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Chapter 11

Slide Contents
Learning Objectives Principles Used in This Chapter

Investment Decision Criteria

1. 2. 3. 4.

An Overview of Capital Budgeting Net Present Value Other Investment Criteria A Glance at Actual Capital Budgeting Practices

Key Terms

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Learning Objectives
1. Understand how to identify the sources and types of profitable investment opportunities. 2. Evaluate investment opportunities using net present value and describe why net present value provides the best measure for evaluating investments.

Learning Objectives (cont.)


3. Use the profitability index, internal rate of return, and payback criteria to evaluate investment opportunities. 4. Understand current business practice with respect to the use of capital budgeting criteria.

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Principles Used in This Chapter


Principle 3: Cash Flows Are the Source of Value.
We value an investment opportunities by evaluating its expected cash flows.

Principles Used in This Chapter (cont.)


Principle 2: There is a Risk-Reward Tradeoff.
While evaluating investment opportunities, we incorporate risk into the analysis by increasing the discount rate while calculating the present value of cash flows.

Principle 1: Money Has a Time Value.


While evaluating investment opportunities, we discount all cash flows back to the present.

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Principles Used in This Chapter (cont.)


Principle 4: Market Prices Reflect Information.
The risk adjusted discount rate used to calculate the present values of projects cash flows depends upon the market prices that reflect information.

11.1 An Overview of Capital Budgeting

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Three Lessons from Disney


Disneys decision to invest $17.5 million to build Disneyland park in California is an example of capital budgeting decision. Subsequently, Disney opened theme parks in Orlando, Tokyo, Paris and most recently invested $3.5 billion to build a theme park in Hong Kong. Today parks and resorts account for over 30% of Disneys Revenue.

Three Lessons from Disney


1. Capital budgeting decisions are critical in defining a companys success. 2. Very large investments are frequently the result of many smaller investment decisions that define a business strategy.

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Three Lessons from Disney (cont.)


3. Successful investment choices lead to the development of managerial expertise and capabilities that influence the firms choice of future investments.

The Typical Capital Budgeting Process


Phase I: The firms management identifies promising investment opportunities. Phase II: The value creating potential of various opportunities are thoroughly evaluated. So the goal is to identify promising opportunities and select those that will create the most value for the firms common stockholders.

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What Are the Sources of Good Investment Projects?


It is not easy to find profitable investment opportunities in competitive markets. Good investments are most likely to be found in markets that are less competitive where barriers to new entrants are sufficiently high to keep out would-be competitors.

Types of Capital Investment Projects


1) Revenue enhancing Investments (for example, entering a new market) 2) Cost-reduction investments (for example, installing a more efficient equipment) 3) Mandatory investments that are a result of government mandate (for example, installing mandatory safety features in a car)

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Types of Capital Investment Projects (cont.)


Before an investments is made, the firm will like to ensure that it will create value. To determine the desirability of investment proposals, we can use several analytical tools such as: Net Present Value (NPV), Equivalent Annual Cost (EAC), the Profitability Index (PI), the Internal Rate of Return (IRR), the Modified Internal Rate of Return (MIRR), the payback period, and discounted payback period.

11.2 Net Present Value

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Net Present Value


The net present value (NPV) is the difference between the present value of cash inflows and the cash outflows. NPV estimates the amount of wealth that the project creates. Decision Criteria: Investment projects should be accepted if the NPV of project is positive and should be rejected if the NPV is negative.
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Calculating an Investments NPV


The NPV of an investment proposal can be defined as follows:

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Independent Versus Mutually Exclusive Investment Projects


An independent investment project is one that stands alone and can be undertaken without influencing the acceptance or rejection of any other project. A mutually exclusive project prevents another project from being accepted.

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Evaluating an Independent Investment Opportunity


It will require two steps:
1. Calculate NPV; 2. Accept the project if NPV is positive and reject if it is negative.

Checkpoint 11.1
Calculating the NPV for Project Long
Project Long requires an initial investment of $100,000 and is expected to generate a cash flow of $70,000 in year one, $30,000 per year in years two and three, $25,000 in year four, and $10,000 in year 5. The discount rate (k) appropriate for calculating the NPV of Project Long is 17 percent. Is Project Long a good investment opportunity?

