6.Capital Budgeting and Investment Criteria Flashcards
Capital budgeting
is a process of planning that is used to ascertain the long-term investments of the firm.
Definition of Net Present Value (NPV
The difference between the market value of a project and its cost. In other words, benefits versus costs.
• NPV indicates how much value is created from undertaking an investment.
NPV Decision Rule
• If the NPV is positive, accept the project
o A positive NPV means that the project is expected to increase the value of the firm and will therefore increase the wealth of the owners.
o Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.
• If the NPV is negative, reject the project
On the discount rate
- The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision.
- The hurdle rate is the minimum acceptable return on an investment. It should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix (i.e. cost of capital).
Definition of Discounted Payback Period (DPP
The payback period is a kind of “break-even” point in time.
• Computation:
o Compute the present value of each future cash flow.
o Determine how long it takes to pay back on a discounted basis i.e. break-even.
o Compare it to a specified required period or a benchmark (usually measured in years or months).
o For example, in manufacturing companies, this benchmark period is often two years.
Discounted Payback Period (DPP) Decision Rule
• If the DPP is less than the benchmark, accept the project
o When DPP is less than the benchmark, the project will break-even sooner than expected and thus increase the value of the firm.
• If the DPP is greater than the benchmark, reject the project
Advantages and disadvantages of DPP
Advantages: Includes time value of money, easy to understand , biased towards liquidity.
Disadvantages:
May reject positive NPV investments
Projects with negative NPV might be accepted
Ignores cash glows beyond the cutoff point
Biased against long-term projects, such as RsD and new products
Internal Rate of Return
• Basic idea: What is the rate of return if the project/investment were to break-even?
• Definition of IRR: IRR is the return rate that makes the NPV = 0.
• Computation:
o Guess a return rate (usually start with the required rate of return) and calculate the NPV.
o Depending on the sign of the NPV, increase or decrease the return rate and calculate the NPV.
o Repeat the previous step until the NPV changes sign.
Internal Rate of Return (IRR) Decision Rule
• If the IRR is greater than the required rate of return, accept the project
o The required rate of return is usually chosen to ensure that the benefits derived from the project/investment outweigh the costs e.g. costs of capital. Thus, if the IRR is greater than the required rate of return, the project/investment will increase the value of the firm.
• If the IRR is less than the required rate of return, reject the project
IRR versus NPV
exceptions
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• NPV and IRR will basically give us the same decision.
• Exceptions
o Non-conventional cash flows – cash flow signs change more than once.
o Mutually exclusive projects
Initial investments are substantially different.
Timing of cash flows is substantially different.
• Whenever there is a conflict between NPV and another decision rule, you should always use NPV.
‘Mutually exclusive’
means that if you choose one, you can’t choose the other
Examples
o You can choose to attend graduate school at either Harvard or Stanford, but not both.
o You can build one hotel in one town, you do not normally build another one in the same town – at least not in close proximity to one another.
Intuitively you would use the following decision rules:
® NPV – choose the project with the higher NPV.
® IRR – choose the project with the higher IR
Advantages and disadvantages of IRR
ADVANTAGES: Knowing a return is intuitively appealing
Simple way to communicate the value of a project to someone who does not know all the estimation details
Do not need a required return to calculate IRR. If the IRR is high enough , you may not need to estimate an exact return
Disadvantages:
IRR does not work in case of non conventional cash flows
IRR does not work with mutually exclusive projects
Profitability index and its decision rule
measures the value created per unit cost, based on the time value of money.
Decision Rule:
o Accept the project if the PI is greater than 1.
o Reject the project if the PI is less than 1.
Advantages ans Disadvantages of profutability index
Advantages:
Closely related to NPV,generally leading to undentical decisions
Easy to understand and communicate
May be useful when available investment funds are limited
Disadvantages: May lead to incorrect decisions in comparison of mutually exclusive investments
