Capital Budgeting

Investment Rules

Finance - Pedro Barroso

Net Present Value (NPV) Rule

Net Present Value (NPV) = Total PV of future CFs - Initial Investment Estimating NPV:
1. Estimate future cash flows: how much? and when? 2. Estimate discount rate: time value of money; risk 3. Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV

Finance - Pedro Barroso

Why Use Net Present Value?

Accepting positive NPV projects benefits shareholders
NPV uses cash flows NPV discounts the cash flows properly Maximizes shareholder value (stock price)

Reinvestment assumption: NPV rule assumes that all cash flows can be reinvested at the discount rate
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Example: Project
Using previous example and discount rate of 10%:
34,680 49,990 82,893 69,634 219,421 NPV 260,000 2 3 4 (1.1) (1.1) (1.1) (1.1) (1.1)5 NPV 58,924

NPV > 0: go-on with project

Finance - Pedro Barroso

Payback Period Rule

How long does it take the project to pay back its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria:
Set by management

Ranking Criteria:
Set by management
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Problems with Payback Period

Ignores the time value of money Ignores cash flows after the payback period (biased against long-term projects) Requires an arbitrary acceptance criteria

Finance - Pedro Barroso

Discounted Payback Period

How long does it take the project to pay back its initial investment, taking the time value of money into account? Decision rule: Accept the project if it pays back on a discounted basis within the specified time

Finance - Pedro Barroso

Payback Period: Example

Project A (-100, 100, 25, 25) Project B (-100, 25, 75, 150) Discount rate = 0% Project A: Payback = 1, NPV = 50 Project B: Payback = 2, NPV = 150

Finance - Pedro Barroso

Internal Rate of Return (IRR)

IRR: discount rate that sets NPV to zero Minimum Acceptance Criteria:
Accept if the IRR exceeds the discount rate Select alternative with the highest IRR All future cash flows assumed reinvested at the IRR
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Ranking Criteria:

Reinvestment assumption:

IRR: Example
Consider the project:
-200 50 100 150

50 100 150 200 0 2 3 (1 IRR) (1 IRR) (1 IRR) IRR 19.44%

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NPV Payoff Profile

If we graph NPV versus the discount rate, we can see the IRR as the x-axis intercept
Discount rate 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% NPV 100.00 86.48 73.88 62.11 51.11 40.80 31.13 22.05 13.52 5.49
120

NPV
100
80 60 40 20 0 -20 -40 -60 -80 0% 5% 10% 15% 20% 25% 30% 35% 40%

20%
22% 24%

-2.08
-9.22 -15.97

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Problems with IRR

Investing or financing? Multiple IRRs Problems with mutually exclusive

investments (alternative)
Scale Problem Timing Problem

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IRR: Investing or Financing?

Project (financing) (100,-130)
130 100 0 IRR 30% 1 IRR

Project (investing) (-100, 130) also has IRR = 30%

NPV (financing)
10 0 0% -10 -20 -30 -40 10% 20% 30% 40% 40 30

NPV (invest)

20
10 0 0% -10 10% 20% 30% 40%

Do financing project if IRR < discount rate!

Finance - Pedro Barroso 13

Multiple IRRs
Consider the project: (-100, 230, -132) Project has two IRRs: 10% and 20%. Which one to use? NPV
0.50 0.00 0% -0.50 -1.00 -1.50 -2.00 -2.50 5% 10% 15% 20% 25% 30%

We can have multiple IRR (or none) when cash flows change signs two or more times
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Mutually Exclusive vs. Independent

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

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IRR: Scale Problem

Consider two mutual exclusive projects (r = 10%): Small (-1000, 2000) IRR = 100% NPV = 818 Large (-2000, 3500) IRR = 75% IRR and NPV give different answers: NPV = 1182

IRR favors small scale project, which has lower NPV; but we should pick large scale project
Look at incremental cash flows Large-Small (-1000, 1500) IRR = 50% > 10%
Finance - Pedro Barroso 16

IRR: Timing Problem

Consider two mutual exclusive projects (r = 10%): Slow (-100, 10, 35, 100) IRR = 15.4% NPV = 13 Fast (-100, 60, 60, 10) IRR = 18% NPV = 12 IRR and NPV give different answers:

IRR favors fast project, which has lower NPV; but we should pick slow project
Look at incremental cash flows Slow-Fast (0, -50, -25, 90) IRR = 11.5% > 10%
Finance - Pedro Barroso 17

IRR: Timing Problem

50.0 NPV Slow 40.0

NPV Fast
30.0

Cross-over rate = 11.5%

20.0

10.0
0.0 0% -10.0 -20.0 5% 10% 15% 20% 25%

Slow project is better at lower discount rates < 11.5% Fast project is better at higher discount rates > 11.5%

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Summary: NPV versus IRR

NPV and IRR will generally give the same decision Exceptions:
Non-conventional cash flows cash flow signs change more than once Mutually exclusive projects (reinvestment rate = IRR)
Initial investments are substantially different Timing of cash flows is substantially different
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Profitability Index (PI)

