capital budgeting techniques pp13

7/15/2019 Capital Budgeting Techniques Pp13

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13.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Chapter 13

Capital BudgetingTechniques


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After Studying Chapter 13,

you should be able to:

1. Understand the payback period (PBP) method of project evaluation andselection, including its: (a) calculation; (b) acceptance criterion; (c)advantages and disadvantages; and (d) focus on liquidity rather thanprofitability.

2. Understand the three major discounted cash flow (DCF) methods of

project evaluation and selection internal rate of return (IRR), netpresent value (NPV), and profitability index (PI).

3. Explain the calculation, acceptance criterion, and advantages (over thePBP method) for each of the three major DCF methods.

4. Define, construct, and interpret a graph called an NPV profile.

5. Understand why ranking project proposals on the basis of IRR, NPV, and

PI methods may lead to conflicts in rankings.6. Describe the situations where ranking projects may be necessary and

justify when to use either IRR, NPV, or PI rankings.

7. Understand how sensitivity analysis allows us to challenge the single-point input estimates used in traditional capital budgeting analysis.

8. Explain the role and process of project monitoring, including progress

reviews and post-completion audits.


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Cap ital Budgeting

Techniques

Project Evaluation and Selection

Potential Difficulties Capital Rationing

Project Monitoring Post-Completion Audit


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Projec t Evaluat ion :

A lternat ive Methods

Payback Period (PBP)

Internal Rate of Return (IRR) Net Present Value (NPV)

Profitability Index (PI)

Refer to the additional PowerPoint slides and the Excelspreadsheet VW13E-13b.xlsx for computer-basedsolutions.


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Proposed Pro ject Data

Julie Miller is evaluating a new projectfor her firm, Basket Wonders (BW).

She has determined that the after-taxcash flows for the project will be

$10,000; $12,000; $15,000; $10,000;

and $7,000, respectively, for each oftheYears 1 through 5. The initial

cash outlay will be $40,000.


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Independen t Projec t

Independent A project whoseacceptance (or rejection) does notprevent the acceptance of otherprojects under consideration.

For this project, assume that it isindependentof any other potential

projects that Basket Wondersmayundertake.


7/6513.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Payback Period (PBP)

PBP is the period of timerequired for the cumulative

expected cash flows from aninvestment project to equal the

initial cash outflow.

0 1 2 3 4 5

40 K 10 K 12 K 15 K 10 K 7 K


8/6513.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

(c)10 K 22 K 37 K 47 K 54 K

Payback Solu t ion (#1)

PBP = a + ( bc ) / d= 3 + (4037) / 10

= 3 + (3) / 10= 3.3 Years

0 1 2 3 4 5

40 K 10 K 12 K 15 K 10 K 7 K

Cumulative

Inflows

(a)

(-b) (d)


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Payback Solu t ion (#2)

PBP = 3 + ( 3K ) / 10K

= 3.3 Years

Note: Take absolute value of lastnegative cumulative cash flow value.

Cumulative

Cash Flows

40 K 10 K 12 K 15 K 10 K 7 K

0 1 2 3 4 5

40 K 30 K 18 K 3 K 7 K 14 K


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PBP Acceptance Criter ion

Yes! The firm will receive back theinitial cash outlay in less than 3.5years. [3.3 Years < 3.5 Year Max.]

The management ofBasket Wondershas set a maximum PBP of3.5

years for projects of this type.

Should this project be accepted?


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PBP Streng ths

and Weaknesses

Strengths:

Easy to use andunderstand

Can be used as ameasure ofliquidity

Easier to forecastST than LT flows

Weaknesses:

Does not accountfor TVM

Does not considercash flows beyondthe PBP

Cutoff period issubjective


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In ternal Rate o f Retu rn (IRR)

IRR is the discount rate that equates thepresent value of the future net cash

flows from an investment project withthe projects initial cash outflow.

CF1 CF2 CFn

(1 + IRR)1 (1 + IRR)2 (1 + IRR)n+ . . . ++ICO =


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$15,000 $10,000 $7,000

IRR So lu t ion

$10,000 $12,000

(1+IRR)1

(1+IRR)2

Find the interest rate (IRR) that causes thediscounted cash flows to equal $40,000.

+ +

++$40,000 =

(1+IRR)3 (1+IRR)4 (1+IRR)5


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IRR So lu tion (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +

$ 7,000(PVIF10%,5)$40,000 = $10,000(0.909) + $12,000(0.826) +

$15,000(0.751) + $10,000(0.683) +$ 7,000(0.621)

$40,000 = $9,090 + $9,912 + $11,265 +$6,830 + $4,347

= $41,444 [Rate is too low !!]


