CB techniques.pptx

8/10/2019 CB techniques.pptx

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Capital Budgeting TechniquesThis is only a summary. Please read the text for details. Removalof errors and omissions, if any, in this ppt is your responsibility.


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Agenda

NPV Rule & and Stand-Alone Projects

IRR

MIRR

Payback Rule

Book rate of Return

Profitability Index

Numerical


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Techniques Used

Profitability

Index, 12%

Payback, 57%

IRR, 76%

NPV, 75%

Book rate of

return, 20%

0% 20% 40% 60% 80% 100%

Survey Data on CFO Use of Investment Evaluation Techniques

Source - Graham and Harvey, The Theory and Practice of Finance: Evidence from the

Field, Journal of Financial Economics 61 (2001), pp. 187-243.


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Techniques Used

Two approaches:Discounting: takes time value of money into consideration

Non-discounting: simple and still of value


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NPV Rule

Why use NPV rule to evaluate projects

Accepting positive NPV projects increases valueof the firm

NPV uses cash flows (CF)

NPV uses not just CF but allthe CFs of theproject

NPV discounts the cash flows appropriately(opportunity cost of capital)


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NPV Rule

Net Present Value (NPV) =

Total PV of future CFs + Initial Investment

Estimating NPV

Estimate future cash flows - how much? and when?

Estimate rate

Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV


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NPV Rule

Consider the following two options:

1. Invest the $100 in a riskless project and pay out $107,1 year from now as dividends

2. Pay out the $100 today

The opportunity cost is 6%

Consider the options from the firms angle and theshareholders anglerefer to your text for greaterdetails


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NPV Rule & Stand-Alone Projects

Consider a take-it-or-leave-it investment decision

involving a single, stand-alone project for FFF Co

The project costs $250 million and is expected to

generate cash flows of $35 million per year, starting at

the end of the first year and lasting forever

What is the NPV of the project?


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NPV Rule & Stand-Alone Projects -

Sensitivity

At 10% cost of capital (opportunity cost, discountrate) the NPV is 100 million

At 14%, the NPV is equal to 0, thus the projectsIRR is 14%

For FFF, if their cost of capital is more than 14%,the NPV would be negative


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NPV Rule & Stand-Alone Projects

In general, the difference between the actual cost ofcapital (r) and the IRR is the maximum amount ofestimation error in the cost of capital estimate that can

exist without altering the original decision

(150.00)

(100.00)

(50.00)

-

50.00

100.00

150.00

200.00

250.00

300.00

350.00

400.00

6% 8.50% 11.00% 13.50% 16.00% 18.50% 21.00% 23.50%

14%


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NPV Rule

Why is NPV widely used

Uses cash flows (not accounting numbers)

Uses ALL cash flows of the project

Discounts ALL cash flows appropriately

Reinvestment assumption: the NPV rule assumes

that all cash flows can be reinvested at thediscount rate


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NPV Rule

Sometimes alternative investment rules may givethe same answer as the NPV rule, but at othertimes they may disagree.

When the rules conflict, the NPV decision rule shouldgenerally be followed.


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NPV Rule

Consider the following example

XYZ company has the following cash flows for aproject

Plot the NPV profile

What is the IRR

If the cost of capital is 12%, would you accept it

Year CF

0 (5,550,000)

1 5,000,0002 4,000,000

3 (3,000,000)


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Internal Rate of Return (IRR)

IRR is the discount that sets NPV to zero or It is the discount rate that will equate the present

value of the outflows with the present value of theinflows

The IRR is the projects intrinsic rate of return Minimum Acceptance Criteria

Accept if the IRR exceeds the required return

Ranking Criteria Select alternative with the highest IRR

Reinvestment assumption All future cash flows assumed reinvested at the IRR


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Disadvantages

Does not distinguish between investing and borrowing

IRR may not exist

There may be multiple IRR Mutually exclusive projects (scale and timing of CF)

Advantages

Easy to understand and communicate


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Situations where the IRR rule and NPV rule may bein conflict

Delayed Investments (Are we borrowing or lending)

Nonexistent IRR

Multiple IRRs Mutually exclusive projects (timing and scale)

Implicit in the IRR calculation is that that discountrates are stable during the term of the project -This implies that all funds are reinvested at theIRR (which may not be the case)


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You can purchase a turbo powered machine toolgadget for $6,500. The investment will generate$3,500 and $5,500 in cash flows for two years,respectively. What is the IRR on this investment?


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Delayed Investments Assume you have just retired as the CEO of a

successful company - A major publisher has offeredyou a book deal

The publisher will pay you $1.0 million upfront if youagree to write a book about your experiences

You estimate that it will take three years to write thebook

Assume that the time you spend writing will cause you

to give up speaking engagements amounting to$500,000 per year

You estimate your opportunity cost to be 10% Should you accept the deal?


