Gitman Ch09 01 Student

BFA281 Financial Management
Tony Stanger Weeks 5 & 6 Capital Budgeting Techniques (Chapter 9)

Gitman, Juchau, Flanagan, Principles of Managerial Finance 5e: 2008 Pearson Education Australia 1
Learning Objectives
Discuss the role of capital project evaluation techniques Apply the payback period method Apply the net present value method Apply the internal rate of return method Compare NPV and IRR Describe some other methods
Overview
Capital budgeting is used to accept or rank capital projects The techniques employed need to integrate - time value (chapter 4) - risk and return (chapter 5) - valuation (chapters 6 and 7) The goal is to maximise shareholder wealth i.e. share price
Payback period
Definition: the payback period is the exact amount of time required for the firm to recover its initial investment Payback is calculated from net (after-tax) cash inflows Decision criterion:
Independent projects acceptance of one project does not exclude the acceptance of other projects
accept if payback period < maximum acceptable reject if payback period > maximum acceptable
Mutually exclusive projects acceptance of one project excludes the acceptance of other projects
accept project with shortest payback period if < maximum acceptable
Gitman, Juchau, Flanagan, Principles of Managerial Finance 5e: 2008 Pearson Education Australia
Payback period
Example: Project A Initial cash outlay Annual net cash-flows Year 1 Year 2 Year 3 Year 4 Year 5 ($10,000) Project B ($10,000)
$6,000 $4,000 $3,000 $2,000 $1,000
$5,000 $5,000 -
These projects have the same payback period which is two years
Payback period
Reasons for popularity:
Simple to calculate and easy to understand
Widely used in practice
inconjuction with other techniques e.g. NPV and IRR especially with small projects
Deals with cash flows, not accounting profits Used as a risk indicator
The longer the payback period, the riskier the project
Places emphasis on liquidity

Favours projects that alleviate liquidity problems
Payback period
Disadvantages Unsophisticated as fails to properly account for timing of projects cash flows
does not discount cash flows i.e. ignores time value of money
Fails to take full account of projects economic life

ignores cash flows after payback period
Maximum acceptable period is arbitrarily chosen In general, discriminates against projects with long gestation periods
Discounted (sophisticated) cash flow methods of capital project evaluation

Net present value method (NPV) and internal rate of return method (IRR) Not as simple to calculate and easy to understand as payback period method However, increasingly used in practice because:
focus on cash-flows, not accounting profits take full account of timing of cash-flows and time value of money
If required rate of return for capital projects is properly determined, both methods result in shareholder wealth maximisation
Net present value (NPV)

Difference between present value of projects net cash receipts and present value of initial cash outlay, both calculated using businesss required rate of return for capital projects as discount rate NPV = (present value of net cash inflows) (initial investment) = CF1/(1+k)1 + + CFt/(1+k)t - CF0 = [ CFt / (1 + k)t ] - CF0 from t = 1 n If CFt is an annuity = (CFt)(PVIFAk,t) CF0
Net present value (NPV)

Decision criterion
For independent projects:
accept if NPV > 0 reject if NPV < 0 indifferent if NPV = 0
For mutually exclusive projects:

project with highest positive NPV should be preferred
Value additivity principle

Value of business is sum of NPVs of its capital projects
If the NPV is positive, the firm will earn a greater return than its cost of capital
Internal rate of return (IRR)

The discount rate that equates the PV of net cash inflows with the initial investment Alternatively, the highest interest rate a business could afford to pay if it borrowed all funds needed for project, and used proceeds when received to pay interest and repay loan The IRR test guarantees the firm will earn at least its required return The IRR implies NPV = $0 More difficult than NPV to calculate

Decision criterion:
For independent projects
accept if IRR cost of capital reject if IRR < cost of capital indifferent if IRR = cost of capital
For mutually exclusive projects

project with the highest IRR above the cost of capital should be preferred
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Multiple or no IRRs
There may be as many IRRs as there are sign changes in the cash flows e.g.
A project has the following cash flows: Initial investment ($14,545) Year 1 $34,182 Year 2 ($20,000) Solve for IRR: $14,545 = 34,182/(1+IRR) 20,000/(1+IRR)2 IRR = 10% and 25% If Required Rate of Return is 15%, it is unclear whether the project should be accepted