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Checkpoint 11.1

Checkpoint 11.1

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Step 3 cont.
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Checkpoint 11.1

Checkpoint 11.1

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Checkpoint 11.1: Check Yourself


Saber Electronics provides specialty manufacturing services to defense contractors located in the Seattle, WA area. The initial outlay is $3 million and, management estimates that the firm might generate cash flows for years one through five equal to $500,000; $750,000; $1,500,000; $2,000,000; and $2,000,000. Saber uses a 20% discount rate for projects of this type. Is this a good investment opportunity?

Step 1: Picture the Problem


k=20% Years
Cash flows (in $ millions)
Net Present Value =?

0
-$3M

1
+$0.5M

4
$2M

5
$2M

+$0.75M +$1.5M

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Step 2: Decide on a Solution Strategy


We need to analyze if this is a good investment opportunity. We can do that by computing the Net Present Value (NPV), which requires computing the present value of all cash flows. We can compute the NPV by using a mathematical formula, a financial calculator or a spreadsheet.
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Step 3: Solve
Using Mathematical Formula

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Step 3: Solve (cont.)


NPV = -$3m + $.5m/(1.2) + $.75m/(1.2)2 + $1.5m/(1.2)3 + $2m/(1.2)4 + $2m/(1.2)4 NPV = -$3,000,000 + $416,666.67 + $520,833.30 + $868,055.60 + $964,506 + $803,755.10 NPV = $573,817

Step 3: Solve (cont.)


Using an Excel Spreadsheet NPV = NPV (discount rate, CF1-5 ) + CF0 = NPV(.20, 500000, 750000, 1500000, 2000000,2000000) - 3000000 = $573,817

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Step 4: Analyze
The project requires an initial investment of $3,000,000 and generates futures cash flows that have a present value of $3,573,817. Consequently, the project cash flows are $573,817 more than the required investment. Since the NPV is positive, the project is an acceptable project.

Evaluating Mutually Exclusive Investment Opportunities


There are times when a firm must choose the best project or set of projects from the set of positive NPV investment opportunities. These are considered mutually exclusive opportunities as the firm cannot undertake all positive NPV projects.

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Evaluating Mutually Exclusive Investment Opportunities (cont.)


Following are two situations where firm is faced with mutually exclusive projects: 1.Substitutes Where firm is trying to pick between alternatives that perform the same function. For example, a new machinery for the new project. While there might be many good machines, the firm needs only one.

Evaluating Mutually Exclusive Investment Opportunities (cont.)


2. Firm Constraints Firm may face constraints such as limited managerial time or limited financial capital that may limit its ability to invest in all the positive NPV opportunities.

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Choosing Between Mutually Exclusive Investments


1. If mutually exclusive investments have equal lives, we will calculate the NPVs and choose the one with the higher NPV. 2. If mutually exclusive investments do not have equal lives, we must calculate the Equivalent Annual Cost (EAC), the cost per year. We will then select the one that has a lower EAC.

Choosing Between Mutually Exclusive Investments (cont.)


Computation of EAC requires two steps:
1. Compute NPV 2. Compute EAC as per equation 11-2

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Checkpoint 11.2
Calculating the Equivalent Annual Cost (EAC)
Suppose your bottling plant is in need of a new bottle capper. You are considering two different capping machines that will perform equally well, but have different expected lives. The more expensive one costs $30,000 to buy, requires the payment of $3,000 per year for maintenance and operation expenses, and will last for 5 years. The cheaper model costs only $22,000, requires operating and maintenance costs of $4,000 per year, and lasts for only 3 years. Regardless of which machine you select, you intend to replace it at the end of its life with an identical machine with identical costs and operating performance characteristics. Because there is not a market for used cappers, there will be no salvage value associated with either machine. Lets also assume that the discount rate on both of these machines is 8 percent.

