Business Ethics & Financial Management homework assessments

BBA 3301, Financial Management 1

UNIT VII STUDY GUIDE

Capital Budgeting

Learning Objectives Upon completion of this unit, students should be able to:

1. Contrast mutually exclusive project decisions and stand-alone project decisions.

2. Calculate payback periods. 3. Calculate net present value (NPV) for various investment projects. 4. Calculate internal rate of return (IRR) using Excel. 5. Calculate the profitability index (PI) to compare capital projects. 6. Contrast results from various capital budgeting techniques by assessing

the strengths and weaknesses.

Written Lecture This unit combines tools from time value of money and applies them to the most important element of management, long-term planning. The managerial function is concerned with the allocation of resources and the deployment of capital (money) to long-term projects and is pivotal to the life of a business. Capital budgeting involves the planning of large expenditures on long-term (capital) projects. Ranked in order of increasing risk, common categories of capital budgeting include replacement, expansion, or new products/ventures. Capital budgeting projects can be further classified as either stand-alone or mutually exclusive. A stand-alone project has no competing alternatives. Mutually exclusive projects involve selecting one project from among two or more alternatives. Mutual exclusivity may be due to constraints in budget (amount), or limited resources (available land, human resources, machinery, etc.). The typical structure of a capital budgeting analysis involves a negative initial outlay, then a series of positive cash flows such as those provided below: Example C0 $(50,000) C1 15,000 C2 15,000 C3 15,000 C4 15,000 C5 15,000 The above example will be used to illustrate the commonly used capital budgeting techniques. The following techniques are stressed in this unit: Payback Period: determines how many years it takes to recover initial cost. Using this method, shorter paybacks are better (when comparing mutually exclusive projects). Payback is often considered the “weakest” capital budgeting tool as it does not consider time value of money or the cash flows after the payback period.

Reading Assignment Chapter 10: Capital Budgeting

Key Terms 1. Cost of capital 2. Internal rate of return

(IRR) 3. Mutually exclusive 4. Net present value

(NPV) 5. Payback period 6. Profitability index (PI) 7. Stand alone

BBA 3301, Financial Management 2

Using the above example the payback is: 3.33 years. After three years, it has recovered $45,000, thus only $5,000 is needed from the 4

th year.

$5,000/$15,000 results in .33 year. Net Present Value (NPV): determines present value of inflows less outflows. Specifically, NPV is the sum of the present values of a project’s cash flows at the cost of capital. The cost of capital is the average rate a firm pays investors for use of its long term money which comes from two sources, debt and equity. To maximize shareholder wealth, select the capital spending program with the highest NPV.

The decision rules for NPV are as follows: Stand-alone Projects

 NPV > 0  accept

 NPV < 0  reject Mutually Exclusive Projects

 NPVA > NPVB  choose Project A over B Assuming a cost of capital of 10%, the net-present-value of the above cash flows would be calculated as: Time Period 0 1 2 3 4 5

Cash Flow

- 50,000.

00 15,000.0

0 15,000.

00 15,000.

00 15,000.

00 15,000.

00 NPV

Present Value

- 50,000.

00 13,636.3

6 12,396.

69 11,269.

72 10,245.

20 9,313.8

2 6,861.

80 Cost of Capital

10%

Note, that the cash flows above are calculated for each year based on this formula, then summed for the NPV. For example the present value of $15,000 received in the 4

th year is: $15,000/1.10

4 = $10,245.20

Internal Rate of Return (IRR): A project’s IRR is the return it generates on the investment of its cash outflows. Furthermore, the IRR is the interest rate that makes a project’s NPV zero. Finding IRRs usually require an iterative technique where you guess the project’s IRR through trial and error. The first step involves calculating the project’s NPV using this interest rate. If NPV = zero, the guessed interest rate is the project’s IRR. If NPV > 0, try a higher interest rate. If NPV < 0, try a lower interest rate. In lieu of this iterative process, financial calculators and Excel (IRR function) both have features that can calculate the IRR of a series of cash flows. For Excel go to insert function, go to financial functions and type in IRR. The relationship between IRR and NPV is as follows:

BBA 3301, Financial Management 3

The above figure can be found in your textbook on page 468.

There are technical problems with IRR which include:

 Multiple solutions for unusual projects can have more than one IRR.

Specifically, the number of positive IRRs to a project depends on the

number of sign reversals to the project’s cash flows. Thus, IRR can be

applied to a situation where there is one negative outflow (initial

investment)

 The IRR reinvestment assumption implicitly assumes cash inflows will

be reinvested at the project’s IRR

It should be noted that the NPV and IRR do not always select the same project in mutually exclusive decisions. A conflict can arise if NPV profiles cross in the first quadrant (see below). In the event of a conflict, the selection of the NPV method is preferred.

BBA 3301, Financial Management 4

The above figure can be found in your textbook on page 471.

Profitability Index Ratio (PI) is a variation (an improvement) of the NPV method as it is the ratio of present value of inflows to outflows. Projects are acceptable if PI > 1. PI is also known as the benefit/cost ratio because positive future cash flows are the benefit and the negative initial outlay is the cost. With mutually exclusive projects NPV and PI methods may not lead to the same choices. But, PI includes the size (magnitude of the initial investment). Thus, PI is preferred because it compares the benefits to the size of the initial investment. Decision rules for PI: For stand-alone projects

 If PI > 1.0  accept

 If PI < 1.0  reject

For mutually exclusive projects

 PIA > PIB choose Project A over Project B

Using the previous example, the profitability index is calculated as: PV of benefits/PV of costs = $56,861.80/$50,000 = 1.137 (approve for investment based on decision rule)