capital budgeting criteria for investments projects mutually exclusive versus independent project
DESCRIPTION
Chapter 6. Capital Budgeting Criteria for Investments Projects Mutually Exclusive versus Independent Project. Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system. RANK all alternatives and select the best one. - PowerPoint PPT PresentationTRANSCRIPT
Jacoby, Stangeland and Wajeeh, 2000
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Capital Budgeting Criteria for Investments Projects
Mutually Exclusive versus Independent Project
Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system.
RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria.
Chapter 6
Jacoby, Stangeland and Wajeeh, 2000
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The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CF’s - Initial Investment
Estimating NPV: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs
Minimum Acceptance Criteria:
Accept if: NPV > 0
Ranking Criteria: Choose the highest NPV
Jacoby, Stangeland and Wajeeh, 2000
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NPV - An Example
Assume you have the following information on
Project X:
Initial outlay -$1,100 Required return = 10%
Annual cash revenues and expenses are as follows:
Year Revenues Expenses
1 $1,000 $500
2 2,000 1,300
3 2,200 2,700
4 2,600 1,400
Draw a time line and compute the NPV of project X.
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The Time Line & NPV of Project X0 1 2
Initial outlay($1,100)
Revenues $1,000Expenses 500
Cash flow $500
Revenues $2,000Expenses 1,300
Cash flow $700
– $1,100.00
+454.54
+578.51
-375.66
+819.62
1$500 x 1.10
1$700 x 1.10
2
3
Revenues $2,200Expenses 2,700
Cash flow (500)
1- $500 x 1.10
3
4
Revenues $2,600Expenses 1,400
Cash flow $1,200
1$1,200 x 1.10
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NPV = -C0 + PV0(Future CFs)= -C0 + C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + C4/(1+r)4
= - + + + +
= $377.02 > 0
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First, clear previous data, and check that your calculator is set to 1 P/YR:NPV in your HP 10B Calculator
CFj
I/YR
Key in CF0
Key in CF4
Key in r
Key in CF3 +/- CFj500
1,200
CFjKey in CF1500
CFjKey in CF2700
+/- CFj1,100
The display should show: 1 P_YrInput data (based on above NPV example)
Display should show: CF 0
Display should show: CF 1
Display should show: CF 2
Display should show: CF 3
Display should show: CF 4
PRCNPV
Compute NPVDisplay should show:
377.01659723
10
Yellow
YellowC
C ALL
Jacoby, Stangeland and Wajeeh, 2000
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The Payback Period Rule
How long does it take the project to “pay back” its initial investment?
Payback Period = # of years to recover costs of project
Minimum Acceptance Criteria: set by management
Ranking Criteria: set by management
Jacoby, Stangeland and Wajeeh, 2000
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Discounted Payback - An Example
Initial outlay -$1,000r = 10%
PV of Year Cash flow Cash flow 1 $ 200 $ 182 2 400 331 3 700 526 4 300 205
Accumulated Year discounted cash flow 1 $ 182 2 513 3 1,039 4 1,244
Discounted payback period is just under 3 years
Jacoby, Stangeland and Wajeeh, 2000
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Average Accounting Return (AAR)
You want to invest in a machine that produces squash balls. The machine costs $90,000.
The machine will ‘die’ after 3 years (assume straight line depreciation, the annual depreciation is $30,000).
You estimate for the life of the project:
Year 1 Year 2 Year 3
Sales 140 160 200
Expenses 120 100 90
EBD 20 60 110
Jacoby, Stangeland and Wajeeh, 2000
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Year 1 Year 2 Year 3
Sales 140 160 200
Expenses 120 100 90
E.B.D.
Depreciation
E.B.T.
