13b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson...

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13b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Chapter 13 – Chapter 13 – Support Support Capital Capital Budgeting Budgeting Techniques Techniques

Transcript of 13b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson...

13b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Chapter 13 – Chapter 13 – SupportSupport

Capital Budgeting Capital Budgeting TechniquesTechniques

Capital Budgeting Capital Budgeting TechniquesTechniques

13b.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Remember? Remember? The Different The Different Methods of Evaluation? Methods of Evaluation? Remember? Remember? The Different The Different Methods of Evaluation? Methods of Evaluation?

• Payback Period (PBP)• Internal Rate of Return (IRR)• Net Present Value (NPV)• Profitability Index (PI)

Let us use the ‘New Asset’ project from Chapter 12 (VW13E-13b.xlsx)

• Payback Period (PBP)• Internal Rate of Return (IRR)• Net Present Value (NPV)• Profitability Index (PI)

Let us use the ‘New Asset’ project from Chapter 12 (VW13E-13b.xlsx)

13b.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Project Evaluation: Project Evaluation: Alternative MethodsAlternative MethodsProject Evaluation: Project Evaluation: Alternative MethodsAlternative Methods

Discount rate: 16%PBP: 2.19IRR: 28.40%

NPV: 19,328.69$ PI: 1.26

Accept: Exceeds discount rate

Accept: Increase shareholder wealthAccept: Greater than 1.00

Accept: Assume want payback within 3 yrs

0 (75,000)$ (75,000)$

1 33,332$ (41,668)$ 2 36,446$ (5,222)$

3 28,147$ 22,925$ 4 37,075$ 60,000$

Cumulative CFYear Cash FlowWe will start with the cash

flows of the project and also calculate the cumulative

cash flow values.

We can use Excel functions / approaches to calculate each of the following methods from the above cash flows.

13b.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

IRR: IRR: Project EvaluationProject EvaluationIRR: IRR: Project EvaluationProject Evaluation

Discount rate: 16%PBP: 2.19IRR: 28.40%

NPV: 19,328.69$ PI: 1.26

Accept: Exceeds discount rate

Accept: Increase shareholder wealthAccept: Greater than 1.00

Accept: Assume want payback within 3 yrs

The Internal Rate of Return function is built into Excel! Simply use the formula above:

• $L$24:$L$$L$24:$L$28: represents the cash flows from period 0 through the last period (4 in our example)• K31K31: represents a “guess” as to the answer, but you do not need to put this in the formula

IRR: 28.40% =IRR($L$24:$L$28,K31)

Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.

13b.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

NPV: NPV: Project EvaluationProject EvaluationNPV: NPV: Project EvaluationProject Evaluation

Discount rate: 16%PBP: 2.19IRR: 28.40%

NPV: 19,328.69$ PI: 1.26

Accept: Exceeds discount rate

Accept: Increase shareholder wealthAccept: Greater than 1.00

Accept: Assume want payback within 3 yrs

•The Net Present Value (NPV) function is built into •Excel and we used it in the TVM chapter!

• K31K31: represents the rate of return investors expect to earn for the given amount of risk (discount rate)• $L$25:$L$28$L$25:$L$28: represents the cash flows from period 1 through the last period (we do NOT use period 0)• $L$24$L$24: We subtract the ICO (or add if we already assigned it a negative sign as we did in slide 3).

• This is an important “quirk” with the Excel function

NPV: 19,328.69$ =NPV($K$31, $L$25:$L$28)+$L$24

Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.

13b.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

PI: PI: Project EvaluationProject EvaluationPI: PI: Project EvaluationProject Evaluation

Discount rate: 16%PBP: 2.19IRR: 28.40%

NPV: 19,328.69$ PI: 1.26

Accept: Exceeds discount rate

Accept: Increase shareholder wealthAccept: Greater than 1.00

Accept: Assume want payback within 3 yrs

The Profitability Index (PI) function does not exist inExcel, but we can use a simple calculation using the NPV answer

or a second method directly using the NPV function.

• We can simply use the NPV earlier ($K$34) and divide by the ICO (-$L$24) and add this to 1.00 – [Method #1]• Second, we use the NPV formula and calculate the present value of cash flows in periods 1 through 4 discounted at the $K$31 discount rate. This value we simply divide by the ICO of -$L$24 – [Method #2]

PI: 1.26 =1+$K$34/-$L$24PI: 1.26 =NPV($K$31, $L$25:$L$28)/-$L$24

Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.

