1、9,Corporate Financial Management 3e Emery Finnerty Stowe,Business Investment Rules,Learning Objectives,Describe the process of capital budgeting. Calculate various investment criteria. Understand the strengths and weaknesses of NPV, IRR, and other investment criteria. Explain why an NPV profile is t
2、he most useful investment criterion.,Chapter Outline,9.1 The Capital Budgeting Process 9.2 Net Present Value 9.3 Internal Rate of Return 9.4 Using the NPV and IRR 9.5 Other Capital Budgeting Criteria 9.6 Business Investment in Practice,Focus on Principles,Valuable Ideas Look for new ideas to use as
3、a basis for capital budgeting projects will create value Comparative Advantage Look for capital budgeting projects that will use the firms comparative advantage to create value. Incremental benefits Identify and estimate the expected future cash flows for a capital budget project on an incremental b
4、asis.,Focus on Principles,Risk-Return Trade-Off Incorporate the risk of a capital budgeting project into its cost of capitalthe projects required return. Time-Value-Of-Money Measure the current value a capital budgeting project will create, its NPV.,Focus on Principles,Options Recognize the value of
5、 options, such as the option to delay, expand, or abandon a project. Two-Sided Transactions Consider why the other party to a transaction is willing to participate. Signaling Consider the products and actions of competitors.,9.1 The Capital Budgeting Process,Generating ideas for capital budgeting pr
6、ojects.Reviewing existing projects and facilities.Preparing proposals.Evaluating proposed projects and creating the capital budget.Preparing appropriation requests.,The process can be broken down into five steps as a project moves from idea to reality:,Generating ideas for capital budgeting projects
7、,The Capital Budget,The capital budget is made up of the firms planned capital expenditures. Capital budgeting projects can be classified into several categories: Maintenance Projects Cost Savings/Revenue Enhancement Capacity Expansions in Current Business New Products and New Businesses Projects Re
8、quired by Government Regulation or Firm Policy,Preparing Proposals,Generally, the originator presents a written proposal.Most large firms use standard forms, and these are typically supplemented by written memoranda.There may be consulting studies prepared by outside experts.,9.2 Net Present Value,R
9、ecall that net present value (NPV) is the difference between what something is worth and what it costs.Suppose you notice a run-down house for sale near your own house. The price is $150,000. The house requires $110,000 in repairs, which would take a year. You estimate that you could then sell the h
10、ouse for $300,000. Having this house fixed up would increase the value of your house by $15,000. If the cost of capital is 10%, what is the NPV of this project?,Calculating NPV,You invest $260,000 (= 150 + 110). If your cost of capital is 10%, the projects NPV is $26,363.64:,Notice that the projects
11、 NPV for someone who does not live in the neighborhood is only $12,727.27:,9.3 Internal Rate of Return,The internal rate of return is the discount rate that sets NPV of the expected cash flows to zero. The internal rate of return is the projects expected return. Undertake a project if the IRR exceed
12、s r, the projects cost of capital.,Calculating IRR,Example: A project costs $100,000 and is expected to generate a $28,600 cash flow per year for six years. What is the projects IRR?IRR = 18.0123% N=6 PV=-100,000 PMT=28,600 FV=0 i=18.0123,Recall that the IRR is the projects expected return. Usuallyb
13、ut not alwaysif the IRR exceeds the cost of capital, the NPV is positive. This is always true for independent, conventional projects.,9.4 Using NPV and IRR,Most of the time NPV and IRR are both valuable guides to making decisions. There are occasions, however, where NPV and IRR disagree. When in dou
14、bt, go with NPV.,NPV Profile,An NPV profile plots the projects NPV as a function of the discount rate. It shows both the NPV and the IRR of the project.It can be used to identify the range of cost of capital at which the project would add value to the firm.,NPV Profile: Example,NPV Profile,NPV ($ th
15、ousands),Discount Rate,The project has a positive NPV at discount rates less than 16.95%,And a negative NPV at discount rates more than 16.95%,Types of Projects,A conventional project is one that has an initial cash outflow, followed by one or more expected future net cash inflows. Buying a stock or
16、 bond.A non-conventional project may have several net cash outflows and inflows. Some net cash outflows may occur in the future. For example, an environmental clean up cost at the end of a project or a major overhaul during the projects life.,Types of Projects,Two projects are independent if underta
17、king one does not affect the other. IRR and NPV methods agree for conventional, independent projects.Two projects are mutually exclusive if undertaking one precludes taking the other. IRR and NPV methods can yield conflicting decisions when choosing between mutually exclusive projects.,When IRR and
