Chapters 11. Capital Budgeting

. Capital budgeting

. Project classifications

. Capital budgeting techniques

. Cash flow estimation

. Risk analysis in capital budgeting

. Optimal capital budget

. Capital budgeting

Strategic business plan: a long-run plan that outlines in broad terms the firm’s

basic strategy for the next 5 to 10 years

Capital budgeting: the process of planning expenditures on assets with cash flows

that are expected to extend beyond one year

. Project classifications

Replacement Projects:

Need to continue current operations

Need to reduce costs

Expansion Projects:

Need to expand existing products or markets

Need to expend into new products or markets

Others: safety/environmental projects, mergers

. Capital Assets - Projects Appraisal techniques

(1) Net present value (NPV): present value of future net cash flows, discounted at the cost of capital

, where r is the cost of capital, CFt is the cash flow in time t ..

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(2) Internal rate of return (IRR): rate of return a project earns (a discount rate that forces a project’s NPV to equal zero)

..

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Problems associated with IRR:

Multiple rates of return and unrealistic reinvestment rate assumption

(3) Modified internal rate of return (MIRR): discount rate at which the present value of initial cost is equal to the present value of the terminal value

(4) Payback period: the length of time (years) required for an investment’s cash flows to cover its cost

(5) Discounted payback period: the length of time (years) required for an investment’s cash flows, discounted at the investment’s cost of capital to recover its cost

Decision rule: if NPV > 0, accept the project; if NPV < 0, reject the project

Independent vs. mutually exclusive projects

Independent projects are projects with cash flows that are not affected by the acceptance or rejection of other projects

Mutually exclusive projects are a set of projects where only one can be accepted

In general, you should choose the project with the highest positive NPV

If they are independent, you choose all projects with NPV > 0

Decision rule: if IRR > r, accept the project; if IRR < r, reject the project

where r is the hurdle rate (the required rate of return for the project)

Multiple IRRs: the situation where a project has two or more solutions (or IRRs)

Reinvestment rate assumptions: NPV approach is based on the assumption that

cash flows can be reinvested at the project’s risk-adjusted WACC, where the IRR

approach is based on the assumption that cash flows can be reinvested at the

project’s IRR

(3) MIRR approach

(1) Compound each future cash inflow to the “terminal year”, using WACC

(2) Add all the future values to get “terminal value”

(3) Calculate I/YR to get MIRR

Decision rule: if MIRR > r, accept the project; if MIRR < r, reject the project

where r is the hurdle rate (the required rate of return for the project)

NPV profile: a graph that shows the relationship between a project’s NPV and the firm’s cost of capital

Crossover rate: the cost of capital at which the NPV profiles of two projects cross and thus, at which the projects’ NPVs are equal

Ranking problem (conflict): NPV approach and IRR approach sometimes will

lead to different rankings for mutually exclusive projects

If ranking problem occurs use NPV approach to make the final decision

Main conditions to cause conflicts

a. Timing of cash flows

b. Scale of cash flows

(4) Payback period approach

Decision rule:

If payback < maximum payback, then accept the project

If payback > maximum payback, then reject the project

Weaknesses:

Arbitrary maximum payback

Ignores time value of money

Ignores cash flows after maximum payback period

(5) Discounted payback period approach

Step 1: discount future cash flows to the present at the cost of capital (round to the

nearest whole dollar)

Step 2: follow the steps similar to payback period approach

Decision rule: similar to that of payback period

Weaknesses:

Arbitrary maximum discounted payback period

Ignores cash flows after maximum discounted payback period

. Cash flow estimation

Guidelines when estimating cash flows:

Use after tax cash flows

Use increment cash flows

Changes in net working capital should be considered

Sunk costs should not be included

Opportunity costs should be considered

Externalities should be considered

Ignore interest payments (separate financing decisions from investment decisions)

FCF = [EBIT*(1 - T) + depreciation] – [capital expenditures + NOWK) .

EBIT*(1 - T) = net operating profit after tax = NOPAT

NOWK = change in net operating working capital

Steps in estimating cash flows:

(1) Initial outlay

(2) Differential (operating) cash flows over project’s life

(3) Terminal cash flows

(4) Time line and solve

MBA Core Management Knowledge - One Year Revision Schedule

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