Checkpoint 11.2

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Checkpoint 11.2

Checkpoint 11.2

Step 3 cont.
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Step 3 cont.

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Checkpoint 11.2

Checkpoint 11.2

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Checkpoint 11.2: Check Yourself


What is the EAC for a machine that costs $50,000, requires payment of $6,000 per year for maintenance and operation expense, and lasts for 6 years? You may assume that the discount rate is 9% and there will be no salvage value associated with the machine. In addition, you intend to replace this machine at the end of its life with an identical machine with identical costs.

Step 1: Picture the Problem


k=9% Years
Cash flows (in $, thousands)
EAC =?

0
-$50

1
-$6

2
-$6

3
-$6

4
-$6

5
-$6

6
$6

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Step 2: Decide on a Solution Strategy


Here we need to calculate the EAC, which will tell us the annual cost for a machine that lasts 6 years. EAC can be computed using mathematical formula or calculator.

Step 3: Solve
Using Mathematical Formula It requires 2 steps:
Computation of NPV
Here the cash inflows are equal so we can use the annuity equation to determine the PV of cash inflows.

Computation of EAC

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Step 3: Solve (cont.)

Step 3: Solve (cont.)


EAC = NPV Annuity Factor = -$76,915 4.4859 = -$17,145.95

NPV = -$50,000 + PV of $6,000 each year = -$50,000 + -$6,000 (PV of Annuity Factor) = -$50,000 + -$6,000 { 1-(1/(1.09)6

(.06)}

= -$50,000 + -$6,000 {4.4859) = -$76,915

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Step 3: Solve (cont.)


Using a Financial Calculator Data and Key Input CF; -50000; ENTER ;-6000; ENTER ;6; ENTER NPV;8; ENTER CPT Display CFO=-50000 CO1=-6000 FO1=6.00 i=8 NPV=-77,372

Step 3: Solve (cont.)


Enter
N=6 1/y = 9 PV = -76915 FV = 0 PMT = -17,145.86 Thus EAC = $-17,145.86

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Step 4: Analyze
Here EAC is equal to $17,145.86. EAC indicates the annual cost that is adjusted for time value of money. 11.3 Other Investment Criteria

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Profitability Index
The profitability index (PI) is a costbenefit ratio equal to the present value of an investments future cash flows divided by its initial cost:

Profitability Index (cont.)


Decision Criteria:
If PI is greater than one, it indicates that the present value of the investments future cash flows exceeds the cost of making the investment and the investment should be accepted. If PI is greater than one, the NPV will be positive. If PI is less than one, the project should be rejected. If PI is less than one, the NPV will be negative.

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Checkpoint 11.3
Calculating the Profitability Index for Project Long
Project Long is expected to provide five years of cash inflows and to require an initial investment of $100,000. The discount rate that is appropriate for calculating the PI of Project Long is 17 percent. Is Project Long a good investment opportunity?

Checkpoint 11.3

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Checkpoint 11.3

Checkpoint 11.3

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Checkpoint 11.3: Check Yourself


PNG Pharmaceuticals is considering an investment in a new automated materials handling system that is expected to reduce its drug manufacturing costs by eliminating much of the waste currently involved in its specialty drug division. The new system will require an initial investment of $50,000 and is expected to provide cash savings over the next six-year period as shown on next slide.

The Problem (cont.)


Year 0 1 2 3 4 5 6 Expected Cash Flow -$50,000 $15,000 $8,000 $10,000 $12,000 $14,000 $16,000

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Step 1: Picture the Problem


k=10% Years
Cash flows (in $, thousands)
PI =?

Step 2: Decide on a Solution Strategy


5
+$14

0
-$50

1
+$15

2
+$8

3
+$10

4
+$12

6
+$16

The PI for a project is equal to the present value of the projects expected cash flows for years 1-6 divided by the initial outlay. PI = PV of expected cash flows -Initial outlay

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Step 3: Solve
We can proceed in two steps:
1. Compute PV of expected cash flows by discounting the cash flows from Year 1 to Year 6 at 10%.
PVt = CFt(1.09)t

Step 3: Solve (cont.)


