khalid aziz capital budgeting. 2 join khalid aziz economics of icmap, icap, ma-economics, b.com....
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KHALID AZIZ
Capital Budgeting
2
JOIN KHALID AZIZ
• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
• FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
• COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
• CONTACT:
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• 0312-2302870
• 0300-2540827
• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
3
The capital budgeting process involves three basic steps:
• Generating long-term investment proposals;
• Reviewing, analyzing, and selecting from the proposals that have been granted, and
• Implementing and monitoring the proposals that have been selected.
Managers should separate investment and financing decisions.
The Capital Budgeting Decision Process
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Payback period: most commonly used
Accounting rate of return (ARR): focuses on project’s impact on accounting profits
Net present value (NPV): best technique theoretically; difficult to calculate realistically
Internal rate of return (IRR): widely used with strong intuitive appeal
Profitability index (PI): related to NPV
Capital Budgeting Decision Techniques
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Account for the time value of money;
Account for risk;
Focus on cash flow;
Rank competing projects appropriately, and
Lead to investment decisions that maximize shareholders’ wealth.
A Capital Budgeting Process Should:
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Example: Global Wireless
• Global Wireless is a worldwide provider of wireless telephony devices.
• Global Wireless is contemplating a major expansion of its wireless network in two different regions:– Western Europe expansion– A smaller investment in Southeast U.S. to
establish a toehold
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Global Wireless
Initial Outlay
-$250
Year 1 inflow
$35
Year 2 inflow
$80
Year 3 inflow
$130
Year 4 inflow
$160
Year 5 inflow
$175Initial Outlay
-$50
Year 1 inflow
$18
Year 2 inflow
$22
Year 3 inflow
$25
Year 4 inflow
$30
Year 5 inflow
$32
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Can be computed from available accounting data
ARR uses accounting numbers, not cash flows; no time value of money.
vestmentAverage in
r taxesofits afteAverage prARR
Average profits after taxes
Average annual operating cash inflows
Average annual depreciation
= –
• Need only profits after taxes and depreciation.
• Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows.
Accounting Rate Of Return (ARR)
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The payback period is the amount of time required for the firm to recover its initial investment.
• If the project’s payback period is less than the maximum acceptable payback period, accept the project.
• If the project’s payback period is greater than the maximum acceptable payback period, reject the project.
Management determines maximum acceptable payback period.
Payback Period
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• Management’s cutoff is 2.75 years.
• Western Europe project: initial outflow of -$250M– But cash inflows over first 3 years is only $245 million.– Global Wireless will reject the project (3>2.75).
• Southeast U.S. project: initial outflow of -$50M– Cash inflows over first 2 years cumulate to $40 million.– Project recovers initial outflow after 2.40 years.
• Total inflow in year 3 is $25 million. So, the project generates $10 million in year 3 in 0.40 years ($10 million $25 million).
– Global Wireless will accept the project (2.4<2.75).
Payback Analysis For Global Wireless
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Advantages of payback method:
• Computational simplicity• Easy to understand
• Focus on cash flow
Disadvantages of payback method:
• Does not account properly for time value of money
• Does not account properly for risk• Cutoff period is arbitrary
• Does not lead to value-maximizing decisions
Pros and Cons of the Payback Method
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• Discounted payback accounts for time value.• Apply discount rate to cash flows during payback period.• Still ignores cash flows after payback period.
• Global Wireless uses an 18% discount rate.
Discounted Payback
Reject (46.3<50)Reject (166.2 < 250)
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NPV: The sum of the present values of a project’s cash inflows and outflows.
Discounting cash flows accounts for the time value of money.
Choosing the appropriate discount rate accounts for risk.
NN
r
CF
r
CF
r
CF
r
CFCFNPV
)(...
)()()(
1111 33
221
0
Accept projects if NPV > 0.
Net Present Value (NPV)
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NN
r
CF
r
CF
r
CF
r
CFCFNPV
)(...
)()()(
1111 33
221
0
A key input in NPV analysis is the discount rate.
r represents the minimum return that the project must earn to satisfy investors.
r varies with the risk of the firm and /or the risk of the project.
