Chapter 10: The Fundamentals of Capital Budgeting PDF

Chapter 10: The Fundamentals of Capital Budgeting Copyright© 2015 John Wiley & Sons, Inc. Learning Objectives 1. Discuss why capital budgeting decisions are the most important investment decisions made by a firm’s management 2. Explain the benefits of using the net present value (NPV) met...

Chapter 10: The Fundamentals of Capital Budgeting Copyright© 2015 John Wiley & Sons, Inc. Learning Objectives 1. Discuss why capital budgeting decisions are the most important investment decisions made by a firm’s management 2. Explain the benefits of using the net present value (NPV) method to analyze capital expenditure decisions and calculate the NPV for a capital project 3. Describe the strengths and weaknesses of the payback period as a capital expenditure decision- making tool and compute the payback period for a capital project Copyright© 2015 John Wiley & Sons, Inc. Learning Objectives 4. Compute the internal rate of return (IRR) for a capital project and discuss the conditions under which the IRR technique and the NPV technique produce different results Copyright© 2015 John Wiley & Sons, Inc. Learning Objectives 5. Explain how the profitability index can be used to rank projects when a firm faces capital rationing and describe the limitations that apply to the profitability index 6. Explain the benefits of post-audit and periodic reviews of capital projects Copyright© 2015 John Wiley & Sons, Inc. The Importance of Capital Budgeting Capital budgeting decisions are the most important investment decisions made by management These decisions determine the long-term productive assets that will create wealth for a firm’s owners Capital investments are large cash outlays, long-term commitments, not easily reversed, and primary factors in a firm’s long-run performance Capital budgeting techniques help management systematically analyze potential opportunities in order to decide which are worth undertaking Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Sources of Information Most of the information needed to make capital budgeting decisions is generated internally, often beginning with the sales force followed by marketing team Next the production team gets involved, followed by cost accountants All the information is reviewed by financial managers/CFO who evaluate the feasibility of the project based on cash outflows and inflows Copyright© 2015 John Wiley & Sons, Inc. Classification of Investment Projects Independent projects Projects for which the decision to accept or reject is not influenced by decisions about other projects being considered by the firm Mutually exclusive projects Projects for which the decision to accept one project is simultaneously a decision to reject another project These projects typically perform the same function Contingent projects Projects for which the decision to accept one project depends on acceptance of another project Mandatory optional Copyright© 2015 John Wiley & Sons, Inc. Basic Capital Budgeting Terms Capital rationing: a firm with limited funds chooses the best projects to undertake Capital asset: a long-term assets Cost of capital: rate of return that a project must earn to be accepted by management Conventional and Un-conventional cash flows Copyright© 2015 John Wiley & Sons, Inc. Net Present Value (NPV) Net Present Value is the best capital budgeting technique and is consistent with the goal of maximizing shareholder wealth NPV compares the present value of expected benefits and cash flows from a project to the present value of the expected costs; if the benefits are larger, the project is feasible Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Valuation of Real Assets Valuing real assets requires the same steps as valuing financial assets 1. Estimate future cash flows 2. Estimate cost of capital/required-rate-of return 3. Calculate present value of future cash flows Practical difficulties in valuing real assets Cash flow estimates must be prepared in-house and are not as readily available as those for financial assets with legal contracts Estimating required-rates-of-return for real assets is more difficult than estimating required return for financial assets because no market data is available Copyright© 2015 John Wiley & Sons, Inc. Net Present Value The NPV of a project is the difference between the present values of its expected cash inflows and expected cash outflows Positive NPV projects increase shareholder wealth Negative NPV projects decrease shareholder wealth In theory, managers should be indifferent about accepting or rejecting zero NPV projects Copyright© 2015 John Wiley & Sons, Inc. Net Present Value NPV is the present value of the expected net cash flows (NCF), where Equation 10.1 Copyright© 2015 John Wiley & Sons, Inc. A Five-Step Approach for Calculating NPV 1. Estimate project cost Identify and add the present value of expenses related to the project There are projects whose entire cost occurs at the start of the project, but many projects have costs occurring beyond the first year The cash flow in year zero (NCF0) on the timeline is negative, indicating and outflow 2. Estimate project net cash flows Both cash inflows and outflows are likely in each year of the project; estimate the net cash flow for each year Include the salvage value of the project in its terminal year Copyright© 2015 John Wiley & Sons, Inc. A Five-Step Approach for Calculating NPV 3. Determine project risk and estimate cost of capital The cost of capital is the discount rate used to determine the present value of expected net cash flows The riskier a project, the higher its cost of capita 4. Compute the project’s NPV Determine the difference between the present values of the expected net cash flows from the project and the expected cost of the project 5. Make a decision Accept the project if it has a positive NPV Reject the project if it has a negative NPV Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Example: Net Present Value Find the NPV of the example in Exhibit 10.3 Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Payback Period The Payback Period is the amount of time it takes for the sum of the net cash flows from a project to equal the project’s initial investment The project is acceptable if the payback period is shorter than a certain amount of time Can serve as a risk indicator: the quicker a project’s cost is recovered, the less risky the project Payback Period is one of the most widely used tools for evaluating capital projects Projects with shorter payback periods are more desirable Copyright© 2015 John Wiley & Sons, Inc. Payback Period To compute the payback period, estimate a project’s cost and its future net cash flows Equation 10.2 Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Example: Payback Period Find the Payback Period of the example in Exhibit 10.5 Copyright© 2015 John Wiley & Sons, Inc. Evaluating the Payback Rule Although the Payback Period is easy to calculate and understand, There is no economic rationale that makes the payback method consistent with shareholder wealth maximization It ignores the time value of money Does not account for differences in the overall risk of projects Cash flows occurring after the payback period are not considered Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Discounted Payback Period Future cash flows are discounted by the firm’s cost of capital The major advantage of the discounted payback is that it tells management how long it takes a project to reach a positive NPV Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc.  Internal Rate of Return (IRR) The IRR technique compares a firm’s cost of capital (opportunity cost/required return of investors used in NPV) discount rate to the rate-of-return that makes the net cash flows from a project equal to the project’s cost A project is acceptable if its IRR is greater than the firm’s cost of capital The IRR is analogous to the yield-to-maturity on a bond The NPV and IRR techniques are similar in that both utilize discounted cash flows The IRR is the discount rate that makes a project have an NPV equal to zero The NPV and IRR methods will agree when projects are independent and the cash flows are conventional (initial outflow and net inflows thereafter) Copyright© 2015 John Wiley & Sons, Inc. Internal Rate of Return Equation 10.4 Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Calculator Example: Ford IRR Find the IRR of the cash flows in Exhibit 10.8 Enter 3 -560 240 0 N i PV PMT FV Answer 13.7 Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. When IRR and NPV Disagree The IRR and NPV methods can produce different accept/reject decisions if a project has unconventional cash flows or projects are mutually exclusive Unconventional cash flow may exhibit many patters Positive initial cash flow followed by negative net cash flows (life insurance companies) Positive and negative net cash flows (major renovations) Conventional except for a negative net cash flow at the end of a project’s life (decomposition plant or environment cleaning cost) With unconventional cash flows, the IRR technique may provide more than one rate of return. This makes the calculation unreliable and it should not be used to determine whether a project should be accepted or rejected Copyright© 2015 John Wiley & Sons, Inc. IRR and NPV A major weakness of the IRR compared to the NPV method is the reinvestment rate assumption IRR assumes that cash flows from a project are reinvested to earn the IRR while NPV assumes that they are reinvested and earn the firm’s cost of capital The optimistic assumption in the IRR method leads to some projects being accepted when they should not – the reinvested cash flows cannot earn the IRR Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. IRR for Mutually Exclusive Projects There is a discount rate at which the NPVs of two mutually exclusive projects will be equal; that rate is the crossover point Depending on whether the required rate of return is higher or lower than the crossover rate, the ranking of the projects will be different It is easy to identify the superior project based on NPV but it cannot be done using IRR due to ranking conflicts Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Modified Internal Rate of Return (MIRR) A major weakness of the IRR compared to the NPV method is the reinvestment rate assumption In the MIRR technique, cash flow is assumed to be reinvested at the firm’s cost of capital The compounded value are summed to get a projects terminal value (TV) at then end of its life The MIRR is the rate which equates a project’s cost to its terminal value Equation 10.5 Copyright© 2015 John Wiley & Sons, Inc. Example: Modified Internal Rate of Return A project costs $1,200 and will generate net cash inflows of $400 for four years. Calculate the MIRR of the project. Copyright© 2015 John Wiley & Sons, Inc. Profitability Index (PI) The PI provides a measure of the value of project generates for each dollar invested in that project Useful because firms have limited resources and therefore cannot invest in all projects that have a positive NPV The PI will choose a set of projects that is consistent with the idea of shareholder wealth maximization Equation 10.6 Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc. Copyright© 2015 John Wiley & Sons, Inc.  https://www.sciencedirect.com/science/article/pii/ S0970389617300587 Copyright© 2015 John Wiley & Sons, Inc.  Accounting Rate of Return (ARR) The ARR is also called the Book Value Rate-of-Return ARR uses Net Income and Book Value rather than cash flows to compute the return on a capital project Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. More than half of large firms calculate ARR when appraising projects. Copyright© 2015 John Wiley & Sons, Inc. Accounting Rate of Return (ARR) ARR also has flaws as a tool for making capital expenditure decisions The ARR is not a true rate of return; it is generated from the income statement and balance sheet It ignores the time value of money There is no economic rationale that makes it consistent with the goal of maximizing shareholder wealth Copyright© 2015 John Wiley & Sons, Inc. Capital Budgeting in Practice Many financial managers use multiple capital budgeting tools Management should systematically review the status of all ongoing capital projects and perform post-audits on completed capital projects A review should challenge the business plan, including cash flow projections, cost assumptions, and the performance of people responsible for implementing the capital project A post-audit examination may reveal why a project was successful or failed to achieve its financial goals Copyright© 2015 John Wiley & Sons, Inc.