Finance - Capital Budgeting Techniques

NPV profile

A graph that illustrates the relationship between a project's net present value (NPV) calculated at a range of hurdle rates. An NPV profile is a graph or curve showing the relationship between a projects's NPV and a range of discount (hurdle) rates. The slope of the curve is an indication of the sensitivity, or riskiness, of the project, given its estimated cash flows. The profile can be used to graphically determine or decide which proposed capital projects should be deemed acceptable using either their NPV or IRR values.

If the project's desired rate of return increased, how would that affect the IRR?

The IRR will not change. The IRR is the internal rate of return, or the project's expected return if intermediate cash flows earn the same return as the IRR. The IRR is the rate that forces the NPV to equal zero; hence, the calculated IRR is independent of a project's rate of return.

Darling Corporation is evaluating a proposed capital budgeting project that will require an initial investment of $172,000. The project is expected to generate the following net cash flows: Year Cash Flow 1:$45,400 2:$51,800 3:$48,900 4:$48,400 Assume the desired rate of return on a project of this type is 9%. The net present value of this project is? Suppose Darling Corporation has enough capital to fund the project, and the project is not competing for funding with other projects. Should Darling Corporation accept or reject this project?

-14,702.05 Net present value (NPV)=PV of future cash flows =($172,000)+(45,400(1.09)^1)+(51,800(1.09)^2)+(48,900(1.09)^3)+(48,400(1.09)^4) =-$14,702.05 Reject the project When capital is not restricted and funds are available for investment, a project should be accepted if its NPV is greater than or equal to zero, and rejected if its NPV is less than zero. When an investment has a negative NPV, it fails to provide the firm the minimum desired rate of return it requires for such a project. In this case, Darling's project has a negative NPV, so it should be rejected.

Companies often use several methods to evaluate the project's cash flows and each of them has its benefits and disadvantages. Based on your understanding of the capital budgeting evaluation methods, which of the following conclusions about capital budgeting are valid? Check all that apply. -Managers have been slow to adopt the IRR, because percentage returns are a harder concept for them to grasp. -For most firms, the reinvestment rate assumption in the MIRR is more realistic than the assumption in the IRR. -The NPV shows how much value the company is creating for its shareholders.

-For most firms, the reinvestment rate assumption in the MIRR is more realistic than the assumption in the IRR. -The NPV shows how much value the company is creating for its shareholders. The MIRR reinvestment rate assumption is more realistic than the IRR assumption, because most firms are more likely to earn their required rate of return when they reinvest a project's cash flows. The MIRR assumes that cash flows are reinvested at the required rate of return, whereas the IRR assumes that they earn the IRR. The NPV gives a direct measure of the dollar benefit that each project would add to the firm's shareholders. For this reason, the NPV is considered the best decision criterion. However, that does not mean that you can ignore other decision criteria. All decision criteria provide useful information for evaluating projects. A good capital budgeting decision takes into account all these factors. The IRR is actually a popular measure among managers, because percentage returns are an easy concept to understand and can be compared to the firm's cost of capital very easily. Even though the NPV offers a better indication of value added, many managers continue using the IRR for these reasons.

Capital budgeting involves evaluating the value of long-term assets or projects. Which of the following should be included in the capital budgeting process? Check all that apply. -Estimate sunk costs and add them to the valuation. -Compute depreciation using different methods to include in the analysis. -Include all relevant cash flows. -Evaluate the riskiness of the projected cash flows. -Consider expansion projects over replacement projects.

-Include all relevant cash flows. -Evaluate the riskiness of the projected cash flows. The steps used to evaluate long-term assets and projects are: 1.Estimate the relevant future cash flows, including taxes and financing requirements. 2.Evaluate the riskiness of the projected cash flows. This is necessary to calculate the required rate of return. 3.Compute the present value of the expected cash flows. 4.Compare the present value of the cash flows to the initial investment or cost required to acquire the asset.

Capital projects are either mutually exclusive or independent. Which of the following phrases correctly describe mutually exclusive projects? Check all that apply. -Project choices that rule out competing project choices -Those projects that, if rejected, preclude the acceptance of all other competing projects -Those projects that are best analyzed without considering the time value of money -Those projects that, if accepted, preclude the acceptance of all other competing projects -By definition, they are not also independent projects

-Project choices that rule out competing project choices -Those projects that, if accepted, preclude the acceptance of all other competing projects -By definition, they are not also independent projects Mutually exclusive projects are those projects that, if accepted, preclude the acceptance of all other competing projects. In other words, mutually exclusive projects are investment choices that rule out competing investment choices. Independent projects are projects that, whether accepted or rejected, do not affect the cash flows of other projects. All capital investments are best analyzed by considering the time value of money.

