Capital Budgeting, Part I

Lakehead University

Fall 2004

Capital Budgeting Techniques

1. Net Present Value 2. The Payback Rule 3. The Average Accounting Return 4. The Internal Rate of Return 5. The Protability Index 6. The Practice of Capital Budgeting

Net Present Value

The net present value (NPV) of a project measures the difference between the present value of the projects future cash ows and the present value of its costs. The process of valuing an investment by discounting its future cash ows is often called discounted cash ow (DCF) valuation.

Net Present Value: An Example

Consider a project with an initial cost of $30 and subsequent costs of $14 per year. That is, some equipment is purchased at time 0 for $30 and will cost $14 per year to operate. The project is expected to generate a cash ow of $24 per year for eight years. At the end of the eighth year, the equipment used in the project will be sold for $2 (salvage value). What is the net present value of this project?

Net Present Value: An Example

Timing of Cash Flows
Year Initial cost Inows Outows Salvage Net cash ow -30 10 10 10 10 10 10 10 0 -30 24 -14 24 -14 24 -14 24 -14 24 -14 24 -14 24 -14 24 -14 2 12 1 2 3 4 5 6 7 8

Net Present Value: An Example

This projects cash ows can be divided in three parts: 1. An outlay of $30 at time 0; 2. An annuity of $10 per year for eight year, the rst payment taking place in year 1; 3. A lump-sum payment of $2 at the end of year 8.

Net Present Value: An Example

Using a discount rate of 12%, the net present value of this project is 10 NPV = 30 + .12 1 1 1.12
8

2 = $20.48. (1.12)8

The NPV Rule: An investment should be accepted if its net present value is positive and should be rejected otherwise.

The Payback Rule

The payback period of a project is the time it takes to recover the projects initial cost. The payback rule does not consider the time value of money. In the previous example, the payback period is exactly 3 years.

The Payback Rule

What is the payback period for each of these projects? Year 0 1 2 3 4 5 6 7 8

Project 1 -50 12 12 12 12 12 12 12 12 Project 2 -50 20 15 10 6 4 3 2 2

The Payback Rule

Let CCFi cumulative cash ow from project i. Year 0 1 2 3 4 5 6 7 8

Project 1 -50 12 12 12 12 12 12 12 12
CCF1 -50 -38 -26 -14 -2 10 22 34 46

Project 2 -50 20 15 10
CCF2 -50 -30 -15 -5

6
1

4
5

3
8

2
10

2
12

10

The Payback Rule

Project 1s cost is paid back between year 4 and year 5. The exact time can be approximated as follows: Payback period = 4 + 2 2 = 4+ = 4.17 years. 10 (2) 12

Project 2s cost is paid back between year 3 and year 4. The exact time can be approximated as follows: Payback period = 3 + 5 5 = 3+ = 3.83 years. 1 (5) 6

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The Payback Rule

The Payback Rule: Accept any investment with a payback period below some prespecied number of years. Project 2 pays itself back before project 1. Is project 2 better than project 1?

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The Payback Rule

Let the discount rate be 12%. Then NPV of project 1 = $9.61.

NPV of project 2 = $3.75. That is, if the payback rule were Only accept projects with a payback period under 4 years, then project 2 would be accepted and project 1 would be rejected, even though NPV of project 2 < 0 < NPV of project 1.

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The Payback Rule

Advantages of the Payback Rule 1. Easy to understand. 2. Adjusts for uncertainty of later cash ows. 3. Biased toward liquidity.

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The Payback Rule

Disadvantages of the Payback Rule 1. Ignores the time value of money. 2. requires an arbitrary cutoff point. 3. Ignores cash ows beyond the cutoff date. 4. Biased against long-term projects.

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The Discounted Payback Rule

The discounted payback period of a project is the time it takes to repay the projects initial cost with the discounted future cash ows. This rule thus takes into account the time value of money. The rule is that a project is accepted if its discounted payback period is below some prespecied number of years.

