Chapter 9 capital budgetting techniques

to accompany Chapter 9 Capital Budgeting Techniques... Learning Goals: Understand the role of capital budgeting techniques in the capital budgeting process..  Calculate, interpret and

to accompany

Chapter 9

Capital Budgeting Techniques

Learning Goals:

 Understand the role of capital budgeting techniques in the capital budgeting process.

 Calculate, interpret and evaluate the payback period.

 Calculate, interpret and evaluate net present value

(NPV).

 Calculate, interpret and evaluate internal rate of return (IRR).

 Use NPV profiles to compare NPV and IRR

techniques.

 Discuss NPV and IRR in terms of conflicting rankings and the strengths/weaknesses of each approach.

 Calculate, interpret and evaluate other capital

Net Present Value

 Regarded as a sophisticated capital budgeting

technique, due to its explicit consideration of the time value of money.

 Calculated by:

NPV = Present Value Of - Initial Investment

Net Cash Inflows

[Equation 9.1a]

Where:

CF 0 = Project’s initial investment

CF t = Net cash inflows for year t

r = the firm’s cost of capital

0 ,

1

) ( CF PVIF CF

t

 



 Decision criteria:

 Accept if NPV > $0

 Reject if NPV < $0

If the NPV is greater than $0, the firm will earn a return greater than its cost of capital.

Using the Bennett Company data from Table 9.1,

if the firm has a cost of capital of 10%, the NPV’s

of projects A & B can be calculated as follows:

Net Present Value

Project A:

NPV = Initial Investment - PVA n

= - $42,000 + ($14,000 x 3.7908) = $11,071.20

Net Present Value

Project B:

NPV = Initial Investment - PV n

= - $42,000 + ($28,000 x 0.9091 ) + ($12,000 x 0.8264 ) + ($10,000 x 0.7513 ) + ($10,000 x 0.6830) + ($10,000 x 0.6209)

= $10,923.60

Net Present Value

Internal Rate Of Return

• Regarded as a sophisticated capital budgeting

technique for evaluating investments.

• More difficult than NPV to calculate by hand.

• The discount rate that equates the PV of net cash inflows with the initial investment in the project

• Therefore equating the NPV of the investment

opportunity with $0.

 Calculated by:

[Equation 9.2]

Where:

CF 0 = Project’s initial investment

CF t = Net cash inflows for year t

t = Year t

 Requires a trial and error approach, substituting different discount rates until the equation

balances.

Internal Rate Of Return

0

1 ( 1 )

0

IRR

CF

t









 Decision criteria:

• Accept if IRR > Cost Of Capital

• Reject if IRR < Cost Of Capital

Using the Bennett Company data from Table 9.1, if the firm has a cost of capital of 10%, the IRR of projects A & B can be calculated as follows:

Project A:

 Financial Calculator:

CF0 = -42,000, CF1 = $14,000, n = 5

IRR = 19.9%

Financial Calculator:

CF0 = -42,000, CF1 = $14,000, i = 10, n = 5

NPV = $11,071.01

Internal Rate Of Return

Project B:

 Financial Calculator:

CF 0 = -45,000, CF 1 = $28,000, CF 2 = $12,000,

CF 3 = $10,000, n = 3

IRR = 21.7%

Based on IRR project B is most preferable as it will provide the highest return on the investment.

 Formula:

If calculating IRR manually we substitute different interest rates into the equation using the cash

Internal Rate Of Return

Ranking & Conflicting

Rankings

 Ranking is necessary when:

 Conflicting rankings arise due to differences in cash flow:

 Which are a result of differences in the underlying

assumptions concerning the reinvestment of intermediate net cash flows.

Which Is Better – NPV Or IRR?

 On a theoretical basis NPV is preferred as:

• it assumes intermediate flows are reinvested at the firm’s cost of capital.

• avoids possibility of time consuming multiple IRR’s.

• it directly reflects the actual project return.

 On a practical basis, many financial managers prefer

IRR because:

• it works with rates of return not dollars.

• NPV does not measure benefits relative to the

amount invested

Most organisations use both.