Finance assignment ASPS
mk59
finslides_1.pptxParrino chapter 9
Capital budgeting techniques
WSJ chapters 6 and 7
Insurance
Taxes
Return Exam 2
Return graded assignments at end of class
WSJ Assignment #3
International Finance Module Assignment
Pre-Exam “In-Class” Assignment #2
Today’s Agenda
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12/4/2014
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Capital Budgeting
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Discuss why capital budgeting decisions are most important investment decisions made by a firm’s management
Explain benefits of using net present value (NPV) method to analyze capital expenditure decisions
Calculate NPV for a capital project
Describe strengths and weaknesses of payback period as a capital expenditure decision-making tool
Compute payback period
Compute discounted payback period
Learning Objectives
(continued)
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Compute internal rate of return (IRR) for a capital project
Discuss conditions under which IRR technique and NPV technique produce different results
Discuss and compute Modified IRR (MIRR)
Explain how Profitability Index can be used to rank projects
Valid when a firm faces capital rationing
Describe limitations that apply to Profitability Index
Explain benefits of post-audit and ongoing reviews of capital projects
Learning Objectives (cont’d)
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Investment opportunities
Increase shareholder wealth
Enhance a firm’s competitive advantage
Ideas often generated by employees
Typically long-term projects
Should be evaluated using time value of money techniques
Large investment
Relate to firm’s mission
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Capital Budgeting Projects
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Key Reasons for Making Capital Expenditures
Renewal
Replacement
Expansion
Regulatory
Other
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Renewal: major repairs, overhauls, rebuilds, retrofits
Replacement
Expansion
Regulatory: e.g., environmental controls, workplace safety standards
Other: office buildings, parking, executive aircraft
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Independent projects
Accepting or rejecting one project has no effect on other projects
Cash flows are unrelated
Mutually exclusive projects
Accepting one project is a simultaneous decision to reject another project
These projects typically perform the same function
Example: Build new manufacturing plant in different locations
Contingent projects
Decision to accept one project depends on acceptance of another project
Types of contingent projects
Mandatory projects – evaluate with main as one project
Optional projects – evaluate as separate projects
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Classifications of Investment Projects
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Generating proposals
Alignment with strategic plan ideal
Find opportunities; replacement and/or expansion
Reviewed by Finance personnel
Review and analysis
Estimate cash flows (in and out)
Use capital budgeting techniques for evaluation
Decision making
Which projects will be accepted/rejected?
Implementation – make it happen
Post audit and ongoing reviews
Track, review, analyze or audit decisions/projects
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Capital Budgeting Process
Useful timeline example in Parrino Exhibit 9.2.
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Best method to evaluate capital projects
Considers time value of money
Includes all of project’s cash flows
Value measures dollar impact on shareholder wealth
NPV inputs
Cash inflows/outflows
Cost of capital (firm’s required rate of return)
Decision Rule: Accept projects with NPV > $0
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Net Present Value (NPV) Technique
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NPV Process
Determine initial cost of starting the project
Estimate project’s future net cash flows by year over its expected life (cash inflows minus cash outflows)
Determine appropriate cost of capital based on riskiness of project
Compute project’s NPV
Make decision
Accept projects with NPV > $0
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NPV = PV (project’s expected future cash flows) – PV (cost of project)
Next week we’ll talk about how cash flows are estimated.
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Cash Flow Data for Potential Projects
| Year | Replacement Project | Expansion Project |
| 0 (today) | (20,000) | (25,000) |
| 1 | 5,800 | 4,000 |
| 2 | 5,800 | 4,000 |
| 3 | 5,800 | 8,000 |
| 4 | 5,800 | 10,000 |
| 5 | 5,800 | 10,000 |
Cost of capital (WACC) = 10%
NPV Sample Calculations
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Cost of capital (WACC)= 10%
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NPV of Replacement Project
| Year | Cash Flow | Number of Years | Present Value |
| 0 | ($20,000) | 0 | ($20,000) |
| 1-5 | 5,800 | 5 | ? |
| Net present value | $ ? |
PV of
ordinary
annuity
Sample Calculation
Answer on next slide.
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Cost of capital (WACC)= 10%
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NPV of Replacement Project
| Year | Cash Flow | Number of Years | Present Value |
| 0 | ($20,000) | 0 | ($20,000) |
| 1-5 | 5,800 | 5 | ? |
| Net present value | $ ? |
PV of
ordinary
annuity
Sample Calculation
Enter
Answer
N
i
PMT
PV
FV
5
?
