1、Introduction to Capital BudgetingInvestment Evaluation Techniques2010EFN406 Managerial Finance Slide2 Lecture Notes PBEHP Chapter 5,Project Evaluation:Principles and Methods Preview the first few pages of Chapter 62010EFN406 Managerial Finance Slide3 The Nature of Capital Budgeting Types of project
2、The Investment Decision Model DCF methods Non-DCF Methods Evaluation of the Methods2010EFN406 Managerial Finance Slide4 Generation of investment proposals Evaluation and selection(forward)Approval and control of capital expenditure Post-completion audit(forward&backward)2010EFN406 Managerial Finance
3、 Slide5 Independent Mutually Exclusive Physical constraint Financial constraintUnless otherwise stated in this course we are referring to physical constraints(see section 6.8 of the textbook for analysis under financial constraints)2010EFN406 Managerial Finance Slide6 Non-Discounting Methods Account
4、ing Rate of Return Payback Period Discounting Methods Net Present Value Internal Rate of Return Profitability Index Annual EquivalentsEach has its variations2010EFN406 Managerial Finance Slide7 The net present value of a project is given by deducting the outlay(investment)from the present value of t
5、he future cash flows.In a multi-period framework this is given by the following:10)1(tttkXINPVNote the timing convention used is 0,1,2,.2010EFN406 Managerial Finance Slide8 Payback Accounting Rate of Return These methods do not explicitly involve discounting procedures-they ignore time value of mone
6、y Fairly widely used in practice Not consistent with objective of the firm2010EFN406 Managerial Finance Slide9 PB and PBR simple-common It is the time it takes the projects cash flows to pay back its initial investment normally use net cash flows Decision rule:if payback is less than target accept p
7、roject,if more then reject.2010EFN406 Managerial Finance Slide10A firm proposes to install a labour-saving machine(cost$16000)which will save$3600 in cash operating expenses per year.Life of eight year,no salvage value.Even cash flows-calculation easyPayback=$16000/$3600=4.44 yearsTarget payback set
8、 arbitrarily-usually in the range 2-5 years2010EFN406 Managerial Finance Slide11 1/PB =1/4.44=.225 Payback Reciprocal=$3600/16000=.225 or 22.5%reasonable approximation of IRR if:approximately equal cash flows small salvage value long project life(2xPB)2010EFN406 Managerial Finance Slide12012345A-900
9、0 4000 3000 2000B-9000 2000 3000 4000C-9000 3000 3000 3000 5000 5000Uneven cash flows2010EFN406 Managerial Finance Slide13 ignores time value of money ignore economic life of project ignore timing of cash flows during PB ignore cash flows after PB unable to rank projects with same PB not a good meas
10、ure of risk Could modify using discounted payback DPB which adjust for time value2010EFN406 Managerial Finance Slide14 Payback period is calculated after the cash flows have been discounted by the appropriate cost of capitalRate10%Year012345Cash Flows-9000 3000 3000 300050005000PV of Cash Flow2727 2
11、479 225434153105Cumulative2727 5207 7461 10876 139802010EFN406 Managerial Finance Slide15 Uses accounting profits as a ratio of investment to measure the return on investment Numerous variations Be sure to maintain consistency Common definitions ARRnet=Avg Acc Profit/Average Investment ARRgross=Avg
12、Acc Profit/Initial Investment2010EFN406 Managerial Finance Slide16 Using example one and assuming straight depreciation over eight years:Dep=2000.Dep=(C SV)/life=(16000 0)/8=2000 Initial Investment is 16000 Average Investment is(16000+0)/2 Profit=$3600-$2000=$1600 per year ARRgross=1600/16000=10%ARR
13、net=1600/16000+0/2=1600/8000=20%Gross uses initial investment,while net uses average investment over the period(initial investment plus salvage value)/22010EFN406 Managerial Finance Slide17 decision rule:if ARR target ARR accept,if 1 accept,if i accept,if less then reject2010EFN406 Managerial Financ
14、e Slide29011111101220122 ICFrCFrCFrICFrCFrCFrnnnn()().()()().()2010EFN406 Managerial Finance Slide3010%95115%34818%2720%-172432)1(334)1(2700)1(31501230060000rrrrIRR=18.26%2010EFN406 Managerial Finance Slide31NPV v IRR$(500)$-$500$1,000$1,500$2,000$2,500$3,0000%5%10%15%20%25%Cost of Capital%NPV$NPV20
15、10EFN406 Managerial Finance Slide32 IRR can give incorrect ranking for mutually exclusive projects.IRR multiple IRR indeterminate IRR difficult to distinguish between+ve and-ve IRR Can modify IRR to make it consistent with objective of the firm,marginal IRR2010EFN406 Managerial Finance Slide332010EF
16、N406 Managerial Finance Slide34 NPV and IRR are both DCF methods(adjust for time value of money)For independent projects they give the same accept/reject decision and are consistent with the firms objective For mutually exclusive projects,sometimes they give conflicting rankings It turns out that NP
17、V is the method which is consistent with the objective2010EFN406 Managerial Finance Slide35 Occurs when we have two mutually exclusive projects with equal lives but different initial outlays Assume two mutually exclusive projects A and B whose cash flows are as follows:012 NPVPVIIRRA-300020002000471 1.1622%B-620040004000742 1.1219%2010EFN406 Managerial Finance Slide36 Conflicts can arise for projects with the same initial outlay,eg when the pattern of cash flows is different-time disparity0123 NPVPVIIRRC-110014002001004461.4145%D-1100100500200010101.9238%2010EFN406 Managerial Finance Slide37