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The Discounted Payback Rule

Suppose r = 12% and let CDCFi cumulative discounted cash ow from project i. Then
Year Project 1
CCF1 CDCF1

0 -50

1 12

2 12

3 12

4 12
-2

5 12
10

6 12
22

7 12
34
4.8

8 12
46
9.6

-50 -38 -26 -14

-50 -39.3 -29.7 -21.2 -13.6 -6.7 -0.7

Project 2
CCF2 CDCF2

-50

20

15

10

-50 -30 -15 -5 5 8 10 12 1 -50 -32.1 -20.2 -13.1 -9.3 -7.0 -5.5 -4.6 -3.8

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The Discounted Payback Rule

The discounted payback period for project 1 is between year 6 and year 7, whereas project 2 never pays back its initial cost with its discounted cash ows. The discounted payback rule never selects projects with negative net present value.

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The Discounted Payback Rule

Advantages of the Discounted Payback Rule 1. Takes the time value of money into account. 2. Easy to understand. 3. Does not accept projects with negative NPV. 4. Biased toward liquidity.

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The Discounted Payback Rule

Disadvantages of the Discounted Payback Rule 1. May reject projects with positive NPV. 2. requires an arbitrary cutoff point. 3. Ignores cash ows beyond the cutoff date. 4. Biased against long-term projects.

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The Average Accounting Return

The average accounting return (AAR) is measured as follows: Some measure of average accounting prot . Some measure of average accounting value We could use, for instance, Average net income . Average book value of investment

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The Average Accounting Return

Consider a project that requires an initial outlay of $500. The project has a 5-year life, during which the initial investment depreciates linearly (straight-line depreciation) to zero. That is, the initial investment depreciates by $100 each year, and thus its average book value is
500 + 400 + 300 + 200 + 100 + 0 6 = = 100(5 + 4 + 3 + 2 + 1) 6 100 56 500 2 = = 250. 6 2

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The Average Accounting Return

Note that we are using the following result: 1 + 2 + 3 + . . . + (n 1) + n = n(n + 1) 2

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The Average Accounting Return

If an asset of value A depreciates on a straight line to 0 over n years, i.e. if it loses A of its value each year, and its average book n value (ABV) over the life of the project is
ABV = = = = A + A A + A 2A + . . . + 2A + A + 0 n n n n n+1 A A A A A n n + n (n 1) + n (n 2) + . . . + n 2 + n 1 + 0 n+1 A (n + (n 1) + (n 2) + . . . + 2 + 1) n(n + 1) A n(n + 1) A = . n(n + 1) 2 2

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The Average Accounting Return

Back to our example, suppose the project is expected to generate the following stream of net incomes:
Year Net income

1 100

2 80

3 70

4 90

5 110

The average net income is then 100 + 80 + 70 + 90 + 110 = 90. 5

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The Average Accounting Return

The average accounting return in our example is then AAR = 90 = 0.36. 250

The Average Accounting Return Rule: A project is acceptable if its AAR is above some target AAR.

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The Average Accounting Return

Advantages of the AAR Rule 1. Easy to calculate. 2. Needed information usually available.

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The Average Accounting Return

Disadvantages of the AAR Rule 1. Ignores the time value of money. 2. Uses an arbitrary cutoff rate. 3. Based on book values instead of cash ows or market values.

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The Internal Rate of Return

The internal rate of return (IRR) is the most important alternative to NPV. It provides the discount rate at which an investment has a zero net present value. The IRR Rule: If the IRR of an investment is greater than the required rate of return, then the investment is worth undertaking.

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The Internal Rate of Return: An Example

Year Cash ow

0 -50

1 11

2 13

3 15

4 15

5 14

The internal rate of return in this example is 10.71%:

11 13 15 15 14 + + + + 0. 1.1071 (1.1071)2 (1.1071)3 (1.1071)4 (1.1071)5

50 +

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The Internal Rate of Return

With an IRR of 10.71%, will the project be undertaken? If the rm requires a return of 12%, say, or higher on any of its projects, then this one wont be undertaken. If, on the other hand, the rm requires a return of 9% or higher on any of its projects, then this one will be undertaken.

