AEC 422
Fall 2013
Unit 2
Financial Decision Making
Capital Budgeting
 Defined as process by which a firm
decides which long term investments
to make
 Decision to accept or reject a capital
budgeting project depends on an
analysis of the cash flows generated
by the project and its cost
Five Capital Budgeting
Performance Measures
 1. Payback
 2. Average Rate of Return
 3. Net Present Value
 4. Profitability Index
 5. Internal Rate of Return
Starting with Net Cash Flow
Statement
 Cash Flow Statement: sources and
uses of cash for a business over a
certain period of time.
 Period coincides with the reporting
period of the income statement.
 Cash Flow Statement is basic to
calculating performance measures
Cash Flow Statement
 A cash flow statement shows how your
business is performing on a “cash” basis
 The income statement shows how your
business performs on an “accrual” basis
while the cash flow statement provides a
source of cash receipts shown in the
income statement
Cash Versus Accrual Accounting
Methods
 Basic difference between the two is
the timing of the income and expense
recording.
Cash versus Accrual
 Cash accounting is based on real time
cash flow. Revenues (expenses) are
reported when received (paid).
 Accrual accounting reports income
(expenses) when earned (or received)
and expenses when earned and not
necessarily when received (or paid).
Three General Categories of a
Cash Flow Statement
 Net flows from operations activities
 Net flows from investing activities
consisting primarily of purchase or
sale of equipment
 Net flows from financing activities
such as issuing and borrowing funds.
Steps in Preparing a Cash Flow
Budget
 1. Prepare a sales forecast
 2. Project anticipated cash inflows
 3. Project anticipated cash outflows
 4. Putting the projections together to
come up with your cash flow
“bottom line”
Capital Budgeting Decision
Rules
 1. You must consider all the project’s
cash flows
 2.Must consider time value of money.
Dollar earned next year is not the
same as a dollar earned today
 3. Must always lead to the correct
decision when choosing among
mutually exclusive projects
Time Value of Money
 At it’s most basic level, the time value
of money demonstrates that it is
better to have money now rather
than later.
 Would you rather have $10,000 today
or receive it next year?
 Why?
Would You Rather Receive
$10,000 Today or Next Year?
 Inflation
 Could have it invested and earning
money
Project Classification
 Projects being considered and
evaluated can be divided into two
categories:
 1. Independent projects
 2. Mutually exclusive projects
Independent Projects
 A project whose cash flows are not
affected by the accept or reject
decision of other projects.
Mutually Exclusive Projects
 Defined as a set of projects from which
at most one will be accepted.
 All the projects being considered may be
acceptable, but we’ll choose the “best”
one.
 Can’t always do everything – often have
a budget constraint
Capital/Investment Projects in
Agribusiness









Wind turbine
New ag chemical
Plastic reusable containers vs cardboard
High speed wine bottling equipment
Flash freezer vs IQF freezer for fruit
Electronic Point of Sale systems for retail store
Employee health insurance plan A vs B
New line of equipment for a farm supply store
New service division for a bank
Cash Flow Returns
 Based on project outcomes that
either lead to
 New net revenue
 New net cost savings
 Typically over a period of time
The Discount Rate
It’s the firm’s cost of capital. The latter
reflects the firm’s cost of acquiring
capital to invest in long term assets.
Discount rate reflects future value of
money. Has two components:
 An adjustment for inflation
 A risk-adjusted return on the use of
the money
Investment Example
 Initial Investment: $400,000
 Cash Flow Returns





Year
Year
Year
Year
Year
1:
2:
3:
4:
5:
$115,000
$115,000
$115,000
$115,000
$115,000
 Salvage Value: $50,000
Payback Period
 A capital budget performance
measure
 Defined as the length of time it takes
for a capital budgeting project to
recover it’s initial cost
Calculating Payback
Payback
=
Net Investment
Average Annual Net Cash Flow
*Note that net cash flow is after
taxes
Calculating Payback
 Using the Net Cash Flow example
provided, what is the payback
period?
Example Calculating
Payback
Net
Investment
Payback =
Average Annual Net Cash Flow
=
$400,000
$115,000
= 3.48 Years
Decision Rule: The lower the
better!
Payback
 Advantages:
 Easy to calculate
 Give you a rough idea of liquidity
 Disadvantages:
 Ignores time value of money
 Ignores project profitability
Average Rate of Return
 A second capital budgeting performance
measure
 Defined as:

