs in advance)
• Net Revenues560-140420M on delivery

7
Tri-Star Cash Flows(210 Planes)
8
Tri-Star NPV _at_10 in 1967
9
Accounting Profits at 210

• Production revenues are 16M per plane and
  production costs are 14M per plane. Profit is
  2M per plane.
• 2102M 420M production profits. 420M vs.
  900M preproduction costs is breakeven?
• Suppose production cost is 12.5M per plane
  (learning curve hits early). Profit per plane is
  3.5M. At 210 planes this is 735M production
  profit.
• Now take the extreme low-end of the 800M - 1B
  preproduction cost range.
• Suddenly you have breakeven. Smart huh?

10
Tri-Star NPV 1967 (Millions)
Units Sold Average Unit Cost Accounting Profit NPV
323 12.25 311 -195
400 12.00 700 -12
400 11.75 800 42
500 11.00 1,600 441
11
Tri-Star Cash Flows 1970(210 Planes)
12
1970 Tri-Star NPV _at_10
13
Tri Star Post Mortem

• Accounting breakeven approximately 275 planes
• 16M - 12.5M 3.5M per plane
• 3.5M?275 962M profit versus 960M in actual
  development costs known in 1970
• This more realistic breakeven level announced
  subsequent to the guarantees being granted.
• NPV breakeven approximately 400 planes
• Total free world market demand for wide-body
  aircraft approximately 325 planes
• Optimistic estimate total demand 775 and 40 of
  that is 310
• Lockheed share price
• 64 Jan 1967 drops to 11 Jan 1971
• (64-11)(11.3 Million shares)-599 Million
• Compare to -584 Million NPV

14
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.

15
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.

16
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

17
The Merit to the IRR Approach

• The IRR (as with the YTM) is an approximation to
  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.

18
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
19
Pitfalls of IRR cont

20
Pitfalls of IRR cont
21
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.

22
Mutually Exclusive Projects and IRR
23

• 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.

24
Summary of IRR vs. NPV

• IRR analysis can be misleading if you dont 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 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.

25
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 the projects with a PIgt1.
• The PI does a benefit/cost (bang for the buck)
  analysis. Any time the PV of the future benefits
  is larger than the current cost PI gt 1. When
  this is true what is the NPV? Thus for
  independent projects the rules make exactly the
  same decision.

26
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.

27
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?

28
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 1,000,000
• The payback period is 3 years. Is that good or
  bad?

29
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 payback or discounted payback period
  may be valuable information but it is not often
  that this information alone makes for good
  decision-making.

30
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).

31
AAR

• Problems
• 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.