Step 1: Computing PV of Cash Inflows
Year 1 2 3 4 5 6 NPV of Expected Cash flows, Years 1-6 Expected Cash flow $15,000 $8,000 $10,000 $12,000 $14,000 $16,000 Present Value at 10% discount rate $13,636.36 $6,611.57 $7,513.14 $8,196.16 $8,692.90 $9,031.58 $53,681.72

2. Compute PI

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Step 3: Solve (cont.)


Step 2: Compute the PI PI = PV of expected CF1-6 Initial Outlay = $53,681.72 $50,000 = 1.073

Step 4: Analyze
PNG Pharmaceuticals requires an initial investment of $50,000 and provides future cash flows that have a present value of $53,681.72. Thus, the future cash flows are worth 1.073 times the initial investment or PI is equal to 1.073. It is an acceptable project since PI is greater than 1.

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Internal Rate of Return


The internal rate of return (IRR) of an investment is analogous to the yield to maturity (YTM) of a bond defined in Chapter 9.

Internal Rate of Return (cont.)


Decision Criteria: Accept the project if the IRR is greater than the discount rate used to calculate the net present value of the project, and reject it otherwise.

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Checkpoint 11.4
Calculating the IRR for Project Long
Project Long is expected to provide five years of cash inflows and to require an initial investment of $100,000. The required rate of return or discount rate that is appropriate for valuing the cash flows of Project Long is 17 percent. What is Project Longs IRR, and is it a good investment opportunity?

Checkpoint 11.4

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Checkpoint 11.4

Checkpoint 11.4

Step 3 cont. 11-73 Step 3 cont. 11-74

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Checkpoint 11.4

Checkpoint 11.4

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Checkpoint 11.4: Check Yourself Knowledge Associates is a small consulting firm in Portland, Oregon, and they are considering the purchase of a new copying center for the office that can copy, fax, and scan documents. The new machine costs $10,010 to purchase and is expected to provide cash flow savings over the next four years of $1,000; $3,000; $6,000; and $7,000.
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The Problem (cont.)


The employee in charge of performing financial analysis of the proposed investment has decided to use the IRR as her primary criterion for making a recommendation to the managing partner of the firm. If the discount rate the firm uses to value the cash flows from office equipment purchases is 15%, is this a good investment for the firm?
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Step 1: Picture the Problem


0 Years
Cash flows -$10,010 +$1,000 +$3,000 +$6,000 +$7,000

Step 2: Decide on a Solution Strategy


Here we have to calculate the projects IRR. IRR is equal to the discount rate that makes the present value of the future cash flows (in years 1-4) equal to the initial cash outflow of $10,010. We can compute the IRR using trial & error, financial calculator or an excel spreadsheet.

IRR =?

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Step 3: Solve
Using Mathematical Formula
This will require finding the rate at which NPV is equal to zero. We compute the NPV at different rates to determine the range of IRR.

Step 3: Solve (cont.)


This table suggests that IRR is between 15 and 20%.

Discount Rate 0% 5% 10% 15% 20%

Computed NPV $6,990 $4,605 $2,667 $1,075 -$245

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Step 3: Solve (cont.): Using Financial Calculator


Data and Key Input
CF; -100000; ENTER 1000; ENTER ;1; ENTER ;3000; ENTER ;1; ENTER ;6000; ENTER ; 1; ENTER ; 7000; ENTER 1; ENTER IRR; CPT

Step 3: Solve (cont.)


Using an Excel Spread sheet
Rows in Excel 1 2 3 4 5 6 7 8
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Display
CFO=-100000 CO1=1000 FO1=1.00 C02=3000 FO2=1.00 C03=6000 FO3=1.00 CO4 = 7000 FO4 =1.00 IRR = 19%

Column A in Excel Year 0 1 2 3 4 IRR

Column B in Excel Annual Cash flow -$10,010 $1,000 $3,000 $6,000 $7,000 19% Enter: IRR(b2:b6)

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Step 4: Analyze
The new copying center requires an initial investment of $10,010 and provides future cash flows that offer a return of 19%. Since the firm has decided 15% as the minimum acceptable return, this is a good investment for the firm.

