1

Capital Budgeting Principles and Techniques

Chapter 2

2

Prospective investment project must satisfy 3 criteria:◦It must focus on cash and only cash.

◦It must account for the time value of money.

◦It must account for risk.

2.1 Net Present Value

3

The NPV rule is implemented as follows: Calculate the present value of the expected net cash flows generated by the investment, using an appropriate discount rate, and subtract fro this present value the initial cash outlay for the project. If the resulting NPV is positive, accept the project; if it is negative, reject it. If 2 projects are mutually exclusive, accept the one with the higher net present value.

In other words, if the investment is worth more than it costs, accept it; if it costs more than it’s worth, reject it.

Net Present Value Decision Rule

4

Net Cash Flow: usually calculated as profit after tax, plus depreciation and other non-cash charges such as deferred income taxes less any additions to working capital during the period.

Working Capital: refers to the money the firm must invest in A/R, Inventory, and cash to support the sales and production of its products or services.

Additions to working capital are subtracted from earnings because they consume cash, even though they do not affect reported earnings.

Definitions:

5

Cost of Capital: the discount rate used in calculating an investment’s NPV.

Noncash charge: one that shows up as a cost of doing business but that entails no cash outlay; example: depreciation.

Definitions:

6

NPV evaluates investments in the same way that shareholders do; consistent with shareholder wealth maximization.

NPV obeys the value additivity principle: The NPV of a set of independent projects is just the sum of the values of its component parts.

Strengths & Weakness of NPV

7

2 categories: Non-discounted cash flow (non DCF) methods & discounted cash flow (DCF) methods.

Non-discounted cash flow criteria:

◦Payback Period

◦Accounting Rate of return

2.2 Alternative Investment Evaluation Criteria

8

Non-discounted cash flow criteria:◦Payback Period: the length of time necessary to recoup

the initial investment from net cash flows. Decision Rule: Projects with a payback less than a

specified cutoff period are accepted, whereas those with a payback beyond this figure are rejected.

Strengths & Weakness: Weakness:

1). It ignores the time value of money 2). It ignores cash flows beyond the payback

period◦One variant: discounted payback period: the length of

time it takes for the present value of the cash inflows to equal the cost of the initial investment.

Payback Period

9

Non-discounted cash flow criteria:◦ Accounting Rate of Return: average rate of return or average

return on book value, is defined as the ratio of average after-tax profit to average book investment-the initial investment less accumulated depreciation; it is an average return on investment (ROI).

◦ Decision Rule: The firm must specify its target rate of return. Investments yielding a return greater than this standard are accepted, whereas those falling below it would be rejected.

◦ Strengths & Weakness: Weakness:

1). It ignores the time value of money 2). It is based on accounting income instead of cash flow

Accounting Rate of return

10

Internal Rate of Return (IRR) is the discount rate that sets the present value of the project cash flows equal to the initial investment outlay. The IRR is the discount rate that equates the project NPV to -0-.

The IRR of a project therefore determines the maximum interest rate at which you would be willing to borrow to finance the project.

Discounted Cash Flow (DCF) Criteria

11

Net Present value profile: The relationship between the NPV of a project and the discount rate used to calculate the NPV.

Decision Rule: If the IRR exceeds the cost of capital for the project, the firm should undertake the project; otherwise, the project should be rejected. The rationale for this rule is that any project yielding more than its cost of capital will have a positive net present value.

Internal Rate of Return (IRR)

12

Strengthens & Weakness:◦Weakness: Multiple rates of return. When an investment

has an initial cash outflow, a series of positive cash inflows, and then at least one additional cash outflow, there may be more than one IRR, that is, more than one discount rate will produce a -0- NPV.

Mutually exclusive projects: sometimes firms have to select one of several alternatives to do the same thing. NPV & IRR can favor conflicting projects.

Internal Rate of Return (IRR)

13

When the mutually exclusive projects are substantially different in:◦Timing of Cash Flows: Some projects cash inflows

in the early years, some in the later years. ◦Forced to choose between 2 mutually exclusive

investments, the NPV method will always provide the correct answer because it is more realistically represents the opportunity cost of funds for the firm’s shareholders.

◦Scale Differences: NPC takes account of the size differences in the initial investment, whereas IRR does not.

NPV & IRR can give conflicting signals

14

Profitability Index (PI): also called the benefit-cost ratio, of a project equals the present value of future cash flows divided by the initial investment. The project returns a present value of the PI calculated for every $1.00 of the initial investment.

Decision Rule: As long as the (PI) exceeds $1.00, the project should be accepted.

Mutually exclusive projects, there can be a conflict with (PI) over project rankings.

Discounted Cash Flow (DCF) Criteria

15

(See page 29 of text for all) IRR NPV Hurdle Rate, Discount rate, weighted average cost of

Capital or cost of capital Payback

Most companies use a combination of some techniques.

2.3 Surveys of Capital Budgeting Techniques Used in Practice

16

Examined several different evaluation procedures that managers use to analyze projects:

3 DCF Techniques◦Net Present Value◦ Internal Rate of Return◦ Profitability Index

2 non-discounted cash flow techniques◦ Payback Period◦ Accounting Rate of return

2.4 Summary and Conclusion