Capital Budgeting Techniques

This week’s overarching topic is capital budgeting techniques. Please share your observations and takeaways of this week’s learning objectives as they relate to your job/role (CLINICAL ANALYST). How do capital budgeting techniques impact you personally and/or what impact does capital budgeting techniques have on your professional role?
Principles of Managerial Finance
Sixteenth Edition
Chapter 10
Capital Budgeting Techniques
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Pearson Education, Inc. All Rights
Reserved.
Learning Goals (1 of 2)
LG 1 Understand the key elements of the capital budgeting
process.
LG 2 Calculate, interpret, and evaluate the payback period.
LG 3 Calculate, interpret, and evaluate the net present value
(NPV) and economic value added (EVA).
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Learning Goals (2 of 2)
LG 4 Calculate, interpret, and evaluate the internal
rate of return (IRR).
LG 5 Use net present value profiles to compare
NPV and IRR techniques.
LG 6 Discuss NPV and IRR in terms of conflicting
rankings and the strengths of each approach.
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10.1 Overview of Capital Budgeting
(1 of 10)
• Capital Budgeting
• The process of evaluating and selecting long-term
investments that are worth more than they cost and
create wealth for investors
• Capital Expenditure
• An outlay of funds that produces benefits over several
years
.
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10.3 Net Present Value (NPV) (4 of 10)
• Decision Criteria
• If the NPV is greater than $0, accept the project
• If the NPV is less than $0, reject the project
• If the NPV is greater than $0, the firm will earn a return
greater than its cost of capital
• The investment’s cash inflows exceed outflows on a
present value basis, so the firm’s market value will
increase by an amount equal to the NPV
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Example 10.6 (1 of 5)
We can use Equation 10.1a to calculate the NPV for
Bennett Company projects A and B, whose cash flows
appeared in Table 10.1. Using Bennett’s 10% cost of
capital to discount the project cash flows, the calculations
result in net present values for projects A and B of
$110,710 and $109,244, respectively.
NPVA = ?$420, 000 +
$140, 000 140, 000
140, 000
140, 000
140, 000
+
+
+
+
(1 + 0.10)1 (1 + 0.10) 2 (1 + 0.10)3 (1 + 0.10) 4 (1 + 0.10)5
NPVB = ?$450, 000 +
$120, 000
$120, 000 $120, 000 $120, 000 $120, 000
+
+
+
+
+
(1 + 0.10)1
(1 + 0.10) 2 (1 + 0.10)3 (1 + 0.10) 4 (1 + 0.10)5
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Example 10.6 (2 of 5)
Figure 10.2 depicts the cash flows and NPVs for the
Bennett projects. With positive NPVs, both projects are
acceptable, but project A is more valuable than B.
Project A’s higher NPV means that it creates more value
for investors, so if managers can pursue only one
investment, they would choose A.
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Figure 10.2 Calculation of NPVs for
Bennett Company’s Capital Expenditure
Alternatives
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Example 10.6 (3 of 5)
Calculator use We can use the
cash flow register CF and
preprogrammed NPV function in a
financial calculator to perform the
NPV calculation. The keystrokes
for project A begin with entering
the investment amount as a cash
outflow at time 0, CF0 = -420,000.
Next, enter the first annuity cash
inflow, CF1 = 140,000, and then
indicate the frequency of the
annuity’s cash inflow, F01 = 5.
After entering the discount rate, I/Y
= 10, compute the NPV.
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Example 10.6 (4 of 5)
The keystrokes for project B—the mixed
stream—appear in the left margin.
Because the last three cash inflows for
project B are the same (CF3 = CF4 = CF5
= 100,000), after inputting the first of
these cash inflows, CF3, we merely input
its frequency, F03 = 3.
The calculated NPVs for projects A and
B of $110,710 and $109,244,
respectively, agree with the NPVs
already cited.
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Example 10.6 (5 of 5)
Spreadsheet use The following Excel screenshot illustrates how
to calculate the NPVs using a spreadsheet.