Taxes (40%)
NI:
Calculating Projected NI
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We calculate:
(i) Average NI =
(ii) Average book value (BV) of the investment (machine):
time-0 time-1 time-2 time-3
BV of investment: 90 60 30 0
=> Average BV = (divide by 4 - not 3)
(iii) The Average Accounting Return:
AAR = = 44.44%
Conclusion: If target AAR < 44.44% => accept
If target AAR > 44.44% => reject
203
603
48186
454
0306090
4520
Jacoby, Stangeland and Wajeeh, 2000
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The Internal Rate of Return (IRR) Rule
IRR: the discount rate that sets the NPV to zero Minimum Acceptance Criteria:
Accept if: IRR > required return
Ranking Criteria: Select alternative with the highest IRR
Reinvestment assumption: the IRR calculation assumes that all future cash flows are reinvested at the IRR
Disadvantages: Does not distinguish between investing and financing IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments
Advantages: Easy to understand and communicate
Jacoby, Stangeland and Wajeeh, 2000
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Internal Rate of Return - An Example
Initial outlay = -$2,200
Year Cash flow
1 800 2 900 3 500 4 1,600
Find the IRR such that NPV = 0
0 = - + + + + (1+IRR)1 (1+IRR)2 (1+IRR)3 (1+IRR)4
Or:
800 900 500 1,600
2,200 = + + + (1+IRR)1 (1+IRR)2 (1+IRR)3 (1+IRR)4
Jacoby, Stangeland and Wajeeh, 2000
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First, clear previous data, and check that your calculator is set to 1 P/YR:IRR in your HP 10B Calculator
CFj
CFj500
1,600
CFj800
CFj900
+/- CFj2,200
The display should show: 1 P_YrInput data (based on above NPV example)
Display should show: CF 0
Display should show: CF 1
Display should show: CF 2
Display should show: CF 3
Display should show: CF 4
CSTIRR/YR
Compute IRRDisplay should show:
23.29565668%Yellow
Key in CF0
Key in CF4
Key in CF3
Key in CF1
Key in CF2
YellowC
C ALL
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The NPV Profile
Discount rates NPV
0% $1,600.00
5% 1,126.47
10% 739.55
15% 419.74
20% 152.62
25% -72.64
IRR is between 20% and 25% -- about 23.30%
If required rate of return (r) is lower than IRR => accept the project (e.g. r = 15%)
If required rate of return (r) is higher than IRR => reject the project (e.g. r = 25%)
Internal Rate of Return and the NPV Profile
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Year Cash flow
0 – $2,200 1 800 2 900 3 500 4 1,600
The Net Present Value Profile
Discount rate2% 6% 10
%14% 18%
1,600.00
1,126.47
739.55
419.74
Net present value
159.62
– 72.64 22%
IRR=23.30%
0
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IRR: Investment vs. Financing Project
Initial outlay = $4,000
Year Cash flow
1 -1,200 2 -800 3 -3,500
Find the IRR such that NPV = 0
0 = + + + (1+IRR)1 (1+IRR)2 (1+IRR)3
Or:
-1,200 -800 -3,500
- 4,000 = + + (1+IRR)1 (1+IRR)2 (1+IRR)3
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The NPV Profile of a Financing Project:
Discount rates NPV
0% -$1,500.00
5% -891.91
10% -381.67
15% 50.2
20% 418.98
IRR is between 10% and 15% -- about 14.37%
For a Financing Project, the required rate of return is the cost of financing, thus
If required rate of return (r) is lower than IRR => reject the project (e.g. r = 10%)
If required rate of return (r) is higher than IRR => accept the project (e.g. r = 15%)
Internal Rate of Return and the NPV Profile for a Financing Project
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The NPV Profile for a Financing Project
-$2,000.00
-$1,500.00
-$1,000.00
-$500.00
$0.00
$500.00
$1,000.00
$1,500.00
$2,000.00
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
Rate of Return (%)
NP
V (
$)
Jacoby, Stangeland and Wajeeh, 2000
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Assume you are considering a project for which the cash flows are as follows:
Year Cash flows
0 -$900
1 1,200
