capital budgeting arguing for your project capital budgeting cfo receives proposals from divisions...
Post on 19-Dec-2015
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Arguing for your project
Capital budgeting CFO receives proposals from divisions Projects described by cash flows
Arguing means applying measures
Net present value is the right measure. Many smart people use the wrong
ones. Alternative ways to the same end.
Survey of use of measures by corporations
Measure Primary Secondary
Internal rate of return 49% 15%Accounting rate of return 8% 19%Net present value 21% 24%Payback period 19% 35%Other 17% 7%
Total responses 587 469
Make no mistake
NPV is the right measure always. Others work sometimes. NPV measures value to owners, their
wealth.
NPV’s merits
Values cash flows as the market does. Responsive because the discount rate
is the current market rate. Measures increase in shareholder
value.
Payback period is
The time required for undiscounted cash flows to add up to the initial investment.
e.g., build a Wendy’s if it “pays for itself” in two years or less.
Payback defects
No market response.When r is high, payback period should be shorter.
Subtracts time-t dollars from time-0 dollars, a cardinal sin.
Ignores cash flow after payback. Ignores timing during payback.
The well-informed capital budgeter knows
When to accept payback period as a measure.
When it is likely to fail.
Accounting rate of return
Doesn’t value cash flows No market response Ignores market values Scaling problems: melons or malls
Merits of accounting r.o.r.
Easily understood. Sometimes okay in stable markets. Smart application can overcome
defects.
Internal rate of return
Definition: IRR is the discount rate that makes NPV = 0
CFCF
r
CF
r
CF
rTT0
1 221 1 1
0
( )
. . .( )
That is, IRR is the r such that
Internal rate of return
Definition: IRR is the discount rate that makes NPV(r) = 0.
NPV(r) is a function. RWJ Figures 6.4 and 6.5.
Applications of IRR measure
Hurdle rate = market rate Project acceptance: Accept a project if
IRR > hurdle rate. Mutually exclusive projects: Take the
one with the highest IRR (> hurdle rate)????? Don’t rely on it.
Project acceptance:
NPV and IRR give the same conclusion when ...
Cash flows have one sign change. In the example: IRR = 23.37% > hurdle
= 10% for an investment project. IRR = 23.37% < hurdle rate = 30% for a
financing or “borrowing from nature” project.
Objective
Learn to recognize the times when NPV and IRR are the same.
and also the problems with IRR
Defects of IRR -- project acceptance
Lending to nature or borrowing from her?
Multiple IRR's may occur.
Defects of IRR -- mutually exclusive projects
Ignores market values. Scale problems -- melons or malls.
Typical hour exam question
What is the scale problem in using IRR to choose between mutually exclusive projects?
Scale problem in IRR
Time 0 1 IRR NPV(r=.1)Little dam -100 200 1 81.8181…Big dam -1000 1500 0.5 363.6363…
One canyon, one dam.
Sketch of answer
The smaller dam has the higher IRR. The big dam has higher value. The big dam extends consumption
possibility of owners more than the little dam does.
It is wrong to take the higher IRR in this case.
Scale problems in IRR
Time 0 1 IRR NPV(r=.1)
Littledam
-100 200 1 81.8181...
Bigdam
-1000 1500 .5 363.63...
More answer
Consider the project of replacing the little dam by the big dam.
Cash flows are -900, +1300. IRR of the project is 4/9 = .4444 > .1 NPV is 281.8181… So replace the little dam. Capital budgeting jiu jitsu.
Big dam, little dam
NPV
NPV of the big dam
NPV of the small dam
500
100
.51
r
r*
For hurdle rates below r*,the big dam is preferred.
r* = .4444...