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10.3 Net Present Value (NPV) (5 of 10)
• NPV and the Profitability Index
• A variation of the NPV rule
• For a project that has an initial cash outflow followed by
cash inflows, the profitability index (PI) is simply equal to
the present value of cash inflows divided by the absolute
value of the initial cash outflow:
n
CFt
?
t
t =1 (1 + r )
PI =
CF0
(10.2)
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10.3 Net Present Value (NPV) (6 of 10)
• NPV and the Profitability Index
• A PI greater than one implies that the present value of
•
cash inflows is greater than the (absolute value of the)
initial cash outflow, so a profitability index greater than
one corresponds to a positive net present value
In other words, the NPV and PI methods will always
come to the same conclusion regarding whether a
particular investment is worth doing or not
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Example 10.7 (1 of 2)
Figure 10.2 shows the present value of cash inflows for
Bennett’s projects A and B. Dividing those present
values by each investment’s initial cost gives the
profitability index for each investment.
PIA = $530,710 ÷ $420,000 = 1.26
PIB = $559,244 ÷ $450,000 = 1.24
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Example 10.7 (2 of 2)
According to the profitability index, both projects are
acceptable (because PI > 1.0 for both), which shouldn’t
be surprising because both projects have positive NPVs.
Furthermore, in this particular case, the NPV rule and the
PI both indicate that project A is preferred over project B.
It is not always true that the NPV and PI methods will
rank projects in exactly the same order. Different
rankings can occur when alternative projects require
initial outlays that have very different magnitudes.
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10.3 Net Present Value (NPV) (7 of 10)
• NPV and Economic Value Added
• Economic Value Added (EVA), a registered
•
•
trademark of the consulting firm Stern Stewart & Co.,
is another close cousin of the NPV method
Whereas the NPV approach calculates the value of
an investment over its entire life, the EVA approach
gives managers a tool to measure an investment’s
performance on a year-by-year basis as well as over
its entire life
The EVA method begins the same way that NPV
does: by calculating a project’s net cash flows
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10.3 Net Present Value (NPV) (8 of 10)
•
NPV and Economic Value Added
However, the EVA approach subtracts from those cash
flows a charge that is designed to capture the return that
the firm’s investors demand on the project
•
EVA = NOPAT – EVA charge
= (OCF – Depreciation) – (Invested
capital × cost of capital)
(10.3)
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10.3 Net Present Value (NPV) (9 of 10)
• NPV and Economic Value Added
• By subtracting a capital charge from each year’s
•
•
NOPAT, the EVA calculation asks whether a project
generates positive cash flows above and beyond
what investors demand based on their investment in
the project
To calculate the EVA for the project over its entire
life, simply discount the annual EVA figures using
the firm’s cost of capital
If the resulting figure is positive, the project
generates a positive EVA and is worth undertaking
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10.3 Net Present Value (NPV) (10 of 10)
• NPV and Economic Value Added
• The EVA method determines whether a project earns a
pure economic profit
• Pure Economic Profit
• A profit above and beyond the normal competitive
rate of return in a line of business
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Example 10.8 (1 of 5)
Table 10.5 shows the calculations for the annual EVA and
project EVA for Bennett Company’s projects A and B using the
initial investment and operating cash flows shown in Table 10.1.
To find the annual NOPAT and invested capital each year, we
have to make an assumption about how the initial investment for
each project depreciates over time.
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Table 10.5 Annual EVA and Project
EVA for Projects A and B (1 of 4)
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Project A
Year
OCF
Depreciation
NOPAT
Beginning of Year
Invested Capital
1
$140,000
$84,000
$140,000 ? $84,000 =
$56,000
$420,000 ? $84,000 × 0 =
$420,000
2
$140,000
$84,000
$140,000 ? $84,000 =
$56,000
$420,000 ? $84,000 × 1 =
$336,000
3
$140,000
$84,000
$140,000 ? $84,000 =
$56,000
$420,000 ? $84,000 × 2 =
$252,000
4
$140,000
$84,000
$140,000 ? $84,000 =
$56,000
$420,000 ? $84,000 × 3 =
$168,000
5
$140,000
$84,000
$140,000 ? $84,000 =
$56,000
$420,000 ? $84,000 × 4 =
$84,000
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Table 10.5 Annual EVA and Project
