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Capital Budgeting

Professor Trainor

11-1
Capital Budgeting Decision
Techniques
Payback period: most commonly used
Discounted Payback, not as common

Net present value (NPV): best technique


theoretically; difficult to calculate realistically

Internal rate of return (IRR): widely used with


strong intuitive appeal.
Modified IRR can be used if several neg. cash flows

Profitability index (PI): related to NPV


11-2
A Capital Budgeting Process
Should:
Account for the time value of money;

Account for risk;

Focus on cash flow;

Rank competing projects appropriately, and

Lead to investment decisions that maximize


shareholders wealth. 11-3
Payback Period
The payback period is the amount of time required
for the firm to recover its initial investment.

If the projects payback period is less than the


maximum acceptable payback period, accept
the project.
If the projects payback period is greater than
the maximum acceptable payback period,
reject the project.
Management determines maximum acceptable
payback period. 11-4
Global Wireless
Global Wireless is a worldwide provider of
wireless telephony devices.
Global Wireless evaluating major expansion of
its wireless network in two different regions:
Western Europe expansion
A smaller investment in Southeast U.S. to establish a
toehold
Western Europe ($ millions) Southeast U.S. ($ millions)

Initial outlay -$250 Initial outlay -$50


Year 1 inflow $35 Year 1 inflow $18
Year 2 inflow $80 Year 2 inflow $22
Year 3 inflow $130 Year 3 inflow $25
Year 4 inflow $160 Year 4 inflow $30
Year 5 inflow $175 Year 5 inflow $32
11-5
Calculating Payback Periods for

Global Wireless Projects


Management selects a 2.75 years payback period.
Western Europe project has initial outflow of -$250
million,
But cash inflows over first 3 years only $245 million.
Global Wireless would reject Western Europe project.

Southeast U.S. project: initial outflow of -$50


million
Cash inflows over first 2 years cumulate to $40
million.
Project recovers initial outflow after 2.40 years.
Total inflow in year 3 is $25 million. We estimate that
the projects generates $10 million in year 3 in 0.40
years ($10 million $25 million).
Global Wireless would accept the project. 11-6
Pros and Cons of Payback Method
Advantages of payback method:

Computational simplicity

Easy to understand
Focus on cash flow
Disadvantages of payback method:

Does not account properly for time value of money


Does not account properly for risk

Cutoff period is arbitrary


11-7
Does not lead to value-maximizing decisions
Discounted Payback Period
Discounted payback accounts for time value.
Apply discount rate to cash flows during
payback period.
Still ignores cash flows after payback period

Global Wireless uses an 18% discount rate.


PV Factors Southeast U.S.
Western Europe
Item project
(18%) project ($million)
($million)
PV Year 1 inflow 0.8475 $29.7 $15.2

PV Year 2 inflow 0.7182 $57.4 $15.8

PV Year 3 inflow 0.6086 $79.1 $15.2

Cumulative PV -- $166.2 $46.2

Accept / reject -- Reject Reject


11-8
Net Present Value
The present value of a projects cash inflows and
outflows

Discounting cash flows accounts for the time value of


money.

Choosing the appropriate discount rate accounts for


risk.

CF1 CF2 CF3 CFN


NPV CF0 ...
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N

Accept projects if NPV > 0. 11-9


Net Present Value
CF1 CF2 CF3 CFN
NPV CF0 ...
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N

A key input in NPV analysis is the discount rate.

r represents the minimum return that the project


must earn to satisfy investors.

r varies with the risk of the firm and/or the risk of


the project.
11-10
Calculating NPVs for Global
Wireless Projects
Assuming Global Wireless uses 18% discount rate,
NPVs are:

Western Europe project: NPV = $75.3 million


35 80 130 160 175
NPVW esternEurope $75.3 250
(1.18) (1.18) 2 (1.18)3 (1.18) 4 (1.18)5

Southeast U.S. project: NPV = $25.7 million

18 22 25 30 32
NPVSoutheastU .S . $25.7 50
(1.18) (1.18) 2 (1.18)3 (1.18) 4 (1.18)5

Should Global Wireless invest in one project or both?


