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Edit Comment Close Premium member Presentation Transcript Capital Budgeting: Capital Budgeting Arguing for your projectArguing for your project: Arguing for your project Capital budgeting CFO receives proposals from divisions Projects described by cash flowsArguing means applying measures: Arguing means applying measures Net present value is the right measure. Many smart people use the wrong ones. Alternative ways to the same end.Uses of measures: Uses of measures Project acceptance Mutually exclusive alternatives.Capital Budgeting Techniques: Capital Budgeting Techniques Kim, Crick, and Kim, Management Accounting Nov. 1986, p. 49-52Survey of use of measures by corporations: Survey of use of measures by corporationsMake no mistake: Make no mistake NPV is the right measure always. Others work sometimes. NPV measures value to owners, their wealth.Objectives of a good measure: Objectives of a good measure Value cash flows. Respond to the market.NPV’s merits: NPV’s merits Values cash flows as the market does. Responsive because the discount rate is the current market rate. Measures increase in shareholder value.Payback period is: Payback period is The time required for undiscounted cash flows to add up to the initial investment. e.g., build a Wendy’s if it “pays for itself” in two years or less.Payback merits: Payback merits Based on cash flowsPayback defects: Payback defects No market response. When r is high, payback period should be shorter. Subtracts time-t dollars from time-0 dollars, a cardinal sin. Ignores cash flow after payback. Ignores timing during payback.Defects are not necessarily fatal: Defects are not necessarily fatal Repeated, similar investments. Stable financial conditions.The well-informed capital budgeter knows: The well-informed capital budgeter knows When to accept payback period as a measure. When it is likely to fail. Accounting rate of return: Accounting rate of return Doesn’t value cash flows No market response Ignores market values Scaling problems: melons or mallsMerits of accounting r.o.r.: Merits of accounting r.o.r. Easily understood. Sometimes okay in stable markets. Smart application can overcome defects. Internal rate of return: Internal rate of return Definition: IRR is the discount rate that makes NPV = 0 That is, IRR is the r such thatInternal rate of return: Internal rate of return Definition: IRR is the discount rate that makes NPV(r) = 0. NPV(r) is a function. RWJ Figures 6.4 and 6.5.Project: ProjectFigure 6.4: NPV(r)=0 at r=23.37%: Figure 6.4: NPV(r)=0 at r=23.37% NPV r 100 NPV(.1) = 48.68520Figure 6.4: Figure 6.4 NPV (r) = 0 at r = 23.37% Applications of IRR measure: Applications of IRR measure Hurdle rate = market rate Project acceptance: Accept a project if IRR > hurdle rate. Mutually exclusive projects: Take the one with the highest IRR (> hurdle rate)????? Don’t rely on it.Project acceptance:: Project acceptance: NPV and IRR give the same conclusion when ... Cash flows have one sign change. In the example: IRR = 23.37% > hurdle = 10% for an investment project. IRR = 23.37% < hurdle rate = 30% for a financing or “borrowing from nature” project.Merits: Merits Uses cash flows. Responds to the market when the hurdle rate changesObjective: Objective Learn to recognize the times when NPV and IRR are the same. and also the problems with IRRDefects of IRR -- project acceptance: Defects of IRR -- project acceptance Lending to nature or borrowing from her? Multiple IRR's may occur.Financing (borrowing from nature): Financing (borrowing from nature) Seek IRR < hurdle rate Same as NPV > 0 Multiple IRR's: Multiple IRR'sIRR’s at r = 1 and r = 2: IRR’s at r = 1 and r = 2 100% per decade = 7.17735% per year. 200% per decade = 11.61232% per year. IRR’s at r=1 and r=2.: IRR’s at r=1 and r=2. NPV r 100% 200%Descartes’ Rule: Descartes’ Rule The number of internal rates of return is no more than the number of sign changes.Defects of IRR -- mutually exclusive projects: Defects of IRR -- mutually exclusive projects Ignores market values. Scale problems -- melons or malls. Typical hour exam question: Typical hour exam question What is the scale problem in using IRR to choose between mutually exclusive projects?Scale problem in IRR: Scale problem in IRR One canyon, one dam.Sketch of answer: Sketch of answer The smaller dam has the higher IRR. The big dam has higher value. The big dam extends consumption possibility of owners more than the little dam does. It is wrong to take the higher IRR in this case.Scale problems in IRR: Scale problems in IRRMore answer: More answer Consider the project of replacing the little dam by the big dam. Cash flows are -900, +1300. IRR of the project is 4/9 = .4444 > .1 NPV is 281.8181… So replace the little dam. Capital budgeting jiu jitsu. Slide38: r NPV 50% 100% 100 500 Big dam Little dam IRR IRRSlide39: Big dam, little dam NPV NPV of the big dam NPV of the small dam 500 100 .5 1 r r* For hurdle rates below r*, the big dam is preferred. r* = .4444... You do not have the permission to view this presentation. In order to view it, please contact the author of the presentation.
