Capital budgeting

JOIN KHALID AZIZ ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

[object Object],The Capital Budgeting Decision Process ,[object Object],[object Object],[object Object],[object Object]

Capital Budgeting Decision Techniques ,[object Object],Accounting rate of return (ARR): focuses on project’s impact on accounting profits Net present value (NPV): best technique theoretically; difficult to calculate realistically Internal rate of return (IRR): widely used with strong intuitive appeal Profitability index (PI): related to NPV

A Capital Budgeting Process Should: Account for the time value of money; Account for risk; Focus on cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders’ wealth.

Example: Global Wireless ,[object Object],[object Object],[object Object],[object Object]

Global Wireless $175 Year 5 inflow $160 Year 4 inflow $130 Year 3 inflow $80 Year 2 inflow $35 Year 1 inflow -$250 Initial Outlay $32 Year 5 inflow $30 Year 4 inflow $25 Year 3 inflow $22 Year 2 inflow $18 Year 1 inflow -$50 Initial Outlay

Accounting Rate Of Return (ARR) Can be computed from available accounting data ARR uses accounting numbers, not cash flows; no time value of money. ,[object Object],[object Object],Average profits after taxes Average annual operating cash inflows Average annual depreciation = –

[object Object],Payback Period ,[object Object],[object Object],Management determines maximum acceptable payback period.

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Payback Analysis For Global Wireless

Pros and Cons of the Payback Method ,[object Object],[object Object],[object Object],[object Object],Disadvantages of payback method: ,[object Object],[object Object],[object Object],[object Object]

[object Object],[object Object],[object Object],[object Object],Discounted Payback Reject (46.3<50) Reject (166.2 < 250)

Net Present Value (NPV) NPV: The sum of the present values of a project’s cash inflows and outflows. Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk. Accept projects if NPV > 0.

[object Object],Net Present Value (NPV) ,[object Object],[object Object]

[object Object],NPV Analysis for Global Wireless Should Global Wireless invest in one project or both? Western Europe project: NPV = $75.3 million Southeast U.S. project: NPV = $25.7 million

The NPV Rule and Shareholder Wealth

Pros and Cons of NPV NPV is the “gold standard” of investment decision rules. ,[object Object],[object Object],[object Object],[object Object],Though best measure, NPV has some drawbacks: ,[object Object],[object Object]

Internal Rate of Return (IRR) IRR: the discount rate that results in a zero NPV for a project. The IRR decision rule for an investing project is : ,[object Object],[object Object]

NPV Profile and Shareholder Wealth

IRR Analysis for Global Wireless Global Wireless will accept all projects with at least 18% IRR. Western Europe project: IRR ( r WE ) = 27.8% Southeast U.S. project: IRR (r SE ) = 36.7%

Pros and Cons of IRR ,[object Object],[object Object],[object Object],[object Object],[object Object],Disadvantages of IRR: ,[object Object],[object Object],[object Object]

Multiple IRRs Which IRR do we use? When project cash flows have multiple sign changes, there can be multiple IRRs. IRR IRR

No Real Solution Sometimes projects do not have a real IRR solution . Modify Global Wireless’ s Western Europe project to include a large negative outflow ( -$ 355 million ) in year 6 . ,[object Object],Project is a bad idea based on NPV. At r =1 8 %, project has negative NPV, so reject!

Conflicts Between NPV and IRR: The Scale Problem NPV and IRR do not always agree when ranking competing projects. ,[object Object],The scale problem: $25.7 mn 36.7% Southeast U.S. $75.3 mn 27.8% Western Europe NPV (18%) IRR Project

Conflicts Between NPV and IRR: The Scale Problem ,[object Object],[object Object],[object Object]

Conflicts Between NPV and IRR: The Timing Problem ,[object Object]

Profitability Index Decision rule: Accept project with PI > 1.0, equal to NPV > 0 ,[object Object],Calculated by dividing the PV of a project’s cash inflows by the PV of its initial cash outflows. Like IRR, PI suffers from the scale problem. 1.5 $50 million $75.7 million Southeast U.S. 1.3 $250 million $325.3 million Western Europe PI Initial Outlay PV of CF (yrs1-5) Project

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Capital Budgeting

Capital budgeting

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Capital budgeting