11-11
Pros and Cons of Using NPV as
Decision Rule
NPV is the gold standard of investment decision
rules.
Key benefits of using NPV as decision rule:

Focuses on cash flows, not accounting earnings


Makes appropriate adjustment for time value of money
Can properly account for risk differences between
projects
Though best measure, NPV has some drawbacks:

Lacks the intuitive appeal of payback, and


Doesnt capture managerial flexibility (option value) well.
11-12
Internal Rate of Return
Internal rate of return (IRR) is the discount rate that
results in a zero NPV for the project:
CF1 CF2 CF3 CFN
NPV 0 CF0 ....
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N
IRR found by computer/calculator or manually by
trial and error.
The IRR decision rule is:

If IRR is greater than the cost of capital, accept


the project.
If IRR is less than the cost of capital, reject the
project. 11-13
Calculating IRRs for Global
Wireless Projects
Global Wireless will accept all projects with at least
18% IRR.

Western Europe project: IRR (rWE) = 27.8%


35 80 130 160 175
0 250
(1 rW E ) (1 rW E ) 2
(1 rW E ) 3
(1 rW E ) 4
(1 rW E )5

Southeast U.S. project: IRR (rSE) = 36.7%

18 22 25 30 32
0 50
(1 rSE ) (1 rSE ) 2
(1 rSE ) 3
(1 rSE ) 4
(1 rSE )5
11-14
Advantages and Disadvantages of
IRR
Advantages of IRR:

Properly adjusts for time value of money


Uses cash flows rather than earnings
Accounts for all cash flows
Project IRR is a number with intuitive appeal

Disadvantages of IRR

Mathematical problems: multiple IRRs, no real solutions


Scale problem
Timing problem 11-15
Multiple IRRs
NPV ($)

NPV>0
IRR

NPV>0
Discount
NPV<0 NPV<0 rate

IRR

When project cash flows have multiple sign changes,


there can be multiple IRRs.
With multiple IRRs, which do we compare with the
cost of capital to accept/reject the project?11-16
No Real Solution
Sometimes projects do not have a real IRR solution.

Modify Global Wirelesss Western Europe project to


include a large negative outflow (-$355 million) in
year 6.

There is no real number that will make NPV=0,


so no real IRR. However, can use something
called modified IRR.
Project is a bad idea based on NPV. At r =18%,
project has negative NPV, so reject!
11-17
Conflicts Between NPV and
IRR
NPV and IRR do not always agree when ranking
competing projects.

The scale problem:

Project IRR NPV (18%)


Western Europe 27.8% $75.3 mn
Southeast U.S. 36.7% $25.7 mn

Southeast U.S. project has higher IRR, but


doesnt increase shareholders wealth as much as
Western Europe project.
11-18
The Timing Problem
Long-term
NPV IRR = 15%
project

Short-term
IRR = 17%
project

Discount
rate
13% 15% 17%

The NPV of the long-term project is more sensitive to the


discount rate than the NPV of the short-term project is.
Long-term project has higher NPV if the cost of capital is
less than 13%. Short-term project has higher NPV if the
cost of capital is greater than 13%.
11-19
Profitability Index
Calculated by dividing the PV of a projects cash
inflows by the PV of its outflows:
CF1 CF2 CFN
...
(1 r ) (1 r ) 2
(1 r ) N
PI
CF0
Decision rule: Accept project with PI > 1.0, equal to NPV > 0

Project PV of CF (yrs1-5) Initial Outlay PI

Western Europe $325.3 million $250 million 1.3

Southeast U.S. $75.7 million $50 million 1.5

Both projects PI > 1.0, so both acceptable if


independent.
Like IRR, PI suffers from the scale problem.
11-20