Which of the following statements indicates a disadvantage of using the regular, or conventional, payback period for capital budgeting decisions? Check all that apply. -The payback period does not take into account the cash flows produced over a project's entire life. -The payback period is calculated using net income instead of cash flows. -The payback period does not take into account the time value of money effects of a project's cash flows.

-The payback period does not take into account the cash flows produced over a project's entire life. -The payback period does not take into account the time value of money effects of a project's cash flows. The payback period takes into account only those cash flows that occur up to the point where the project recovers the amount of the initial investment. You could have two mutually exclusive payback-period projects: project A's is 5 years, and project B's is 6 years. Using just the payback period, you would likely make the capital budgeting decision to accept project A and reject project B. However, project A might have no cash flows in the periods after it recovers its initial investment, and project B could have cash flows of $1 million every year for the 20 years after the project's initial investment is recovered. You can see, if this were the case, project B would be the better project to accept. The regular payback period also does not take the time value of money into account when calculating a project's payback period. The discounted payback period corrects this disadvantage by taking the effects of the time value of money into account when calculating the payback period.

A key to resolving this conflict is the assumed reinvestment rate. The NPV calculation implicitly assumes that intermediate cash flows are reinvested at the _______________________ , and the IRR calculation assumes that the rate at which cash flows can be reinvested is the________________________. As a result, when evaluating mutually exclusive projects, the ________________ is usually the better decision criterion.

-required rate of return -internal rate of return -NPV method The IRR assumes that intermediate cash flows can be reinvested and continue earning the IRR. For most firms, it is more accurate to assume that the firm can reinvest cash flows at the required rate of return, not the IRR. Remember, the required rate of return is the opportunity cost of capital and represents the rate at which external capital can be attained. The required rate of return is the assumed reinvestment rate when calculating the NPV. If a firm had poor access to external capital markets but many high IRR projects, the IRR reinvestment rate would make sense. This situation is rare because firms with good investment opportunities generally have access to external capital markets. Therefore, the assumption built into the NPV method (reinvestment rate equals required rate of return) is more valid.

Whippet Industries Corp. is evaluating a proposed capital budgeting project that will require an initial investment of $1,350,000. The project is expected to generate the following net cash flows: Year Net Cash Flow 1:$300,000 2:$425,000 3:$400,000 4:$425,000 Whippet Industries Corp. has been basing capital budgeting decisions on a project's NPV; however, its new CFO wants to start using the internal rate of return (IRR) method for capital budgeting decisions. The CFO says that the IRR is a better method, because percentages and returns are easier to understand and to compare to required returns. Whippet Industries Corp.'s desired rate of return is 5%. Which of the following is the IRR of the project?

5.50% $0 =-$1,350,000+($300,000/(1 + IRR)^1)+($425,000/(1 + IRR)^2)+($400,000(1 + IRR)^3)+($425,000(1 + IRR)^4) If this is an independent project, the IRR method states that the firm should accept the project.

Replacement decisions

A capital budgeting analysis that determines if a capital asset should be purchased to take the place of a worn out, damaged, or obsolete existing asset. A replacement decision and analysis is used to determine if a capital asset should be purchased to take the place of a worn out, damaged, or obsolete existing asset and thereby maintain or improve the firm's existing operations. In contrast, an expansion decision and analysis is used to determine if additional capital projects should be added to a firm's existing asset base.

Required Rate of Return (RRR)

Also called a firm's hurdle rate, it is used as the discount rate in a firm's net present value (NPV) calculations or the basis of comparison for a project's internal rate of return (IRR). The required rate of return is the discount rate (cost of funds) that a project's internal rate of return (IRR) must exceed for a project to be considered acceptable. The required rate of return is what investors require to invest in the firm. Any return over the required rate increases the wealth of the firm.

True or False: Sophisticated firms use only the NPV method in capital budgeting decisions.

False This is false. Net present value (NPV) is considered to be the single best method for capital budgeting decisions, because it provides a direct measure of the project's added value to shareholder wealth. However, sophisticated firms generally calculate all five measures (NPV, IRR, payback period, discounted payback period, and MIRR) when evaluating capital budgeting decisions, because each provides different information. Calculating all the measures is easy, so all should be considered when making capital budgeting decisions.

