Chapter 10 DSM

Capital budgeting is the process of:

evaluating a firm's investment choices. Capital budgeting is the process of evaluating a firm's investment choices. Viable firms constantly seek out ways to invest funds in order to increase shareholder wealth. After potential investment options are identified they need to be evaluated. Capital budgeting is the process of identifying and evaluating these options and then investing in the ones that will increase shareholder wealth. Making cash budgets for the firm and preparing a statement of cash flows are also critical activities for the firm but are not considered to be capital budgeting. Note that capital budgeting will involve identifying project-specific cash inflows and outflows in order to evaluate the project using NPV, IRR, payback or any other evaluation tool.

When resources are limited you should select the projects with the:

highest NPV When resources are limited you should select the projects with the highest NPV. The highest NPV project will contribute the most toward increasing shareholder wealth. If the payback period is used as a selection tool, you select the projects with shorter paybacks instead of longer ones. However, payback should never be used in isolation but instead used in conjunction with the NPV. When you use IRR as the selection tool, you will be looking for the highest IRR, not the lowest. The IRR should also be used in conjunction with the NPV and never in isolation. The NPV is the only capital budgeting tool that will always generate the correct accept/reject decision and the best project ranking. However, when resources are constrained you can use the profitability index to help make the appropriate project selection.

One weakness of the payback period is that it:

ignores cash flows that occur after the end of the payback period. One weakness of the payback period is that it ignores cash flows that occur after the end of the payback period. For example, if a firm uses a 4-year payback as a project cutoff point then any cash flows that occur after four years are not considered. This practice can cause a firm to reject many positive NPV projects. The payback method does not use a discount rate and it places emphasis on cash flows occurring within the payback period (i.e. sooner). The payback period tool should be used in conjunction with other methods.

Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as:

independent projects Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as independent projects. Accepting an independent project does not automatically reject a competing project so the accept/reject decision is a stand alone decision. Mutually exclusive projects are projects where the acceptance of one project automatically means we are rejecting other options. This type of capital budgeting decision is common in equipment replacement decisions. Common examples of mutually exclusive projects are when you are faced with constructing a factory that requires more workers and, therefore, less automation versus the decision to use robotics. You can manufacture your product using either method but you will only choose one.

A firm has undertaken a project with an initial investment of $100,000. The firm's cost of capital is 14%. Year Cash Inflow 1 $50,000 2 $65,000 3 $90,000 What is the NPV for this project?

$54,623 A firm has undertaken a project with an initial investment of $100,000. The firm's cost of capital is 14%. Year Cash Inflow 1 $50,000 2 $65,000 3 $90,000 The NPV for this project is $54,623. You calculate the NPV for this project by subtracting the initial investment from the present value of the project's cash flows calculated using the firm's cost of capital. So for this project the; NPV = $50,000/(1.14) + $65,000/(1.14)2 + $90,000/(1.14)3 - $100,000 = $43,860 + $50,015 + $60,748 - $100,000 = $54,623

Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. What is the investment's internal rate of return?

10% Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. The investment's internal rate of return is 10%. When you have a series of cash flows that represent an annuity it is very easy to calculate the IRR with your financial calculator using the following inputs: PV = -$16,000 N = 8; FV = 0 PMT = $3,000 CPT I/Y, which gives you 10.0082 or approximately 10%. Note that you would then compare this interest rate to your required return or hurdle rate to determine whether or not to accept this project. The IRR of an uneven cash flow stream can also be calculated with a financial calculator by inputting the cash flows for each year and then solving. Note that this process is a trial and error process if you do not use a spreadsheet or calculator that has this functionality.

A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback period of the project is:

3.5 years A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback period of the project is 3.5 years. The payback period is the length of time it takes to recover the initial investment so in this case you see that a total of $40,000 is recovered in the first three years, which leaves $5,000 to be recovered. In the fourth year, you will generate $10,000 so the fraction of the year required to capture the remaining $5,000 investment is $5,000/$10,000 or 0.5. The payback period is, therefore, 3.5 years.