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Nonexistent IRR

Assume now that you are offered $500,000 per year ifyou agree to go on a speaking tour for the next threeyears

If you lecture, you will not be able to write the book(however, as of now there is no book deal)

Compute the IRR and NPV


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Multiple IRRs Now assume the lecture deal is still in

discussion with a tentative offer and you decideto negotiate with the book publisher

You inform the publisher that they need toincrease the offer before you will accept it

The publisher then agrees to make royaltypayments of $20,000 per year forever, starting a

year after the book is published in three years Should you accept or reject the new offer?


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When do you have multiple IRRs?

Generally when the cash flows change directionyou have multiple IRRs


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Mutually exclusive projects

IRR sometimes ignores the magnitude and timingof the projects cash flows

The following two projects illustrate that problem

0 1 2 3

$10,000 $1,000 $1,000

-$10,000

Project A

0 1 2 3

$1,000 $1,000 $12,000

-$10,000

Project B

Assume costof capital is

8%


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In such a case the crossover rate is important and thediscount rate to be usedStepsCompute IRR (A)Compute IRR (B)

NPV (A)NPV (B)Compute the incremental CFensure the first one isnegative to the extent possible

Compute the crossover rate/IRR of the incremental CFCompute the NPV of the incremental project CF at the costof capitalChoose A or B


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Shortcomings of the Incremental IRR RuleThe incremental IRR may not exist

Multiple incremental IRRs could exist

You must ensure that the incremental cash flows are initiallynegative and then become positive

The incremental IRR rule assumes that the riskiness of the

two projects is the same


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Scale (example 5.2 pg 174-175)

Two options to a project: small budget or longbudget

CF (0) CF (1) NPV at 25% IRR

Small Budget -10m 40m 22m 300%

Large Budget -25m 65m 27m 160%

You want to go by the NPV rule and choose the large

budget project but your manager says convince mewhy is the IRR rule may not be appropriate given thatthat small budget project has a higher IRR. What doyou do, given that the discount rate is 25%?


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Scale

If a projects size is doubled, its NPV will double

This is not the case with IRR In such cases, the IRR rule cannot be used to

compare projects of different scales


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Friends

BusinessYour

LaundromatInitial Investment $1,000 $1,000

Cash FlowYear 1 $1,100 $400

Annual Growth Rate -10% -20%Cost of Capital 12% 12%



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What if the laundromatproject is 20 times largerassumeyou can scale it up easily but not the friends business

The NPV would be 20 times larger but the IRR

remains the same at 20%

Now what would be your decision?


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IRR using interpolation

Consider the following cash flows. The hurdle rateis 25%. Compute the IRR and based on the IRRwhat is your decision?

0 -27001 1100

2 1600

3 8504 1100

5 900


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Percentage Return Versus Impact on Value

Would you prefer a 200% return on $2 or a 10%return on $2 million?

The former investment makes only $4, while thelatter opportunity makes $200,000

The IRR is a measure of the average return, butNPV is a measure of the total dollar impact on value


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Modified Internal Rate of Return (MIRR)

Let PV = PV of the cash outflows(discounted appropriately)

Let TV = FV of all cash inflows(compounded appropriately)The compounding and discounting is at the cost ofcapital

Then MIRR is obtained by solving the followingequation

PV = TV/(1+MIRR)N

Advantagecash flows are reinvested at the cost ofcapitalThe issue with multiple rates would not exist


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ABC Ltd. is evaluating a project that has an initial

investment of 1200 and the following cash flow

stream

The cost of capital (opportunity cost) is 12.0% -

Should ABC Ltd. accept the project using the MIRR

rule

1 2 3 4 5

200 100 -300 500 700


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Consider the XYZ Co. example from before

Compute the MIRR

Does the decision change?


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Payback Rule

How long does it take the project to pay back itsinitial investment

Payback Period = number of years to recover

initial costs Minimum Acceptance Criteria:

set by management

Ranking Criteria:

set by management


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Payback Rule

Disadvantages Ignores the time value of money

Ignores cash flows after the payback period

Biased against long-term projects

Requires an arbitrary acceptance criteriaA project accepted based on the payback

criteria may not have a positive NPV

Advantages Easy to understand

Biased toward liquidity


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Payback Rule


Suppose that FFF company requires all projects tohave a payback period of 5 years or lesswouldthey undertake the project we discussed?


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Payback Rule

Consider the following problem Projects A, B, and C each have an expected

life of 5 years

Given the initial cost and annual cash flowinformation below, what is the payback periodfor each project?

A B CCost $75 $110 $150

Cash Flow $20 $25 $30


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Payback Rule


Infoline Online has the following cash flows for a periodof four years. What is the payback period

Year CF

0 (5,450,000)

1 1,508,000

2 1,773,1003 1,897,910

4 2,753,941


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Payback Rule

To incorporate the Time value of money there is amodification of the payback rule calledthediscounted payback rule.