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The Internal Rate of Return

There exists a positive IRR to any project with a positive NPV. A project with a negative NPV, i.e. a project that never pays back the initial investment, has a negative IRR. Given a certain discount rate, the fact that project A, say, has a greater NPV than project B does not imply that As IRR is greater than Bs IRR, and vice versa. A single project may have more than one IRR.

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Problems with the IRR

Multiple IRRs Consider the following stream of cash ows:
Year Cash ow

0 -60

1 155

2 -100

This project would have two IRRs: 25% and 33.33%. The maximum number of IRRs a project can have is equal to the number of times cash ows change sign.
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Problems with the IRR

Mutually Exclusive Investments Is the IRR the right rule to use when a rm has access to mutually exclusive projects? Consider the two following projects:
Year Project A Project B

0 -50

8 10 11 12 14 15 15 17 8

-50 16 13 12 12 12 11 10

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Problems with the IRR

Mutually Exclusive Investments From these cash ows, we nd: IRRA = 16.71% and IRRB = 18.69%.

Is project B better than project A? The NPV of B is not always greater than that of A.

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Problems with the IRR

Mutually Exclusive Investments
Rate 5% 7% 9% 11% 13% 15% NPVA 30.39 23.56 17.53 12.20 7.47 3.25 NPVB 27.40 22.03 17.23 12.94 9.07 5.59

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Problems with the IRR

Mutually Exclusive Investments Project A and project B have the same NPV when the discount rate is around 9.5458%. This is the crossover rate. The Crossover rate is the internal rate of return of A B. Let rc denote the crossover rate. Then, when r = rc , NPVA = NPVB NPVA NPVB = 0.

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Problems with the IRR

Mutually Exclusive Investments Let CFA,t and CFB,t denote the cash ow at time t of project A and project B, respectively. Then NPVA NPVB CFA,t = (1 + r)t t=0
8 8

t=0

(1 + r)t

CFB,t

CFA,t CFB,t (1 + r)t t=0

= NPVAB .

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Problems with the IRR

Mutually Exclusive Investments

Year Project A Project B AB

0 -50

8 10 11 12 14 15 15 17 8 9

-50 16 13 12 12 12 11 10 0 -8 -3 -1 0 2 4 5

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Problems with the IRR

Mutually Exclusive Investments When r < 9.5458%, then NPVA > NPVB and thus the IRR rule may contradict the NPV rule. There is no conict when When r > 9.5458%. Looking at different streams of cash ows, can you tell whether the IRR and the NPV rules contradict each other?

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The IRR Rule

Advantages Closely related to the NPV rule. Easy to understand and communicate. Disadvantages May provide multiple answers. May provide the wrong answer when comparing mutually exclusive projects.

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The Protability Index

The protability index (PI) is a benet/cost ratio. If a project costs $25 and the present value of its future cash ows is $37.5, then this project has a protability index of 37.5 = 1.5. 25 A project with a positive NPV will have a PI greater than one. A project with a negative NPV will have a PI smaller than one.

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The Protability Index

Mutually Exclusive Investments This measure may also lead to the wrong decision when selecting among mutually exclusive projects. Suppose project A costs $5 and pays off $11 in one year. Suppose project B costs $100 and pays off $121 in one year. If the discount rate is 10%, then PIA = 2 > 1.1 = PIB but NPVA = 5 < 10 = NPVB .

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The Protability Index

Advantages Closely related to the NPV rule. Easy to understand and communicate. Useful when capital available is limited. Disadvantages May lead to incorrect decisions when comparing mutually exclusive projects.

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The Practice of Capital Budgeting

Since the NPV tells us what we want to know, why do these other measures exist? The NPV is only an approximation. The actual cash ows may be different from what is expected. Firms usually use multiple criteria to evaluate a proposal. For instance, a positive NPV, a short payback period and a high AAR mean that the project is probably a good one. If, on the other hand, the rm receives conicting signals (positive NPV, long payback period and low AAR), then it must be more careful when making its decision.
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