chapter 17 capital budgeting analysis © 2000 john wiley & sons, inc
TRANSCRIPT
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Chapter 17
Capital Budgeting Analysis
© 2000 John Wiley & Sons, Inc.
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Chapter Outcomes
Explain how the capital budgeting process should be related to a firm’s mission and strategies.
Identify and describe the five steps in the capital budgeting process.
Identify and describe the methods or techniques used to make proper capital budgeting decisions.
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Chapter Outcomes, continued
Explain how relevant cash flows are determined for capital budgeting decision purposes.
Describe the importance of determining the correct base case from which to estimate project cash flows.
Discuss how a project’s risk can be incorporated into capital budgeting analysis.
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Capital Budgeting Projects
Seek investment opportunities to enhance a firm’s competitive advantage and increase shareholder wealth– Typically long-term projects– Should be evaluated by time value of
money techniques– Large investment
Mutually exclusive versus independent
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Capital Budgeting Process
Identification Development Selection Implementation Follow-up
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Data Needs
Economic and Political Data
Financial Data
Non-Financial Data
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Capital Budgeting Techniques
Net Present Value
NPV = Present value of all cash flows minus cost of project
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Cash Flow Data
YEAR PROJECT A PROJECT B
1 5,800 4,000
2 5,800 4,000
3 5,800 8,000
4 5,800 10,000
5 5,800 10,000
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NPV of Project ACASH 10% PRESENT
YR FLOW x PVIF = VALUE
0 –$20,0001.000 –$20,000
1 5,800 0.909 5,272
2 5,800 0.826 4,791
3 5,800 0.751 4,356
4 5,800 0.683 3,961
5 5,800 0.621 3,602
Net Present Value =$ 1,982
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NPV of Project BCASH 10% PRESENT
YR FLOW x PVIF = VALUE
0 -$25,0001.000 -$25,000
1 4,000 0.909 3,636
2 4,000 0.826 3,304
3 8,000 0.751 6,008
4 10,000 0.683 6,830
5 10,000 0.621 6,210
Net Present Value = $ 988
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What Does the NPV Represent?
NPV represents the dollar gain in shareholder wealth from undertaking the project
If NPV > 0, do the project as shareholder wealth rises
If NPV <0, do not undertake; it reduces shareholder wealth
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Internal Rate of Return
It is the discount rate that causes NPV to equal zero
N
NPV = [CFt / (1 + IRR)t ] – Inv = 0 t = 1
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Solution Methods
Compute the IRR by:
– Trial and error
– Financial calculator
– Spreadsheet software Accept the project if IRR > minimum
required return on the project
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What Does the IRR Measure?
IRR measures the return earned on funds that remain internally invested in the project
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Profitability Ratio (Benefit/Cost Ratio)
Profitability Index = Present value of cash flows/initial cost
Accept project if PI > 1.0 Reject project if PI < 1.0 Interpretation: Measures the present
value of dollars received per dollar invested in the project
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Relationships
NPV, IRR, PI will always agree on the Accept/Reject decision
If one indicates we should accept the project, they will all indicate “accept”
NPV > 0
IRR>minimum required return
PI > 1
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Reject Decision, too
If one indicates we should reject the project, they will all indicate “reject”
NPV < 0IRR < minimum required return PI < 1
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A popular, but flawed, measure...
Payback period = number of years until the cash flows from a project equal the project’s cost
Accept project is payback period is less than a maximum desired time period
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Payback’s Drawbacks
Ignores time value of money Any relationship between the
payback, the decision rule, and shareholder wealth maximization is purely coincidental!
It ignores the cash flows beyond the payback period
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Estimating Project Cash Flows
Important: Stand-alone principle Incremental after-tax cash flows
from the base case Cannibalization or enhancement
effects Opportunity costs
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Ignore….
Sunk costs
Financing costs
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Up-front or “time zero” investment
Investment =
cost + transportation, delivery, and installation charges
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Cash-Based Income StatementCash revenues $12,000
Cash operating expenses –5,600
Cash earnings before depreciation 6,400
Depreciation –4,000
Cash earnings before taxes 2,400
Income taxes (25%) –600
Cash earnings after taxes $ 1,800
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Periodic after-tax cash flows Cash revenues - cash expenses - tax
= $12,000 - 5,600 - 600 = $5,800 Cash earnings after tax+Depreciation
= $1,800 + 4,000 = $5,800 (Cash revenues-cash expenses) (1-T)
+ T (Depreciation expense)
= ($12,000-5,600)(1-.25) + (.25)($4,000)
= $5,800
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Risk-related Considerations
Expected return/risk tradeoff
Higher (lower) than average risk projects should have a higher (lower) than average discount rate
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Cost of Capital
Required return on average risk project = firm’s cost of capital, or cost of financing
For average risk projects, use this number as the discount rate (NPV, PI) or the minimum required rate of return (IRR)
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Risk-adjusted Discount Rate
Adjust the project’s discount rate up or down from the firm’s cost of capital for projects of above-average or below-average risk
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An Example
Below-average risk:
Discount rate = cost of capital –2%
Average risk:
Discount rate = cost of capital
Above-average risk:
Discount rate = cost of capital + 2%
High risk:
Discount rate = cost of capital + 5%
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Learning Extension 17A: Strategic Analysis and Cash Flow Estimation
Strategic analysis, marketing analysis, and financial analysis should agree on the accept/reject decision of a project
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Common Problem Areas
Determining the correct base case Overvaluing a strategy Define project boundaries at the
corporate level
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Depreciation and Project Cash Flows
Straight-line depreciation MACRS--accelerated depreciation
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Depreciation Classes3-year class
5-year class
7-year class
10-year class27.5-year class
31.5-year class
Designated tools and equipment used in research
Cars, trucks, and some office equipment such as computers and copiers
Other office equipment and industrial machinery
Other long-lived equipmentResidential real estate
Commercial and industrial real estate
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Some MACRS PercentagesAsset class
Year 3-year 5-year 7-year
1 33.33% 20.00% 14.29%
2 44.45 32.00 24.49
3 14.82 19.20 17.49
4 7.40 11.52 12.49
5 11.52 8.93
6 5.76 8.93
7 8.93
8 4.45
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An example
For an asset in the three-year class that originally cost $50,000, the first first year’syear’s depreciation is $50,000 x 0.3333 = $16,665; the second year’ssecond year’s depreciation is $50,000 x 0.4445 = $22,225; for the third yearthird year, depreciation will be $50,000 x 0.1482 = $7,410; the final year’sfinal year’s depreciation expense will be $50,000 x 0.0740 = $3,700.