5800
0
10
PV of future cash flows = $21,986.56
PMT = 5800
FV = 0
N = 5
I/Y = 10
PV = ?
NPV of replacement project = PV (future cash flows) – PV (cost of project)
NPV = 21,986.56 – 20,000 = 1,986.56
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| Year | Cash Flow | Number of Years | Present Value |
| 0 | $(25,000) | 0 | $(25,000) |
| 1 | 4,000 | 1 | ? |
| 2 | 4,000 | 2 | ? |
| 3 | 8,000 | 3 | ? |
| 4 | 10,000 | 4 | ? |
| 5 | 10,000 | 5 | ? |
| Net present value | $ ? |
Sample Calculation
Cost of capital (WACC)= 10%
NPV of Expansion Project
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| Year | FV | N | PMT | I/Y | PV |
| 1 | 4000 | 1 | 0 | 10 | 3636.36 |
| 2 | 4000 | 2 | 0 | 10 | 3305.79 |
| 3 | 8000 | 3 | 0 | 10 | 6010.52 |
| 4 | 10000 | 4 | 0 | 10 | 6830.13 |
| 5 | 10000 | 5 | 0 | 10 | 6209.21 |
| PV of project’s estimated cash flows | 25992.01 | ||||
| PV of project cost | (25000.00) | ||||
| NPV | 992.01 |
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Sample Calculation
Decision: Accept if NPV > $0
NPV Decisions on Capital Projects
| Replacement Project | Expansion Project | |
| Project cost | $(20,000) | $(25,000) |
| NPV | $1,987 | $992 |
Based on NPV, which project(s) should you accept if:
Projects are independent and company has unlimited funds?
Company only has $25,000 to spend?
Explain your decision
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Summary
Net Present Value (NPV) Method
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IRR is the discount rate or “cost of capital” at which NPV = zero
Compute IRR by:
Trial and error
Financial calculator
Spreadsheet software
Easier to compute for annuity cash flows
Decision Rule: Accept if IRR > r
r = required return on project or cost of capital
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Internal Rate of Return (IRR) Technique
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Time Line and Expected Net Cash Flows
EXHIBIT 9.8 The cash flow data in the exhibit are used to compute the project’s IRR. The project’s NPV is a positive $16,440, which indicates that the IRR is greater than the cost of capital of 12%.
Parrino text p. 302 demonstrates the trial-and-error method of determining IRR for this project.
The Ford Project
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0
3
2
1
Time line
Net cash flow
Year
$240
$(560)
Cost of capital = 12%
NPV = $576.44 - $560 = $16.44
$240
$240
($ thousands)
Have students check NPV calculation.
NPV = PV (future cash flows) – PV (cost of project)
PV (future cash flows): PMT = 240; N = 3; I = 12; FV = 0; PV = ?
PV (future cash flows) = 576.44
NVP = 576.44 – 560 = 16.44 in thousands
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IRR Calculation Example
The Ford Project
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0
3
2
1
Time line
Net cash flow
Year
$240
$(560)
Cost of capital = 12%
NPV = $576.44 - $560 = $16.44
$240
$240
($ thousands)
Enter
Answer
N
i
PMT
PV
FV
3
13.7
240
0
-560
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NPV Profile for Ford Project
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Cash Flow Data for Potential Projects
| Year | Replacement | Expansion |
| 0 (today) | (20,000) | (25,000) |
| 1 | 5,800 | 4,000 |
| 2 | 5,800 | 4,000 |
| 3 | 5,800 | 8,000 |
| 4 | 5,800 | 10,000 |
| 5 | 5,800 | 10,000 |
| IRR | ? % | ? % |
Cost of capital (WACC) = 10%
Sample Calculations
Based on IRR, which project(s) should you accept if:
Projects are independent and company has unlimited funds?
Company only has $25,000 to spend?
Explain your decision
IRR (replacement project) = 13.82%
IRR (expansion project) = 11.2957%
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IRR: A Final Comment
Summary
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Always agree on whether to accept or reject a project if projects are independent and cash flows are “conventional” (i.e., no sign changes)
If projects are independent: Either method is acceptable
Problem: NPV and IRR may rank projects differently
Lemonade stand vs. convenience store (Parrino p. 309)
What if projects are mutually exclusive and rankings conflict?