The profitability index is a ratio of:

the present value of cash inflows to initial cash outflow The profitability index is a ratio of NPV to investment cost. The profitability index (PI) is calculated by taking a project's NPV and dividing it by the cost. This gives us a measure of "bang for the buck", or how much NPV will you generate per unit of resources (costs) consumed. The PI allows you to rank projects if resources are limited.

Capital rationing is the process of:

using limited cash to select among investments available Capital rationing is the process of using limited cash to select among investments available. Firms generally have a fixed budget that they can allocate to capital budgeting projects and often have more potential projects than they have budget to fund. Under this situation, known as capital rationing, firms must select which projects are appropriate to invest in and which projects to exclude. That process typically involves determining the present values of the firm's investment choices and then applying some other ranking metric like profitability index. Making a firm's cash budget is one of the tasks completed by a financial manager but it is not considered capital rationing. In theory, a firm should accept all positive NPV projects but the resources are not always available. Some firms impose internal capital rationing as a project screening tool so that only the very best projects get selected. Keep in mind that while we do very elaborate calculations to determine a project's NPV the ultimate answer is still based on estimated cash flows.

A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is:

-$2,000 A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is -$2,000. The NPV is defined as the present value of the project's cash flows minus the initial investment. In this case: NPV = $6,000 - $8,000 = -$2,000. This project should be rejected since it has a negative NPV. The present value of the project's cash flows needs to be at least as much as the initial investment. If the NPV was zero or higher you would accept the project since a zero NPV means the project generated your minimum required return.

A firm must choose from the 5 capital budgeting proposals outlined below. The firm is subject to capital rationing and has a capital budget of $500,000. The firm's cost of capital is 12%. Project 1 Initial investment - $100,000 IRR - 17% NPV - $50,000 Project 2 Initial investment - $200,000 IRR - 15% NPV - $10,000 Project 3 Initial investment - $125,000 IRR - 14% NPV - $30,000 Project 4 Initial investment - $100,000 IRR - 11% NPV - -$2,500 Project Initial investment - $75,000 IRR - 19% NPV - $25,000 Using the net present value approach to ranking projects, which projects should the firm accept?

1,2,3 and 5 A firm must choose from 5 capital budgeting proposals outlined below. The firm is subject to capital rationing and has a capital budget of $500,000. The firm's cost of capital is 12%. Project 1 Initial investment - $100,000 IRR - 17% NPV - $50,000 Project 2 Initial investment - $200,000 IRR - 15% NPV - $10,000 Project 3 Initial investment - $125,000 IRR - 14% NPV - $30,000 Project 4 Initial investment - $100,000 IRR - 11% NPV - -$2,500 Project Initial investment - $75,000 IRR - 19% NPV - $25,000 Using the net present value approach to ranking projects, the firm should accept projects 1,2,3 and 5. According to the net present value decision rule, you should accept any project with a positive NPV. Any project with a positive NPV makes at least the minimum required return. Therefore, the only project that should not be accepted is project 4.

__________ are projects where the acceptance of one project automatically means we are rejecting other options.

Mutually exclusive projects Mutually exclusive projects are projects where the acceptance of one project automatically means we are rejecting other options. This is type of capital budgeting decision is common in equipment replacement decisions but there are also other applications. Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as independent projects. Accepting an independent project does not automatically reject a competing project so the accept/reject decision is a stand-alone decision.

Which of the following decision techniques provides the clearest link to the goal of maximizing shareholder wealth?

NPV NPV measures how much wealth a project creates for shareholders, so it creates the clearest link to the goal of maximizing shareholder wealth. Any project that generates a positive NPV will provide the firm's required return since it was used as the discount rate to compute the present value of the project's cash flows. Therefore, any positive NPV project will continue to increase shareholder wealth since a positive number means it generates returns even higher than the required return. Using the IRR can generate incorrect accept/reject decisions if the project's cash flows change signs. The payback period method ignores the time value of money and can be inaccurate as well, particularly in rejecting good projects that have large cash flows occurring later in the project's life.

To evaluate differences in project scale, a financial manager should always use ___________ as the primary capital budgeting evaluation tool.

