1、PowerPoint to accompanyChapter 4&5Capital budgetingFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaThis lecture The decision as to which projects should be undertaken by a corporation is known as the investment decision,and the process is known as capital budgeting In this
2、 lecture we will examine 4 techniques:Net present value(NPV)Internal rate of return(IRR)Payback technique Average accounting rate of return(ARR)We will also compare these techniques and ascertain their strengths and weaknessesFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson Australi
3、aThis lecture Given a projects expected cash flows,it is easy to calculate its NPV,IRR,payback and ARR However,it can be difficult to estimate future cash flows(and there are uncertainties due to varying levels of risk between different projects)In this lecture we will:Develop procedures for estimat
4、ing cash flows,including a discussion of issues such as cash flow identification,taxation and inflation Describe techniques for assessing the risk level Discuss some special cases in capital budgetingFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaWhat is Capital Budgeting
5、?When a corporation allocates funds to long-term investment projects,the outlay is made in the expectation of generating future cash flows In making the decision to invest in a project,the key consideration is whether or not the proposal provides an adequate return to investors The process used by a
6、 corporation to select projects to invest in is called capital budgeting(or project evaluation)Capital budgeting is essentially the process used to decide on the optimum use of scarce resourcesFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaWhat is Capital Budgeting?There
7、are three fundamental stages in making capital budgeting decisions:Stage 1 is the forecasting of financial costs and benefits associated with a project Stage 2 involves the application of an investment evaluation technique to decide whether a project is acceptable,or optimal amongst a set of alterna
8、tive projects Stage 3 is the ultimate decision to accept or reject a projectFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaTechniques The four best-known investment evaluation techniques will be discussed Two of these are based on the discounted cash flow(DCF)model:Net pr
9、esent value Internal rate of return(IRR)The other two are ad-hoc(accounting-based)techniques:Payback(Average)accounting rate of return(ARR)Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaTechniques Four general criteria provide a basis for assessing the acceptability of th
10、e methods1.Does the method correctly rank competing projects?2.Does the method correctly identify wealth-increasing project?1.Does the method recognise the timing of the cash flows and their relative magnitudes?1.Can management understand the results?Frino,Hill,Chen:Introduction to Corporate Finance
11、,4e 2009 Pearson AustraliaNet Present Value(NPV)This technique involves calculating the present value of all future cash inflows and cash outflows that will result from undertaking a project These positive and negative present values are then netted off against one another to determine the net prese
12、nt value of the project The firm should accept all positive-NPV projects and reject negative-NPV projects,because NPV is a measure of the increase in firm value(and therefore the wealth of the firms owners)from undertaking the projectFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson
13、AustraliaNPV If the NPV of a project is zero,it is a matter of indifference as to whether the firm should undertake the project or pay the available cash back to shareholders This is because zero NPV indicates that the project yields the same future cash that the investors could obtain by investing
14、themselves A project is acceptable if the accumulated cash flow at the end of the project exceeds the cash flow that investors could have generated by investing the cash in the project themselvesFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaNPVExample:A company has$100 m
15、illion in surplus cash and has the following alternatives available:Option 1:Invest the cash in a project paying$106m in 1 yearOption 2:Pay$100m in dividends,which shareholders can invest at 7%Shareholders are clearly better off under Option 2,because investing$100m at 7%will allow them to accumulat
16、e$107m by the end of the year.If the company chose Option 1,they would be reducing shareholder wealth by$1 million.Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaNPV The net present value of a project is calculated as follows:(4.1)where:Ft=cash flow generated by the proje
17、ct in year tr=the opportunity cost of capitalC0=the cost of the project(initial cash flow,if any)n=the life of the project in years 0n1tttCr1FNPV Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaNPVExample:Apply the NPV rule to a project that costs$100 million and yields$10