18、NPV Can Disagree,Mutually exclusive projects with: Differences in size. Differences in cash flow timing. Reverse conventional projects.,Projects Of Different Size,A firm is considering two mutually exclusive one-year projects, with the cash flows shown below. The cost of capital for both projects is
19、 12%. Compute the NPV and IRR for each project and indicate which one should be undertaken. Project CF0 CF1 NPV IRR Small -1,000 +1,200 71.43 20% Big -8,000 +9,200 214.29 15%Take the higher-NPV project, Big.,Cash Flow Timing Differences,The conflict between the NPV and the IRR arises because of diff
20、erences in each methods assumption regarding the reinvestment rate. The NPV method assumes that future cash flows from the project will be reinvested at the projects cost of capital. The IRR method assumes that future cash flows from the project will be reinvested at the IRR.,Cash Flow Timing Differ
21、ences,Plot each projects NPV profile. Find each projects IRR. If each project has a cost of capital of 10%, which project should be selected? If each project has a cost of capital of 17%, which project should be selected?,A firm is considering two mutually exclusive projects, L and H. Their cash flo
22、ws are shown in the table.,Cash Flows for Projects L and H,IRR and NPV for L and H,NPV Profiles for L and H,Project H,Project L,Discount Rate,NPV,Consider this project: Year Cash flows0 -$2521 1,4312 -3,0353 2,8504 -1,000 What is the IRR? NPV = 0 at 25.00%; at 33.33%; at 42.86%, and at 66.67% The IR
23、R rule breaks down.,IRRs and Non-Conventional Projects,IRRs and Non-Conventional Projects,9.5 Other Capital Budgeting Criteria,Profitability Index Modified Internal Rate of Return (MIRR) Payback Discounted Payback Urgency,Profitability Index,Decision Rule:Undertake the project if PI 1.0,Profitabilit
24、y Index,Perma-Filter is considering two mutually exclusive one-year projects, whose cash flows are shown below. The cost of capital for either project is 12%. Compute the NPV and the PI for each project and indicate which one should be undertaken.,Profitability Index,Profitability Index,PI measures
25、the NPV per dollar invested. For independent projects, the PI method yields conclusions identical to the NPV method. For mutually exclusive projects, differences in project size can lead to conflicting conclusions. Use the NPV method. PI is useful when there is capital rationing.,Modified IRR: MIRR,
26、The MIRR is the return that equates the future value of all the projects cash flows reinvested at the cost of capital to the present value of all those cash flows.Decision Rule:Undertake the project if the MIRR exceeds the cost of capital.,Modified IRR: MIRR,A project with a 12% cost of capital cost
27、s $2,000, and is expected to return $600 per year for five years plus a salvage value of $700 at the end of five years. The MIRR = 17.6690% (IRR = 21.5226%):N=5 I=12 PV=0 PMT=600 FV=-3,811.713,811.71 + 700 = 4,511.71N=5 PV=-2,000 PMT=0 FV=4,511.71 I=17.6690N=5 PV=-2,000 PMT=600 FV=700 I=21.5226,Payb
28、ack Method,The payback is the length of time it takes for the projects cash flows to equal its investment.Decision Rule:Undertake the project if the payback is less than a preset amount of time.,Discounted Payback Method,The discounted payback is the length of time it takes for the projects discount
29、ed cash flows to equal its investment.Decision Rule:Undertake the project if the discounted payback is less than a preset amount of time.,Payback and Discounted Payback,The cash flows for two mutually exclusive projects X and Y are shown below. The cost of capital for each project is 12%. Compute th
30、e NPV, the payback, and the discounted payback for each project. Which project should the firm choose?,Payback and Discounted Payback for Project X,Payback and Discounted Payback for Projects X and Y,* Discount rate = 12%,*For Project X: 2 + 1,240/1,424*Choose Project Y,Payback and Discounted Paybac
31、k,Payback ignores the time value of money. Both require an arbitrary cutoff value. Payback ignores risk differences between projects. Both ignore cash flows after the payback period.,Urgency,This method says “invest in the project when you absolutely have to.” Replacement decisions: replace the asse
32、t only after it has broken down! It ignores planning ahead. “An ounce of prevention is worth a pound of cure.” If its worth doing . . . its worth doing right. It is the most widely used decision method. If its not important . . . do it at the last minute!,9.6 Business Investment in Practice,Most fir
33、ms use more than one method for evaluating capital budgeting projects. The NPV profile is the most useful item. It provides the most complete view of the project. Most firms also use a process for appropriating capitaleven after the projects have been selected. Firms should review project performance periodically.,Summary,The capital budgeting process and the investment criteria used to make capital budgeting decision are critical because firms are effectively defined by the products and services they provide using their capital assets.,
