Chapter 8 Capital Budgeting Decision Criteria8章资本预算决策标准.docx

Chapter 8 Capital Budgeting Decision Criteria8章资本预算决策标准.docx

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Chapter8CapitalBudgetingDecisionCriteria8章资本预算决策标准

Chapter11:

TheBasicsofCapitalBudgeting

I.WhatisCapitalBudgeting?

Theprocessofdeterminingwhatcapitalprojectstoaccept

ProjectClassificationisthestartingpointfordeterminingtheappropriatediscountrate

Replacementtomaintaincurrentoperations

Replacementtoreducecosts

Expansionofexistingproductsormarkets

Expansionintonewproductsormarkets

Pureresearch&development（example:

pharmaceuticalfirms）

Exploration（example:

energyfirms）

Safetyand/orenvironmental（governmentmandated）projects

II.DecisionCriteria

Whatarethemajorinvestmentdecisioncriteria?

NetPresentValue-NPV

InternalRateofReturn-IRR

ModifiedInternalRateofReturn-MIRR

PaybackPeriod-Payback

DiscountedPaybackPeriod–DiscountedPayback

ProfitabilityIndex-PI

Whataretheyusedfor?

Toevaluatethecashflowsfromcapitalinvestmentprojects

Tomaketheacceptorrejectdecision

A.TheNPVRule:

1.WhyIsNetPresentValuetheBestDecisionCriteria?

-Itconsidersthetimevalueofmoney（TVM）…adollartodayisworthmorethanadollarinthefuture

-Itconsidersallcashflowsduringtheproject’sentirelife

-NPVletsyouknowexactlyhowmuchvalueisbeingaddedbytheproject

-Youcansettheappropriaterequirerateofreturn（discountrateorhurdlerate）dependingonaproject’srisk

2.CalculatingNetPresentValue（NPV:

NPV=CF0+CF1+CF2+...+CFt

（1+r）1（1+r）2（1+r）t

3.TheNPVdecision（accept/reject）rule:

-Accepttheproject（investment）ifNPV>zero

-RejecttheprojectifNPV

4.WhatdoesapositiveNPVmean?

-ThePVofcashinflows>PVofcashoutflows

-ThevalueofthecompanyisbeingincreasedbytheamountofNPV

-Theprojectmeetstherequiredrateofreturn…andthensome

NPVExample1:

Afriendasksyoutoinvest$20,000andpromisestopayyou$26,000attheendof2years.Yourrequiredrateofreturnis15%.Doyoutaketheoffer?

NPV=CF0+CF2

（1+r）2

NPV=-20,000+26,000=>-20,000+19,660

1.152

NPV=$-340Youshouldrejectyourfriend’soffer!

*Ifthiswereacapitalinvestmentproject,acceptancewouldreducethevalueofthecompanyby$340!

*Acceptanceoftheprojectwouldnotincreasethevalueofthecompanyby$6,000!

Thekeyvariablehereistherequiredrateofreturn（ordiscountrate）.

Therequiredrateofreturn（RRR）is:

*Thehurdlerate

*Thecostofcapital（funds）

*Thebestrateofreturnthecompanycouldexpectonotherprojectsofsimilarrisk

Note:

Inacompetitivemarket,positiveNPVprojectsareconsideredrareandrequirediligentefforttouncover

NPVExample2:

Twoprojectswithidenticalcashoutflows（investment=$1,000）butdifferenttimingofcashinflows.Discountrate=10%

NPVforprojectS:

（Largecashinflowscomesooner）

01234

|---------------|---------------|---------------|--------------|

NetCF-1,000500400300100

NPV（S）=$78.82

NPVforprojectL:

（Largecashinflowscomelater）

01234

|---------------|---------------|---------------|--------------|

NetCF-1,000100300400500

NPV（L）=-$19.12

B.ThePaybackRule:

Timeperiodrequiredforaprojecttogenerateenoughcashinflowstorecovertheinitialcost.

ThePaybackdecision（accept/reject）rule:

-Acceptifpaybackperiod

-Rejectifpaybackperiod>maximumacceptablepaybackperiod.

Advantages

-Easytounderstand:

theshorterthepaybackperiod,thebetter

-Quickindicatoroftheliquidityriskoftheproject（howlongfundswillbetiedup）

Disadvantages

-Ignorestimevalueofmoney

-Ignorescashflowsbeyondacceptablepaybackdate

-Acceptablepaybackdateisusuallyanarbitrarycutoffpoint.Riskisnotquantifiedinarequiredrateofreturn.Theliquidityriskissimplya“ruleofthumb”

ProjectS:

01234

|---------------|---------------|---------------|---------------|

NetCF-1,000500400300100

Cumulative-1,000-500-100200300

NCF

Payback=yearsbefore+uncoveredcostatendofyear

fullrecoveryNCFduringfollowingyear

=2+100/300

=2.33years

Ifacceptablepaybackperiodis2.33ormoreyears,youacceptprojectS

C.TheDiscountedPaybackRule:

Timeperiodrequiredforaprojecttogenerateenoughdiscountedcashinflowstorecovertheinitialcost.

TheDiscountedPaybackdecision（accept/reject）rule:

-Acceptifdiscountedpaybackperiod

-Rejectifdiscountedpaybackperiod>maximumacceptablepaybackperiod.