Calculating IRR
Set NPV = $0 = CF1/(1+IRR)1 ++ CFt/(1+IRR)t - CF0 for t = 1 n, where IRR = k, or Set NPV = $0 = [ CFt / (1 + IRR)t ] - CF0 for t = 1 n, where IRR = k If net cash flows CFt are constant i.e. an annuity NPV = $0 = (CFt)(PVIFAIRR,t) CF0
=> (PVIFAIRR,t) = CF0/CFt use Table A-4 to solve for IRR E.g. Bennett Company, Figure 9.3, p.395 PVIFAIRR,5 = $42,000/$14,000 = 3 From Table A-4 IRR is 19 to 20%, approx. 20%

Calculating IRR
set NPV = $0 = [ CFt / (1 + IRR)t ] - CF0 from t = 1 n, where IRR = k
if net cash flows CFt are not an annuity

manually finding IRR from the above equation involves trial and error and is time consuming use financial calculator with IRR program or spreadsheet graphically plot NPV for various required rates of return Interpolation (not covered in Gitman et al.)
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Example
Kentiki Fast Food is developing an extra fast-food outlet. Costs and income flows are:
$2 million site acquisition and development costs (this includes plant and equipment)
$400,000 plant & equipment straight line depreciable over 5 years (assume no salvage value)
Sales in year 1 of $600,000, $700,000 per year thereafter Cost of labour & materials = 40% of sales Policy is to sell outlet in 3 years, estimated sale price is 20% more than initial cost including equipment at book value (ignore capital gains tax consequences for this example) Sales in a similar outlet of ours to decline by $70,000 in year 1 only due to loss of customers and experienced staff to new outlet Other costs: $150,000 annually (salaries, wages, training, power, cleaning, advertising) Investment in working capital = 10% of annual sales The required rate of return is 10% Tax rate 47%
Example: cash flows in year 0

Initial development costs Incremental working capital Net cash flow, after tax Net cash flow, pre tax -$2,000,000
-$53,000
-$2,053,000 -$2,053,000
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Sales Less: Cost of sales Gross profit Less: Operating costs Depreciation Net profit before tax Less: Tax Net profit after tax Add: Depreciation Operating cash flow after tax Incremental working capital Net cash flow, after tax Net cash flow, pre tax $530,000 212,000 318,000 150,000 80,000 88,000 41,360 46,640 80,000 126,640 -17,000 109,640 151,000
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Sales Less: Cost of sales Gross profit Less: Operating costs Depreciation Net profit before tax Less: Tax Net profit after tax Add: Depreciation Operating cash flow after tax Incremental working capital Net cash flow, after tax Net cash flow, pre tax 700,000 280,000 420,000 150,000 80,000 190,000 89,300 100,700 80,000 180,700 0 180,700 270,000
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Sales Less: Cost of sales Gross profit Less: Operating costs Depreciation Net profit before tax Less: Tax Net profit after tax Add: Depreciation Operating cash flow after tax Proceeds of sale Recovery of working capital Net cash flow, after tax Net cash flow, pre tax $700,000 280,000 420,000 150,000 80,000 190,000 89,300 100,700 80,000 180,700 2,400,000 70,000 2,650,700 2,740,000
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Example: summary
Pre tax cash flows
-$2,053,000 0 $151,000 1 $270,000 2 $2,740,000 3
After tax cash flows

-$2,053,000 0 $109,640 1 $180,700 2 $2,650,700 3
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Example: calculating NPV and IRR

NPV = $109,640 + $180,700 + $2,650,700 - $2,053,000 (1.1) (1.1)2 (1.1)3 = 99,672.73 + 149,338.84 + 1,991,510.14 2,053,000 = 2,240,521.71 2,053,000 = $187,521.71 Accept project as NPV is > o
IRR (using IRR calculator function) $2,053,000 = $109,640 + $180,700 + $2,650,700 (1 + IRR) (1 + IRR)2 (1 + IRR)3
IRR = 0.1344 or 13.44% Accept project as IRR > 0.10 or 10%
Comparing NPV and IRR

Example: Bennett Company
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Example: Bennett Company (Gitman et al)
NPV discount rate 0% 10% 19.9% 21.7% see next slide
project A $28,000 11,084 0 <0
project B $25,000 10,914 >0 0

the NPV profile is a graph that depicts the NPV of a project at various discount rates
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Example: Bennett Company (continued)
we observe from Figure 9.4 (previous slide) that: - NPV (A) > NPV (B) for any discount rate below 10.7% - NPV (A) < NPV (B) for any discount rate above 10.7%
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Conflicting rankings
Bennett Company example gives conflicting rankings between NPV and IRR for discount rates below 10.7%
At 10%, NPV(A) > NPV(B), but IRR(B) > IRR(A) At > 10.7% NPV(B) > NPV(A) and IRR(B) > IRR(A)
Ranking is necessary when

