Capital Budgeting 1l6560
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Chapter
Capital Budgeting
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Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 2
Net Present Value Net Present Value - Present value of cash flows minus initial investments.
Opportunity Cost of Capital - Expected rate of return given up by investing in a project
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 3
Net Present Value NPV = PV of all cash inflows - initial investment
Ct NPV C0 (1 r ) t C1 C2 Ct NPV C0 ... 1 2 (1 r ) (1 r ) (1 r ) t Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 4
Net Present Value Terminology C = Cash Flow and C0 = Initial Investment t = time period of the investment r = “opportunity cost of capital”
The Cash Flow could be positive or negative at any time period. Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 5
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 6
Irwin/McGraw Hill
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7- 7
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 8
Net Present Value Net Present Value Rule Managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value.
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 9
Payback Method Payback Period - Time until cash flows recover the initial investment of the project. The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period. The following example will demonstrate the absurdity of this statement.
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 10
Payback Method Example The three project below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact our decision. Cash Flows Project C0 C1 C2 C3 A -2000 +1000 +1000 +10000 B -2000 +1000 +1000 0 C -2000 0 +2000 0
Irwin/McGraw Hill
Payback 2 2 2
NPV@10% + 7,249 264 347
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 11
Other Investment Criteria Internal Rate of Return (IRR) - Discount rate at which NPV = 0. Rate of Return Rule - Invest in any project offering a rate of return that is higher than the opportunity cost of capital.
C1 - investment Rate of Return = investment Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 12
Internal Rate of Return IRR is the discount rate that makes your NPV equals to zero thus following relationship hold: PV (inflows) = PV (Outflow)
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 13
Internal Rate of Return
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 14
Internal Rate of Return
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 15
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 16
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 17
Discounted Payback Period
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 18
Discounted Payback Period
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 19
Profitability Index
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 20
Profitability Index
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 21
Profitability Index
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 22
Modified IRR (MIRR) While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project.
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Capital Budgeting
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 2
Net Present Value Net Present Value - Present value of cash flows minus initial investments.
Opportunity Cost of Capital - Expected rate of return given up by investing in a project
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 3
Net Present Value NPV = PV of all cash inflows - initial investment
Ct NPV C0 (1 r ) t C1 C2 Ct NPV C0 ... 1 2 (1 r ) (1 r ) (1 r ) t Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 4
Net Present Value Terminology C = Cash Flow and C0 = Initial Investment t = time period of the investment r = “opportunity cost of capital”
The Cash Flow could be positive or negative at any time period. Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 5
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 6
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 7
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 8
Net Present Value Net Present Value Rule Managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value.
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 9
Payback Method Payback Period - Time until cash flows recover the initial investment of the project. The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period. The following example will demonstrate the absurdity of this statement.
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 10
Payback Method Example The three project below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact our decision. Cash Flows Project C0 C1 C2 C3 A -2000 +1000 +1000 +10000 B -2000 +1000 +1000 0 C -2000 0 +2000 0
Irwin/McGraw Hill
Payback 2 2 2
NPV@10% + 7,249 264 347
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 11
Other Investment Criteria Internal Rate of Return (IRR) - Discount rate at which NPV = 0. Rate of Return Rule - Invest in any project offering a rate of return that is higher than the opportunity cost of capital.
C1 - investment Rate of Return = investment Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 12
Internal Rate of Return IRR is the discount rate that makes your NPV equals to zero thus following relationship hold: PV (inflows) = PV (Outflow)
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 13
Internal Rate of Return
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 14
Internal Rate of Return
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 15
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 16
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 17
Discounted Payback Period
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 18
Discounted Payback Period
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 19
Profitability Index
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 20
Profitability Index
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 21
Profitability Index
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
7- 22
Modified IRR (MIRR) While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project.
Irwin/McGraw Hill
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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