PI = PV of cash flows subsequent to initial investment / Initial investment Minimum Acceptance Criteria:
Accept if PI > 1

Ranking Criteria:
Select alternative with highest PI
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PI: Example
Consider the project (discount rate = 10%):
-200 50 100 150

50 100 150 240.8 2 3 (1.1) (1.1) (1.1) 240.8 PI 1.204 200

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Problem with PI
Problem:
Problem with mutually exclusive investments (scale problem)

Advantages:
May be useful when available investment funds are limited

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PI: Limited Funds

Consider three independent projects (r = 12%): A (-20, 70, 10) NPV = 50.5 PI = 3.53 B (-10, 15, 40) NPV = 35.3 PI = 4.53 C (-10, -5, 60) NPV = 33.4 PI = 4.34

We have 20 to invest; which projects to pick?

Project A does not maximize NPV

Rank projects by PI (B, C, A); pick B and C as NPV = 35.3 + 33.4 = 68.7 > 50.5
Finance - Pedro Barroso 23

Inflation and Capital Budgeting

Inflation is an important fact of economic life and must be considered in capital budgeting Consider the relationship between interest rates and inflation, often referred to as the Fisher equation:
(1 + Nominal Rate) = (1 + Real Rate) (1 + Inflation Rate)

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Inflation and Capital Budgeting

In capital budgeting:
discount real cash flows with real rates discount nominal cash flows with nominal rates

When using real cash flows do not forget that depreciation (tax shield) is a nominal quantity

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Inflation and Capital Budgeting: Example

Real cash flows Year 0 Investment EBITDA Depreciation (nominal) Depreciation (real) Operational cash flow Total cash flow NPV -1,210 268 Nominal cash flows Year 0 Investment EBITDA Depreciation Operational cash flow Total cash flow NPV -1,210 268 -1,210 1,045 605 869 869 1,210 605 968 968 Year 1 Year 2 -1,210 950 605 550 790 790 1,000 605 500 800 800 Tax rate 40% Year 1 Year 2 Nominal discount rate Inflation Real discount rate 15.5% 10.0% 5.0%

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Investments of Unequal Lives

NPV rule can lead to the wrong decision when we have to decide between alternative projects with unequal lives Consider a two machines that do the same job, but: Machine A costs $4,000, has annual operating costs of $100, and lasts 10 years Machine B costs $1,000, has annual operating costs of $500, and lasts 5 years Assuming a 10% discount rate, which one should we choose?

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Investments of Unequal Lives

Machine A:
10 PVcos ts 4 ,000 100 A10% 4 ,614.5

Machine B:
5 PVcos ts 1,000 500 A10% 2,895.4

Using NPV rule we pick machine B, but

Overlooks that the machine A lasts twice as long When we incorporate difference in lives, machine A is actually cheaper (i.e., has a higher NPV)

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Investments of Unequal Lives

Replacement Chain
Repeat projects until they end at the same time Compute NPV for the repeated projects

Equivalent Annual Cost Method

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Replacement Chain Approach

Machine A time line of cash flows:
-4,000 100 -100 -100 -100 -100 -100 -100 -100 -100 -100

10

Machine B cash flows over ten years:

-1,000 500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

10
30

Finance - Pedro Barroso

Replacement Chain Approach

Machine A:
10 PVcos ts 4 ,000 100 A10% 4 ,614.5

Machine B:
5 PVcos ts 1,000 500 A10%

1,000 500 A
5 10%

1.15

2,895.4 2,895.4 4 ,693.2 5 1.1

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Equivalent Annual Cost (EAC)

Simple approach to compare two machines with different lives Puts costs on a per-year basis EAC is the value of constant annuity that has the same NPV as our original set of cash flows (with no initial investment) Assumes machines can be replaced by similar machines at end of its life
Finance - Pedro Barroso 32

EAC: Example
Machine A:

4 ,614.5 EAC A
Machine B:

10 10%

EAC 751.0

5 2,895.5 EAC A10% EAC 763.8

Pick machine A because has lower EAC

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Decision to Replace
A common decision is when to replace an existing machine by a new one When annual cost of new machine is less than annual cost of old machine We can use EAC to decide

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Decision to Replace: Example

New machine: costs $9,000, annual maintenance cost of $1,000, lasts for 8 years and salvage value of $2,000 after taxes (discount rate = 15%)
2,000 12,833 8 1.15 8 12,833 EAC A15% EAC 2,860
8 PVcos ts 9,000 1,000A15%

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Decision to Replace: Example

Old machine: can last one more year with maintenance cost of $1,000; salvage value after taxes is now $4,000 and $2,500 in one-year
1,000 2,500 PVcos ts 4 ,000 2,696 1.15 1.15 1 2,696 EAC A15% EAC 2,696 1.15 3,100

Replace machine immediately because has lower (absolute) EAC than keeping the old machine one more year
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Investments of Unequal Lives

If projects differ in revenues as well as costs We can use the same methods applied to NPV:
NPV of replacement chain Equivalent annual NPV

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