- projects are mutually exclusive OR - capital is limited and must be rationed Assume in the following examples ranking is necessary as projects are mutually exclusive

Conflicting rankings (continued)
Conflicts between NPV and IRR can arise due to differences in the magnitude and/ or timing of project cash flows which can arise due to the following project differences:
Size disparity - projects of unequal size (initial investment), e.g. if k = 10%, then for:
Project A: CF0 = ($200), CF1 = $300
NPV=$72.70, IRR = 50% Project B: CF0 = ($1,500), CF1 = $1,900 NPV=$227.10, IRR= 27%
Conflict: NPVB > NPVA, but IRRA > IRRB


Time disparity projects of equal size have significantly different cash flow patterns over the lives of the projects, e.g. if k = 10%, then for:
Project E: CF0 = ($1,000), CF1 = $100, CF2 = $200, CF3 = $2,000
NPV = $758.10, IRR = 35%
Project F: CF0 = ($1,000), CF1 = $650, CF2 = $650, CF3 = $650

NPV = $616.55, IRR = 42%
Conflict: NPVE > NPVF, but IRRF > IRRE
Unequal lives projects have different life spans

Project J: CF0 = ($1,000), CF1 = $500, CF2 = $500 CF3 = $500
NPV = $243.43, IRR = 23%
Project K: CF0 = ($1,000), CF1 to CF6 = $300

NPV = $306.58, IRR = 20%
Conflict: NPVK > NPVJ, but IRRJ > IRRK


Reason why size, timing and life disparities between projects can lead to conflicting rankings
NPV and IRR make different assumptions about the rate (%) intermediate cash flows are reinvested at intermediate cash flows are net cash inflows received prior to the termination of the project
They have an opportunity cost or a rate at which they can be invested somewhere
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NPV assumes minimum opportunity cost (= the return on a hypothetical alternative project) i.e. the discount rate
Intermediate cash flows are reinvested at the discount rate This is usually a more reasonable reinvestment assumption
IRR assumes maximum opportunity cost (= IRR): - as the maximum cost of capital a project could sustain and still be acceptable, OR - as the opportunity cost on a hypothetical alternative project with return = IRR
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Projects with lower net cash inflows in the early years (and higher in later years) tend to be preferred at lower discount rates by NPV, increasing likelihood of conflicting rankings Projects with higher net cash inflows in the early years (and lower in later years) tend to be preferred at higher discount rates by NPV, reducing likelihood of conflicting rankings (as per Bennett example slides 23-4)
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Which is better, NPV or IRR?
Despite conflicting rankings, both NPV and IRR give same accept-reject decisions Theoretically speaking, NPV is better: - it assumes intermediate flows are reinvested at the firms cost of capital - it directly reflects the actual project return Practically speaking, many financial managers prefer IRR: - it works with rates of return not dollars - NPV does not measure benefits relative to the amount invested
Other techniques
Accounting Rate of Return (ARR) = average accounting profit generated by project as percentage of average investment outlay
ARR can be calculated in a number of ways e.g. ROA ROA = (net profit after tax) / (total assets) = (average net profit) / (average book value)
accountingprofit / n
t
t !1
initialout lay salvagevalue / 2

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Other techniques
Accounting Rate of Return (ARR) measures return on investment, for example ROA
Return on Assets (ROA) = (net profit after tax)/(total assets) Decision criterion:
accept if ROA > reference rate of return reject if ROA < reference rate of return
Weakness: ignores cash flows and time value of money Example

