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Summary of Previous Lecture
We covered the following topics;• Understand why ranking project proposals on the basis
of IRR, NPV, and PI methods “may” lead to conflicts in ranking.
• Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or PI rankings.
• Understand how “sensitivity analysis” allows us to challenge the single-point input estimates used in traditional capital budgeting analysis.
• Explain the role and process of project monitoring, including “progress reviews” and “post-completion audits.”
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Chapter 13 (III)
Capital Budgeting Techniques
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Learning OutcomesAfter studying Chapter 13, you should be able to:• Understand the payback period (PBP) method of project evaluation and
selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability.
• Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and profitability index (PI).
• Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods.
• Define, construct, and interpret a graph called an “NPV profile.”• Understand why ranking project proposals on the basis of IRR, NPV, and
PI methods “may” lead to conflicts in ranking. • Describe the situations where ranking projects may be necessary and
justify when to use either IRR, NPV, or PI rankings.• Understand how “sensitivity analysis” allows us to challenge the single-
point input estimates used in traditional capital budgeting analysis.• Explain the role and process of project monitoring, including “progress
reviews” and “post-completion audits.”
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Other Project Relationships
Mutually Exclusive - A project whose acceptance precludes the acceptance of one or more alternative projects. For example if the firm is considering purchasing a truck from two available options.
Dependent (or Contingent) - A project whose acceptance depends on the acceptance of one or more other projects. For example, construction of new building for the new machinery to be installed.
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Ranking Problems
A. Scale of InvestmentB. Cash-flow PatternC. Project Life
Potential Problems under mutual exclusive projects; ranking of proposals using DCF methods may produce contradictory results in the form of;
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Examine NPV Profiles
Discount Rate (%)0 5 10 15 20 25-2
00
0
200
4
00
60
0
IRR
NPV@10%
Plot NPV for eachproject at various
discount rates.
Net
Pre
sent
Val
ue ($
)
Project I
Project D
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Fisher’s Rate of Intersection
Discount Rate ($)0 5 10 15 20 25-2
00
0
200
4
00
60
0N
et P
rese
nt V
alue
($)
At k<10%, I is best! Fisher’s Rate ofIntersection
At k>10%, D is best!
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Capital Rationing
Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period. For example a budget ceiling on investment projects where the firms have a policy of internally financing capital expenditures.
Example: Mr. A from AB Corporation (ABC) must determine what investment opportunities to undertake for ABC. He is limited to a maximum expenditure of $32,500 only for this capital budgeting period.
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Available Projects for ABC
A $ 500 18% $ 50 1.10 B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 E 12,500 26 500 1.04 F 15,000 28 21,000 2.40 G 17,500 19 7,500 1.43 H 25,000 15 6,000 1.24
Project ICO IRR NPV PI
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Single-Point Estimate and Sensitivity Analysis
• Allows us to change from “single-point” (i.e., changes in revenue, installation cost, final salvage, etc.) estimates to a “what if” analysis
• Utilize a “base-case” to compare the impact of individual variable changes– E.g., Change forecasted sales units to see impact on
the project’s NPV
Sensitivity Analysis: A type of “what-if” uncertainty analysis in which variables or assumptions are changed from a base case in order to determine their impact on a project’s measured results (such as NPV or IRR).
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Post-Completion Audit
Post-completion AuditA formal comparison of the actual costs and benefits of a project with original estimates.
– Identify any project weaknesses– Develop a possible set of corrective actions– Provide appropriate feedbackResult: Making better future decisions!
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Multiple IRR Problem*
Two; There are as many potential IRRs as there are sign changes.
Let us assume the following cash flow pattern for a project for Years 0 to 4:-$100 +$100 +$900 -$1,000How many potential IRRs could this project have?
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NPV Profile -- Multiple IRRs
Discount Rate (%)0 40 80 120 160 200
Net
Pre
sent
Val
ue($
000s
)
Multiple IRRs atk = 12.95% and 191.15%
75
50
25
0
-100
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SummaryIn this chapter we covered following topics;• Payback period (PBP) method of project evaluation and
selection, discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and profitability index (PI).
• Understand why ranking project proposals on the basis of IRR, NPV, and PI methods “may” lead to conflicts in ranking.
• Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or PI rankings.
• Understand how “sensitivity analysis” allows us to challenge the single-point input estimates used in traditional capital budgeting analysis.
• Explain the role and process of project monitoring, including “progress reviews” and “post-completion audits.”