134a 04 05 Davide Download Post to : URL : Related Presentations : Share Add to Flag Embed Email Send to Blogs and Networks Add to Channel Uploaded from authorPOINTLite Insert YouTube videos in PowerPont slides with aS Desktop Copy embed code: (To copy code, click on the text box) Embed: URL: Thumbnail: WordPress Embed Customize Embed The presentation is successfully added In Your Favorites. Views: 332 Category: Education License: All Rights Reserved Like it (0) Dislike it (0) Added: January 31, 2008 This Presentation is Public Favorites: 0 Presentation Description No description available. Comments Posting comment... By: vinay5209 (36 month(s) ago) how will i download it? Saving..... Post Reply Close Saving..... Edit Comment Close By: gautam_sharad (39 month(s) ago) can i download this presentation for teaching purposes Saving..... Post Reply Close Saving..... Edit Comment Close Premium member Presentation Transcript Capital Budgeting: Capital Budgeting Arguing for your projectArguing for your project: Arguing for your project Capital budgeting CFO receives proposals from divisions Projects described by cash flowsArguing means applying measures: Arguing means applying measures Net present value is the right measure. Many smart people use the wrong ones. Alternative ways to the same end.Uses of measures: Uses of measures Project acceptance Mutually exclusive alternatives.Capital Budgeting Techniques: Capital Budgeting Techniques Kim, Crick, and Kim, Management Accounting Nov. 1986, p. 49-52Survey of use of measures by corporations: Survey of use of measures by corporationsMake no mistake: Make no mistake NPV is the right measure always. Others work sometimes. NPV measures value to owners, their wealth.Objectives of a good measure: Objectives of a good measure Value cash flows. Respond to the market.NPV’s merits: NPV’s merits Values cash flows as the market does. Responsive because the discount rate is the current market rate. Measures increase in shareholder value.Payback period is: Payback period is The time required for undiscounted cash flows to add up to the initial investment. e.g., build a Wendy’s if it “pays for itself” in two years or less.Payback merits: Payback merits Based on cash flowsPayback defects: Payback defects No market response. When r is high, payback period should be shorter. Subtracts time-t dollars from time-0 dollars, a cardinal sin. Ignores cash flow after payback. Ignores timing during payback.Defects are not necessarily fatal: Defects are not necessarily fatal Repeated, similar investments. Stable financial conditions.The well-informed capital budgeter knows: The well-informed capital budgeter knows When to accept payback period as a measure. When it is likely to fail. Accounting rate of return: Accounting rate of return Doesn’t value cash flows No market response Ignores market values Scaling problems: melons or mallsMerits of accounting r.o.r.: Merits of accounting r.o.r. Easily understood. Sometimes okay in stable markets. Smart application can overcome defects. Internal rate of return: Internal rate of return Definition: IRR is the discount rate that makes NPV = 0 That is, IRR is the r such thatInternal rate of return: Internal rate of return Definition: IRR is the discount rate that makes NPV(r) = 0. NPV(r) is a function. RWJ Figures 6.4 and 6.5.Project: ProjectFigure 6.4: NPV(r)=0 at r=23.37%: Figure 6.4: NPV(r)=0 at r=23.37% NPV r 100 NPV(.1) = 48.68520Figure 6.4: Figure 6.4 NPV (r) = 0 at r = 23.37% Applications of IRR measure: Applications of IRR measure Hurdle rate = market rate Project acceptance: Accept a project if IRR > hurdle rate. Mutually exclusive projects: Take the one with the highest IRR (> hurdle rate)????? Don’t rely on it.Project acceptance:: Project acceptance: NPV and IRR give the same conclusion when ... Cash flows have one sign change. In the example: IRR = 23.37% > hurdle = 10% for an investment project. IRR = 23.37% < hurdle rate = 30% for a financing or “borrowing from nature” project.Merits: Merits Uses cash flows. Responds to the market when the hurdle rate changesObjective: Objective Learn to recognize the times when NPV and IRR are the same. and also the problems with IRRDefects of IRR -- project acceptance: Defects of IRR -- project acceptance Lending to nature or borrowing from her? Multiple IRR's may occur.Financing (borrowing from nature): Financing (borrowing from nature) Seek IRR < hurdle rate Same as NPV > 0 Multiple IRR's: Multiple IRR'sIRR’s at r = 1 and r = 2: IRR’s at r = 1 and r = 2 100% per decade = 7.17735% per year. 200% per decade = 11.61232% per year. IRR’s at r=1 and r=2.: IRR’s at r=1 and r=2. NPV r 100% 200%Descartes’ Rule: Descartes’ Rule The number of internal rates of return is no more than the number of sign changes.Defects of IRR -- mutually exclusive projects: Defects of IRR -- mutually exclusive projects Ignores market values. Scale problems -- melons or malls. Typical hour exam question: Typical hour exam question What is the scale problem in using IRR to choose between mutually exclusive projects?Scale problem in IRR: Scale problem in IRR One canyon, one dam.Sketch of answer: Sketch of answer The smaller dam has the higher IRR. The big dam has higher value. The big dam extends consumption possibility of owners more than the little dam does. It is wrong to take the higher IRR in this case.Scale problems in IRR: Scale problems in IRRMore answer: More answer Consider the project of replacing the little dam by the big dam. Cash flows are -900, +1300. IRR of the project is 4/9 = .4444 > .1 NPV is 281.8181… So replace the little dam. Capital budgeting jiu jitsu. Slide38: r NPV 50% 100% 100 500 Big dam Little dam IRR IRRSlide39: Big dam, little dam NPV NPV of the big dam NPV of the small dam 500 100 .5 1 r r* For hurdle rates below r*, the big dam is preferred. r* = .4444...