Answer: Use NPV because it measures change in shareholder wealth
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NPV vs. IRR
| Investment | NPV | IRR | |
| Convenience store | $1,000,000 | $179,190 | 18.0% |
| Lemonade stand | 1,000 | 1,694 | 76.2% |
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A project may have more than one IRR
Occurs if project has alternative positive and negative future cash flows (i.e., more than one sign change)
Most likely to occur if project requires:
Substantial renovations or maintenance during its life (periodic cash outflows)
High end-of-life shut-down costs
Solution? MIRR
Find the Terminal Value (TV): future value at project’s end of all future net cash flows
MIRR is the return earned when the PV of COF = PV of CIF
PV (cost of project) = PV (future net cash flows)
Decision Rule: Accept if MIRR > r
r = required return on project or cost of capital
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Problems with IRR
Solution: Modified IRR (MIRR)
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MIRR Calculation Example
The Ford Project
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$240.00
268.80
301.06
$809.86
Net cash flow
$240
$(560)
$240
Time line
Year
2
0
1
3
12%
Terminal Value (TV)
MIRR = 13.09%
$560
PV =
Enter
Answer
N
i
PMT
PV
FV
3
?
0
809.86
(560)
For those of you who like equations, the relevant equations for MIRR are in the appendix.
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Expansion Project MIRR Calculation Example
$25,000 Investment with 10% Cost of Capital (WACC)
| Year | Cash Flow = PV | N | I | PMT | FV |
| 1 | $4,000 | ? | ? | ? | ? |
| 2 | 4,000 | ? | ? | ? | ? |
| 3 | 8,000 | ? | ? | ? | ? |
| 4 | 10,000 | ? | ? | ? | ? |
| 5 | 10,000 | ? | ? | ? | ? |
| Terminal Value (TV) | ? |
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| IRR Calculation: PV = Investment; FV = TV; N = 5; PMT = 0; I = ? | ? |
Answers on next slide
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Expansion Project MIRR Calculation Example
$25,000 Investment with 10% Cost of Capital (WACC)
| Year | Cash Flow = PV | N | I | PMT | FV |
| 1 | $4,000 | 4 | 10 | 0 | $ 5,856.40 |
| 2 | 4,000 | 3 | 10 | 0 | 5,324.00 |
| 3 | 8,000 | 2 | 10 | 0 | 9,680.00 |
| 4 | 10,000 | 1 | 10 | 0 | 11,000.00 |
| 5 | 10,000 | 0 | 10 | 0 | 10,000.00 |
| Terminal Value (TV) | $41,860.40 |
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| IRR Calculation: PV = Investment; FV = TV; N = 5; PMT = 0; I = ? | 10.86% |
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Number of years until the cash flows from a project equal the project’s cost
Time to recoup an investment’s cost
Decision Rule: Accept if payback period is less than a maximum desired time period
Management determines the required time period
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Payback Period Method
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Payback Period Example
Replacement Project with $20,000 Investment
| Year | Cash Flow | Cumulative Cash Flow | Dollars Needed to Recoup Costs |
| 1 | $5,800 | ||
| 2 | 5,800 | ||
| 3 | 5,800 | ||
| 4 | 5,800 | ||
| 5 | 5,800 | ||
| Fraction of year: ________/5,800 = | |||
| Payback = _______ years |
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Answers on next slide
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Payback Period Example
Replacement Project with $20,000 Investment
| Year | Cash Flow | Cumulative Cash Flow | Dollars Needed to Recoup Costs |
| 1 | $5,800 | $5,800 | $14,200 |
| 2 | 5,800 | 11,600 | 8,400 |
| 3 | 5,800 | 17,400 | 2,600 |
| 4 | 5,800 | 23,200 | |
| 5 | 5,800 | 29,000 | |
| Fraction of year: 2,600/5,800 = 0.45 year | |||
| Payback period = 2.45 years |
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Ignores time value of money
Ignores cash flows beyond payback period
Ignores timing of cash flows
Any relationship between payback period and shareholder wealth maximization is purely coincidental
Many companies use it in addition to other methods
Payback Period Method’s Drawbacks
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Same idea as Payback Period method
Find PV of net cash flows
Determine payback of initial investment using PV of net cash flows
Considerations
TVM
Liquidity of project
Decision Rule: Accept if DPB Period < Project’s Useful Life
Discounted Payback Period
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Discounted Payback Period
Example Cash Flows and Calculations
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Net cash flow (NCF)
Cumulative NCF
Discounted NCF (at 10%)
Cumulative discounted NCF
Payback period = 2 years
Discounted payback period = 2 years + $5,289/$15,026 = 2.35 years
Cost of capital = 10%
NPV = $49,737 - $40,000 = $9,737
Time line
Year
2
0
1
3
$20,000
$(40,000)
$20,000
$20,000
$0
$(40,000)
$(20,000)
$20,000
$16,529
$(40,000)
$18,182
$15,026
$(5,289)
$(40,000)
$(21,818)
$9,737
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Measures the value a project generates for each dollar invested in that project
PI value indicate the value of the expected future free cash flows per dollar invested in each project
Useful when firms have funding constraints (i.e., capital rationing)
Choose a set of projects consistent with the idea of shareholder wealth maximization
Can lead to suboptimal project choices in situations involving multiple periods
More sophisticated analytical techniques (such as linear programming) beyond scope of this course
Profitability Index
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See Parrino pp. 313=314 regarding issues with use of PI for multiple-period decisions.
