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FINANCE 7311

FINANCE 7311. CAPITAL BUDETING. Outline. Projects Investment Criteria NPV v. IRR Sources of NPV Project Cash Flow Checklist. Projects. A project is any potential real investment opportunity Distinguish real from financial Mutually Exclusive - can do only one

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FINANCE 7311

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  1. FINANCE 7311 CAPITAL BUDETING

  2. Outline • Projects • Investment Criteria • NPV v. IRR • Sources of NPV • Project Cash Flow Checklist

  3. Projects • A project is any potential real investment opportunity • Distinguish real from financial • Mutually Exclusive - can do only one • Independent - decision about one does not affect decision w/r/t the others • Replacement - special case

  4. Investment Criteria • Investment criteria are the rules by which we decide whether or not to accept a particular project; consider the following:

  5. Accounting Rate of Return • ARR = Avg. Income / Avg. Investment • Uses Income rather than Cash Flow • Ignores Time Value of Money

  6. Payback • Years needed to recover initial investment • To Find: Calculate where cumulative cash flows become positive • Project A: 2 1/6 years • Project B: 2 6/7 years

  7. Problems with Payback • Ignores Time Value of Money • Can use Discounted Payback; Why? • Ignores CF’s after payback • To see: Assume Project B’s cash flow in year 4 is 1,000,000; how does this affect payback

  8. Net Present Value • This rule is always consistent with maximizing the value of the firm • Economically, take all projects for which benefits > costs (in PV dollars) • Mathematically, sum the present values of all the cash flows

  9. Net Present Value

  10. NPV example

  11. Internal Rate of Return (IRR) • IRR - That rate which causes NPV to = 0.

  12. IRR • Independent Projects - select all projects for which IRR > Cost of Capital • Mutually Exclusive - select project with highest IRR • Use ‘well-designed’ spreadsheet

  13. Comparison of NPV & IRR • Business people are accustomed to thinking in rates of return, so does it matter which of NPV or IRR we use? • Independent - the two rules are equivalent • NPV > 0 <==> IRR > Cost of Capital

  14. Comparison of NPV & IRR • Mutually Exclusive Projects - can get different answers • NPV Profile for Example • Reinvestment Assumption

  15. NPV v. IRR Example • Project 1: (100,000) 125,000 • Project 2: 1,000 2,000 • NPVIRR • Project 1 13,636 25% • Project 2 818 100%

  16. NPV v. IRR, cont. • IRR ==> Do Project 2 • NPV ==> Do Project 1 • Problem: Reinvestment Assumption • What are you going to do with the other $99,000?

  17. Profitability Index • PV Cash Inflows / PV Cash Outflows • Independent: Choose all with PI > 1 • Mutually Exclusive: Choose highest PI • Project 1: 1.136 • Project 2: 1.818 • May be useful for capital rationing

  18. Other Real Options • Option to Expand • Option to Abandon • Strategic Options • Excluding biases NPV down • Decision Tree: Capital Budgeting should be dynamic, not static

  19. Source of NPV • Market Opportunities - ‘deviations from equilibrium’ • Economies of Scale • Cost Advantages • Product differentiation • Distribution Advantage • Regulatory Protection

  20. Relevant Cash Flows • We can always write: • EBIT • + Depreciation • - Taxes (t x EBIT) • = Operating Cash Flow • - ∆ NWC • - Capital Spending • = FCF

  21. Cash Flows • Focus on Cash Flows; not accounting #’s • Depreciation • Not a cash flow • Affects Cash Flow through depreciation • Capital spending • Capitalized for accounting purposes • Cash outflow for finance purposes

  22. Project Cash Flows • Focus on Incremental Cash Flows • “What is different if project is accepted?” • Sunk Costs - those costs which have been incurred and are not affected by project decision • Opportunity Cost - highest value use of an asset if not used in project

  23. Project CF’s, cont. • Externalities - less obvious costs/benefits which should be included in analysis • Change in NWC - often a cash outflow initially and cash inflow at end • Cash flows should be after tax • ∆Rev/Exp x (1-t) • Depreciation x t • Do not include interest as a cash flow

  24. Project CF’s, cont. • Replacement problem - should you keep an existing asset, or replace it with a new one • ∆ in Cash Flows • Net of tax proceeds from disposal of existing asset

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