Average Annual Net Cash Flow – Average Annual Depreciation
Net Investment
Average ROR
Calculate the Average ROR using the
example net cash flow statement
Calculating Average ROR
ROR =
$115,000 - $70,000 = 11.25%
$400,000
Decision Rule: Must be
positive and the higher the
better!
Average ROR
 Advantages:
 Again, simple to calculate
 Does account for salvage value
 Begins to consider profitability
 Disadvantages:
 Ignores time value of money
Net Present Value
 A third capital budgeting performance
measure concept
 Net Present Value is a measure of
how much value is created or added
today by undertaking an investment.
Net Present Value
 It does this by accounting for the
time value of money. A $ today
is worth more than a $ tomorrow
because of the “erosive” effects
of inflation
Net Present Value
 It is the present (discounted) value of
future cash inflows minus the present
value of the investment and any
associated future cash outflows
 It’s the net result of a multiyear
investment expressed in today’s
dollars
Net Present Value
T
∑
t=1
NCFt
(1 + r)t
- NINV
Net Present Value Key
 NCFt
Net Cash Flow in Year t
 T
is the life of the project
 r
is the discount rate or cost of
capital
 NINV
is the net investment of the
project
 Note that in year T, Net Cash Flow must
include the salvage value of the initial
investment
Calculate Net Present Value
 Using the example provided, how
would you structure the equation for
calculating net present value?
 Assume Discount Rate = 10%
Calculating Net Present Value
$115,000
(1.1)1
+ $115,000
+ $115,000
+
2
3
(1.1)
(1.1)
$115,000
(1.1)4
+
$115,000
1.1
+ $115,000 +
$115,000
1.331
$115,000
1.4641
+
1.21
$104,545 + $95,041
$466,984
$66,987
-
$400,000
+
$86,401
+
+
$78,547
$115,000 + $50,000
(1.1)5
$165,000
1.61051
+ $102,452
- $400,000
- $400,000
-
$400,000
Net Present Value
 Decision Rule: Accept project if NPV > 0
 $66,987 > 0 so we accept the project
given it’s the only one we’re considering
 Note if mutually exclusive projects
being considered, accept the one with
the highest NPV
NPV
 Advantages:
-Accounts for time value of money
correctly
-Considers firm profitability
-Consistent with notion of
maximizing owner wealth
NPV
 Disadvantages:
-More complex to calculate
-Difficult to explain to non-financial
managers
-Not always easy to determine the
correct “discount rate”
Profitability Index (PI)
or Benefit Cost Ratio (BCR)
Defined as the present value of the
future cash flows divided by the
initial investment
Profitability Index
T
∑
t=1
NCFt
(1 + r)t
NINV
Profitability Index--Where
 NCFt
=
Net Cash Flow in Year t
 T
=
Life of the Project
 r
=
Discount Rate
 NINV
=
Net investment of Project
 Note that Net Cash flow must include
the salvage value of the initial
investment
Calculating PI
 Using the example provided, what is
the profitability index?
Calculate PI
 For our example:
PI
=
$466,987 = 1.17
$400,000
Calculate PI
 Decision Rule: Accept if PI >1.0
But the bigger the PI the better
 Hence, we accept this project
 Note: PI is a unit free performance
measure
Pros and Cons of PI
 Advantages:
 Accounts for time value of money
 Considers project profitability
 Considers owner wealth maximization
 Disadvantages:
 Complex to calculate
 Difficult to explain to non-financial types
 May not pick project with largest NPV
Internal Rate of Return
(IRR)
 The IRR on an investment is the
required return that results in a zero
NPV when it is used as the discount
rate
 In some ways it’s an alternative to
NPV
Internal Rate of Return
 Note that NPV is some mathematical
function of r (the discount rate)
 So IRR is the level of r (call it r*)
such that the NPV = 0
Thus,
Internal Rate of Return
T
∑
t=1
NCFt
(1 + r*)t
-
NINV = 0
Internal Rate of Return
 Unfortunately, one cannot solve for
IRR using algebra.
 Rather we must solve by trial and
error
Calculating IRR-Using Example
 r%
6
8
10
12
14
16
18
20
22
24
NPV ($)
121,785
93,191
66,987
42,921
20,773
349
-18,520
-35,986
-52,181
-67,225
PI
1.3
1.23
1.17
1.11
1.05
1.0
.95
.91
.87
.83
Calculating IRR
 From previous table we note that
NPV = 0 somewhere between r =
16% and r = 18%.
 Bit more trial and error and we can
discover that IRR = 16.04%
 Plug 16.04% into NPV formula and
you get NPV = 0
Calculating IRR
 Decision Rule says that for a single
project accept if IRR > 0.
 The higher the better.
Pros and Cons of IRR
 Advantages:
Accounts for time value of money
Considers profitability
Consistent with maximizing wealth
Doesn’t require analyst to specify r
 Disadvantages:
Complex to calculate
Difficult to explain
May not pick project with largest NPV