Advantages

-Easytounderstand:

theshorterthepaybackperiod,thebetter

-Quickindicatoroftheliquidityriskoftheproject（howlongfundswillbetiedup）

-Doesconsiderthetimevalueofmoney

Disadvantages

-Ignorescashflowsbeyondacceptablepaybackdate

-Acceptablepaybackdateisusuallyanarbitrarycutoffpoint.

ProjectS:

Assumea10percentdiscountrate

01234

|---------------|---------------|---------------|---------------|

NetCF-1,000500400300100

PVNCF-1,00045433122568

Cumulative-1,000-546-21510

PVNCF

Payback=yearsbefore+uncoveredcostatendofyear

fullrecoveryNCFduringfollowingyear

=2+215/225

=2.96years

Ifacceptablepaybackperiodis2.96ormoreyears,youacceptprojectS

D.InternalRateofReturn

TheIRRissimilartoabond’syieldtomaturity.Itistheratethatmakesthepresentvalueofcashinflows（CIF）equaltothepresentvalueofcashoutflows（COF）.Thus,itistherateofreturnthatresultsinazeroNPVwhenitisusedasthediscountrate.

NPV=CF0+CF1+CF2+...+CFt

（1+r）1（1+r）2（1+r）t

0=CF0+CF1+CF2+...+CFt

（1+IRR）1（1+IRR）2（1+IRR）t

IRRDecisionRule

-AccepttheprojectifIRR>req’drateofreturn（discountrate）

-RejecttheprojectifIRR

Advantages

-ConsidersTVM

-Considersallcashflows

-Easytounderstand

Disadvantages

-Mayuseunreasonablediscountrate

-CanconflictwithNPVifprojectsaremutuallyexclusive

IRRExamples:

IRRforProjectS

01234

ProjectS|---------------|---------------|---------------|---------------|

-1,000500400300100

0=-1000+500+400+300+100

（1+Irr）1（1+Irr）2（1+Irr）3（1+Irr）4

SolvefortheIRR.Thatisthediscountratethatsolvesthisequationandmakestheanswer（NPV）equaltozero.

IRRforProjectS=14.49%

IRRforProjectL

01234

ProjectL|---------------|---------------|---------------|----------------|

-1,000100300400500

0=-1000+100+300+400+500

（1+Irr）1（1+Irr）2（1+Irr）3（1+Irr）4

IRRforProjectL=9.27%

TheIRRisthemostpopularmethod,afterNPV,forevaluatingcashflowsandisalmostasgood.

ProblemswithIRR:

ThereareproblemswithusingIRRratherthanNPVwithyouarechoosingbetweenmutuallyexclusiveprojects:

-Independentprojects:

Whenevaluatingmultipleprojectsandany,none,orallofthemcanbeaccepted.Acceptanceofanyprojecthasnobearingontheacceptanceorrejectionofanother.

-Mutuallyexclusiveprojects:

Whenevaluatingmultipleprojectsandonlyonecanbeaccepted.Acceptanceofoneprojectmeansrejectionoftheother（s）.

ThereisneveraconflictbetweenIRRandNPVcriterionwhenevaluatingindependentprojects.Butwhenchoosingbetweenmutuallyexclusiveprojects,theIRRchoicemayconflictwiththeNPVchoiceundercertainconditions.

TheScaleProblem:

Apotentialconflictexistswhentherearesignificantdifferencesinthesizeofthecashflows.Anexamplewouldbeifcomparingaprojectwitha$100,000initialinvestment（COF）withanotherprojectwitha$1,000,000initialinvestment.

TheTimingProblem:

Apotentialconflictexistswhenthetimingofthecashflowsfortwoprojectsareradicallydifferent.ThiscanresultinaconflictbetweentheNPVchoiceandtheIRRchoiceatlowdiscountrates.

MultipleIRRs:

Projectswithnon-normal（non-conventional）cashflowsmayhavemultipleIRRs.Anormal（orconventional）cashflowisacashoutflowatthebeginningofaproject,followedbycashinflowsthereafter.

TheNPVProfile:

NPVgraphedagainstthediscountrate

RecalltheNPV&IRRacceptancerules:

NPV:

AccepttheprojectifNPV>zero

IRR:

AccepttheprojectifIRR>RRR

NPV

CashFlows

-1000

$300500

400

300

100

IRR

0r

.1449

AnyprojectwithapositiveNPVwillalsohaveanIRRthatexceedsthediscountrate（requiredrateofreturn）.

NPVProfilesforMutuallyExclusiveProjects:

NPVCashFlows

AB

ProjectB-10,000-10,000

10,0001,000

1,0001,000

1,00012,000

Crossoverrate

ProjectA

r

Example:

IRRvsNPVforMutualExclusiveProjects

CashFlows

AB

-10,000-10,000

10,0001,000

1,0001,000

1,00012,000

IRRforA_____________IRRforBis___________

NPVat0%____________NPVat0%____________

NPVat10%___________NPVat10%___________

NPVat15%___________NPVat15%___________

Whichprojectisacceptableiftheyareindependent?

Why?

Whichprojectisacceptableiftheyaremutuallyexclusive?

Why?

E.ModifiedInternalRateofReturn

-AccepttheprojectifMIRR>req’drateofreturn（di