capital budgeting tecchniques

7/29/2019 Capital Budgeting Tecchniques

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McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

9Net Present Value

and OtherInvestment Criteria

Salman Masood SheikhM.Com, MBA, M.Phil, ACMA, FPA, CA (Int.)

Director Quality Assurance

Superior University, Lahore


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9-1

Key Concepts and Skills

Be able to compute payback and discountedpayback and understand their shortcomings

Understand accounting rates of return and

their shortcomings

Be able to compute the internal rate ofreturn and understand its strengths and

weaknesses Be able to compute the net present value

and understand why it is the best decision

criterion


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9-2

Chapter Outline

Net Present Value

The Payback Rule The Internal Rate of Return

The Profitability Index

The Practice of Capital Budgeting


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9-3

Good Decision Criteria

We need to ask ourselves thefollowing questions when evaluating

capital budgeting decision rules Does the decision rule adjust for the

time value of money?

Does the decision rule adjust for risk? Does the decision rule provide

information on whether we are creating

value for the firm?


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9-4

Calculation of Future value:

FVn = PVn (FVIFk%, ny)

Where : FVn is Future value

PVn is Present value

FVIF is Future value interest factor

k% is rate of interest

ny is Number of year


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9-5

Future Value Table


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9-6

Calculation of Present value:

PVn = FVn (PVIFk%, ny)

Where : PVn is Present value

FVn is Future value

PVIF is Present value interest factor

k% is rate of interest

ny is Number of year


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9-7

Present Value Table


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9-8

Calculation Present value for Annuity:

PVAD= PMTn (PVIFAk%, ny)

Where :

PVAD is Present value annuity due PMTn is Payment made each period PVIFA is Present value interest factor of annuity

k% is rate of interest ny is Number of year


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9-9

Present Value of Annuity Table


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Calculation Future value for Annuity:

FVAD = PMTn (FVIFAk%, ny)

Where :

FVAD is Future value annuity due PMTn is Payment made each period FVIFA is Future value interest factor of annuity

k% is rate of interest ny is Number of year


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9-11

Future Value of Annuity Table


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9-12

Net Present Value

The difference between the market valueof a project and its cost

How much value is created from

undertaking an investment? The first step is to estimate the expected

future cash flows.

The second step is to estimate the requiredreturn for projects of this risk level.

The third step is to find the present value ofthe cash flows and subtract the initialinvestment.


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9-13

Computing NPV of the Projects

Table 9.1 Capital Expenditure Data for BennettCompany


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NPV of the Project BEnd of Year Cash Flows PVIF20%,ny Present Value

1 28,000 0.833 23,324

2 12,000 0.694 8,328

3 10,000 0.579 5,790

4 10,000 0.482 4,820

5 10,000 0.402 4,020.

Total Present Value of Cash Flows 46,282

Less Initial Cash Out Flow (45,000).

Net Present Value 1,282 .


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9-15

NPV Decision Rule

If the NPV is positive, accept theproject

A positive NPV means that the project isexpected to add value to the firm and willtherefore increase the wealth of theowners.

Since our goal is to increase ownerwealth, NPV is a direct measure of howwell this project will meet our goal.


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9-16

Payback Period

How long does it take to get the initialcost back in a nominal sense?

Computation

Estimate the cash flows

Subtract the future cash flows from the initialcost until the initial investment has been

recovered

Decision RuleAccept if the paybackperiod is less than some preset limit


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9-17

Computing Payback for theProject

Assume we will accept the project if itpays back within two years.

Year 1: 165,000 63,120 = 101,880 still to

recover

Year 2: 101,880 70,800 = 31,080 still torecover

Year 3: 31,080 91,080 = -60,000projectpays back in year 3

Do we accept or reject the project?


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9-18

Advantages and Disadvantages ofPayback

Advantages Easy to understand

Adjusts for

uncertainty of latercash flows

Biased towardliquidity

Disadvantages Ignores the time value

of money

Requires an arbitrarycutoff point

Ignores cash flowsbeyond the cutoff date

Biased against long-term projects, such asresearch anddevelopment, and new

projects


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9-19

Internal Rate of Return

This is the most important alternativeto NPV

It is often used in practice and isintuitively appealing

It is based entirely on the estimated

cash flows and is independent ofinterest rates found elsewhere


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9-20

IRR Definition and DecisionRule

Definition: IRR is the return that makesthe NPV = 0

Decision Rule: Accept the project if theIRR is greater than the cost of capital


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9-21

Computing IRR for the Project

If you do not have a financial calculator,then this becomes a trial and errorprocess

Calculator

Enter the cash flows as you did with NPV

Press IRR and then CPT

IRR = 16.13% > 12% cost of capital

Do we accept or reject the project?


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9-22

Computing IRR of the Projects

Table 9.1 Capital Expenditure Data for BennettCompany


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9-23


IRR when Cash Flows are equal1. Calculate the payback period of the projectPayback Period = Initial Cash Outflow .

