1 southern illinois university“the nature of it outsourcing”april 2006 lecture 5-2: capital...
TRANSCRIPT
![Page 1: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/1.jpg)
1
Southern Illinois University “The Nature of IT Outsourcing” April 2006
Lecture 5-2: Lecture 5-2:
Capital Budgeting Techniques Capital Budgeting Techniques
Azerbaijan State Economic University
Principles of Finance
Instructor: Asif Shamilov
Spring 2010
Should we build this
plant?
![Page 2: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/2.jpg)
2
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
Profitability Index
• Profitability Index is the ratio of project PV to initial cost
or
.
Decision rule
Take the project if PI > 1
IO
PVPI IO
NPVPI 1
![Page 3: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/3.jpg)
3
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
Capital rationing
• Happens when the firm (or division) has a limited amount of capital to invest
• In the case of capital rationing, it is better to select projects based on the profitability index
• When funds are limited, a firm should choose those projects that give more for each dollar invested
• Rank projects based upon their PIs. Invest in the projects with the highest PIs until all capital is exhausted (provided PI > 1).
![Page 4: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/4.jpg)
4
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
Profitability Index Example
Suppose your division has been given a capital budget of $6,000. Which projects do you choose?
Project I NPV PI
A 1,000 600 1.6
B 4,000 2,000 1.5
C 6,000 2,400 1.4
D 3,000 600 1.2
E 5,000 500 1.1
![Page 5: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/5.jpg)
5
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
Profitability Index Example
• Suppose your budget increases to $7,000.
• Choosing projects in descending order of PIs no longer maximizes the aggregate NPV.
• Projects A and C provide the highest aggregate NPV = $3,000 and stay within budget.
![Page 6: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/6.jpg)
6
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
Strengths and Weaknesses of PI Method
• Strength- It measures the wealth created per dollar of initial outlay
• Weakness- It does not take into account any investments in future periods (PV index is better in this case)
![Page 7: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/7.jpg)
7
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
Example:
Project x Project y
Present value $25,000,000 $3,000
Initial cost $24,000,000 $1,000
PI 1.042 3
NPV $1,000,000 $2,000
![Page 8: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/8.jpg)
8
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
PI(x) < PI(y)
but
NPV(x) > NPV(y)
Example:
![Page 9: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/9.jpg)
9
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:
In other words, IRR makes the present value of the
project equal to its initial cost.
n
0tt
t
) IRR 1 (CF
0
Internal Rate of Return (IRR)
![Page 10: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/10.jpg)
10
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
Decision rule:
Take the project If the IRR exceeds the required rate of return
If IRR > k, accept project.
If IRR < k, reject project.
• If projects are independent, accept both projects if IRR > k.
• If projects are mutually exclusive, accept one with the highest IRR
IRR Acceptance Criteria
![Page 11: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/11.jpg)
11
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
If IRR > the required rate of return, the
project’s rate of return is greater than its
costs. There is some return left over to boost
stockholders’ returns.
Rationale for the IRR method
![Page 12: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/12.jpg)
12
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
IRR Example
• Consider the company that has the opportunity to invest $100 million into the new equipment that will the following after-tax cash flows:
Then, the IRR is
Time 0 1 2 3-100.00 -50.00 30.00 200.00
NPV
IRR IRR IRR
100
50
1
30
1
200
102 3
IRR = 18.29%Therefore, accept the project if r<18.29%
IRR = 18.29%Therefore, accept the project if r<18.29%
![Page 13: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/13.jpg)
13
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
How is a project’s IRR similar to a bond’s YTM?
• They are the same thing.
• Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project.
• EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20.
– Solve for IRR = YTM = 7.08%, the annual return for this project/bond.
![Page 14: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/14.jpg)
14
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
Strengths:• Many people find it a more intuitive measure than NPV• Usually gives the same signal as NPV
Weaknesses:• Reinvestment rate assumption is unrealistic (IRR method
assumes CFs are reinvested at IRR, whereas NPV method assumes CFs are reinvested at the required rate of return)
• Multiple IRR
Strengths and Weaknesses of IRR Method
![Page 15: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/15.jpg)
15
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
IRR Problems I:Borrowing or Lending?
• Consider the following two investment projects faced by a firm with k = 10%.
Both projects have an IRR = 40%, but only
project B is acceptable.– What is happening here?
Project 0 1 2 IRRB -5000 0 9800 40%C 5000 -9800 40%
![Page 16: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/16.jpg)
16
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
IRR Problems II: Multiple IRRs/No IRRs
Consider a firm with the following investment project and a discount rate of k= 25%.
Typical if investment at the end: a) Repair environmental damage b) Dismantling of machine
This project has two IRRs: one above k and the other below k. Which should be compared to the required rate of return?
Happens with the non-conventional cash flows
Year 0 1 2 IRR
A -5000 16000 -12000 100%, 20%
![Page 17: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/17.jpg)
17
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
IRR Problems III:Mutually Exclusive Projects with different time horizon
Consider the following two mutually exclusive projects.
The discount rate is k = 20%.
• Despite having a higher IRR, project A is less valuable than project B.
Project 0 1 2 IRR NPV(k=20%)
A -5,000 8,000 0 60% 1,667
B -5,000 0 9,800 40% 1,806
![Page 18: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/18.jpg)
18
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
• Consider the following two mutually exclusive projects:
– Project A has higher IRR– Project D has higher NPV at discount rates of 10%
or 20%
IRR Problems IV:Mutually Exclusive Projects with different scale
Project 0 1 2 IRR NPV @ 10% NPV @ 20%A -5000 8000 0 60% 2273 1667D -10000 15000 0 50% 3636 2500
![Page 19: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/19.jpg)
19
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
NPV Profiles
A graphical representation of project NPVs at various different costs of capital.
Year 0 1 2 3
Project L -100 10 60 80
Project S -100 70 50 20
![Page 20: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/20.jpg)
20
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
-10
0
10
20
30
40
50
60
0 5 10 15 20 23.6
NPV ($)
Discount Rate (%)
IRRL = 18.1%
IRRS = 23.6%
Crossover Point = 8.7%
k
0
5
10
15
20
NPVL
50
33
19
7
(4)
NPVS
40
29
20
12
5
S
L
![Page 21: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/21.jpg)
21
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
• If projects are independent, the two methods always lead to the same accept/reject decisions. If NPV says accept the IRR also says accept
• If projects are mutually exclusive …– If k > crossover point, the two methods lead to
the same decision and there is no conflict.– If k < crossover point, the two methods lead to
different accept/reject decisions.
Comparing the NPV and IRR methods
![Page 22: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/22.jpg)
22
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
• Size (scale) differences – the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high k favors small projects.
• Timing differences – the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
Reasons why NPV profiles cross
![Page 23: 1 Southern Illinois University“The Nature of IT Outsourcing”April 2006 Lecture 5-2: Capital Budgeting Techniques Azerbaijan State Economic University](https://reader031.vdocuments.net/reader031/viewer/2022032604/56649e6b5503460f94b6a09c/html5/thumbnails/23.jpg)
23
PF Lecture 5 “Capital Budgeting Techniques” Spring 2008
Conclusions
NPV has strong attractions:– based on cash flows– fully reflects time value of money– takes into account riskiness of project– gives clear go/no go answer