NPV To evaluate differences in project scale, a financial manager should always use NPV as the primary capital budgeting evaluation tool. If a manager looks only at the IRR as an evaluation tool they will always select the highest IRR. However, a project with a 100% IRR that only requires an initial investment of $5 is likely not preferred to a much larger scale project with a lower IRR such as one where you invest $100,000 and get a 50% IRR. Using the NPV would highlight those scale differences immediately. The IRR gives you an easy to use percentage return but should always be used in conjunction with the NPV. The MIRR is a modification of the IRR that is typically used when cash flows change direction and is not used to correct for scale differences.

Chris has been offered the chance to invest $120,000 in a partnership, which is expected to return $25,000 per year. If Chris is in the 30% tax bracket and limits investments to those with a payback of six years, should Chris invest?

No, because the payback period is 6.86 years. Chris has been offered the chance to invest $120,000 in a partnership, which is expected to return $25,000 per year. If Chris is in the 30% tax bracket and limits investments to those with a payback of six years, should Chris invest? No, because the payback period is 6.86 years. To calculate the payback you need to calculate Chris' annual cash return which is equal to $25,000 (1 - 0.30) = $17,500 per year in after-tax proceeds from the investment. Given that annual amount, his payback is equal to $120,000 / $17,500 = 6.86 years. Since the payback exceeds his six year cut off he should not make the investment. Since Chris is in a 30% tax bracket that means he gets to keep 70% of his earnings and he remits 30% in taxes. So, to get his after-tax benefit you can multiply the amount by (1 - T), where T = marginal tax rate. So, (1 - 0.30) gives you the 70% after-tax fraction he gets to keep.

Software Design Inc. is considering a number of capital budgeting projects. However, the company is currently constrained by the number of programmers that it employs. The company has 20 programmers on its staff and will not be able to hire any new programmers in the near future. Which of the following methods should the company use to choose which projects to accept?

Rank the projects based on profitability index (PI) and select the highest PIs. Software Design, Inc. is considering a number of capital budgeting projects. However, the company is currently constrained by the number of programmers that it employs. The company has 20 programmers on its staff and will not be able to hire any new programmers in the near future. The company should choose which projects to accept by ranking the projects based on profitability index (PI) and selecting the highest PIs. When you are resource constrained, the PI will give you a metric that tells you how much "bang for the buck" you get. In this case, you would generate a PI that gives you the amount of NPV per programmer and select the highest ones until you have allocated 20 programmers. The payback period and the IRR do not take into consideration the resource shortage you face. In this case, it is a skilled labor shortage and you need to select the projects that give the highest return per unit of skilled labor. PI is commonly used to rank projects according to the amount of profit per dollar invested but you can see it has other applications when facing resource constraints that are not monetary.

An NPV profile is __________.

a graph of a project's NPV over a range of different discount rates An NPV profile is a graph of a project's NPV over a range of different discount rates. An NPV profile is useful when there is uncertainty surrounding a project's cost of capital. Some firms may use different costs of capital for projects with different levels of risk. When this is the case, the NPV profile provides some additional information regarding the discount rate where the NPV turns negative. The NPV of a project should be calculated using all cash flows and so looking at an NPV at various points in time is meaningless. Estimating the IRR using trial-and-error is cumbersome given the computing tools available today and it has no bearing on a project's NPV. Make use of the spreadsheet software available to you to calculate NPV profiles and IRRs. Both processes are much easier to do with computers even though you may be forced to do one by hand to ensure you understand the process.

A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by:

a series of inflows A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by a series of inflows. In most cases, a firm will make an initial investment that will then begin generating cash inflows for the firm. This is the conventional cash flow pattern. However, the firm may be evaluating a project that will require an initial outflow followed by a series of outflows. A piece of pollution control equipment would fall under this category. For these projects, you are looking for the piece of equipment that will accomplish your goals at the least cost. Other projects may have some costs associated with termination that would require an additional outlay at the end of the project. A mining project that required land reclamation at the end would fall into this category. Some projects may flip back and forth between inflows and outflows.