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IRR So lu tion (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +

$ 7,000(PVIF15%,5)$40,000 = $10,000(0.870) + $12,000(0.756) +

$15,000(0.658) + $10,000(0.572) +$ 7,000(0.497)

$40,000 = $8,700 + $9,072 + $9,870 +$5,720 + $3,479

= $36,841 [Rate is too h igh!!]


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0.10 $41,444

0.05 IRR $40,000 $4,603

0.15 $36,841

X $1,4440.05 $4,603

IRR Solu t ion (In terpo late)

$1,444X

=


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0.10 $41,444

0.05 IRR $40,000 $4,603

0.15 $36,841

X $1,4440.05 $4,603


$1,444X

=


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0.10 $41,444

0.05 IRR $40,000 $4,603

0.15 $36,841

($1,444)(0.05)$4,603


$1,444X

X = X = 0.0157

IRR = 0.10 + 0.0157 = 0.1157 or11.57%


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IRR Accep tance Cri ter ion

No! The firm will receive 11.57% foreach dollar invested in this project ata cost of13%. [ IRR< Hurdle Rate ]

The management ofBasket Wondershas determined that the hurdle rate

is 13% for projects of this type.Should this project be accepted?


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IRRs on the Calcu lato r

We will use thecash flow registry

to solve the IRRfor this problem

quickly and

accurately!


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Actual IRR Solut ion Using

Your Financ ial Calcu lato r

Steps in the ProcessStep 1: Press CF key

Step 2: Press 2nd CLR Work keys

Step 3: ForCF0Press -40000 Enter keysStep 4: ForC01Press 10000 Enter keysStep 5: ForF01Press 1 Enter keysStep 6: ForC02Press 12000 Enter keysStep 7: ForF02Press 1 Enter keysStep 8: ForC03Press 15000 Enter keysStep 9: ForF03Press 1 Enter keys


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Actual IRR Solut ion Using


Steps in the Process (Part II)Step 10:ForC04Press 10000 Enter keysStep 11:ForF04Press 1 Enter keysStep 12:ForC05Press 7000 Enter keysStep 13:ForF05Press 1 Enter keysStep 14: Press keysStep 15: Press IRR key

Step 16: Press CPT key

Result: In ternal Rate o f Return= 11.47%


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IRR Streng ths

and Weaknesses

Strengths:

Accounts forTVM

Considers all

cash flows Less

subjectivity

Weaknesses:

Assumes all cashflows reinvested atthe IRR

Difficulties withproject rankings andMultiple IRRs


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Net Present Value (NPV)

NPVis the present value of aninvestment projects net cash

flows minus the projects initialcash outflow.

CF1 CF2 CFn

(1+k)1 (1+k)2 (1+k)n+ . . . ++ -ICONPV =


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Basket Wondershas determined that theappropriate discount rate (k) for this

project is 13%.

$10,000 $7,000

NPV So lut ion

$10,000 $12,000 $15,000

(1.13)1 (1.13)2 (1.13)3+ +

+ - $40,000(1.13)4 (1.13)5

NPV= +


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NPV So lut ion

NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +$ 7,000(PVIF13%,5)$40,000

NPV = $10,000(0.885) + $12,000(0.783) +$15,000(0.693) + $10,000(0.613) +$ 7,000(0.543)$40,000

NPV = $8,850 + $9,396 + $10,395 +$6,130 + $3,801$40,000

= - $1,428


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NPV Accep tance Cri ter ion

No! The NPV is negat ive. This meansthat the project is reducing shareholderwealth. [Rejectas NPV< 0]

The management ofBasket Wondershas determined that the required

rate is 13% for projects of this type.



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NPV on the Calcu lato r

We will use the cashflow registry to solve

the NPV for thisproblem quickly and

accurately!

Hint: If you have no tcleared the cash flowsfrom your calculator, thenyou may skip to Step 15.


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Actual NPV Solut ion Using


Steps in the Process

Step 1: Press CF key

Step 2: Press 2

nd

CLR Work keysStep 3: ForCF0Press -40000 Enter keysStep 4: ForC01Press 10000 Enter keysStep 5: ForF01Press 1 Enter keysStep 6: ForC02Press 12000 Enter keysStep 7: ForF02Press 1 Enter keysStep 8: ForC03Press 15000 Enter keysStep 9: ForF03Press 1 Enter keys


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Steps in the Process (Part II)Step 10:ForC04Press 10000 Enter keysStep 11:ForF04Press 1 Enter keysStep 12:ForC05Press 7000 Enter keysStep 13:ForF05Press 1 Enter keysStep 14: Press keysStep 15: Press NPV key

Step 16: For I=, Enter 13 Enter keysStep 17: Press CPT key

Result: Net Presen t Value= -$1,424.42

Actual NPV Solut ion Using



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NPV Streng ths

and Weaknesses

Strengths:

Cash flowsassumed to bereinvested at thehurdle rate.

