Capital Budgeting

1. Big Picture… Capital Budgeting • Select investments which increase value of firm • Maximize wealth of shareholders • Important to firm’s long-term success • Substantial cost • Cash flows over long time period Capital Budgeting

2. Steps in evaluating capital assets • Determine cost of asset • Estimate incremental cash flows • Very difficult but… • Very important… • Determine decision criteria • Apply decision criteria • Compare actual results to projected Capital Budgeting

3. Capital Budgeting Decision Criteria • Should you sign Shaq O’ Squeal to a four-year contract for $100 million??? Capital Budgeting

4. Capital Budgeting Decision Criteria • Determine cost • Estimate incremental cash flows • Increase in revenue • Increase in expenses Capital Budgeting

5. Capital Budgeting Decision Criteria • Payback period • NPV • Profitability index • IRR Capital Budgeting

6. Payback Period • How long until we get our money back??? Capital Budgeting

7. Payback Period Capital Budgeting

8. Payback Period • Payback: length of time to get $$$ back • Rule: accept investments that payback before required period Capital Budgeting

9. Payback Period • Advantages: • Easy to calculate and understand • Useful for small investments • Favors investments with quick returns Capital Budgeting

10. Payback Period • Disadvantages: • Future cash flows not discounted • Since favors quick returns, not huge problem • Ignores cash flows after payback • Coal mine: negative cash flows at end • Must select cutoff period • Three or four years reasonable • 20 years, probably not Capital Budgeting

11. Net Present Value • NPV: PV of cash flow – Cost of Investment • Rule: accept investments with a positive NPV Capital Budgeting

12. Net Present Value Capital Budgeting

13. Net Present Value • Advantages: • If assumptions correct, increases value of firm • Discounts future cash flows Capital Budgeting

14. In an efficient market, should projects have huge positive NPVs??? Net Present Value • Disadvantages: • Determining proper discount rate • Should it be adjusted for riskiness of each project’s cash flows??? • Set too high, pass up acceptable projects • Buyer with lower discount rate will pay highest price • Set too low, decrease wealth of firm • Ignores relative cost of investments • Project A: cost $1 million; NPV $20 • Project B: cost $50; NPV $19 Capital Budgeting

15. Profitability Index • PI: PV Cash Flows / Cost • Rule: accept investments with a PI above 1.0 Capital Budgeting

16. Profitability Index Capital Budgeting

17. Profitability Index • Advantages: • Comparing alternative investments • Discounts future cash flows • Disadvantages: • Favors lower cost investments Capital Budgeting

18. Internal Rate of Return • IRR: Discount rate where NPV = 0 • Rule: accept investments with an IRR above required return Capital Budgeting

19. IRR Capital Budgeting

20. IRR • Advantages: • Most often used criteria in capital budgeting • Not required to select a discount rate • Does discount future cash flows Capital Budgeting

21. IRR • Disadvantages: • Assumes can reinvest cash flows at IRR • NPV assumes reinvest at required rate return • NPV assumption more logical • Favors short-term investments • Difficult to achieve high IRR on distant cash flows Capital Budgeting

22. Calculating IRR • Spend $10,000 today and receive $17,182 in 8 years • Spend $10,000 today and receive $1,993 at the end of the next 10 years • Spend $10,000 today and receive $2,000 in year 1; $5,000 in year 2 and $8,000 in year 3 (all at end of year) Capital Budgeting