Complications with IRR: Unconventional Cash Flows


For a typical investment, an initial outlay is followed by a period of cash inflows. In such cases, the NPV will always be positive if IRR is greater than 1. However, if the cash flow pattern is the reverse i.e. cash inflow followed by a series of cash outflows (as in the case of a loan), NPV greater than zero indicates that IRR is less than the discount rate used to calculate the NPV.
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Complications with IRR: Unconventional Cash Flows (cont.)


NPV leads to the appropriate decision in both conventional and unconventional cash flow pattern. Thus it is prudent to use NPV while evaluating projects with unconventional cash flow pattern.

Complications with IRR: Multiple Rates of Return


Although any project can have only one NPV, a single project can, under certain circumstances, have more than one IRR. Checkpoint 11.5 illustrates a case of multiple IRRs.

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Checkpoint 11.5
The Problem of Multiple IRRs for Projects
Descartes Rule of Signs tells us that there can be as many IRRs for an investment project as there are changes in the sign of the cash flows over its n-year life. To illustrate the problem, consider a project that has three cash flows: a $235,000 outlay in year 0, a $540,500 inflow in year 1, and a $310,200 outflow at the end of year 2. Calculate the IRR for the investment.

Checkpoint 11.5

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Checkpoint 11.5

Checkpoint 11.5

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Checkpoint 11.5: Check Yourself


McClary Custom Printers is considering whether to purchase a printer. The printer costs $200,000 to purchase, and McClary expects it can earn an additional $1.2 million in cash flows in the printers first year of use. However, there is a problem with purchasing the printer today because it will require a very large expenditure in year 2, such that year 2s cash flow is expected to be -$2.2million. Finally, in year 3, the printer investment is expected to produce a cash flow of $1.2 million. Use the IRR to evaluate whether the printer purchase will be worthwhile.

Step 1: Picture the Problem

0 Years
Cash flows -$200,000

1
+$1.2m

2
-$2.2m

3
+$1.2m

IRR =?

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Step 2: Decide on a Solution Strategy


To solve the problem, we can construct an NPV profile that reports the NPV at several discount rates. We will use discount rates of 0 to 200% in increments of 50% to compute the NPV.

Step 3: Solve
The NPV profile on next slide is based on various discount rates. For example, NPV at discount rate of 50% is computed as follows: NPV = -$200,000 + $1,200,000/(1.5)1 + -2,200,000/(1.5)2 + $1,200,000/(1.5)3 = -$22,222.22

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Step 3: Solve (cont.)

Step 4: Analyze
There are three IRRs for this project 0%, 100% and 200%. At all of these rates, NPV is equal to zero. However, NPV will be a better decision tool to use under this situation as it is not subject to multiple answers like IRR.

Discount Rate 0% 50% 100% 150% 200%

NPV $0 -$22,222.22 $0 $4,800 $0

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Using the IRR with Mutually Exclusive Investments


When we are comparing two mutually exclusive projects, IRR and NPV may not lead to the same conclusion. For example, we may be selecting between 2 projects and both IRR and NPV values may suggest that the projects are financially feasible. However, the ranking of two projects may not be the same using NPV and IRR.
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Using the IRR with Mutually Exclusive Investments (cont.)


Figure 11-2 shows that if we use NPV, project AA+ is better while if we use IRR, project BBR is better. How to select under such circumstances?
Use NPV as it will give the correct ranking for the projects.

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Figure 11.2 cont.

Figure 11.2 cont.

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Modified Internal Rate of Return


Modified Internal Rate of Return (MIRR) deals with the problem of multiple IRRs. This is done by rearranging the cash flows so that there is only one change of sign of the cash flows over the life of the project.

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Modified Internal Rate of Return (cont.)


MIRR Process: 2 Steps 1.Modify the projects cash flow stream by discounting the negative future cash flows back to the present using the same discount rate that is used to calculate the projects NPV.

Modified Internal Rate of Return (cont.)