13b.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

PBP: PBP: Project EvaluationProject EvaluationPBP: PBP: Project EvaluationProject Evaluation

Discount rate: 16%PBP: 2.19IRR: 28.40%

NPV: 19,328.69$ PI: 1.26

Accept: Exceeds discount rate

Accept: Increase shareholder wealthAccept: Greater than 1.00

Accept: Assume want payback within 3 yrs

The Payback Period (PBP) function does not exist inExcel either, but this complicated formula is one way to write a set of if

functions to determine PBP.

• The IF statements attempt to find when the cumulative cash flows change from a negative sign to a positive sign.• Once that occurs, we know the core number of years and we can then calculate the portion of the next year to get payback• To make this work for a longer project life, you need to add additional imbedded if statements

PBP: 2.19 =IF(M24<0,IF(M25<0,IF(M26<0,IF(M27<0,IF(M28<0,"Exceeds 4 Years",K27+

(-M27/L28)),K26+(-M26/L27)),K25+(-M25/L26)),K24+(-M24/L25)),K23+(-M23/L24))

Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.

13b.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Asset Replacement?Asset Replacement?Asset Replacement?Asset Replacement?

• Now go back to Chapter 12 and the cash flows we developed for the ‘Asset Replacement’ project and calculate the PBP, IRR, NPV and PI.

• Hint: The answers are shown in ‘VW13E-13b.xlsx’ file on the ‘Asset Replacement’ tab.

• Given are assumptions, would you want to replace the project? Why or why not?

13b.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Remember?Remember? Potential Problems Potential Problems Under Mutual ExclusivityUnder Mutual ExclusivityRemember?Remember? Potential Problems Potential Problems Under Mutual ExclusivityUnder Mutual Exclusivity

A. Scale of InvestmentA. Scale of Investment

B. Cash-flow PatternB. Cash-flow Pattern

C. Project LifeC. Project Life

A. Scale of InvestmentA. Scale of Investment

B. Cash-flow PatternB. Cash-flow Pattern

C. Project LifeC. Project Life

Ranking of project proposals may create contradictory results.

13b.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Remember?Remember?A. Scale DifferencesA. Scale DifferencesRemember?Remember?A. Scale DifferencesA. Scale Differences

Compare a small (S) and a large (L) project.

NET CASH FLOWSProject S Project LEND OF YEAR

0 –$100 –$100,000

1 0 0

2 $400 $156,250

13b.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

A. Scale DifferencesA. Scale DifferencesA. Scale DifferencesA. Scale Differences0 (100)$ (100,000)$ 1 -$ -$ 2 400$ 156,250$

Discount rate: 10%IRR: 100.00% 25.00%

NPV: 230.58$ 29,132.23$ PI: 3.31 1.29

BEST!!

Greatest NPV

Rate NPV - Small NPV Large0% $300.00 $56,250.002% $284.47 $50,182.624% $269.82 $44,461.916% $256.00 $39,061.948% $242.94 $33,959.19

10% $230.58 $29,132.2312% $218.88 $24,561.5414% $207.79 $20,229.3016% $197.27 $16,119.2018% $187.27 $12,216.3220% $177.78 $8,506.9422% $168.74 $4,978.5024% $160.15 $1,619.41

Year CF - Small CF - Large

$0.00

$10,000.00

$20,000.00

$30,000.00

$40,000.00

$50,000.00

$60,000.00

$0.00

$50.00

$100.00

$150.00

$200.00

$250.00

$300.00

$350.00

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%

Axis Title

Graph the NPV Profiles for 'Small' and 'Large' projects

NPV - Small

NPV Large

Refer to VW13E-13b.xlsx on the ‘Scale’ tab.

Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘Scale’ tab.

13b.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

A. Scale DifferencesA. Scale DifferencesA. Scale DifferencesA. Scale Differences

• Remember that we evaluate the projects based on maximizing shareholder wealthmaximizing shareholder wealth

• So we choose the ‘Large’ project even though the other evaluation methods seem better!

• In Excel, we can use the functions or alternatively ‘Data TablesData Tables’ to create the chart on the previous slide which allows us to easily graph the NPV Profiles.

13b.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Remember?Remember?B. Cash Flow PatternB. Cash Flow PatternRemember?Remember?B. Cash Flow PatternB. Cash Flow Pattern

Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project.

NET CASH FLOWSProject D Project IEND OF YEAR

0 –$1,200 –$1,200 1 1,000 100

2 500 600

3 100 1,080

13b.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

B. Cash Flow PatternB. Cash Flow PatternB. Cash Flow PatternB. Cash Flow Pattern

Refer to VW13E-13b.xlsx on the ‘Pattern’ tab.