Accounts for TVM.

Considers all

cash flows.

Weaknesses:

May not includemanagerialoptions embeddedin the project. See

Chapter 14.


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Net Present Value Pro f i le

Discount Rate (%)

0 3 6 9 12 15

IRRNPV@13%

Sum of CFs Plot NPV for eachdiscount rate.

N

etPresentValue

$000s

15

10

5

0

-4


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Creating NPV Pro fi les

Using the Calcu lator

Hint: As long as youdo not clear the

cash flows from theregistry, simply startat Step 15 and entera different discount

rate. Each resultingNPV will provide apoint for yourNPV

Profi le!


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Pro fi tab i l i ty Index (PI)

PI is the ratio of the present value ofa projects future net cash flows to

the projects initial cash outflow.

CF1 CF2 CFn

(1+k)1 (1+k)2 (1+k)n+ . . . ++ ICOPI =

PI = 1 + [ NPV / ICO]

>

Method #2:

Method #1:


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PI Accep tance Cri ter ion

No! The PI is less than 1.00. Thismeans that the project is not profitable.[Rejectas PI< 1.00]

PI = $38,572 / $40,000

= .9643 (Method #1, previous sl ide)



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PI Streng ths

and Weaknesses

Strengths:

Same as NPV Allows

comparison of

different scaleprojects

Weaknesses:

Same as NPV Provides only

relative profitability

Potential RankingProblems


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Evaluation Summary

Method Project Comparison DecisionPBP 3.3 3.5 Accept

IRR 11.47% 13% Reject

NPV -$1,424 $0 Reject

PI .96 1.00 Reject

Basket WondersIndependent Project


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Project Evaluat ion : Remember

Chapter 12 New Asset project?

We will start with the cashflows of the project and also

calculate the cumulative

cash flow values.

We can use Excel functions / approaches to calculate each ofthe following methods from the above cash flows.


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Other Pro jec t

Relat ionships

Mutually Exclusive A project whose

acceptance precludes the acceptanceof one or more alternative projects.

Dependent A project whoseacceptance depends on the

acceptance of one or more otherprojects.


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Poten t ial Prob lems

Under Mu tual Exclus iv i ty

A. Scale of Investment

B. Cash-flow Pattern

C. Project Life

Ranking of project proposals maycreate contradictory results.


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A. Scale Differences

Compare a small (S) and alarge (L) project.

NET CASH FLOWS

Project S Project LEND OF YEAR

0 -$100 -$100,0001 0 0

2 $400 $156,250


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Calculate the PBP, IRR, NPV@10%,and PI@10%.

Which project is preferred? Why?

Project IRR NPV PI

S 100% $ 231 3.31

L 25% $29,132 1.29

Remember to refer to Excel spreadsheet


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Refer to VW13E-13b.xlsx on the Scale tab.

Remember to refer to Excel spreadsheetVW13E-13b.xlsx and the Scale tab.


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B. Cash Flow Pattern

Let us compare a decreasingcash-flow (D)project and an increasingcash-flow (I) project.

NET CASH FLOWSProject D Project IEND OF YEAR

0 -$1,200 -$1,200

1 1,000 1002 500 600

3 100 1,080


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D 23% $198 1.17

I 17% $198 1.17

Cash Flow Pattern

Calculate the IRR, NPV@10%,and PI@10%.

Which project is preferred?

Project IRR NPV PI


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Exam ine NPV Pro fi les

Discount Rate (%)

0 5 10 15 20 25-200

0

200

400

600

IRR

NPV@10%

Plot NPV for eachproject at various

discount rates.

NetPresentValue($)

Project I

Project D


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Fishers Rate of Intersection

Discount Rate ($)

0 5 10 15 20 25-200

0

200

400

600

Net

PresentValue($)

At k10%, D is best!



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B. Cash Flow Pattern

Refer to VW13E-13b.xlsx on the Pattern tab.

Remember to refer to Excel spreadsheetVW13E-13b.xlsx and the Pattern tab.


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C. Pro jec t L ife Differences

Let us compare a l onglife (X) projectand a shor tlife (Y) project.

NET CASH FLOWSProject X Project YEND OF YEAR

0 -$1,000 -$1,000

1 0 2,0002 0 0

3 3,375 0


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X 50% $1,536 2.54

Y 100% $ 818 1.82

Pro jec t L ife Differences

Calculate the PBP, IRR, NPV@10%,and PI@10%.

Which project is preferred? Why?

