BUA321 Chapter 10 Capital Budgeting Techniques

Capital Budgeting Terminology

• What kinds of projects are analyzed with capital budgeting?• What is meant by unlimited

funds?• Describe mutually exclusive

projects.

Techniques

• What is the goal of the financial manager?• What are the basic investment

rules?

Techniques

• What does payback period tell us?• Why is NPV the superior

technique for analyzing projects?• Describe the profitability index.

Economic Value added

http://www.youtube.com/watch?feature=player_detailpage&v=ZCaeMTSTWYs

Techniques

• Describe IRR.• What can cause techniques to

provide conflicting solutions?• What methods are generally used

by companies?

Example• Calculate the capital budgeting solutions for the following techniques:

• NPV• Profitability Index• IRR• Payback

• The company has decided to purchase a new asset. The expected cost of the project is $195,000. The cost of financing projects is 13%. The expected cash flows follow:

• 1 $40,000• 2 $60,000• 3 $85,000• 4 $70,000• 5 $50,000

Investment (CF0) -$195,000 negative 13.00% Discount RateCF1 $40,000 15.00% Reinvestment Rate for MIRRCF2 $60,000CF3 $85,000CF4 $70,000CF5 $50,000CF6CF7CF8

Benchmarks Accept or RejectPayback Period 3.143 3.00Discounted Payback 4.397 3.00Net Present Value $16,366.60IRR 16.207%Modified IRR 15.690%Profitability Index 1.084

Example

• The company is considering another project. This one costs $400,000. The cost of financing is the same. The forecasted cash flows are below.– 1 $70,000– 2 $100,000– 3 $120,000– 4 $145,000– 5 $100,000– 6 $80,000– 7 $70,000

Investment (CF0) -$400,000 negative 13.00% Discount RateCF1 $70,000 15.00% Reinvestment Rate for MIRRCF2 $100,000CF3 $120,000CF4 $145,000CF5 $100,000CF6 $80,000CF7 $70,000CF8

Benchmarks Accept or RejectPayback Period 3.650 3.00Discounted Payback Greater than 6 years 3.00Net Present Value $34,814.53IRR 15.734%Modified IRR 15.362%Profitability Index 1.087

Capital Budgeting Decisions

• Using the above projects, decide which projects you would do? First, assume both projects are independent. Next, assume they are mutually exclusive.• • Use the two projects and create the

NPV profiles for the projects.

Cash Flows Project A Project B0 -$195,000 -$400,0001 $40,000 $70,0002 $60,000 $100,0003 $85,000 $120,0004 $70,000 $145,0005 $50,000 $100,0006 $80,0007 $70,00089

101112131415

NPV 16,367$ 34,815$ IRR 16.21% 15.73%

Discount Rate 13%Rate Increments 2%

Project A Project B16,367$ 34,815$

10% $33,669 $78,64712% $21,905 $48,72114% $11,042 $21,55716% $994 ($3,163)18% ($8,316) ($25,714)20% ($16,959) ($46,336)22% ($24,993) ($65,236)24% ($32,475) ($82,596)26% ($39,452) ($98,574)28% ($45,969) ($113,312)

Project 1 CF Project 2 CF Incremental CF0 -$195,000 -$400,000 205,000$ 1 $40,000 $70,000 (30,000)$ 2 $60,000 $100,000 (40,000)$ 3 $85,000 $120,000 (35,000)$ 4 $70,000 $145,000 (75,000)$ 5 $50,000 $100,000 (50,000)$ 6 $80,000 (80,000)$ 7 $70,000 (70,000)$ 8 -$ 9 -$

10 -$ 11 -$ 12 -$

Discount Rate 13.00%NPV $16,366.60 $34,814.53 ($18,447.92) Should we do Project 1?IRR 16.21% 15.73% 15.41% Cross Over Rate

Chapter 10 ExerciseComplete the following table using the data in this table.  Project A   12% Project B    12% Project C    12%

0 40000 40000 40000

1 13000 7000 19000

2 13000 10000 16000

3 13000 13000 13000

4 13000 16000 10000

5 13000 19000 7000

  Project A Project B Project C

Payback rule 3.75 3.75 3.75

Discounted payback rule 4.0 4.0 4.0

Discount rate 12% 12% 12%

Payback      

Discounted Payback      

NPV      

IRR      

PI      

Accept if independent? Yes / No

Payback      

Discounted Payback      

NPV      

IRR      

PI      

Best if mutually exclusive (mark yes / no)

Payback      

Discounted Payback      

NPV      

IRR      

PI      

Net Present Value Profile• Copy and paste the net Present Value Profile with all

three projects. (10)• What does the profile illustrate?