Capital Budgeting Techniques

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Capital Budgeting Techniques:

Capital Budgeting Techniques Project Evaluation and Selection Potential Difficulties Capital Rationing Project Monitoring Post-Completion Audit

Proposed Project Data:

Proposed Project Data X is evaluating a new project for her firm. She has determined that the after-tax cash flows for the project will be 10,000 ; 12,000 ; 15,000 ; 10,000 ; and 7,000 , respectively, for each of the Years 1 through 5 . The initial cash outlay will be 40,000 .

Payback Period (PBP):

Payback Period (PBP) PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K

Payback Solution :

(c) 10 K 22 K 37 K 47 K 54 K Payback Solution PBP = a + ( b - c ) / d = 3 + ( 40 - 37 ) / 10 = 3 + ( 3 ) / 10 = 3.3 Years 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K Cumulative Inflows (a) ( -b ) (d)

PBP Strengths and Weaknesses:

PBP Strengths and Weaknesses Strengths : Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows Weaknesses : Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective

Internal Rate of Return (IRR):

Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. CF 1 CF 2 CF n (1+ IRR ) 1 (1+ IRR ) 2 (1+ IRR ) n + . . . + + ICO =

IRR Solution:

15,000 10,000 7,000 IRR Solution 10,000 12,000 (1+ IRR ) 1 (1+ IRR ) 2 Find the interest rate ( IRR ) that causes the discounted cash flows to equal $40,000 . + + + + $40,000 = (1+ IRR ) 3 (1+ IRR ) 4 ( 1+ IRR ) 5

IRR Solution (Try 10%):

IRR Solution (Try 10%) 40,000 = 10,000(PVIF 10 % , 1 ) + 12,000(PVIF 10 % , 2 ) + 15,000(PVIF 10 % , 3 ) + 10,000(PVIF 10 % , 4 ) + 7,000(PVIF 10% , 5 ) 40,000 = 10,000 (.909) + 12,000 (.826) + 15,000 (.751) + 10,000 (.683) + 7,000(.621) 40,000 = 9,090 + 9,912 + 11,265 + 6,830 + 4,347 = 41,444 [ Rate is too low!! ]

IRR Solution (Try 15%):

IRR Solution (Try 15%) 40,000 = 10,000(PVIF 15 % , 1 ) + 12,000(PVIF 15 % , 2 ) + 15,000(PVIF 15 % , 3 ) + 10,000(PVIF 15 % , 4 ) + 7,000(PVIF 15 % , 5 ) 40,000 = 10,000 (.870) + 12,000 (.756) + 15,000 (.658) + 10,000 (.572) + 7,000(.497) 40,000 = 8,700 + 9,072 + 9,870 + 5,720 + 3,479 = 36,841 [ Rate is too high!! ]

IRR Solution (Interpolate):

.10 41,444 .05 IRR 40,000 $4,603 .15 $36,841 X $1,444 .05 $4,603 IRR Solution (Interpolate) $1,444 X =

IRR Solution (Interpolate):

.10 41,444 .05 IRR 40,000 4,603 .15 36,841 X $1,444 .05 $4,603 IRR Solution (Interpolate) 1,444 X =

IRR Solution (Interpolate):

.10 R41,444 .05 IRR R40,000 R4,603 .15 R36,841 (R1,444 )(0.05) R4,603 IRR Solution (Interpolate) R1,444 X X = X = .0157 IRR = .10 + .0157 = .1157 or 11.57%

IRR Acceptance Criterion:

IRR Acceptance Criterion No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13% . [ IRR < Hurdle Rate ] The management of has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted?

Net Present Value (NPV):

Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. CF 1 CF 2 CF n (1+ k ) 1 (1+ k ) 2 (1+ k ) n + . . . + + - ICO NPV =

NPV Solution:

Basket Wonders has determined that the appropriate discount rate (k) for this project is 13% . R10,000 R7,000 NPV Solution R10,000 R 12,000 R15,000 (1 .13 ) 1 (1 .13 ) 2 (1 .13 ) 3 + + + - $40,000 (1 .13 ) 4 (1 .13 ) 5 NPV = +

NPV Acceptance Criterion:

NPV Acceptance Criterion No! The NPV is negative . This means that the project is reducing shareholder wealth. [ Reject as NPV < 0 ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted?

NPV Strengths and Weaknesses:

NPV Strengths and Weaknesses Strengths : Cash flows assumed to be reinvested at the hurdle rate. Accounts for TVM. Considers all cash flows. Weaknesses : May not include managerial options embedded in the project. See Chapter 14.

Net Present Value Profile:

Net Present Value Profile Discount Rate (%) 0 3 6 9 12 15 IRR NPV@13% Sum of CF’s Plot NPV for each discount rate. Three of these points are easy now! Net Present Value $000s 15 10 5 0 -4

Profitability Index (PI):

Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. CF 1 CF 2 CF n (1+ k ) 1 (1+ k ) 2 (1+ k ) n + . . . + + ICO PI = PI = 1 + [ NPV / ICO ] << OR >> Method #2: Method #1:

PI Acceptance Criterion:

PI Acceptance Criterion No! The PI is less than 1.00 . This means that the project is not profitable. [ Reject as PI < 1.00 ] PI = 38,572 / 40,000 = . 9643 Should this project be accepted?

PI Strengths and Weaknesses:

PI Strengths and Weaknesses Strengths : Same as NPV Allows comparison of different scale projects Weaknesses : Same as NPV Provides only relative profitability Potential Ranking Problems

Evaluation Summary:

Evaluation Summary

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