EVA for Projects A and B (2 of 4)
Year
EVA Charge
Annual EVA
PV of Annual EVAs
1
$420,000 × 10, =
$42,000
$56,000 ? $42,000 =
$14,000
$14,000 ÷ (1 $ 10%)1 = $12,727
2
$336,000 × 10, =
$33,600
$56,000 ? $33,600 =
$22,400
$22,400 ÷ (1 $ 10%)2 = $18,512
3
$252,000 × 10, =
$25,200
$56,000 ? $25,200 =
$30,800
$30,800 ÷ (1 $ 10%)3 = $23,140
4
$168,000 × 10, =
$16,800
$56,000 ? $16,800 =
$39,200
$39,200 ÷ (1 $ 10%)4 = $26,774
5
$84,000 × 10, =
$8,400
$56,000 ? $8,400 =
$47,600
$47,600 ÷ (1 $ 10%)5 = $29,556
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Sum PVs to find Project EVA =
$110,710
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Table 10.5 Annual EVA and Project
EVA for Projects A and B (3 of 4)
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Project B
Year
OCF
Depreciation
NOPAT
Beginning of Year
Invested Capital
1
$280,000
$90,000
$280,000 ? $90,000 =
$190,000
$450,000 ? $90,000 × 0 =
$450,000
2
$120,000
$90,000
$120,000 ? $90,000 =
$30,000
$450,000 ? $90,000 × 1 =
$360,000
3
$100,000
$90,000
$100,000 ? $90,000 =
$10,000
$450,000 ? $90,000 × 2 =
$270,000
4
$100,000
$90,000
$100,000 ? $90,000 =
$10,000
$450,000 ? $90,000 × 3 =
$180,000
5
$100,000
$90,000
$100,000 ? $90,000 =
$10,000
$450,000 ? $90,000 × 4 =
$90,000
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Table 10.5 Annual EVA and Project
EVA for Projects A and B (4 of 4)
Year
EVA Charge
PV of Annual EVAs
Annual EVA
1
$450,000 × 10, =
$45,000
$190,000 ? $45,000 =
$145,000
2
$360,000 × 10, =
$36,000
$30,000 ? $36,000 = ?
$6,000
?$
3
$270,000 × 10, =
$27,000
$10,000 ? $27,000 = ?
$17,000
? $ 17,000 ÷ (1 + 10%)3 = ? $ 12,772
4
$180,000 × 10, =
$18,000
$10,000 ? $18,000 = ?
$8,000
?$
8,000 ÷ (1 + 10%)4 = ? $ 5,464
5
$90,000 × 10, =
$9,000
$10,000 ? $9,000 =
$1,000
$
1,000 ÷ (1 + 10%)5 = $ 621
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$145,000 ÷ (1 + 10%)1 = $131,818
6,000 ÷ (1 + 10%)2 = ? $ 4,959
Sum PVs to find Project EVA =
$109,244
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Example 10.8 (2 of 5)
Because the projects last five years, let’s assume that
the assets purchased with the initial investments lose
one-fifth of their value through depreciation each year.
Considering project A first, the depreciation is $420,000
÷ 5 = $84,000 and NOPAT is $140,000 – $84,000 =
$56,000 each year. The EVA capital charge is based on
the invested capital at the start of each year, which in
turn equals the initial investment less accumulated
depreciation.
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Example 10.8 (3 of 5)
For example, when the project begins invested capital is
$420,000, so the capital charge is 10% of that value.
After one year, the invested capital declines by $84,000,
so the capital charge in the second year is 10% of
$336,000. With each passing year an additional $84,000
is subtracted from the remaining invested capital such
that during the final year only $84,000 remains invested
in project A. To calculate the EVA charge, multiply the
invested capital at the start of each year times the
Bennett Company’s 10% cost of capital. As the amount
of invested capital decreases over the life of the project,
the EVA charge decreases. Each year the EVA cash
flows equal NOPAT less the EVA capital charge.
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Example 10.8 (4 of 5)
Notice that project A generates a pure economic profit
every year. Repeating the annual EVA calculations for
project B reveals that only during the first and last years
does the project generate enough net operating profit to
cover the annual investment charge. This means that for
years two through four the project is generating an
economic loss. However, before rejecting project B, let’s
consider the project EVAs.
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Example 10.8 (5 of 5)
To find the project EVAs, simply discount the annual EVA cash
flows over the project’s life at Bennett’s 10% cost of capital and
sum them up. Notice that the projects have positive EVAs that
are identical to their NPVs. The NPV and EVA methods reach
the same conclusion, namely, that the projects are acceptable
because they create $110,710 and $109,244, respectively, in
value for shareholders.
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Example 10.9 (1 of 3)
Suppose that an investment in land (which never
depreciates) costs $1,000,000 up front, but after that it
will generate net cash inflows each year (in perpetuity) of
$120,000. To calculate the NPV of this project, simply
discount the cash flows and add them up. If the firm’s
cost of capital is 10%, the project’s NPV is:
NPV = – $1,000,000 + ($120,000 ÷ 0.10) = $200,000
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Example 10.9