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The Basics of Capital Budgeting.13-14st
The Basics of Capital Budgeting.13-14st
Corporate Finance
Dr. A. DeMaskey build this plant?
Learning Objectives
Questions to be answered:
What is capital budgeting? How are investments classified? What methods are used to rank projects? What are the relevant cash flows of a project? What principles underlie the estimation of cash flows? What types of cash flows must be considered when evaluating a proposed project?
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Capital Budgeting
Long-term decisions
Sizable cash outlays Difficult to reverse
Project Classification
According to risk:
Replacement projects Expansion projects New products and markets Mandated projects
Steps
1. Estimate the CFs (inflows & outflows).
2. Assess the riskiness of the CFs. 3. Determine the appropriate discount rate, k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.
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a project. Considers the time value of money. Considers the uncertainty associated with future cash flows.
Payback Period
The length of time it takes to recover the initial
investment outlay.
Equal cash flows Unequal cash flows
Payoff or capital recovery period
Provides an indication of a projects risk and liquidity. Easy to calculate and understand.
Weaknesses
Ignores the TVM. Ignores CFs occurring after the payback period.
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projects investment in terms of discounted cash flows, where the discount rate is the cost of capital.
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Considers the time value of money. Considers the riskiness of the cash flows involved in the payback.
Weaknesses
Requires estimate of cost of capital. Ignores cash flows beyond the payback.
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cash flows, where the discount rate is the cost of capital. n CFt NPV . t t 0 1 k Cost often is CF0 and is negative. n CFt NPV CF0 . t t 1 1 k
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PV inflows Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
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Evaluation of NPV
Strengths
Tells whether firm value is increased. Considers all cash flows. Considers the time value of money. Considers the riskiness of future cash flows.
Weaknesses
discount rates.
Downward sloping Slightly curved Crossover discount rate
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operating cash flows to the present value of the investment cash outflow. n CFt t 1 k t 1 PI CF0 PI vs. NPV
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Evaluation of PI Method
Strengths
Tells whether firm value is increased. Considers all cash flows. Considers the time value of money. Considers the riskiness of future cash flows.
Weaknesses
Requires estimate of cost of capital. May not give correct decision for mutually exclusive projects.
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The discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.
NPV: Enter k, solve for NPV. n CFt NPV. t t 0 1 k IRR: Enter NPV = 0, solve for IRR.
CFt 0. t t 0 1 IRR
is greater than its cost -- some return is left over to boost stockholders returns. Example: WACC = 10%, IRR = 15%. Profitable. IRR acceptance criteria:
If IRR > k, accept project. If IRR < k, reject project.
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Causes:
Different timing in cash flows Scale differences
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Strengths
Tells whether firm value is increased. Considers all cash flows. Considers the time value of money. Considers the riskiness of future cash flows.
Weaknesses
Requires estimate of cost of capital. May not give value-maximizing decisions for mutually exclusive projects. May not give value-maximizing decisions under capital rationing. May produce multiple IRRs.
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projects terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. The internal rate of return on a project assuming that cash inflows are reinvested at some specified rate.
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opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR.
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Strengths
Tells whether firm value is increased. Considers all cash flows. Considers the time value of money. Considers the riskiness of future cash flows.
Weaknesses
May not give value-maximizing decisions for mutually exclusive projects. May not give value-maximizing decisions under capital rationing.
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Managers like rates -- prefer IRR to NPV comparisons. More than one evaluation technique is used.
NPV is used most often.
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Assumptions
End-of period cash flows
Project assets are purchased and put to work
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Initial Outlay
NCF0
1
OCF1
2
OCF2
3
OCF3
4
OCF4
+ Terminal CF
NCF1
NCF2
NCF3
NCF4
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Net Investment
Cost of Asset + Shipping Costs + Installation Costs PLUS Increase/decrease in Working Capital
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Method 2:
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Funds Realized from Sale of New Asset + Tax Consequences from the Sale of the Asset
PLUS Recovery of Net Working Capital
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inflation. If cash flow estimates are not adjusted for inflation (i.e., are in todays dollars), this will bias the NPV downward. This bias may offset the optimistic bias of management.
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funds repatriated may be subject to U.S. taxes. Foreign projects are subject to political risk. Funds repatriated must be converted to U.S. dollars, so exchange rate risk must be taken into account.
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