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Capital Budgeting Processes and Techniques: Professor XXXXX Course Name / #

The document discusses various capital budgeting techniques used to evaluate potential investment projects including payback period, accounting rate of return, net present value, internal rate of return, and profitability index. It explains the advantages and disadvantages of each method and how to reconcile conflicts that can arise when different techniques provide different rankings of projects.

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Shak
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© © All Rights Reserved
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Download as PPT, PDF, TXT or read online on Scribd
44 views

Capital Budgeting Processes and Techniques: Professor XXXXX Course Name / #

The document discusses various capital budgeting techniques used to evaluate potential investment projects including payback period, accounting rate of return, net present value, internal rate of return, and profitability index. It explains the advantages and disadvantages of each method and how to reconcile conflicts that can arise when different techniques provide different rankings of projects.

Uploaded by

Shak
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 24

Chapter 7

Capital Budgeting
Processes And Techniques

Professor XXXXX
Course Name / #

© 2007 Thomson South-Western


The Capital Budgeting Decision
Process
The Capital Budgeting Process involves three
basic steps:

• Identifying potential investments


• Reviewing, analyzing, and selecting from the
proposals that have been generated
• Implementing and monitoring the proposals
that have been selected

Managers should separate investment and


financing decisions
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A Capital Budgeting Process
Should:
Account for the time value of money

Account for risk

Focus on cash flow

Rank competing projects appropriately

Lead to investment decisions that maximize


shareholders’ wealth
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Capital Budgeting Decision
Techniques
 Payback period: most commonly used
 Accounting rate of return (ARR):
focuses on project’s impact on
accounting profits
 Net present value (NPV): best
technique theoretically
 Internal rate of return (IRR): widely
used with strong intuitive appeal
 Profitability index (PI): related to NPV

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Capital Budgeting Example

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Payback Period
The payback period is the amount of time
required for the firm to recover its initial
investment

• If the project’s payback period is less than the


maximum acceptable payback period, accept the
project
• If the project’s payback period is greater than the
maximum acceptable payback period, reject the
project
Management determines maximum acceptable
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payback period
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Pros And Cons Of Payback
Method
Advantages of payback method:

Computational simplicity
Easy to understand
Focus on cash flow

Disadvantages of payback method:

Does not account properly for time value of money


Does not account properly for risk
Cutoff period is arbitrary
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Does not lead to value-maximizing decisions
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Discounted Payback Period

 Discounted payback accounts for time value


 Apply discount rate to cash flows during payback
period
 Still ignores cash flows after payback period

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Accounting Rate Of Return
(ARR)
Can be computed from available accounting data
 Need only profits after taxes and depreciation
 Accounting ROR = Average profits after taxes  Average
investment
 Average profits after taxes are estimated by
subtracting average annual depreciation from the
average annual operating cash inflows
Average profits = Average annual - Average annual
after taxes operating cash inflows depreciation

 ARR uses accounting numbers, not cash flows; no


time value of money
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Net Present Value
The present value of a project’s cash inflows and
outflows
Discounting cash flows accounts for the time value of
money

Choosing the appropriate discount rate accounts for risk

Accept projects if NPV > 0


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Net Present Value

A key input in NPV analysis is the discount rate

r represents the minimum return that the


project must earn to satisfy investors

r varies with the risk of the firm and/or the


risk of the project
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Independent versus Mutually
Exclusive Projects
 Independent projects – accepting/rejecting one
project has no impact on the accept/reject
decision for the other project
 Mutually exclusive projects – accepting one
project implies rejecting another
 If demand is high enough, projects may be
independent
 If demand warrants only one investment, projects
are mutually exclusive
 When ranking mutually exclusive projects,
choose the project with highest NPV
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Pros and Cons Of Using NPV As
Decision Rule
 NPV is the “gold standard” of investment
decision rules
 Key benefits of using NPV as decision rule
 Focuses on cash flows, not accounting earnings
 Makes appropriate adjustment for time value of
money
 Can properly account for risk differences between
projects
 Though best measure, NPV has some drawbacks
 Lacksthe intuitive appeal of payback
 Doesn’t capture managerial flexibility (option value)
well

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Internal Rate of Return
Internal rate of return (IRR) is the discount rate
that results in a zero NPV for the project

 IRR found by computer/calculator or manually


by trial and error
 The IRR decision rule is:
 If IRR is greater than the cost of capital, accept the
project
 If IRR is less than the cost of capital, reject the
project
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Advantages and
Disadvantages of IRR
 Advantages
 Properly adjusts for time value of money
 Uses cash flows rather than earnings
 Accounts for all cash flows
 Project IRR is a number with intuitive appeal
 Three key problems encountered in using
IRR:
 Lending versus borrowing?
 Multiple IRRs
 No real solutions

IRR and NPV rankings do not always agree


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Lending Versus Borrowing

Project #1: Lending


NPV

50%
Discount
rate
IRR

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Lending Versus Borrowing

Project #2: Borrowing


NPV

50%
Discount
rate
IRR

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Problems With IRR: Multiple
IRRs
 If a project has more than one change in the
sign of cash flows, there may be multiple
IRRs.
 Though odd pattern, can be observed in high-
tech and other industries.
 Four changes in sign of CFs, and have four
different IRRs.
 Next figure plots project’s NPV at various
discount rates.
 NPV is the only decision rule that works for
this project type.
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Multiple IRRs
NPV ($)

NPV>0
IRR

NPV>0
Discount
NPV<0 NPV<0
rate

IRR

When project cash flows have multiple sign changes, there can be
multiple IRRs

With multiple IRRs, which do we compare with the cost of


capital to accept/reject the project?
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Conflicts Between NPV and
IRR: Scale
 NPV and IRR do not always agree when
ranking competing projects
 The scale problem:
 When choosing between mutually exclusive
investments, we cannot conclude that the one
offering the highest IRR necessarily provides
the greatest wealth creation opportunity.
 Resolution to the scale problem:
 The solution involves calculating the IRR for a
hypothetical project with cash flows equal to
the difference in cash flows between the two
mutually exclusive investments.
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Conflicts Between NPV and IRR:
Timing

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Reconciling NPV and IRR
 Timing and scale problems can cause NPV
and IRR methods to rank projects differently
 In these cases, calculate the IRR of the
incremental project
 Cash flows of large project minus cash flows of
small project
 Cash flows of long-term project minus cash flows
of short-term project
 If incremental project’s IRR exceeds the cost
of capital
 Accept the larger project
 Accept the longer term project
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Profitability Index
Calculated by dividing the PV of a project’s cash
inflows by the PV of its outflows

 Decision rule: Accept projects with PI >


1.0, equal to NPV > 0
Like IRR, PI suffers from the scale problem

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Capital Rationing

 The profitability index (PI) is a close


cousin of the NPV approach, but it
suffers from the same scale problem as
the IRR approach.
 The PI approach is most useful in capital
rationing situations.

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