0 (1,200)$ (1,200)$ 1 1,000$ 100$ 2 500$ 600$ 3 100$ 1,080$

Discount rate: 10%IRR: 22.79% 16.93%

NPV: 197.45$ 198.20$ PI: 1.16 1.17

BEST??

Greatest NPV

Rate NPV - Decrease NPV Increase0% $400.00 $580.002% $355.21 $492.454% $312.72 $411.006% $272.36 $335.138% $233.98 $264.33

10% $197.45 $198.2012% $162.63 $136.3214% $129.42 $78.3716% $97.72 $24.0118% $67.41 ($27.02)20% $38.43 ($75.00)22% $10.67 ($120.15)24% ($15.92) ($162.69)

Year CF - Decrease CF - Increase

($200.00)

($100.00)

$0.00

$100.00

$200.00

$300.00

$400.00

$500.00

$600.00

$700.00

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%

NPV Profiles for two similar projects

NPV - Decrease

NPV Increase

Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘Pattern’ tab.

13b.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

B. Cash Flow PatternB. Cash Flow PatternB. Cash Flow PatternB. Cash Flow Pattern

• Remember that we evaluate the projects based on maximizing shareholder wealthmaximizing shareholder wealth, but in this case they have essentially the SAMESAME NPVs.

• So we evaluate the uncertainty … to the left of the intersection the increasing CF pattern is best and to the right it is decreasing

• Both are acceptable projects, but if we must choose only one, the “decreasing” pattern might be better• It generates cash quicker which has less risk• It has a positive NPV as long as the discount rate is less

than about 23%• Again, we can use the functions or ‘Data Tables’ to create

the chart on the previous slide.

13b.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Remember?Remember?C. Project Life DifferencesC. Project Life DifferencesRemember?Remember?C. Project Life DifferencesC. Project Life Differences

Let us compare a long life (X) project and a short life (Y) project.

NET CASH FLOWSProject X Project YEND OF YEAR

0 –$1,000 –$1,000 1 0 2,000

2 0 0

3 3,375 0

13b.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

C. Project Life DifferencesC. Project Life DifferencesC. Project Life DifferencesC. Project Life Differences

Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘Life’ tab.

0 (1,000)$ (1,000)$ 1 -$ 2,000$ 2 -$ -$ 3 3,375$ -$

Discount rate: 10%IRR: 50.00% 100.00%

NPV: 1,535.69$ 818.18$ PI: 2.54 1.82

BEST??

Greatest NPV

Rate NPV - X NPV - Y0% $2,375.00 $1,000.002% $2,180.34 $960.784% $2,000.36 $923.086% $1,833.72 $886.798% $1,679.18 $851.85

10% $1,535.69 $818.1812% $1,402.26 $785.7114% $1,278.03 $754.3916% $1,162.22 $724.1418% $1,054.13 $694.9220% $953.13 $666.6722% $858.64 $639.3424% $770.14 $612.90

Year CF - X CF - Y

$0.00

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%

NPV Profiles for X and Y - neither repeated

NPV - X

NPV - Y

13b.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

B. Cash Flow PatternB. Cash Flow Pattern(NOT renewing project)(NOT renewing project)B. Cash Flow PatternB. Cash Flow Pattern(NOT renewing project)(NOT renewing project)

• Remember that we evaluate the projects based on maximizing shareholder wealthmaximizing shareholder wealth, but in this case we have an overriding question – what happens at the end of the first year if we choose project “Y”?

• We do indeed choose Project “X” (see previous slide) because the NPV is greatest if, and only if, this is a project that won’t be repeated or renewed. With the discount rates we used, X is superior to Y in every scenario shown.

• If this project is repeated, then we need to re-evaluate the cash flows as follows.

• Again, we can use the functions or ‘Data Tables’ to create the chart on the previous slide.

13b.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

C. Project Life DifferencesC. Project Life DifferencesC. Project Life DifferencesC. Project Life Differences

Remember to refer to Excel spreadsheet ‘VW13E-13b.xlsx’ and the ‘Life2’ tab.

Year 0 Year 1 Year 2 Year 3-1000 2000

0 (1,000)$ (1,000)$ -1000 20001 -$ 1,000$ -1000 20002 -$ 1,000$ -1000 1000 1000 20003 3,375$ 2,000$

Discount rate: 10%IRR: 50.00% 100.00%

NPV: 1,535.69$ 2,238.17$ PI: 2.54 3.24

BEST??