18、6 million in one year when the opportunity cost of capital is 7%.m1$m10007.1m106Cr1FNPV0n1ttt Since the NPV is negative,it should be rejected.Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaNPVExample:A company is considering whether to outlay$500,000 for a machine that wi
19、ll generate$150,000 p.a.over the next 5 years.What is the NPV of this project,given an opportunity cost of capital of 10%?618,68$000,5001.01.11000,150Crr11FCr1FNPV50n0n1ttt Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaNPV The strengths of the NPV technique are:It always
20、 ensures the selection of projects that maximise the wealth of shareholders It takes into account the time value of money It considers all cash flows expected to be generated by a project Two possible weaknesses are:It requires extensive forecasts of the costs and benefits of a project,which can be
21、problematic The concept is difficult for non-finance-trained managers to understandFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaInternal Rate of Return(IRR)The IRR technique is also based on a DCF model,but focuses on the rate of return in the DCF equation rather than t
22、he NPV The IRR is defined as the discount rate that equates the present value of a projects cash inflows with the present value of the its cash outflows This is the equivalent of saying that the IRR is the discount rate at which the NPV of the project is equal to 0Frino,Hill,Chen:Introduction to Cor
23、porate Finance,4e 2009 Pearson AustraliaIRR Stated formally:(4.2)where:Ft=the cash flow generated by the project in year tC0=the initial cost of the project(initial cash inflow,if any)n=the life of the project in yearsirr=the internal rate of return of the project 0n1tttCirr1F0 Frino,Hill,Chen:Intro
24、duction to Corporate Finance,4e 2009 Pearson AustraliaIRR The unknown variable in Equation 4.2 can be solved using trial-and-error or through computational techniques The decision rule is to accept a project if its IRR is greater than the cost of capital and reject it if its IRR is less than the cos
25、t of capital It is clear from a comparison of Equations 4.1 and 4.2 that NPV and IRR use the same framework and inputs,so they should result in the same accept/reject decisionFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaIRRExample:Apply the IRR rule to a project that co
26、sts$100 million and yields$106 million in one year when the opportunity cost of capital is 7%.%6irrm100irr1m1060Cr1F00n1ttt If the hurdle rate is set at the cost of capital(7%),the project is not acceptable since the IRR is below the hurdle rateFrino,Hill,Chen:Introduction to Corporate Finance,4e 20
27、09 Pearson AustraliaIRR Given that the IRR technique uses the same structure as the NPV technique,it shares most of the latters advantages Furthermore,many financial managers have difficulty understanding what the NPV number actually means IRR is a percentage rate of return that is intuitive to most
28、,and can easily be compared with rates of return on alternative investmentFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaIRR There are some problems in applying the IRR technique(listed below and demonstrated using the following examples):It is difficult to calculate typi
29、cally requires a computational method The decision rule must be modified depending on whether the project being evaluated is an investment or financing(e.g.borrowing)project For projects involving both positive and negative future cash flows,multiple internal rates of return can exist(solution to po
30、lynomial)It can give an incorrect ranking when evaluating projects of different sizeFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaIRR 5432irr14000irr11000irr12000irr12000irr1100020000 Example:The IRR can sometimes only be solved by trial and error.YEAR012345Net cash flow
31、s-2000-100020002000-10004000To solve this problem using trial-and-error,you select a discount rate and substitute it into the equation.If the NPV is negative(positive)the discount rate is too high(low).By narrowing down the difference between the two rates,we can approach the IRR.In this case the IR
32、R is approximately 31%.Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaIRRExample:Applying the IRR rule to investing and financing projects.Investing project:Financing project:YEAR01IRRYEAR01IRRProject A-10013030%Project A100-13030%Project B-10014040%Project B100-14040%In
33、the case of an investment project,a corporation will choose a project with the highest rate of return(Project B in the above example).In the case of a financing project,a corporation is looking for the cheapest source of finance i.e.the lowest interest rate(Project A in the above example).Frino,Hill
