Capital Budgeting

For 9.220, Term 1, 2002/03 02_Lecture9.ppt

Outline
Introduction

Problems with IRR Special Considerations for DCF Techniques Non-Discounted Cash Flow Methods Summary and Conclusions
Payback Average Accounting Return (AAR) Mutually Exclusive Projects Capital Rationing

Introduction

Discounted Cash Flow (DCF) Techniques are widely accepted as being among the better methods used for capital budgeting analysis. The three techniques discussed so far include NPV, IRR, and PI There are situations when one method is better to use than another or when adjustments should be made to use a method correctly.

IRR Problem Cases: Borrowing vs. Lending Consider the Project A Project B following two Year Cash Cash Flows Flows projects. Evaluate with IRR given a 0 -$10,000 +$10,000 hurdle rate of 20%
1 +$15,000 -$15,000

The non-existent or multiple IRR problem Example: Cash flows Cash flows Year of Project A of Project B Do the evaluation using IRR and a 0 -$312,000 +$350,000 hurdle rate of 15%
1 2 +$800,000 -$500,000 -$800,000 +$500,000

NPV Profile where are the IRRs?

$80,000 $60,000 $40,000

NPV

$20,000 $0 0% -$20,000 -$40,000 -$60,000 20% 40% 60% 80%

Project A Project B
100%

Discount Rate

No or Multiple IRR Problem What to do? IRR cannot be used in this circumstance, the only solution is to revert to another method of analysis. NPV can handle these problems. How to recognize when this IRR problem can occur

When changes in the signs of cash flows happen more than once the problem may occur (depending on the relative sizes of the individual cash flows). Examples: +-+ ; -+- ; -+++-; +---+

Special situations for DCF analysis

When projects are independent and the firm has few constraints on capital, then we check to ensure that projects at least meet a minimum criteria if they do, they are accepted. NPV0; IRRhurdle rate; PI1 If the firm has capital rationing, then its funds are limited and not all independent projects may be accepted. In this case, we seek to choose those projects that best use the firms available funds. PI is especially useful here. Sometimes a firm will have plenty of funds to invest, but it must choose between projects that are mutually exclusive. This means that the acceptance of one project precludes the acceptance of any others. In this case, we seek to choose the one highest ranked of the acceptable projects.

Using IRR and PI correctly when projects are

exclusive

and are of

differing scales
Year 0 1

mutually

Consider the following two mutually exclusive projects. Assume the opportunity cost of capital is 12%

Cash flows Cash flows of Project of Project A B -$100,000 +$150,000 -$50 +$100

Incremental Cash Flows: Solving the Problem with IRR and PI

As you can see, individual IRRs and PIs are not good for comparing between two mutually exclusive projects. However, we know IRR and PI are good for evaluating whether one project is acceptable. Therefore, consider one project that involves switching from the smaller project to the larger project. If IRR or PI indicate that this is worthwhile, then we will know which of the two projects is better. Incremental cash flow analysis looks at how the cash flows change by taking a particular project instead of another project.

Using IRR and PI correctly when projects are mutually exclusive and are of differing scales
Incremental Cash flows Cash flows Cash flows of Year of Project A of Project B A instead of B (i.e., A-B) 0 1 -$100,000 +$150,000 -$50 +$100 -$99,950 +$149,900

Using IRR and PI correctly when projects are mutually exclusive and are of differing scales IRR and PI analysis of incremental cash flows tells us which of two projects are better. Beware, before accepting the better project, you should always check to see that the better project is good on its own (i.e., is it better than do nothing).

Incremental Analysis Self Study

For self-study, consider the Cash flows following two Year of Project A investments and do the incremental IRR and PI analysis. 0 -$100,000 The opportunity cost of capital is 10%. Should either project be 1 +$101,000 accepted? No, prove it to yourself!
Incremental Cash flows Cash flows of of A instead of B Project B (i.e., A-B) -$50,000 +$50,001

Mutually Exclusive Projects of Different Length or with Different Risks

IRR gives us one rate of return for all the cash flows relevant to a project. If necessary, NPV and PI allow for different discount rates to be used on different cash flows.

If different rates should be used for different cash flows over a projects life, then IRR cannot be used. If we choose between two mutually exclusive projects of different length, based on IRR, then, by comparing IRRs, we must be assuming that the projects cash flows can be reinvested at their IRR rates. NPV and PI make a more conservative assumption that all reinvested cash flows earn the opportunity cost of capital.

This is useful when cash flows are of differing risk levels or when different discount rates apply due to the different timing of cash flows (recall the term structure of interest rates allows for different interest rates for different cash flows through time).

Mutually Exclusive Projects of Different Lengths Example

Check the IRRs. If Bs cash flows can be reinvested at Bs IRR, then B may indeed be the better investment. Otherwise, it depends on what are the appropriate discount rates for cash flows 1 year in the future, versus cash flows 10 years in the future.
Cash Cash flows flows Year of Project A Projectof B 0 1 -$10,000 0 -$10,000 $11,500 0

10 $31,058.48

Capital Rationing

Recall: If the firm has capital rationing, then its funds are limited and not all independent projects may be accepted. In this case, we seek to choose those projects that best use the firms available funds. PI is especially useful here. Note: capital rationing is a different problem than mutually exclusive investments because if the capital constraint is removed, then all projects can be accepted together. Analyze the projects on the next page with NPV, IRR, and PI assuming the opportunity cost of capital is 10% and the firm is constrained to only invest $50,000 now (and no constraint is expected in future years).

Capital Rationing Example (All $ numbers are in thousands)

Year 0 1 2 NPV IRR PI Proj. A -$50 $60 $0 $4.545 20% 1.0909 Proj. B -$20 $24.2 $0 $2.0 21% 1.1 Proj. C -$20 -$10 $37.862 $2.2 14.84% 1.11 Proj. D -$20 $25 $0 25% 1.136 Proj. E -$10 $12.6 $0 26% 1.145

$2.727 $1.4545

Capital Rationing Example: Comparison of Rankings

NPV rankings (best to worst)
A, D, C, B, E E, D, B, A, C E, D, C, B, A

IRR rankings (best to worst) PI rankings (best to worst)

A uses up the available capital Overall NPV = $4,545.45 E, D, B use up the available capital Overall NPV = NPVE+D+B=$6,181.82 E, D, C use up the available capital Overall NPV = NPVE+D+C=$6,381.82

The PI rankings produce the best set of investments to accept given the capital rationing constraint.

Capital Rationing Conclusions

PI is best for initial ranking of independent projects under capital rationing. Comparing NPVs of feasible combinations of projects would also work. IRR may be useful if the capital rationing constraint extends over multiple periods (see project C).

Other methods to analyze investment projects self study

Discounted Payback
Know thoroughly. Know this method thoroughly.

Payback the simplest capital budgeting method of analysis Average Accounting Return (AAR)

You will not be asked to calculate it, but you should know what it is and why it is the most flawed of the methods we have examined.

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Summary and Conclusions

DCF techniques are the best of the methods we have presented. In some cases, the DCF techniques need to be modified in order to obtain a correct decision. It is important to completely understand these cases and have an appreciation of which technique is best given the situation. Other techniques you should know include payback (which is nice because of its simplicity), discounted payback, and AAR.

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