A machine will cost $62,000 and have a useful life of 5 years with a salvage value of $2,000. It will provide a net cash inflow of $22,000 p.a. Depreciation will be $12,400 p.a. The required rate of return on investments of this type is 17% p.a. What is the accounting rate of return?
Other techniques
Accounting Rate of Return (ARR) - example
Average Accounting profit
= $22,000 $12,400 = $9,600 = ($62,000 + $2,000) / 2 = $32,000 = $9,600 / $32,000 = 30%
Average investment
ARR
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Other techniques
Profitability Index (PI) uses the ratio of PV of annual net cash inflows to the initial investment
PI = [ (CFt/(1+k)t) ] / CF0 for t=1 n
Decision criterion:
Independent projects: accept if PI > 1 Mutually exclusive projects: accept largest PI > 1
Strength: useful where funds are limited Weakness: can give an incorrect ranking for mutually exclusive projects (see next slide)
Other techniques
Profitability Index (PI) example Using the data from the earlier example on projects A & B (slides 28):
PI = PV of net cash inflows Initial Investment PIA = $300/1.1 = 1.36 Accept (NPV = $72.73) $200 PIB = $1,900/1.1 = 1.15 Accept (NPV = $227.30) $1,500 Conflict: PIA > PIB , but NPVB > NPVA
Other techniques
Discounted Payback Period (DPP) uses exact amount of time required for a project to recover its initial investment Decision criterion: accept if DPP < maximum acceptable period reject if DPP > maximum acceptable period Weakness: ignores cash flows after payback period & therefore ranking conflict with NPV possible
Quiz
1. Unsophisticated capital budgeting techniques do NOT:
A) use net profits as a measure of return. B) explicitly consider the time value of money. C) take into account an unconventional cash flow pattern. D) examine the size of the initial outlay. 2. Among the reasons many firms use the payback period as a guideline in capital investment decisions are all of the following EXCEPT: A) it is easy to calculate. B) it gives an implicit consideration to the timing of cash flows. C) it is a measure of risk exposure. D) it recognises cash flows which occur after the payback period. 3. The minimum return that must be earned on a project to leave the firm's market value unchanged is all of the following EXCEPT: A) average rate of return. B) discount rate. C) cost of capital. D) opportunity cost.
Quiz
4. A firm would accept a project with a net present value of zero because:
A) the return on the project would be zero. B) the return on the project would be positive. C) the project would enhance the wealth of the firm's owners. D) the project would maintain the wealth of the firm's owners. 5. The __________ is the discount rate that equates the present value of the cash inflows with the initial investment. A) payback period B) internal rate of return C) average rate of return D) cost of capital 6. The underlying cause of conflicts in ranking for projects by internal rate of return and net present value methods is: A) that neither method explicitly considers the time value of money. B) the reinvestment rate assumption regarding intermediate cash flows. C) the assumption made by the NPV method that intermediate cash flows are reinvested at the internal rate of return. D) the assumption made by the IRR method that intermediate cash flows are reinvested at the cost of capital.
Week 7 Tutorial
Review Questions and Problems to be covered in the Week 7 Tutorial: Review Questions 9.1, 9.3, 9.5, 9.7, 9.8, 9.9 & 9.10 Problems 9.36 & 9.38
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BFA281 Financial Management

Tony Stanger Weeks 5 & 6 Capital Budgeting Techniques (Chapter 9)

$6,000 $4,000 $3,000 $2,000 $1,000

Places emphasis on liquidity

Fails to take full account of projects economic life

Discounted (sophisticated) cash flow methods of capital project evaluation

Net present value (NPV)

Net present value (NPV)

For mutually exclusive projects:

Value additivity principle

Internal rate of return (IRR)

Internal rate of return (IRR)

For mutually exclusive projects

Internal rate of return (IRR)

Internal rate of return (IRR)

Internal rate of return (IRR)

if net cash flows CFt are not an annuity

Example: cash flows in year 0

Example: cash flows in year 1

Example: cash flows in year 2

Example: cash flows in year 3

After tax cash flows

Example: calculating NPV and IRR

Comparing NPV and IRR

Comparing NPV and IRR

project A $28,000 11,084 0 <0

project B $25,000 10,914 >0 0

Comparing NPV and IRR

Comparing NPV and IRR

Comparing NPV and IRR

Ranking is necessary when

Comparing NPV and IRR

Conflict: NPVB > NPVA, but IRRA > IRRB

Comparing NPV and IRR

Project F: CF0 = ($1,000), CF1 = $650, CF2 = $650, CF3 = $650

Conflict: NPVE > NPVF, but IRRF > IRRE

Unequal lives projects have different life spans

Project K: CF0 = ($1,000), CF1 to CF6 = $300

Conflict: NPVK > NPVJ, but IRRJ > IRRK

Comparing NPV and IRR

Comparing NPV and IRR

Comparing NPV and IRR

Comparing NPV and IRR

initialout lay  salvagevalue / 2

Weakness: ignores cash flows and time value of money Example

Average Accounting profit

= $22,000 $12,400 = $9,600 = ($62,000 + $2,000) / 2 = $32,000 = $9,600 / $32,000 = 30%

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initialout lay salvagevalue / 2