How long does it take the project to pay back its

initial investment taking the time value of moneyinto account

By the time you have discounted the cash flows, you might as wellcalculate the NPV!


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Payback Rule

Use the Infoline example from before andassuming a discount rate of 12% compute thediscounted payback


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Profitability Index

If PI > 0 accept,


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Profitability Index

NET BCR (PI) =(PVB-I)/I=BCR-1

Decision Rules:

BCR NBCR(PI) Rule

>1 >0 Accept

=1 =0 Indifferent


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Profitability Index

When resources are limited, the profitability index(PI) provides a tool for selecting among variousproject combinations and alternatives

A set of limited resources and projects can yieldvarious combinations

The highest weighted average PI can indicate whichprojects to select


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Profitability Index


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Profitability Index

In some situations the profitability Index does not give anaccurate answer

Suppose in Example 6.4 that NetIt has an additional small

project with a NPV of only $100,000 that requires 3 engineerswhat happens


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Profitability Index


You only have RS.300,000 to invest, Which do weselect?

Proj NPV Invest PIA 276 200 1.38

B 151.25 125 1.21

C 213.5 175 1.22

D 211.5 150 1.41


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Profitability Index

Compute Weighted average PI, and choose the highest WAPI

Optionsonly A, BC, BD


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Book Rate of Return

Also known as Average Accounting Return Rule

Average net income (project earning) divided by averagebook value over project life (or average book value of theinvestment)

Another simple non-cash flow approach Ranking Criteria and Minimum Acceptance Criteria set by

management Disadvantages

Ignores the time value of money Uses an arbitrary benchmark cutoff rate Based on book values, not cash flowsand market

values Advantages

The accounting information is usually available Easy to calculate


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Book Rate of Return


A manufacturer is considering building a new production plant

in a new town. It will require an initial capital investment of

$12 million and the plant will be depreciated on a straight-

line basis over the next four years of its use. The new

project will generate incremental net income of $1,100,000,

$1,350,000, $1,200,000 and $2,100,000 over each of the

next four years for the company. What is the average

accounting return (AAR)for this project?


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Numerical 1

The firm for which you work must choose between the

following two mutually exclusive projects - The appropriatediscount rate for the projects is 10 percent

The firm chooses to undertake A. At a luncheon for theshareholders, the managers of a pension fund that owns asubstantial amount of the firms stock asked you why the firm

chose project A instead of project B when B is more profitable.How would you justify your firms action? Are there any

circumstances under which the pension fund managers

argument could be correct?

C0 C1 C2 PI NPV

Project A -1000 1000 500 0.32 322.31

Project B -500 500 400 0.57 285.12


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Numerical 2

Orchid Biotech Company is evaluating several development projects for

experimental drugs. Although the cash flows are difficult to forecast, thecompany has come up with the estimates of the initial capital requirementsand NPVs for the projects as shown below. Given a wide variety of staffingneeds, the company has also estimated the number of research scientistsrequirements for each development project (all cost values are given in

millions of dollar)

Project

Initial

Capital

#

Scientists NPV

I 10.00 2 10.10

II 15.00 3 19.00

III 15.00 4 22.00

!V 20.00 3 25.00

V 30.00 10 60.20

Suppose that orchid has a totalcapital budget of $60 million.How should it prioritize theseprojects?

Suppose that orchid currentlyhas 12 research scientists anddoes not anticipate to be ableto hire any more in the future.How should Orchid prioritizethese projects?


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Consider the following 2 mutually exclusive projects

Numerical 3

A B0 (300,000) (40,000)

1 20,000 19,000

2 50,000 12,000

3 50,000 18,000

4 390,000 10,500

Assuming that your opportunity cost is 15%, which projects would you choosea. Using the payback criterion? Why?b. Discounted payback criterion? Why?c. NPV criterion? Why?

d. Using the IRR criterion? Why?e. Using the Profitability criterion? Why?f. Based on your answers in (a)(e) above, which project will you finally

choose? Why?


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Numerical 5

Your firm is considering two mutually exclusiveprojects A and B. Project A involves an initial outlayof Rs.100m and will generate an expected cashinflow of Rs.25 m per year for 6 years. Project B

involves an initial outlay of Rs.50 m and willgenerate an expected cash inflow of Rs.13 m peryear for 6 years. Both projects have a similar riskand the firms cost of capital is 12%

a) Calculate the NPV and IRR of each projectb) Calculate the NPV and IRR of the incremental

(differential) project


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Summary

Discounted CF techniques NPV IRR MIRR

PIPayback Criteria Payback Discounted Payback

Accounting Criterion

AAR/Book Rate of Return


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