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Profitability Index Analysis Process
Calculate the PI for each project.
Rank projects from highest PI to lowest PI.
Starting at top of list (project with highest PI) and working your way down the list, select the projects the firm can afford.
Repeat the third step by starting with the second project on the list, then the third project on the list, and so on, to make sure that a more valuable bundle cannot be identified.
PI = Benefits = Present value of future free cash flows = NPV + Initial investment (9.6)
Costs Initial investment Initial investment
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Profitability Index Examples
Calculating PI and Ranking Projects Using PI
| Project | Year 0 | Year 1 | Year 2 | NPV @ 10% | PI* |
| A | $(5,000) | $5,500 | $6,050 | $5,000 | ? |
| B | (3,000) | 2,000 | 3,850 | 2,000 | ? |
| C | (3,000) | 4,400 | 0 | 1,000 | ? |
| D | (2,000) | 1,500 | 1,375 | 500 | ? |
With only $10,000 to invest, which of these four positive NPV projects would you select?
How much shareholder value would be added by the projects you select? $__________
* PI = NPV + Initial investment
Initial investment
?
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PI (Project A) = (5000 + 5000) / 5000 = 2.000
PI (Project B) = (2000 + 3000) / 3000 = 1.667
PI (Project C) = (1000 + 3000) / 3000 = 1.333
PI (Project D) = (500 + 2000) / 2000 = 1.250
Choose Projects A, B and D
Total investment = $10,000
Total shareholder value added = $7,500
Begin by choosing A and B because there is enough money for them.
Since choosing A and B means there is not enough money for C, skip C and choose D.
No other combination has a larger NPV than A, B and D.
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Systematic reviews of all ongoing and completed capital projects
Post-audit reviews of completed projects
Comparison of actual results of a project with what was projected in the capital budgeting proposal
May reveal why a project was successful or failed to achieve its financial goals
Ongoing reviews of projects in progress
Challenge the business plan, including cash flow projections and cost assumptions
Progress updates on actual costs and time vs. projections
Evaluate the performance of people responsible for implementing a capital project
Post-Audit and Ongoing Reviews
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Capital Budgeting Techniques Used By Businesses
Trends: 1981 - 1999
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Automated Techniques for NPV and IRR
USE THE MANUAL AND/OR AUTOMATED CALCULATION TECHNIQUES WITH WHICH YOU ARE MOST COMFORTABLE
Financial calculator can do NPV and IRR calculations
Be careful doing inputs
Think about how you’ll “show your work” on assignments and exam
Guidebook for TI BAII Plus Calculator available on BbLearn
“Cash Flow Worksheets” chapter 3
http ://education.ti.com/en/us/guidebook/details/en/ADF11FB65B284B6195B0A7E9502784BA/baiiplus?download=8ED6B8A59A0B49C68A7C41F97B5D4EAE #!
Excel contains NPV and IRR functions (not for exams)
Examples: Parrino pp. 295 and 304
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REITERATE: LEARN/USE MANUAL AND/OR AUTOMATED TECHNIQUES WITH WHICH YOU ARE MOST COMFORTABLE.
Review BAII-Plus guidebook pp. 46-50 on Doc-Cam. Handout?
Have students do practice problems on pp. 46-50.
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Appendix
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MIRR Equations
Terminal Value = TV = [CF1 x (1 + k)n-1] + [CF2 x (1 + k)n-2] + . . . +
[CFn x (1 + k)n-t]
= Σ CFt x (1 + k)n-t
Where:
TV = project terminal value
CFt = cash flow from operations in period t
k = cost of capital
n = project life
n
t=1
PVcost = PVTV
PV cost of project = PV terminal value
PVcost = TV
(1 + MIRR)n
MIRR = TV 1/n - 1
PVcost
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