Captial Budgeting : Technique for evaluation-->Whhat long-term…
Captial Budgeting : Technique for evaluation-->Whhat long-term investments should the firm take on
Alternative Decision Methods
Internal Rate OF Return (IRR)
About the Crossover Point:
The discount rate at which the NPV for the 2 projects are equal
(it can be thought of as the rate of indifference)
It is also the IRR of the incremental cash flows.
Reinvestment Rate Assumptions:
1) NPV assumes reinvestment at k
IRR assumes reinvestment at IRR
Reinvestment at opportunity cost, k, is more realistic ==NPV method is best
NPV should always be used to choose betwenn mutually exculsive projects( cash is king)
2 Reasons NPV profiles Cross
1) Size (scale) differences: smaller project frees up funds at T=0 for investment
(the higher the opportunity cost, the more valuable these funds, so high K favours small projects.)
2) Timing differences
Project with faster payback provides more CF in early years for reinvestment
(If k is high, early CFs are especially good, NPVs > NPV L)
To find the crossover Rate:
1) Find cash flow differences between the projects (the incremental cash flows -
the change in cash flows )
2) Incremental CF's L-S and calculate the IRR of incremental cash flow
3) Subtract S from L or vice versa, but better to have first CF negative
4) IF profiles don's cross, one project fominates the other.
Conflict between IRR & NPV
1) when k > crossover rate==IRR & NPV leads to the same decision
2) when k < crossover ==Conflict between NPV & IRR
Among projects with equal lives, NPV is always preferred as it measures additional wealth obtained (which should we use?)
Decisions on Projects S and L using the IRR method:
IF S AND Lare independent projects:
accept both becsuse IRRs>K
IF S AND L are mutually exclusive projects :
accept S ---IRRs > IRR l
there are some potential errors with the use of IRR in deciding between mutually exclusive projects.
IF IRR>0=accept project
IF IRR<k= reject project
( The project's IRR > its cost ---some return id left over to boost stockholders' returns
e.g.:IF k=10% and IRR= 15%, the project is profitable
IRR: Enter NPV=0, Solve for IRR
1) IRR = the discount rate that forces PV inflows= cost
This is the same as forcing the NPV=0
2) IRR is popular==> provides a single number that summarizes the merit of a project.
Profitablity Index (PI)
1) Capital rationing = a limit set on funds availabel for investment
2) soft rationaing limits imposed by top mangerment.
3) Hard rationing- the firms is unbale to raise the money it requires to undertake all profitable projects.
Under 'Hard' rtioning the firm my be forced to pass up positive NPV projects, whereas 'soft' rtionaing should never cost the firm anything as top management can relax captial control at any time.
Is its relative indications
2 projects having vast differernt investment & dollar returen can have same PI
THEREFORE, NPV is the best method.
1) It considers time value of money
2) It presents a relative profitablity of a project.
Relative proftablity allows comparison of 2 irrepective of their amount of investment
A higher PI would indicate a better IRR
A lower PI would have lower IRR.
The PI measures the ratio between CFs to Investment
--> The higher PI=the r more CFs to investment.
Accept a project
IF the PI >0, stay indifferent IF the PT = 0
DON'T accept a project IF the PI is <0
Project Selection with Resource Constraints
The projectablity index is a relatve measure of value
The OT is an investment return measurement much like NPV with the one notable difference.
==> NPV finds the "dollar amount differentce" between the sum of the present values of all future cash flos and the amount of initial investment whereas profitability index finds " the ratios"
Profitabil ity Index = Value Created/ Resource Consumed = NPV / Initial Investment
Net Present Value (NPV)
1) Relies on accurate estimate of CFs & the discount rate
2) Projects likely to be replicated with maturity of differing lengths
1) Uses cash flows (not earnings)
2) Uses ALL cash flows of a project
3) Discounts cahs flows properly
1) NPV= PV( Benefits or Inflows)-PV( Costs)=Net gain in wealth;
2) choose between mutually exclusive projects on the basis of higher NPV
3) The project with the highest NPV +greatest value
-IF projects S & L are mutually exclusive: Accept S NPV s> NPV l
-IF S&L are independent : Accept both as NPV > 0 for both project.
Discounted Rule: Accept a project if NPV >0
NPV: Sum of the PVs of inflows and outflows -cost CF0 = often negative
1) The required rate of return (r)=the minimum return that a project must earn in order to be acceptable
2) The cost of capital (k)= the minimum required rate of return for capital budgeting purposes
3)The cost of capital (k) is the cost of investment funds= a weighted average of the cost of funds from all sources
Discounted pay back
1) Ignores the time of the value of money
2) Ignores CFs occurring after the payback period
1) Provides an indication of a project's risk and liquidity
2) Easy to calculated and understand
An investment is acceptable if its calculated pay back < a pre-specified cut off rate.
2) How long it takes to get our money back.
1) The number of years required to recover a project's cost
Types of project Cash flows
Non-conventional CF project (NC)
2 or more changes of signs==most common is an outlay ==> followed by posiitvw CFs ==a terminal cost in order to complete th eproject (e.g. rapair damged site)
Conventional CF project (C)
A negative CF (initial cost outlay)==a series of positive CF==> one change of singes (-vet to + vet)
Types of Investment Decisions
Mutually exclusive projects
IF accept ==> preculde the acceptance of competing projects
IF accpet / reject==> not affect the cash flows of another project.
Def. of capital bugeting
Assessing the riskness of CFs
Determinig an appropriate discount rate
Acceptance of the project if NPV> 0 and /or IRR > r (WACC)
Finding NPV and/ or IRR
Estimating CFs (inflows & outflows)