Greatest NPV

Rate NPV - X NPV - Y0% $2,375.00 $3,000.002% $2,180.34 $2,826.214% $2,000.36 $2,664.096% $1,833.72 $2,512.638% $1,679.18 $2,370.93

10% $1,535.69 $2,238.1712% $1,402.26 $2,113.6114% $1,278.03 $1,996.6016% $1,162.22 $1,886.5518% $1,054.13 $1,782.9020% $953.13 $1,685.1922% $858.64 $1,592.9524% $770.14 $1,505.79

Year CF - X CF - Y

$0.00

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

$3,000.00

$3,500.00

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%

NPV Profiles for X and Y-repeated

NPV - X

NPV - Y

13b.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

B. Cash Flow PatternB. Cash Flow Pattern(NOT renewing project)(NOT renewing project)B. Cash Flow PatternB. Cash Flow Pattern(NOT renewing project)(NOT renewing project)

• Notice on the previous slide that we created the repeated cash flows for the project assuming no change in cash flows.

• We are still evaluating projects based on maximizing maximizing shareholder wealth.shareholder wealth.

• We now choose Project “Y” (see previous slide) because the NPV is greatest!

• In fact, Y is greatly superior to X in all of the scenarios shown.

• Again, we can use the functions or ‘Data Tables’ to create the chart on the previous slide.

13b.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Remember?Remember?Capital RationingCapital Rationing

Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures

during a particular period.

Example: Julie Miller must determine what investment opportunities to undertake for Basket Wonders (BW). She is limited to a maximum expenditure of $32,500 only for this capital budgeting period.

13b.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

We can use the “Solver” Add-in for Excel to find the optimal mix EASILY!!! First make sure you have it available on your computer by:

• Click the round Microsoft Office button (upper left corner of screen) when Excel is open, click “Excel Options” at the bottom, and then click the “Add-ins” category on the left side.

• In the “Manage” box at the bottom, choose “Excel Add-ins”, and then click the “Go” button.

• In the pop-up box of Add-ins available, check the “Solver Add-in” box, and then click OK.

Remember?Remember?Capital RationingCapital Rationing

13b.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Remember?Remember?Available Projects for BWAvailable Projects for BW

Project ICO IRR NPV PI

A $ 500 18% $ 50 1.10 B 5,000 25 6,500 2.30 C 5,000 37 5,500 2.10 D 7,500 20 5,000 1.67 E 12,500 26 500 1.04 F 15,000 28 21,000 2.40 G 17,500 19 7,500 1.43 H 25,000 15 6,000 1.24

13b.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• We are going to use this data that can be found in VW13E-13b.xlsx or you can enter the data yourself.

• Your data should look something like below in the yellow section.

• The “Yes/No” box is a binary variable that determines if we want to keep that project as being optimal.

Capital RationingCapital Rationing

Project ICO IRR NPV Yes/No ICO NPVA 500.00$ 18% 50.00$ 1 500.00$ 50.00$ B 5,000.00$ 25% 6,500.00$ 1 5,000.00$ 6,500.00$ C 5,000.00$ 37% 5,500.00$ 1 5,000.00$ 5,500.00$ D 7,500.00$ 20% 5,000.00$ 1 7,500.00$ 5,000.00$ E 12,500.00$ 26% 500.00$ 1 12,500.00$ 500.00$ F 15,000.00$ 28% 21,000.00$ 1 15,000.00$ 21,000.00$ G 17,500.00$ 19% 7,500.00$ 1 17,500.00$ 7,500.00$ H 25,000.00$ 15% 6,000.00$ 1 25,000.00$ 6,000.00$

88,000.00$ 52,050.00$

13b.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• Let us open Solver. Click on the ‘Data’ tab and then in the ‘Analysis’ ribbon choose ‘Solver’.

• The box should open like the following example:

Capital RationingCapital Rationing

13b.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• “Set Target Cell” equal to the box that sums the NPVs and click on the “Max” option

• In the “By Changing Cells” area, set it to the binary ‘Yes / No’ values (F3:F10 in this case)

Capital RationingCapital Rationing

13b.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• Now we need to add our constraints.

• We want the values of F3:F10 to be ONLY a “0” or a “1” value

• We want G11, sum of the ICOs to be $32,500 or less

Capital RationingCapital Rationing

13b.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Now we solve by clicking the ‘SOLVE’ button! Look, only projects B, C, D and F are chosen!!

If you look at the Excel formulas for columns ‘G’ and ‘H’ you will see that the values are set to the “Yes/No” variable value (either 0 or 1) multiplied by the original value in columns ‘C’ and ‘E’.

This is a nifty way to find the optimal decision!

Capital RationingCapital Rationing