Annual yearly Cash Flows

Payback Period = 42,000 = 3.000 Years

14,000

2. The project life is 5 years so trace the closest

PVIFA to the factor 3.000 in the year 5, we willget the initial findings IRR >19%


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9-24


We can calculate the exact value of IRRby Interpolation Method

1. IRR = 19% + 1% x (PVIFA19%,5y PBP) .

(PVIFA19%,5y PVIFA20%,5y)

2. IRR = 19% + 1% x (3.058 3.000)

(3.058 2.991)

3. IRR = 19% + 1% x (0.058)(0.067)

4. IRR = 19% + 0.86%

5. IRR = 19.86%


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IRR when Cash Flows are unequal1. Calculate average annual Cash Flows

Avg. Cash Flows = Total Cash Flows

No of Total Years

Avg. Cash Flows = 70,000 = Rs. 14,000

5

2. Calculate average payback period of the projectPayback Period = Initial Cash Outflow .

Annual yearly Cash Flows


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IRR when Cash Flows are unequalPayback Period = 45,000 = 3.214 Years

14,000

3. The project life is 5 years so trace the closestPVIFA to the factor 3.214 in the year 5, we willget the initial findings

4. At 16% the factor is 3.274

5. At 17% the factor is 3.199


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9-27

Computing IRR of the ProjectsEnd of

Year

Cash

Flows

PVIF20%,nyPresent

Value

PVIF22%,nyPresent

Value

1 28,000 0.833 23,324 0.820 22,960

2 12,000 0.694 8,328 0.672 8,064

3 10,000 0.579 5,790 0.551 5,510

4 10,000 0.482 4,820 0.451 4,510

5 10,000 0.402 4,020. 0.370 3,700

Total Present Value of Cash Flows 46,282 44,744

Less Initial Cash Out Flow (45,000). 45,000

Net Present Value 1,282 . ( - 256)


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9-28


We can calculate the exact value of IRRby Interpolation Method

1. IRR = 20% + 2% x (NPV @ 20%) .

(NPV @ 20% NPV @ 22%

2. IRR = 20% + 2% x (1,282) .

(1,282 ( 256)

3. IRR = 20% + 1% x (1,282)(1,538)

4. IRR = 21.67%


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9-29

NPV Profile for the Project

-20,000

-10,000

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

Discount Rate

NPV

IRR = 16.13%


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9-30

Advantages of IRR

Knowing a return is intuitively appealing

It is a simple way to communicate thevalue of a project to someone whodoesnt know all the estimation details

If the IRR is high enough, you may notneed to estimate a required return, which

is often a difficult task


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9-31

Conflicts Between NPV and IRR

NPV directly measures the increase invalue to the firm

Whenever there is a conflict betweenNPV and another decision rule, youshould always use NPV

IRR is unreliable in the following

situations Non-conventional cash flows

Mutually exclusive projects


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9-32

Profitability Index

Measures the benefit per unit cost,based on the time value of money

A profitability index of 1.1 impliesthat for every $1 of investment, wecreate an additional $0.10 in value

This measure can be very useful insituations in which we have limitedcapital


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9-33

Computing Profitability Index

Profitability Index for Given Cash Flows

Profitability Index = Present Values of Cash FlowsInitial Cash Outflow

Decision Criteriathe project with higher Profitability Index will beaccepted.


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Computing Profitability IndexEnd of

Year

Cash

Flows

PVIF20%,nyPresent

Value

PVIF22%,nyPresent

Value

1 28,000 0.833 23,324 0.820 22,960

2 12,000 0.694 8,328 0.672 8,064

3 10,000 0.579 5,790 0.551 5,510

4 10,000 0.482 4,820 0.451 4,510

5 10,000 0.402 4,020. 0.370 3,700

Total Present Value of Cash Flows 46,282 44,744

Initial Cash Out Flow 45,000 45,000

Profitability Index1.028

(Accept)

0.9943

(Reject)


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9-35

Advantages and Disadvantages ofProfitability Index

Advantages

Closely related toNPV, generally

leading to identicaldecisions

Easy to understandand communicate

May be useful whenavailable investmentfunds are limited

Disadvantages

May lead to incorrectdecisions in

comparisons ofmutually exclusiveinvestments


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9-36

Capital Budgeting In Practice

We should consider severalinvestment criteria when making

decisions NPV and IRR are the most

commonly used primary investment

criteria Payback is a commonly used

secondary investment criteria


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9-37

Summary Discounted Cash Flow Criteria

Net present value Difference between market value and cost Take the project if the NPV is positive Has no serious problems Preferred decision criterion

Internal rate of return Discount rate that makes NPV = 0 Take the project if the IRR is greater than the required return Same decision as NPV with conventional cash flows IRR is unreliable with non-conventional cash flows or mutually

exclusive projects

Profitability Index Benefit-cost ratio Take investment if PI > 1 Cannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital

rationing


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9-38

Summary Payback Criteria

Payback Period

Length of time until initial investment is recovered

Take the project if it pays back within some specified

period

Doesnt account for time value of money and there is

an arbitrary cutoff period


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9-39

Quick Quiz

Consider an investment that costs $100,000and has a cash inflow of $25,000 every year for5 years. The required return is 9% and requiredpayback is 4 years.

What is the payback period? What is the discounted payback period?

What is the NPV?

What is the IRR?

Should we accept the project? What decision rule should be the primary

decision method?

When is the IRR rule unreliable?


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9End of Chapter

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