MIRR Process: 2 Steps 2.Calculate the MIRR as the IRR of the modified cash flow stream.

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Checkpoint 11.6
Calculating the Modified Internal Rate of Return (MIRR)
Reconsider the investment project in Checkpoint 11.5. The project we analyze has three cash flows: a $235,000 outlay in year 0, a $540,500 cash inflow in year 1, and a $310,200 outflow at the end of year 2. Our analysis in Checkpoint 11.5 indicated that this investment has two IRRs, 10% and 20%. One way to reduce the number of IRRs to only one is to use the MIRR method, which moves negative cash flows backward discounting them using the required rate of return or discount rate for the project which is 12%.

Checkpoint 11.6

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Checkpoint 11.6

Checkpoint 11.6

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Checkpoint 11.6: Check Yourself Analyze the MIRR for the preceding problem where the required rate of return used to discount the cash flows is 8%. What is the MIRR?

Step 1: Picture the Problem


i=8% Years
Cash flows -$235,000

1
$540,500

2
-$310,200

First Sign change

Second Sign change

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Step 2: Decide on a Solution Strategy


There are two sign changes in the cash flow stream. If we use IRR, we will get multiple IRRs. We can use MIRR by doing the following:
First, discount the year 2 negative cash flows back to year 0 using the 8% discount rate. Second, calculate the MIRR of the resulting cash flows for years 0 and 1.

Step 3: Solve
Discount the year 3 negative cash flows to year 0. 0 1 2
Years
Cash flows -$235,000 -$265,947 -$500,947 $540,500 -$310,200

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Step 3: Solve (cont.)


The modified cash flow stream are as follows:
0 Years
Cash flows -$500,947 $540,500 -$0

Step 4: Analyze
We were able to compute IRR by eliminating the second sign change and thus modifying the cash flows. Since IRR is based on modified cash flows, it is referred to as MIRR.

Calculating the IRR for the above modified cash flows produces MIRR equal to 7.9%

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Step 4: Analyze (cont.)


MIRR is not the same as IRR as modified cash flows are discounted based on the discount rate used to calculate NPV (which is not the same as IRR). If we change the discount rate, MIRR will also change.

Payback Period
The Payback period for an investment opportunity is the number of years needed to recover the initial cash outlay required to make the investment. Decision Criteria: Accept the project if the payback period is less than a pre-specified number of years.

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Limitations of Payback Period


1. It ignores the time value of money 2. The payback period ignores cash flows that are generated by the project beyond the end of the payback period. 3. There is no clear-cut way to define the cutoff criterion for the payback period that is tied to the value creation potential of the investment.

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Discounted Payback Period


Discounted payback period is similar to payback period except it uses discounted cash flows to calculate the discounted period. The discount rate is the same as the one used for calculating the NPV. Decision Criteria: Accept the project if its discounted payback period is less than the pre-specified number of years.

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Attractiveness of Payback Methods


1. Both payback and discounted payback are more intuitive and relatively easier to understand compared to NPV or IRR. 2. Payback period can be seen as a crude indicator of risk as payback favors initial year cash flows, which, in general, are less risky than more distant cash flows.

Attractiveness of Payback Methods (cont.)


3. Discounted payback is used as a supplemental analytical tool in cases where obsolescence is a risk and the emphasis is on getting the money back before the market disappears or the product becomes obsolete. 4. Payback method is useful when capital is being rationed and managers would like to know how long a project will tie up capital.
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11.4 A Glance at Actual Capital Budgeting Practices

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A Glance at Actual Capital Budgeting Practices


Figure 11-3 shows the results of a survey of CFOs of large US firms, showing the popularity of the payback, discounted payback, NPV, PI, and IRR methods for evaluating capital investment opportunities. The results show that NPV and IRR methods are the most popular although many firms use Payback method too.
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Key Terms
Capital rationing Discounted payback Equivalent annual cost (EAC) Independent investment project Internal rate of return (IRR) Modified internal rate of return (MIRR) Mutually exclusive investments

Key Terms (cont.)


Net present value (NPV) Net present value profile Payback period Profitability index

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