34、,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaIRR 2irr1132irr12301000 Example:Multiple rates of return.YEAR012Net cash flows-100230-132Solving for the IRR,we find that IRR=10%or 20%.If the cost of capital were,say,15%,it is unclear whether the project should be undertaken.An appli
35、cation of the NPV technique would resolve this problem(NPV=+$64.69).Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaIRRExample:The IRR does not take into account the size of projects.YEAR01IRRWhich project is better if the opportunity cost of capital is 5%?Small project-11
36、.550%Large project-10011010%The small project is clearly favoured by the IRR technique.However,if a corporation has$100m to spend,takes on the small project,and returns the unspent$99m to shareholders,which is then reinvested at the opportunity cost of capital(5%),their total wealth at the end of th
37、e year will be about$105.5m(99 1.05+1.5).Investing the entire$100m in the large project will generate total wealth of$110m.Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaPayback Technique This method involves determining the time taken for the initial outlay to be repaid
38、by the projects expected cash flows When selecting among a number of projects,the one with the shortest payback period should be chosen However,there is little guidance on what an appropriate payback period should be,making it difficult to decide whether a project should be accepted or notFrino,Hill
39、,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaPayback The payback is given by:(4.3)before full recoveryunrecovered cost at start of yearcash flow during yearyearPayback Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaPaybackExample:The payback approach s
40、ome problems?Year0123456PaybackProject A-1000100200800100100100Cum NCF-900-7001002003004002.88 yrsAt the end of the third year,the sign of the cumulative net cash flow has changed from negative to positive.Therefore,the payback occurred during the third year.If we assume the year 3 cash flow,$800,is
41、 earned evenly during year 3,the payback period is:years875.28007002PaybackA Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaPaybackExample:The payback approach some problems?Year0123456PaybackProject A-1000100200800100100100Cum NCF-900-7001002003004002.88 yrsProject B-100
42、08001500200100100Cum NCF-200-50-501502503503.25 yrsThe payback technique indicates that Project A should be chosen.However,the proceeds acquired in the early years of Project B could be reinvested at current interest rates.The payback technique ignores the time value of money,and therefore can resul
43、t in inferior decisions.Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaPayback The discounted payback period is similar to the normal payback period except that the cash flows are discounted to present value The discounted payback period is the time taken to recover the i
44、nitial outlay from discounted cash flows This technique yields the following periods:Project A:5.22 years Project B:4.20 yearsFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaPaybackExample:The payback approach some problems?Year0123456PaybackProject A-100010020080010010010
45、0Cum NCF-900-7001002003004002.88 yrsProject C-10001001502504505006000Cum NCF-900-750-500-5045064504.10 yrsThe payback technique indicates that Project A should be chosen over Project C,but this fails to take into account the large cash flow($6000)in Project Cs sixth year.The payback technique ignore
46、s cash flows beyond the minimum payback period.Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaPayback Disadvantages of the payback technique include the fact that it:Does not indicate the effects of the project on wealth Does not recognise the time value of money Cannot r
47、ank projects that have the same payback period Does not recognise the cash flows beyond the payback period Since the NPV approach overcomes these problems,it should be used in capital budgetingFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaAverage Accounting Rate of Retur
48、n(ARR)The ARR is the percentage return on invested physical capital,and is based on accounting income and historical cost asset figures The ARR is given by:(4.4)The ARR is compared with a predetermined ARR target,or cut-off rate,to determine whether to proceed with a projectcapital invested averagei
49、ncome averageARR Frino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaARR There are four steps in calculating the ARR:Step 1:The average income over the life of the asset is estimated(where average income equals earnings before depreciation,interest and tax(EBDIT),less deprecia
50、tion and tax)Step 2:The average net investment(after depreciation)is estimated Step 3:The ARR is found using Equation 4.4 Step 4:If the ARR is greater than target return,the project should be acceptedFrino,Hill,Chen:Introduction to Corporate Finance,4e 2009 Pearson AustraliaARRExample:Step 1Calculat
