ENTREP 4

Capital Budgeting Techniques

Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 10.1 and depicted on the time lines in Figure 10.1.

2012 Pearson Education

10-2

Table 10.1 Capital Expenditure Data for Bennett Company

2012 Pearson Education

10-3

Payback Period
The payback method is the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows. Decision criteria:
The length of the maximum acceptable payback period is determined by management. If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project.
2012 Pearson Education 10-4

Net Present Value (NPV)

Net present value (NPV) is a sophisticated capital budgeting technique; found by subtracting a projects initial investment from the present value of its cash inflows discounted at a rate equal to the firms cost of capital. NPV = Present value of cash inflows Initial investment

2012 Pearson Education

10-5

Net Present Value (NPV) (cont.)

Decision criteria:
If the NPV is greater than $0, accept the project. If the NPV is less than $0, reject the project.

If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV.
2012 Pearson Education 10-6

Net Present Value (NPV): NPV and the Profitability Index

For a project that has an initial cash outflow followed by cash inflows, the profitability index (PI) is simply equal to the present value of cash inflows divided by the initial cash outflow:

When companies evaluate investment opportunities using the PI, the decision rule they follow is to invest in the project when the index is greater than 1.0.
2012 Pearson Education 10-7

Net Present Value (NPV): NPV and Value Economic Economic Value Added (or EVA), Added a registered
trademark of the consulting firm, Stern Stewart & Co., is another close cousin of the NPV method. The EVA method begins the same way that NPV doesby calculating a projects net cash flows. However, the EVA approach subtracts from those cash flows a charge that is designed to capture the return that the firms investors demand on the project. EVA determines whether a project earns a pure economic profita profit above and beyond the normal competitive rate of return in a line of business.
2012 Pearson Education 10-8

Net Present Value (NPV): NPV and Economic Value Added

Suppose a certain project costs $1,000,000 up front, but after that it will generate net cash inflows each year (in perpetuity) of $120,000. If the firms cost of capital is 10%, then the projects NPV and EVA are: NPV = $1,000,000 + ($120,000 0.10) = $200,000 EVA = $120,000 $100,000 = $20,000

2012 Pearson Education

10-9

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a sophisticated capital budgeting technique; the discount rate that equates the NPV of an investment opportunity with $0 (because the present value of cash inflows equals the initial investment); it is the rate of return that the firm will earn if it invests in the project and receives the given cash inflows.

2012 Pearson Education

10-10

Internal Rate of Return (IRR)

Decision criteria:
If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project.

These criteria guarantee that the firm will earn at least its required return. Such an outcome should increase the market value of the firm and, therefore, the wealth of its owners.
2012 Pearson Education 10-11

E10-1 Fields uses a maximum payback period of 6 years. It must choose between two mutually exclusive projects. Project Hydrogen requires an initial outlay of $25,000. Project Helium requires $35,000. Compute payback Cash inflows (in 000) Year Hydrogen Helium 0 -25 -35 1 6 7 2 6 7 3 8 8 4 4 5 5 3.5 5 6 2 4 Payback period, in years 4.29 5.75

Year 0 1 2 3 4 5 6

Cash inflows (in 000) Heliu Hydrogen m -25 -35 6 7 6 7 8 8 4 5 3.5 5 2 4

E10-2 Initial investment is $1.25 million The machine will have a 5-year life with no salvage value. Discount rate is 6%. Compute NPV Year Cash inflow (in 000) 1 400 2 375 Year 3 300 0 4 350 5 200 1

Cash flow (in 000) -1250

400
375 300 350 200 $139.68 10.42%

2 3 4 5 NPV IRR

E10-3 Between two mutually exclusive investments. Cost of capital is 8%. Cash flow (in 000) Year Project Kelvin Project Thompson 0 (45,000) (275,000) 1 20,000 60,000 2 20,000 60,000 3 20,000 60,000 E10-3 4 60,000 5 60,000 Between two mutually exclusive investments. Cost of capital is 8%. 6 60,000 NPV $6,541.94 $2,372.78 Cash flow (in 000) ANPV $2,538.49 $513.27 Year Project Kelvin Project Thompson IRR 15.89% 8.28%

0 1 2 3 4 5

(45,000) 20,000 20,000 20,000 -

(275,000) 60,000 60,000 60,000 60,000 60,000

6
NPV

$6,541.94

60,000
$2,372.78

IRR

15.89%

8.28%

E10-4 Year 0 1 2 3 4 5 IRR

Cash flow (in 000) Project T Shirt Project Board Shorts (15,000) (25,000) 8,000 12,000 8,000 12,000 8,000 12,000 8,000 12,000 12,000 39.08% 38.62%

E10-4

Year 0 1 2 3 4

Cash flow (in 000) Project T Shirt (15,000) 8,000 8,000 8,000 8,000 Project Board Shorts (25,000) 12,000 12,000 12,000 12,000

5
IRR

39.08%

12,000
38.62%

P10-6

The viability of investing in a new fragrance-mixing machine is being evaluated. Year I = 10% I = 12% I = 14% 0 (24,000) (24,000) (24,000) 1 5,000 5,000 5,000 P10-6 2 5,000 5,000 5,000 3 5,000 5,000 5,000 Year 4 5,000 5,000 5,000 0 5 5,000 5,000 5,000 1 6 5,000 5,000 5,000 2 7 5,000 5,000 5,000 3 8 5,000 5,000 5,000 4 NPV $2,674.63 $838.20 ($805.68)
5 6 7 8

