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Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability.
Understand the three major discounted cash flow (DCF) methods of project evaluation and selection internal rate of return (IRR), net present value (NPV), and profitability index (PI). Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. Define, construct, and interpret a graph called an NPV profile. Understand why ranking project proposals on the basis of IRR, NPV, and PI methods may lead to conflicts in rankings. Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or PI rankings. Understand how sensitivity analysis allows us to challenge the singlepoint input estimates used in traditional capital budgeting analysis. Explain the role and process of project monitoring, including progress reviews and post-completion audits.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
2.
3. 4. 5. 6. 7. 8.
13.2
Independent Project
For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.
Independent A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.
13.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
1
10 K
2
12 K
3
15 K
4
10 K
5
7K
PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.
13.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
1
10 K 10 K
2
12 K 22 K
3 (a)
15 K 37 K(c)
10 K (d) 7 K 47 K 54 K
Cumulative Inflows
PBP
13.8
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
1
10 K 30 K
2
12 K 18 K
3
15 K 3 K
4
10 K 7K
5
7K 14 K
PBP
Cumulative Cash Flows
Note: Take absolute value of last negative cumulative cash flow value.
13.9
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.]
13.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Weaknesses:
Does not account
for TVM
ICO = (1 + IRR)1
13.12
+...+
CFn
(1 + IRR)n
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution
$10,000 $12,000 $40,000 = + + (1+IRR)1 (1+IRR)2 $15,000 $10,000 $7,000 + + (1+IRR)3 (1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000.
13.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
13.16
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
13.17
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
X = 0.0157
13.20
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
For C01 Press For F01 Press For C02 Press For F02 Press
10000 1 12000 1
15000 1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR CPT
Result:
13.22
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Weaknesses:
Assumes all cash flows reinvested at the IRR
Difficulties with project rankings and Multiple IRRs
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
CF2 (1+k)2
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Solution
Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. NPV = $10,000 +$12,000 +$15,000 + (1.13)1 (1.13)2 (1.13)3
NPV Solution
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
13.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
For C01 Press For F01 Press For C02 Press For F02 Press
10000 1 12000 1
15000 1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
keys key
Result:
13.30
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Weaknesses:
May not include managerial options embedded in the project. See Accounts for TVM. Chapter 14.
Sum of CFs
IRR NPV@13%
15
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
CF1 PI = (1+k)1
ICO
Method #2:
PI = 1 + [ NPV / ICO ]
13.34
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PI Acceptance Criterion
PI = $38,572 / $40,000 = .9643 (Method #1, previous slide) Should this project be accepted? No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI < 1.00 ]
13.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Weaknesses:
Same as NPV
Allows Provides only comparison of relative profitability different scale Potential Ranking projects Problems
13.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Evaluation Summary
Basket Wonders Independent Project
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
13.38
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
13.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A. Scale Differences
Compare a small (S) and a large (L) project.
END OF YEAR 0 1 2
13.41
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A. Scale Differences
Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why?
Project IRR NPV PI
S L
13.42
100% 25%
231
3.31 1.29
$29,132
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A. Scale Differences
END OF YEAR 0 1 2 3
13.44
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR 23%
17%
NPV $198
$198
PI 1.17
1.17
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
400
Project I
-200
0 0
200
25
13.46
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
At k<10%, I is best!
At k>10%, D is best!
25
13.47
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
END OF YEAR 0 1 2 3
13.49
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PI 2.54 1.82
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
13.51
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Year
CF
0
$1,000
1
$0 IRR* = 34.26%
2
$0
3
$2,420
Results:
13.52
NPV = $818
$2,000 1,000
$2,000
$1,000
Results:
13.53
$1,000
IRR = 100%
$1,000
$2,000
NPV* = $2,238.17
13.54
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Rationing
Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.
Example: Julie Miller must determine what investment opportunities to undertake for Basket Wonders (BW). She is limited to a maximum expenditure of $32,500 only for this capital budgeting period.
13.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A B C D E F G H
13.56
18% 25 37 20 26 28 19 15
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
ICO
$ 5,000 15,000 12,500 5,000
IRR
37% 28 26 25
NPV
$ 5,500 21,000 500 6,500
PI
2.10 2.40 1.04 2.30
ICO
$15,000 17,500 5,000
IRR
28% 19 25
NPV
$21,000 7,500 6,500
PI
2.40 1.43 2.30
ICO
IRR
28% 25 37 20 19
NPV
$21,000 6,500 5,500 5,000 7,500
PI
2.40 2.30 2.10 1.67 1.43
Projects F, B, C, and D have the four largest PIs. The resulting increase in shareholder wealth is $38,000 with a $32,500 outlay.
13.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of Comparison
Method Projects Accepted PI NPV F, B, C, and D F and G Value Added $38,000 $28,500
IRR
C, F, and E
$27,000
PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period.
13.60 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Post-Completion Audit
Post-completion Audit
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
How many potential IRRs could this project have? Two!! There are as many potential IRRs as there are sign changes.
* Refer to Appendix A
13.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
100
40
200
13.64
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
13.65
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.