Kế toán, kiểm toán - Chapter 12: Capital budgeting: Decision criteria

Chapter 12Capital Budgeting: Decision Criteria1TopicsOverview and “vocabulary”MethodsNPVIRR, MIRRProfitability IndexPayback, discounted paybackUnequal livesEconomic life2What is capital budgeting?Analysis of potential projects.Long-term decisions; involve large expenditures.Very important to firm’s future.3Steps in Capital BudgetingEstimate cash flows (inflows & outflows).Assess risk of cash flows.Determine r = WACC for project.Evaluate cash flows.4Independent versus Mutually Exclusive ProjectsProjects are:independent, if the cash flows of one are unaffected by the acceptance of the other.mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.5Cash Flows for Franchise L and Franchise S108060012310%L’s CFs:-100.00702050012310%S’s CFs:-100.006NPV: Sum of the PVs of all cash flows.Cost often is CF0 and is negative.NPV = ΣNt = 0CFt(1 + r)tNPV = ΣNt = 1CFt(1 + r)t- CF07What’s Franchise L’s NPV?108060012310%L’s CFs:-100.009.0949.5960.1118.79 = NPVLNPVS = $19.98.8Calculator Solution: Enter values in CFLO register for L.-10010608010CF0CF1NPVCF2CF3I/YR= 18.78 = NPVL9Rationale for the NPV MethodNPV = PV inflows – Cost This is net gain in wealth, so accept project if NPV > 0.Choose between mutually exclusive projects on basis of higher NPV. Adds most value.10Using NPV method, which franchise(s) should be accepted?If Franchise S and L are mutually exclusive, accept S because NPVs > NPVL .If S & L are independent, accept both; NPV > 0.11Internal Rate of Return: IRR0123CF0CF1CF2CF3CostInflowsIRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.12NPV: Enter r, solve for NPV.IRR: Enter NPV = 0, solve for IRR.= NPV ΣNt = 0CFt(1 + r)t= 0 ΣNt = 0CFt(1 + IRR)t= 0 13What’s Franchise L’s IRR?1080600123IRR = ?-100.00PV3PV2PV10 = NPVEnter CFs in CFLO, then press IRR: IRRL = 18.13%. IRRS = 23.56%.14 4040 400123-100Or, with CFLO, enter CFs and press IRR = 9.70%. 3 -100 40 0 9.70%NI/YRPVPMTFVINPUTSOUTPUTFind IRR if CFs are constant:15Rationale for the IRR MethodIf IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns.Example: WACC = 10%, IRR = 15%.So this project adds extra return to shareholders.16Decisions on Projects S and L per IRRIf S and L are independent, accept both: IRRS > r and IRRL > r.If S and L are mutually exclusive, accept S because IRRS > IRRL .17Construct NPV ProfilesEnter CFs in CFLO and find NPVL and NPVS at different discount rates: rNPVLNPVS 05040 5332910192015 71220 (4) 518NPV ProfileIRRL = 18.1%IRRS = 23.6%Crossover Point = 8.7%SL19r > IRRand NPV rand NPV > 0Accept.NPV and IRR: No conflict for independent projects.20Mutually Exclusive Projects 8.7 NPV%IRRSIRRLLSr NPVS , IRRS > IRRLCONFLICT r > 8.7: NPVS> NPVL , IRRS > IRRLNO CONFLICT 21To Find the Crossover RateFind cash flow differences between the projects. See data at beginning of the case.Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%.Can subtract S from L or vice versa, but easier to have first CF negative.If profiles don’t cross, one project dominates the other.22Two Reasons NPV Profiles CrossSize (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects.Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPVS > NPVL.23Reinvestment Rate AssumptionsNPV assumes reinvest at r (opportunity cost of capital).IRR assumes reinvest at IRR.Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.24Modified Internal Rate of Return (MIRR)MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs.TV is found by compounding inflows at WACC.Thus, MIRR assumes cash inflows are reinvested at WACC.2510.080.060.0012310% 66.0 12.1158.1-100.010%10%TV inflows-100.0PV outflowsMIRR for Franchise L: First, find PV and TV (r = 10%)26MIRR = 16.5%158.10123-100.0TV inflowsPV outflowsMIRRL = 16.5% $100 = $158.1(1+MIRRL)3Second, find discount rate that equates PV and TV27To find TV with 12B: Step 1, find PV of InflowsFirst, enter cash inflows in CFLO register:CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80Second, enter I/YR = 10.Third, find PV of inflows:Press NPV = 118.7828Step 2, find TV of inflows.Enter PV = -118.78, N = 3, I/YR = 10, PMT = 0.Press FV = 158.10 = FV of inflows.29Step 3, find PV of outflows.For this problem, there is only one outflow, CF0 = -100, so the PV of outflows is -100.For other problems there