The viability of investing in a new fragrance-mixing machine is being evaluated. I = 10% (24,000) 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 I = 12% (24,000) 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 I = 14% (24,000) 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000

NPV

$2,674.63

$838.20

($805.68)

P10-7 Using a 14% cost of capital, calculate the NPV for each of the independent projects below, and show whehter each is acceptable. (in $000) Year Project A Project B Project C Project D Project E 0 (26) (500) (170) (950) (80) 1 4 100 20 230 2 4 120 19 230 3 4 140 18 230 4 4 160 17 230 20 5 4 180 16 230 30 6 4 200 15 230 7 4 14 230 50 8 4 13 230 60 9 4 12 70 10 4 11 NPV ($5.14) $53.89 ($83.67) $116.94 $9.96 reject accept reject accept accept

P10-7 Using a 14% cost of capital, calculate the NPV for each of the independent projects below, and show whehter each is acceptable. (in $000) Year 0 1 2 3 4 Project A Project B Project C Project D Project E (26) 4 4 4 4 (500) 100 120 140 160 (170) 20 19 18 17 (950) 230 230 230 230 (80) 20

5
6 7 8 9 10 NPV

4
4 4 4 4 4 ($5.14) reject

180
200 -

16
15 14 13 12 11

230
230 230 230 $116.94 accept

30
50 60 70 $9.96 accept

$53.89 ($83.67) accept reject

P10-9 A firm can purchase a fixed asset for a $13,000 initial investment. Cost of capital is 10% Year Cash inflow 0 (13,000) 1 4,000 2 4,000 3 4,000 4 4,000 NPV ($320.54)

P10-9 A firm can purchase a fixed asset for a $13,000 initial investment.

Cost of capital is 10%

Year 0 1 2 3 4 NPV

Cash inflow (13,000) 4,000 4,000 4,000 4,000 ($320.54)

P10-9 Determine the maximum required rate of return the the firm can have and still accept the asset. In other words, solve for IRR. Year Cash inflow 0 (13,000) 1 4,000 2 4,000 3 4,000 4 4,000 IRR 8.86% 8.86% is the maximum required rate of return for this project to be acceptable.

P10-9 Determine the maximum required

rate of return the the firm can have and still accept the asset. In other words, solve for IRR.

Year 0 1 2 3 4 IRR

Cash inflow (13,000) 4,000 4,000 4,000 4,000 8.86%

8.86% is the maximum required rate of return for this project to be acceptable.

C D P10-8 Simes Innovations can choose to pay its inventor a one-time payment of $1.5 milion today or $385,000 per year for the next five years. Cost of capital is 9% pa Year 9 10 11 12 13 1 2 3 4 5 Payment 385,000 385,000 385,000 385,000 385,000 $1,497,515.74 =NPV(0.09,D9:D13) 353,211 324,047 297,291 272,744 250,224 1,497,515.74 PV

Year Payment 1 385,000 2 385,000

385,000

385,000

385,000

P10-10 Cost of capital Year Cash outflow at year 0 1 2 3 4 5 6 7 8 NPV PV of cash inflows Cash outflow Profitability Index

Mutually exclusive projects 15% 15% 15% A B C -85 -60 -130 18 12 50 18 14 30 18 16 20 18 18 20 18 20 20 18 25 30 18 40 18 50 ($4.23) 80.77 85 0.95 $2.58 62.58 60 1.04 $15.04 145.04 130 1.12

P10-10

Mutually exclusive projects 15% A -85 18 18 18 18 18 18 18 18 15% B -60 12 14 16 18 20 25 15% C -130 50 30 20 20 20 30 40 50

Cost of capital Year

Cash outflow at year 0 1 2 3 4 5 6 7 8

NPV

($4.23)

$2.58

$15.04

PV of cash inflows Cash outflow Profitability Index

80.77 85 0.95

62.58 60 1.04

145.04 130 1.12

P10-26 Conflicting rankings Cost of capital is 20%. In $000. 20% 20% Year Plant expansion PV EXPANSION Product introduction PV PROD INTRO 0 (3,500) (500) 1 1,500 1,250 250 208 2 2,000 1,389 350 243 3 2,500 1,447 375 217 4 2,750 1,326 425 205 NPV 1,911.84 373.36 IRR 44% 52% PV $5,412 5,412 873 873 CF AT TIME 0 3,500 500 Profitability index 1.55 1.75

P10-26 Conflicting rankings Cost of capital is 20%. In $000.

20%

20%

PV PV PROD Year Plant expansion EXPANSION Product introduction INTRO 0 (3,500) (500) 1 1,500 1,250 250 2 2,000 1,389 350 3 2,500 1,447 375 4 2,750 1,326 425 NPV 1,911.84 373.36 IRR 44% 52% PV $5,412 5,412 873 CF AT TIME 0 3,500 Profitability index 1.55

208 243 217 205

873 500 1.75

Thank you