MIRR is used when:

cash flows of a project change sign MIRR is used when cash flows of a project change sign. The MIRR, or modified internal rate of return, overcomes the problems that arise when a project has cash flows that change sign throughout the project's life. For example, a project may generate positive cash flows for a few years and then have a year where you anticipate additional investment (negative cash flows) before the cash flows turn positive again. Since the IRR is the rate that makes the NPV equal to zero you will have a new IRR every time the sign changes. So, which IRR do you use? It is impossible to know so the MIRR eliminates this problem by modifying the cash flows until there is only one IRR possible. The MIRR carries all cash flows to a consistent time period, typically at the end of the project's life (FV), which enables you to compute a useful IRR. There is some debate about whether this method is better than IRR but it does overcome some of the problems associated with non-typical cash flows.

Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the:

firm's cost of capital Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the firm's cost of capital. The NPV uses the firm's cost of capital to discount the project cash flows back to the present. Therefore, any positive NPV project earns at least the firm's cost of capital. The market rate of interest can be quite different depending on the riskiness of the firm's business activities and the project's internal rate of return is the discount rate that makes the project's NPV = 0. This rate will likely have no resemblance to the firm's cost of capital for most projects. Any positive NPV project has an IRR that exceeds the firm's cost of capital. However, some positive NPV projects will have much higher IRRs than others.

The IRR can lead to incorrect project rankings because projects with much higher NPVs may also have:

longer project lives The IRR can lead to incorrect project rankings because projects with much higher NPVs may also have longer project lives. A particular project could have a very high IRR and only last one year. Therefore, a project with a slightly lower IRR that lasts several years may be preferred over the higher IRR. The NPV will correctly rank these projects if you rank them from the highest NPV to the lowest NPV. A shorter project life may or may not be the best project but the IRR will not make a distinction in project life. And, if the NPV is computed with a required return higher than the IRR it will generate a negative result and, therefore, should not be accepted. Always use the NPV in addition to other evaluation tools. It will always generate the correct accept/reject decision and project ranking.

The first step in the capital budgeting process is:

proposal generation The first step in the capital budgeting process is proposal generation. In order to evaluate a project you need to identify some promising capital budgeting projects that are consistent with your firm's mission and strategy. These ideas are often generated by the executive team but they can emerge from suggestions made by the sales force, research and development, or a number of other avenues. Once you have identified some possible proposals you will need to identify all relevant cash flows and then you can analyze the project using tools such as NPV, IRR, and payback. Projects can emerge from almost anywhere and can include the acquisitions of existing firms, new product development, expansion of existing product lines, moving into new geographic markets, and a host of other options.

A firm that is earning profits over and above what should be considered normal for that line of business is earning a(n) __________.

pure economic profit A firm that is earning profits over and above what should be considered normal for that line of business is earning a pure economic profit. A firm that is earning a normal return, or that return that investors demand for the level of risk, is said to be earning zero economic profits. If a firm earns above that amount it is said to be earning an economic profit. An accounting profit is determined by whether or not a firm shows a profit when creating financial statements using generally accepted accounting procedures (GAAP). Supernormal profits are not used in this context. Note that the existence of economic profits will attract other firms to enter this market if it is a competitive market or one that has limited barriers to entry.

The minimum return that must be earned on a project in order to leave the firm's value unchanged is:

the discount rate The minimum return that must be earned on a project in order to leave the firm's value unchanged is the discount rate. The firm selects a required rate of return that it must earn on any capital budgeting projects and then uses this rate as the discount rate to compute the present value of the project's cash flows. All projects must earn a minimum return equivalent to this discount rate. The fed funds rate is the interest rate that banks charge each other for overnight lending and the prime rate is the rate that banks charge to make loans to their best customers. Neither of these rates has any bearing on the discount rate used by a firm to evaluate projects. That rate is based on investor expectations and the project's risk. The internal rate of return (IRR) is the rate that makes a project's NPV = 0. If this rate exceeds the discount rate, which is often called the hurdle rate, then it should be accepted.