Capital Budgeting 1

Capital Budgeting

Select investments which increase value of firm

Maximize wealth of shareholders Important to firm’s long-term success

Substantial costCash flows over long time period

BigPicture…

Capital Budgeting 2

Steps in evaluating capital assets Determine cost of asset Estimate incremental cash flows

Very difficult but…Very important…

Determine decision criteria Apply decision criteria Compare actual results to projected

Capital Budgeting 3

Capital Budgeting Decision Criteria Should you sign Shaq O’ Squeal to a four-

year contract for $100 million???

Capital Budgeting 4

Capital Budgeting Decision Criteria Determine cost Estimate incremental cash flows

Increase in revenue Increase in expenses

Capital Budgeting 5

Capital Budgeting Decision Criteria Payback period NPV Profitability index IRR

Capital Budgeting 6

Payback Period

How long until we get our money back???

Capital Budgeting 7

Payback Period

Shaq Hack Mac

2005 30 mil 101 mil 10 mil

2006 40 mil 0 10 mil

2007 40 mil 0 70 mil

2008 70 mil 0 510 mil

170 mil 101 mil 600 mil

Capital Budgeting 8

Payback Period

Payback: length of time to get $$$ back

Rule: accept investments that payback before required period

Capital Budgeting 9

Payback Period

Advantages: Easy to calculate and understand

Useful for small investmentsFavors investments with quick returns

Capital Budgeting 10

Payback Period

Disadvantages: Future cash flows not discounted

Since favors quick returns, not huge problem Ignores cash flows after payback

Coal mine: negative cash flows at endMust select cutoff period

Three or four years reasonable 20 years, probably not

Capital Budgeting 11

Net Present Value

NPV: PV of cash flow – Cost of Investment

Rule: accept investments with a positive NPV

Capital Budgeting 12

Net Present Value

Shaq Mac Hack

2005 30$ 101$ 10$

2006 40$ 10$

2007 40$ 70$

2008 70$ 510$

Total 180$ 101$ 600$

Cost 100$ 100$ 100$

Discount Rate 12% 12% 12%

PV Cash Flows $131.63 $90.18 $390.84

NPV $31.63 ($9.82) $290.84

Capital Budgeting 13

Net Present Value

Advantages: If assumptions correct, increases value

of firmDiscounts future cash flows

Capital Budgeting 14

Net Present Value

Disadvantages:Determining proper discount rate

Should it be adjusted for riskiness of each project’s cash flows???

Set too high, pass up acceptable projects Buyer with lower discount rate will pay highest price

Set too low, decrease wealth of firm Ignores relative cost of investments

Project A: cost $1 million; NPV $20 Project B: cost $50; NPV $19

In an efficient market, should projects have huge positive

NPVs???

Capital Budgeting 15

Profitability Index

PI: PV Cash Flows / Cost Rule: accept investments with a PI

above 1.0

Capital Budgeting 16

Profitability Index

Shaq Mac Hack

2005 30$ 101$ 10$

2006 40$ 10$

2007 40$ 70$

2008 70$ 510$

Total 180$ 101$ 600$

Cost 100$ 100$ 350$

Discount Rate 12% 12% 12%

PV Cash Flows $131.63 $90.18 $390.84

NPV $31.63 ($9.82) $40.84

PI 1.32 0.90 1.12

Capital Budgeting 17

Profitability Index

Advantages:Comparing alternative investmentsDiscounts future cash flows

Disadvantages:Favors lower cost investments

Capital Budgeting 18

Internal Rate of Return

IRR: Discount rate where NPV = 0

Rule: accept investments with an IRR above required return

Capital Budgeting 19

IRR

Shaq Shaq Shaq

Cost (100)$ (100)$ (100)$

2005 30$ 30$ 30$

2006 40$ 40$ 40$

2007 40$ 40$ 40$

2008 70$ 70$ 70$

Total 180$ 180$ 180$

Discount Rate 12% 20% 30%

PV Cash Flows $131.63 $109.68 $89.46

NPV $31.63 $9.68 ($10.54)

IRR 24.39% 24.39% 24.39%

Capital Budgeting 20

IRR

Advantages:Most often used criteria in capital

budgetingNot required to select a discount rateDoes discount future cash flows

Capital Budgeting 21

IRR

Disadvantages:Assumes can reinvest cash flows at IRR

NPV assumes reinvest at required rate return

NPV assumption more logicalFavors short-term investments

Difficult to achieve high IRR on distant cash flows

Capital Budgeting 22

Calculating IRR

Spend $10,000 today and receive $17,182 in 8 years

Spend $10,000 today and receive $1,993 at the end of the next 10 years

Spend $10,000 today and receive $2,000 in year 1; $5,000 in year 2 and $8,000 in year 3 (all at end of year)