Project IRR NPV PI



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Remember to refer to Excel spreadsheetVW13E-13b.xlsx and the Life tab.

A th W t


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Ano ther Way to

Look at Things

1. Adjust cash flows to a common terminalyear if project Y will NOTbe replaced.

Compound Project Y, Year 1 @10% for 2 years.

Year 0 1 2 3

CF $1,000 $0 $0 $2,420

Results: IRR* = 34.26% NPV = $818

*Lower IRRfrom adjusted cash-flow stream. X is still Best.

R l i P j t


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Rep lac ing Pro jec ts

w ith Iden t ical Projects

2. Use Replacement Chain Approach(Appendix B)when project Y will be replaced.

0 1 2 3

$1,000 $2,000

1,000 $2,0001,000 $2,000

$1,000 $1,000 $1,000 $2,000

Results: IRR = 100% NPV* = $2,238.17

*Higher NPV, but the same IRR. Y is Best.



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pVW13E-13b.xlsx and the Life2 tab.


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Cap ital Ration ing

Cap ital Ration ingoccurs when aconstraint (or budget ceiling) is placed

on the total size of capital expendituresduring a particular period.

Example: Julie Miller must determine what

investment opportunities to undertake forBasket Wonders (BW). She is limited to amaximum expenditure of $32,500 onlyforthis capital budgeting period.


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Avai lab le Pro jects fo r BW

Project ICO IRR NPV PI

A $ 500 18% $ 50 1.10

B 5,000 25 6,500 2.30C 5,000 37 5,500 2.10D 7,500 20 5,000 1.67E 12,500 26 500 1.04

F 15,000 28 21,000 2.40G 17,500 19 7,500 1.43H 25,000 15 6,000 1.24


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Choos ing by IRRs for BW


C $ 5,000 37% $ 5,500 2.10

F 15,000 28 21,000 2.40E 12,500 26 500 1.04B 5,000 25 6,500 2.30

Projects C, F, and E have the

three larges t IRRs.

The resulting increasein shareholder wealthis $27,000 with a $32,500 outlay.


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Choos ing by NPVs for BW


F $15,000 28% $21,000 2.40

G 17,500 19 7,500 1.43B 5,000 25 6,500 2.30

Projects F and G have the

two largest NPVs.The resulting increasein shareholder wealth

is $28,500 with a $32,500 outlay.


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Choos ing by PIs for BW


F $15,000 28% $21,000 2.40

B 5,000 25 6,500 2.30C 5,000 37 5,500 2.10D 7,500 20 5,000 1.67G 17,500 19 7,500 1.43

Projects F, B, C, and D have the fourlarges t PIs.

The resulting increasein shareholder wealth is$38,000 with a $32,500 outlay.


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Summary of Compar ison

Method Projects Accepted Value Added

PI F, B, C, and D $38,000

NPV F and G $28,500

IRR C, F, and E $27,000

PI generates the greatestincreaseinshareho lder wealthwhen a limited capital

budget exists for a sing le per iod.

Si l P i t E t i t


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Sing le-Poin t Estimate

and Sens i t iv i ty Analys is

Allows us to change from single-point (i.e.,revenue, installation cost, salvage, etc.) estimatesto a what if analysis

Utilize a base-case to compare the impact ofindividual variable changes

E.g., Change forecasted sales units to seeimpact on the projects NPV

Sens i t iv i ty Analysis: A type of what-ifuncertainty analysis in which variables orassumptions are changed from a base case in

order to determine their impact on a projectsmeasured results (such as NPV or IRR).


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Post-Complet ion Audi t

Post-complet ion Aud i t

A formal comparison of the actual costs and

benefits of a project with original estimates.

Identify any project weaknesses

Develop a possible set of corrective actions Provide appropriate feedback

Result: Making better future decisions!


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Mult iple IRR Prob lem *

Two!! There are as many potentialIRRs as there are sign changes.

Let us assume the following cash flowpattern for a project for Years 0 to 4:

$100 +$100 +$900 $1,000

How many potent ia lIRRs could thisproject have?

* Refer to Appendix A


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NPV Pro fi le Mult ip le IRRs

Discount Rate (%)

0 40 80 120 160 200

NetPresentValue

($000s

)

Multiple IRRs atk = 12.95% and 191.15%

75

50

25

0

100


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NPV Pro fi le Mult ip le IRRs

Hint: Your calculatorwill only find ONE

IRR even if thereare multiple IRRs. It

will give you thelowest IRR. In this

case, 12.95%.

capital budgeting techniques pp13

Documents

van horne

gregory kuhlemeyer

pearson education limited

project whoseacceptance

ranking project proposals

process of project monitoring

npv profile

netpresent value npv