Chap 9 – Capital BudgetingBudgeting CriteriaPayback PeriodNet Present ValueNPV Illustration @ 10% Year CF PVIF PVMore on NPVInternal Rate of ReturnNPV and IRRProblems with IRRNPV Profile – Page 271SummaryCapital RationingExample: $1,000 LimitCapital RationingProject RankingsSize DisparityMethods Used by CompaniesCapital Budgeting Practices T9-11Major Points1Chap 9 – Capital BudgetingKey Sections:•Explain Payback period, NPV and IRR•Evaluate advantages, disadvantages of each and determine project acceptability•Compute payback, NPV and IRR (with projects with irregular cash flows) •Understand capital rationing and disparities2Budgeting Criteria•Capital Budgeting – decision process relative to investing in fixed assets or other long-term investments in a new product or line of business.•Focuses on after-tax cash flows resulting from a project. Should it be undertaken?–Compare returns relative to costs•Criteria: NPV, IRR and payback period3Payback Period•How many years to recover the initial outlay? Does it meet the minimum period?•Main weakness – ignores TVM–But we could PV each cash flow to show TVM•Problems: period is arbitrary and ignores later cash flows•Advantages: understandable, early cash flows more certain4Net Present Value•NPV’s of inflows less NPV’s of outflows•Measures net value in today’s dollars•Criteria: If NPV > 0.0 accept but–If NPV less than zero, reject•Rationale: Discount rate used at least equals cost of capital; if you can’t cover costs, you are destroying shareholder value5NPV Illustration @ 10%Year CF PVIF PV 1 12,000 .909 10,908 2 13,000 .826 10,738 3 14,000 .751 10,574 4 15,000 .683 10,245PV of inflows 42,465Initial out -35,000 1.000 -35,000NPV + 7,4656More on NPV•Depends on accuracy of cash flow projected•Advantages: deals with CF and timing; costs and benefits logically compared•Disadvantages: need detailed, long-term cash forecasts•Theoretically correct – measures project’s impact; authors prefer.7Internal Rate of Return•What rate of return does the project earn? How does it compare to our cost of capital?•Definition: IRR is the discount rate that produces an NPV of zero•What rate does the project earn on the IO?–(Use calculators, not tables)•Criteria: if over the required rate, accept8NPV and IRR9Problems with IRR•Can’t handle later cash outflows•NPV assumes all cash flows reinvested at discount rate (required rate of return)•IRR assumes cash flows are reinvested at IRR (perhaps unrealistically)•Authors believe NPV is better (but industry doesn’t agree)10NPV Profile – Page 271Discount Rate Project’s NPV5% $24,36710 8,20713 015 -4,95220 -15,79811SummaryTechnique Measure Accept ifPayback period Time Sooner thanMaximumNPV Dollars > 0IRR Disc rate > C of C12Capital Rationing•Dollar limit placed on capital spending•Management sees it can’t profitably do all even if NPV positive and IRR>RR•Why: adverse market conditions, lack of qualified managers and intangibles–Related to economy, interest rates, stock prices, credit availability•Effect negative but depends on severity13Example: $1,000 LimitProject Cost NPVA $200 $280 B 200 260 C 800 560 D 300 90Projects A and C have highest total NPVwithin the $1,000 spending limit14Capital Rationing15Project Rankings•Mutually exclusive projects perform same task–Accepting one requires rejection of other•Conflicting rankings may occur–One is caused by size disparity –Not responsible for time disparity16Size Disparity•On your land, you can make a parking lot ($10,000 cost, earns $10,000/yr forever) OR•Build building (costs $20 mil sold year later for $24 mil) IRR NPV @15%Parking lot 100% $66,666Building 20% $869,565•IRR independent of size, NPV better here17Methods Used by Companies•As shown in Table 9-11, more use IRR (on either primary or secondary basis) than use NPV.•Why? With computers, no more difficult to calculate. A rate may be easier to put in perspective than a dollar NPV18Capital Budgeting Practices T9-1119Major Points•Payback emphasizes risk and liquidity•NPV shows profitability and dollar benefits •IRR indicates safety margin measured by returns•Quantitative measures useful but not a substitute for sound judgment–Why are returns so high? What will comp