Independent Projects

The acceptance or rejection decision made for this type of project does not affect the acceptance or rejection of another proposed capital project. Independent projects are those whose cash flows are not affected by, or are independent of, the acceptance or rejection decisions made regarding other projects. For example, the decision to purchase a new delivery truck is not dependent on the decision to purchase, or not purchase, a new advertising campaign. It is reasonable to believe that either the truck, the advertising campaign, neither, or both can be accepted for investment, assuming that the firm has sufficient financial capital to pay for both projects. In contrast, in mutually exclusive projects, the acceptance of one project eliminates one or more other projects from being accepted. For example, the decision to purchase a small parcel of land and construct either a small shopping center or a small office building is an example of two mutually exclusive projects. In this case, assume that the parcel of land is so small that it cannot accommodate both the shopping center and the office building. Therefore, the acceptance of one type of structure precludes, or makes impossible, the construction of the other type of structure. The decision to build the office building eliminates from further consideration the construction of the shopping center, or vice versa.

Modified Internal Rate of Return (MIRR)

The discount rate at which the present value of a project's cash outflows is equal to the present value of the sum of its future cash inflows, assuming that cash flows are reinvested at the firm's required rate of return. The required rate of return is the discount rate (cost of funds) that a project's internal rate of return (IRR) must exceed for a project to be considered acceptable. The required rate of return is what investors require to invest in the firm. Any return over the required rate increases the wealth of the firm.

Internal Rate of Return (IRR)

The discount rate that equates the present value of a capital project's expected cash inflows and its initial cost. The internal rate of return is the discount rate that equates the present, or discounted, value of a project's expected cash inflows with its initial cost. It is the rate that the firm expects to earn if a project is purchased and held for its useful life. Under this technique, a project is acceptable if its IRR is greater than the firm's required rate of return (hurdle rate). The reliability of this capital budgeting technique is diminished when applied to projects exhibiting unconventional cash flows, since it can result in more than one IRR value.

Post Audit Analysis

This analysis is conducted following the implementation of an accepted capital project and is intended to improve a firm's forecasting process and to improve the firm's operations. A post-audit analysis is conducted following the implementation of an accepted capital project and compares its expected and actual cash flow results. By developing explanations for any disparity between the expected and actual results, the post-audit review process can be used to improve a firm's forecasting process as well as its operations.

Payback Period

This analytical technique is less reliable for identifying acceptable projects as it ignores the time value of money. The payback period is the time it takes to recover the original cost of an investment from its expected cash flows. Traditional payback does not use discounted cash flows so it is not considered as good a method as a discounted payback method. Firms may use this method to assess risk because the longer the project, the estimated cash flows are further out into the future which lends the project to more risk.

Net Present Value (NPV)

This capital budgeting technique calculates the net dollar value of a capital project and its effect on the value of the firm. The net present value method is the capital budgeting method that gives a direct and discounted (present value) measure of the dollar benefit of a project to the value of the investing firm. Therefore, the NPV technique is therefore regarded as the best single measure of the increased value to shareholders.

An incentive program that encourages new ideas, whether for new products or better processes, is a good way to generate capital investment proposals.

True Companies that promote a constant flow of new ideas are the most successful. An incentive program that encourages new ideas, whether for new products or better processes, is a good way to generate capital investment proposals.

conventional or normal project

has a cash flow pattern with no more than one sign change, where a sign change involves the change from a negatively signed cash flow (outflow) to a positively signed cash flow (inflow), or vice versa.

Post-audits are generally a waste of time, because it is nearly impossible for actual results to match forecasted results.

False A post-audit is an important aspect of capital budgeting. It's a great way to learn from past mistakes and improve forecasting. Better forecasting makes for better operations just by having to reconcile actual operations to forecasts.

Which version of a project's payback period should the CFO use when evaluating Project Beta, given its theoretical superiority? -The discounted payback period -The regular payback period

The discounted payback period The CFO should use the discounted payback period when evaluating Project Beta, because the discounted payback period takes the expected cash flows' time value of money effects into account and the regular payback period does not.

Capital Budgeting

The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year. Capital budgeting is the process of planning and evaluating expenditures of assets whose cash flows are expected to extend beyond one year. Capital refers to fixed assets used in a firm's production process, and budget is the plan that details the project's cash inflows and outflows into the future. The process of analyzing projects and deciding which are acceptable investments and which actually should be purchased is called capital budgeting.

A post-audit involves comparing actual results with forecasted results.

True A post-audit involves comparing actual results with forecasted results and is an important step in the capital budgeting process that is sometimes overlooked.

Capital budgeting is the long-term planning for the purchase of assets whose cash flows extend beyond one year.

True Capital budgeting is the long-term planning for the purchase of assets whose cash flows extend beyond one year. Because the effect of capital budgeting is long term, it has a significant impact on the company's future value.

nonconventional or nonnormal project

has a cash flow pattern with either more than one or no sign changes.

The NPV and IRR methods can lead to conflicting decisions for mutually exclusive projects.

true This is true. The NPV and IRR methods can lead to conflicting decisions for mutually exclusive projects because of cash flow timing and size differences between projects.