may be negative cash flows for several years, and you must find the present value for all negative cash flows.30Step 4, find “IRR” of TV of inflows and PV of outflows.Enter FV = 158.10, PV = -100, PMT = 0, N = 3.Press I/YR = 16.50% = MIRR.31Why use MIRR versus IRR?MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs.Managers like rate of return comparisons, and MIRR is better for this than IRR.32Normal vs. Nonnormal Cash FlowsNormal Cash Flow Project:Cost (negative CF) followed by a series of positive cash inflows. One change of signs.Nonnormal Cash Flow Project:Two or more changes of signs.Most common: Cost (negative CF), then string of positive CFs, then cost to close project.For example, nuclear power plant or strip mine.33Inflow (+) or Outflow (-) in Year012345NNN-+++++N-++++-NN---+++N+++---N-++-+-NN34Pavilion Project: NPV and IRR?5,000-5,000012r = 10%-800Enter CFs in CFLO, enter I/YR = 10.NPV = -386.78IRR = ERROR. Why?35NPV Profile450-8000400100IRR2 = 400%IRR1 = 25%rNPVNonnormal CFs--two sign changes, two IRRs. 36Logic of Multiple IRRsAt very low discount rates, the PV of CF2 is large & negative, so NPV 0.Result: 2 IRRs. 371. Enter CFs as before.2. Enter a “guess” as to IRR by storing the guess. Try 10%: 10 STO IRR = 25% = lower IRR (See next slide for upper IRR)Finding Multiple IRRs with Calculator38 Now guess large IRR, say, 200: 200 STO IRR = 400% = upper IRR Finding Upper IRR with Calculator39012-800,0005,000,000-5,000,000PV outflows @ 10% = -4,932,231.40.TV inflows @ 10% = 5,500,000.00.MIRR = 5.6%When there are nonnormal CFs and more than one IRR, use MIRR:40Accept Project P?NO. Reject because MIRR = 5.6% NPVS. But is L better? S LCF0-100-100CF1 60 33NJ24I1010NPV4.1326.19051Equivalent Annual Annuity Approach (EAA)Convert the PV into a stream of annuity payments with the same PV.S: N=2, I/YR=10, PV=-4.132, FV = 0. Solve for PMT = EAAS = $2.38.L: N=4, I/YR=10, PV=-6.190, FV = 0. Solve for PMT = EAAL = $1.95.S has higher EAA, so it is a better project.52Put Projects on Common BasisNote that Project S could be repeated after 2 years to generate additional profits.Use replacement chain to put on common life.Note: equivalent annual annuity analysis is alternative method.53Replacement Chain Approach (000s).Franchise S with Replication:NPV = $7,547.01234Franchise S:(100) (100)60 60 60(100) (40)6060606054Compare to Franchise L NPV = $6,190.012344,1323,4157,547 4,13210%Or, use NPVs:55Suppose cost to repeat S in two years rises to $105,000.NPVS = $3,415 < NPVL = $6,190.Now choose L.01234Franchise S:(100) 60 60(105) (45)606056Economic Life versus Physical LifeConsider another project with a 3-year life.If terminated prior to Year 3, the machinery will have positive salvage value.Should you always operate for the full physical life?See next slide for cash flows.57Economic Life versus Physical Life (Continued)YearCFSalvage Value0($5000)$500012,1003,10022,0002,00031,750058CFs Under Each Alternative (000s)01231. No termination(5)2.121.752. Terminate 2 years(5)2.143. Terminate 1 year(5)5.259NPVs under Alternative Lives (Cost of capital = 10%)NPV(3) = -$123.NPV(2) = $215.NPV(1) = -$273.60ConclusionsThe project is acceptable only if operated for 2 years.A project’s engineering life does not always equal its economic life.61Choosing the Optimal Capital BudgetFinance theory says to accept all positive NPV projects.Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:An increasing marginal cost of capital.Capital rationing62Increasing Marginal Cost of CapitalExternally raised capital can have large flotation costs, which increase the cost of capital.Investors often perceive large capital budgets as being risky, which drives up the cost of capital.(More...)63If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.64Capital RationingCapital rationing occurs when a company chooses not to fund all positive NPV projects.The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.(More...)65Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital.Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.(More...)66Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects.Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.(More...)67Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted.Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.68