2 1,300
3 -1,200
Multiple Internal Rates of Return
Example 1
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-$1,000.00
-$800.00
-$600.00
-$400.00
-$200.00
$0.00
$200.00
$400.00
$600.00
-60% -40% -20% 0% 20% 40% 60% 80% 100% 120% 140%
Rate of Return (%)
NP
V (
$)Multiple IRRs and the NPV Profile - Example 1
IRR2=72.25%IRR1=-29.35%
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First, clear previous data, and check that your calculator is set to 1 P/YR:Multiple IRRs in your HP 10B Calculator
CFj1,200
CFj1,200
CFj1,300
+/- CFj900
The display should show: 1 P_YrInput data (based on above NPV example)
Display should show: CF 0
Display should show: CF 1
Display should show: CF 2
Display should show: CF 3
CSTIRR/YR
Compute 1st IRRDisplay should show:
72.252175%Yellow
+/-
CSTIRR/YR
Compute 2nd IRR by guessing it first
Display should show: -29.352494%
Yellow30 +/- RCLSTO
Yellow
Key in CF0
Key in CF3
Key in CF1
Key in CF2
YellowC
C ALL
Jacoby, Stangeland and Wajeeh, 2000
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Assume you are considering a project for which the cash flows are as follows:
Year Cash flows
0 -$260
1 250
2 300
3 20
4 -340
Multiple Internal Rates of Return
Example 2
23
-$80.00
-$70.00
-$60.00
-$50.00
-$40.00
-$30.00
-$20.00
-$10.00
$0.00
$10.00
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Rate of Return (%)
NP
V (
$)Multiple IRRs and the NPV Profile - Example 2
IRR1=11.52%IRR2=29.84%
Jacoby, Stangeland and Wajeeh, 2000
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Assume you are considering a project for which the cash flows are as follows:
Year Cash flows
0 $660
1 -650
2 -750
3 -50
4 850
Multiple Internal Rates of Return
Example 3
Jacoby, Stangeland and Wajeeh, 2000
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-$50.00
$0.00
$50.00
$100.00
$150.00
$200.00
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Rate of Return (%)
NP
V($
)Multiple IRRs and the NPV Profile - Example 3
IRR1=8.05%IRR2=33.96%
Jacoby, Stangeland and Wajeeh, 2000
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-200
-150
-100
-50
0
50
100
150
200
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
Rate of Return (%)
NP
V (
$)
Project A Project B
IRR, NPV, and Mutually Exclusive Projects
Year
0 1 2 3
4
Project A: – $350 50 100 150 200
Project B: – $250 125 100 75 50%80.17BIRR
%91.12AIRR
Jacoby, Stangeland and Wajeeh, 2000
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-200
-150
-100
-50
0
50
100
150
200
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
Rate o Return (%)
NP
V (
$)
Project A Project B Incremental (A-B)
IRR, NPV, and the Incremental Project Year
0 1 2 3
4
Project A: – $350 50 100 150 200
Project B: – $250 125 100 75 50
(A-B):
The Crossover Rate = IRRA-B = 8.07%
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The Profitability Index (PI) Rule PI =
Total Present Value of future CF’s / Initial Investment Minimum Acceptance Criteria: Accept if PI > 1 Ranking Criteria: Select alternative with highest PI Disadvantages:
Problems with mutually exclusive investments Advantages:
May be useful when available investment funds are limited Easy to understand and communicate Correct decision when evaluating independent projects
Jacoby, Stangeland and Wajeeh, 2000
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Profitability Index - An Example
Consider the following information on Project Y:
Initial outlay -$1,100
Required return = 10%
Annual cash benefits:
Year Cash flows
1 $ 500
2 1,000
What’s the NPV? What’s the Profitability Index (PI)?
Jacoby, Stangeland and Wajeeh, 2000
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The NPV of Project Y is equal to:
NPV = (500/1.1) + (1,000/1.12) - 1,100 = ($454.54 + 826.45) - 1,100
= $1,280.99 - 1,100 = $180.99.
PI = PV Cashflows/Initial Investment
=
This is a good project according to the PI rule. Can you explain why?