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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