Net Present Value (NPV)
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• Assuming Global Wireless uses 18% discount rate, NPVs are:
5432 )18.1(
175
)18.1(
160
)18.1(
130
)18.1(
80
)18.1(
352503.75$ EuropeWesternNPV
Western Europe project: NPV = $75.3 million
5432.. )18.1(
32
)18.1(
30
)18.1(
25
)18.1(
22
)18.1(
18507.25$ SUSoutheastNPV
Southeast U.S. project: NPV = $25.7 million
Should Global Wireless invest in one project or both?
NPV Analysis for Global Wireless
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The NPV Rule and Shareholder Wealth
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Key benefits of using NPV as decision rule:
• Focuses on cash flows, not accounting earnings• Makes appropriate adjustment for time value of
money• Can properly account for risk differences between
projects
Though best measure, NPV has some drawbacks:
• Lacks the intuitive appeal of payback, and• Doesn’t capture managerial flexibility (option
value) well.
NPV is the “gold standard” of investment decision rules.
Pros and Cons of NPV
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NN
r
CF
r
CF
r
CF
r
CFCFNPV
)(....
)()()(
11110
33
221
0
IRR: the discount rate that results in a zero NPV for a project.
The IRR decision rule for an investing project is:
• If IRR is greater than the cost of capital, accept the project.
• If IRR is less than the cost of capital, reject the project.
Internal Rate of Return (IRR)
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NPV Profile and Shareholder Wealth
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Western Europe project: IRR (rWE) = 27.8%
5432 )1(
175
)1(
160
)1(
130
)1(
80
)1(
352500
WEWEWEWEWE rrrrr
Southeast U.S. project: IRR (rSE) = 36.7%
5432 )1(
32
)1(
30
)1(
25
)1(
22
)1(
18500
SESESESESE rrrrr
Global Wireless will accept all projects with at least 18% IRR.
IRR Analysis for Global Wireless
21
JOIN KHALID AZIZ
• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
• FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
• COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
• CONTACT:
• 0322-3385752
• 0312-2302870
• 0300-2540827
• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
22
Advantages of IRR:
• Properly adjusts for time value of money
• Uses cash flows rather than earnings
• Accounts for all cash flows
• Project IRR is a number with intuitive appeal
Disadvantages of IRR:
• “ Mathematical problems”: multiple IRRs, no real solutions
• Scale problem
• Timing problem
Pros and Cons of IRR
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Which IRR do we use?
IRR
IRR
When project cash flows have multiple sign changes, there can be multiple IRRs.
Multiple IRRs
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Sometimes projects do not have a real IRR solution.
Modify Global Wireless’s Western Europe project to include a large negative outflow (-
$355 million) in year 6.
•There is no real number that will make NPV=0, so no real IRR.
Project is a bad idea based on NPV. At r =18%, project has negative NPV, so reject!
No Real Solution
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NPV and IRR do not always agree when ranking competing projects.
$25.7 mn36.7%Southeast U.S.
$75.3 mn27.8%Western Europe
NPV (18%)IRRProject
• The Southeast U.S. project has a higher IRR, but doesn’t increase shareholders’ wealth as much as the Western Europe project.
The scale problem:
Conflicts Between NPV and IRR:The Scale Problem
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Conflicts Between NPV and IRR:The Scale Problem
Why the conflict?
• The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project.
• Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive.
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Conflicts Between NPV and IRR:The Timing Problem
• The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR.
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Conflicts Between NPV and IRR:The Timing Problem
Because of the differences in the timing of the two projects’ cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign.
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Decision rule: Accept project with PI > 1.0, equal to NPV > 0
0
221
)1(...
)1()1(CF
r
CF
r
CF
r
CF
PIN
N
• Both PI > 1.0, so both acceptable if independent.
1.5$50 million$75.7 millionSoutheast U.S.
1.3$250 million$325.3 millionWestern Europe
PIInitial OutlayPV of CF (yrs1-5)Project
Calculated by dividing the PV of a project’s cash inflows by the PV of its initial cash
outflows.
Like IRR, PI suffers from the scale problem.
Profitability Index
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Methods to generate, review, analyze, select, and implement long-term investment proposals:
• Accounting rate of return
• Payback Period
• Discounted payback period
• Net Present Value (NPV)
• Internal rate of return (IRR)
• Profitability index (PI)
Capital Budgeting
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JOIN KHALID AZIZ
• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
• FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
• COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
• CONTACT:
• 0322-3385752
• 0312-2302870
• 0300-2540827
• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.