Capital Budgeting: FIN 502: Managerial Finance

Capital Budgeting
FIN 502: Managerial Finance
George W. Gallinger
Associate Professor of Finance
W. P. Carey School of Business
Arizona State University
Typical Capital Budgeting
System
W. P. Carey Executive MBA Program Slide 2

Illustration of Sustainable
Growth

Calculating Accounting Rate
of Return

Calculating Payback Period

Calculating Discounted
Payback Period

Calculating NPV

Calculating NPV…

Use Nominal or Real WACC?
 Nominal return reflects the actual dollar return; real return

measures the increase in purchasing power gained by
holding a certain investment
(1 + nominal rate) = (1 + inflation rate) ×(1 + real rate),

1 + nom 
or, real rate =   −1
 1 + inf 
 Common in capital budgeting is the use of market rates of
return at the time of the analysis
 Market interest rates have embedded an assumption about
inflation
 Use nominal cash flows to reflect the same inflation rate as
that embedded in discount rate.
Risk-Return Tradeoff for
Projects
 Projects plotting above
the security market line
(SML) have rates of
return in excess of their
required market rates
 Positive NPVs
 Projects plotting below
the SML have rates of
return less than their
required market rates
 Negative NPVs
 Projects plotting on the
SML earn their market
rates
 Zero NPVs.

Calculating IRR

Illustration for Calculating IRR

IRR & Required Risk-Adjusted
Rate
 Appropriate rates for
comparing project
returns are those falling
on the upward sloping
market risk-return trade-
off curve
 Not the firm’s horizontal
cost of capital line,
WACC
 WACC is only
appropriate for
evaluating projects with
risk comparable to the
level of risk of the firm
 “Carbon copy” projects.

Size Problem

Cash Flow Pattern Problems

Multiple IRR Solutions

Undervaluation of Later Cash
Flows

Calculating the Profitability
Index

Comparison of Project
Rankings
 Project B is better
than project A
 Project B continues
to earn cash flows
longer
 Project D is more
desirable than
project C
 Although both
projects generate
the same amount
of cash flows,
project D does it
earlier
 Unanswered
question:
 Is Project D better
than
W. P. project
Carey B?MBA Program
Executive Slide 19
Sunk Costs

Salvage Value Comparisons

Calculating Initial Investment

Calculating Annual Operating
Cash Flows

Alternatively, Calculating Annual
Operating Cash Flows…

Calculating Terminal Cash
Flows

Salvage Value: Present vs.
Future

Another Topic:
Competing Projects
 Assume projects
 Mutually exclusive
 On-going
 Different economic lives
 How do you select the correct
project?

Example
 There are times when application of the NPV
rule can lead to the wrong decision
 Consider a factory which must have an air
cleaner
 The equipment is mandated by law, so there is no
“doing without”
 There are two choices:
 The “Cadillac cleaner” costs $4,000 today, has
annual operating costs of $100 and lasts for 10
years
 The “cheaper cleaner” costs $1,000 today, has
annual operating costs of $500 and lasts for 5 years
 Which one should we choose?
Example …
 At first glance, the cheap cleaner has the
“better” NPV (r = 10%):
10
$100
NPVCadillac = −$4,000 − ∑ t
= −4,614.46
t =1 (1.10)
5
$500
NPVcheap = −$1,000 − ∑ t
= −2,895.39
t =1 (1.10)
 Overlooks the fact that the Cadillac cleaner lasts twice as

long
 When we incorporate project life, the Cadillac cleaner is
actually cheaper.
Example …
 The Cadillac cleaner time line of cash flows:
-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100
0 1 2 3 4 5 6 7 8 9 10
10
$100
NPVCadillac = −$4,000 − ∑ t
= −4,614.46
t =1 (1.10)
 The “cheaper cleaner” time line of cash flows over ten

years:
-$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500
0 1 2 3 4 5 6 7 8 9 10
5
$500 $1,000 10 $500
NPVcheap = −$1,000 − ∑ t
− 5
−∑ t
= −$4,693.20
t =1 (1.10) (1.10) t =6 (1.10)
Investments of Unequal Lives
 Replacement Chain
 Repeat the projects forever, find the PV of that
perpetuity
 Assumption: Both projects can and will be repeated
 Matching Cycle
 Repeat projects until they begin and end at the
same time—like we just did with the air cleaners
 Compute NPV for the “repeated projects”
 The Equivalent Annual Annuity (EAA) Method.

Equivalent Annual Cost
Method
 Equivalent Annual Annuity Method
 Provides the value of the level payment annuity that
has the same PV as the original set of cash flows
 NPV = EAA × ArT
 For example, the EAA for the Cadillac air cleaner is
$750.98
10 10
$100 $750.98
∑ (1.10) ∑ (1.10)
Annuity Table
− $4,000 − t
= −4,614.46 = t 10%, 10 years
= 6.1446
t =1 t =1
The EAA for the cheaper air cleaner is $763.80,

which confirms our earlier decision to reject it.
Another Example:
Calculating EAA

Human Face of Capital
Budgeting
 NPV of a project  based on assumptions
 Managers must be aware of optimistic bias in these
assumptions made by supporters of the project
 Companies need control measures to remove
bias
 Analysis done by a group independent of individual or
group proposing the project
 Analysts must have a sense of what is reasonable
when forecasting a project’s profit margin and its
growth potential
 Another side of determining which projects
receive funding – storytelling
 Best analysts not only provide numbers to highlight a
W.good
P. Careyinvestment, but also can explain why this
Executive MBA Program Slide 34
investment makes sense.
The End

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Capital Budgeting

FIN 502: Managerial Finance

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 Nominal return reflects the actual dollar return; real return

(1 + nominal rate) = (1 + inflation rate) ×(1 + real rate),

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 Overlooks the fact that the Cadillac cleaner lasts twice as

 The “cheaper cleaner” time line of cash flows over ten

W. P. Carey Executive MBA Program Slide 31

The EAA for the cheaper air cleaner is $763.80,

W. P. Carey Executive MBA Program Slide 33

W. P. Carey Executive MBA Program Slide 35

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