AN INTRODUCTORY COURSEMODULE #5CORPORATE FINANCE:AN INTRODUCTORY COURSEDISCUSSION NOTESMODULE #51INVESTMENT CRITERIA The objective of these discussion notes is to evaluate different techniques used to analyze the desirability of long-term asset acquisitions. Capital budgeting is the process of making long-termfixed-asset investment decisions. For capital-intensive firms, firms with high percentages of fixed assets to total assets, these are the most critical decisions that the firm makes. Mistakes are painful to rectify. The phrase throwing good money after bad did not arise in a vacuum.To be a well-educated business student, you must understand the decision-making options that a firm may use to make project choices. Importantly, you must understand the strengths and weaknesses of these methods.The capital budgeting analytic techniques we will discuss in turn are:· NPV,· The Profitability Index,· Internal Rate of Return (IRR), ---------------------------------------------· Payback (and Discounted Payback), and· Accounting Rate of ReturnThe techniques above the line discount all project cash flows to make assessments about the merits of the project. All three of these methods also use market-determined discount rates instead of using "ad hoc" cutoff levels for project acceptance. These methods are referred to asDiscounted Cash Flow Techniques, or DCF Techniques.DCF techniques are the most frequently used decision making tools in corporations today, and large firms are more likely to use these tools than are smaller firms as are firms whose CEOs have MBAs. The latter two methods, below the dotted line, do not consider (or inadequately consider in the case of Discounted Payback) the time value of money. There are other problems with theseapproaches that we will discuss later.DCF methods properly focus on the required rate of return for a project, r, or, alternatively, the opportunity cost of capital for the project. Therefore, these techniques acknowledge the time value of money. The cash flows of a project should cover the outlays for the project plus the return you could earn elsewhere instead of this project, i.e., cover the opportunity costs of the investment. However, as we will also discover, not all DCF methods are created equally. The NPV method will emerge as the clear winner1 This lecture module is designed to complement Chapter 6 in B&D.1when all of the "dust settles!"Non-DCF methods ignore the opportunity cost of capital, or the time value of money. This is their main source of error. With respect to the Accounting Rate of Return method, this method "adds insult to injury;" in that cash flows are not even used in the analysis.Proper methods of analyzing capital budget projects should value more highly:· More cash versus less cash,· Nearer cash versus later cash, and· Less risky cash versus more risky cash.As we will discover, only the NPV Rule consistently satisfies all of these criteria! NPV is the method of choice for project evaluation among well-trained financial managers.Having made the above point, you may wonder why we are taking valuable class time to discuss the other methods. Good question!Say you go to work for a firm that does not use NPV. Without insights into the strengths and weakness of the method being used, and the ability to contrast this method to the virtues of the NPV approach, you will not be able to present a very effective case for changing capital budgetingevaluation methods.A) NPV:NPV Decision Rule: Take Positive NPV Projects; Reject Negative NPV Projects.NPV = PV inflows - PV outflows, where all cash flows are discounted at the appropriate rate of return, r. Since we've discussed using NPV in calculating project desirability extensively, we will only briefly review the mechanics of this method.ExampleA project has a required rate of return of 10% and the following cash flowsTime 0 1 2 3 4Cash Flow -$5,000 $2,000 $2,500 $3,000 $2,000NPV = -$5,000 + $2,000/(1.10)1 + $2,500/(1.10)2 + $3,000/(1.10)3 + $2,000/(1.10)4NPV = $2,504. The NPV is (+) and so collective shareholder wealth increases by $2,504 if the project is accepted. Therefore, take the project. If 1,000 shares are outstanding, the price of each share should increase by $2.504 when the firm announces the project.2NPV measures the immediate increase in wealth of shareholders in dollars. If the NPV is positive,the project has earned more than the opportunity cost of funds, r. NPV focuses on cash flows, the timing of the cash flows, and the risk of the cash flows (the higher the risk, the higher the discount rate, r). NPV is expressed in dollars. Measuring project desirability in dollars is consistent with our target objective--maximizing shareholder wealth. After all, isn't wealth expressed in dollars (or pounds, yen, deutsche marks, francs, krona, pesos, krone, lira, peseta, etc.)?B) Profitability Index (PI):Profitability Index Decision Rule: Take Projects when the PI > 1.0; Reject Projects whenthe PI < 1.0.In government “jargon,” the PI method is referred to as Benefit/Cost Analysis. However, it is calculated in the same manner. TPI = [Σ CFt/(1+r)t]/C0 t=1 PI = PV of Cash Flows (after t=0) divided by the negative of the Cash Flow at t = 0.Discuss this equation. If PI > 1.0, the PV of the inflows is greater that the PV of the outflows. Hence, NPV is + when PI > 1.0.For an individual project, the decision made using the PI method always will equal the decision made using the NPV method. When one method signals acceptance, so will the other method. When one method signals rejection, so will the other method. Can you see why? However, PI can give us accept/reject signals that conflict with the NPV Rule when we must rankprojects against one another.When must we rank projects?· Projects are mutually exclusive, and/or· The firm is capital rationed.By mutually exclusive, we mean you can take one project or the other, but not both. Say you own a corner lot. You can build a gas station or you can build a flower shop, but you cannot build both buildings. These options are mutually exclusive.By capital rationing, we mean that the firm has more good projects than it has capital to fund the projects, this requires some capital market imperfection. On the personal level, most of us find ourselves capital rationed most of the time! That’s not a capital market imperfection that’sgreed.3Example--Mutually Exclusive Projects:Let's take two