CAPITAL BUDGETING
CHAPTER 11
Decision Rules
Reinvestment Rate Assumptions
Sensitivity Analysis
CAPITAL BUDGETING
 Investors
require stock price appreciation.
 To
increase stock price, companies must
become more profitable in order to increase
the value of the firm’s stock.
 Accordingly,
[Financial] managers must
make certain that new investments will
increase the value of the firm.
CAPITAL BUDGETING
A. Learning Objectives
1.
Learn key decision rules.
2. Learn analytical methodology
B. Business Objectives
1.
Minimize the probability of losses
2.
Recall that many new products / ventures fail and
failures are expensive.
3.
We want to make the most informed decision.
CAPITAL BUDGETING
C. Capital Investment [Classifications]
1. Renewal: Modernize, Overhaul, Retrofit
2. Replacement: Replace worn out equipment
3. Expansion: Adding physical capacity
4. Other: A variety of corporate objectives.
Primary Objective: Increase value of firm!
CAPITAL BUDGETING
D. The Data Inputs; What Information Is Necessary?
1. Type of project; new investment or replacement?
2. Expected economic life of the project (in years).
3. Initial outlay of cash required to finance project.
4. Identifying timing and magnitude of future cash flows.
CAPITAL BUDGETING
E. The Hurdle Rate
1.
Capital investments subject to one important
constraint:
•
2.
Investment must earn a rate of return greater than the cost of
capital (WACC).
The hurdle rate is the market derived weighted
average of investor required rates of return on
company’s stocks and bonds.
FIVE STEP CAPITAL
BUDGETING PROCESS
A. Proposal Generation: Schedule the
Investment Opportunity Set.
B. Analysis: Evaluate Each Opportunity.
C. Decision Making: Select best of the
Opportunity Set.
D. Implementation: Assure Project
Development Compliance
E. Control: Performance Assessment
CAPITAL INVESTMENT
DECISION RULES
A. Net Present Value: NPV >> 0
1.
Note my use of the much greater than symbol (>>) rather than
the text’s (). If I am going to put capital at risk - I don’t want to
just breakeven!
B. Internal Rate of Return: IRR > ka
1. IRR is the discount rate which makes NPV = zero.
2. The assumed reinvestment rate for cash flows.
3. If NPV greater than zero, then IRR is greater than ka.
CAPITAL INVESTMENT
DECISION RULES
C. Payback Period
1. How long will it take to recover the initial outlay from
After-Tax Cash Flows (ATCF)?
2. Many smaller companies are asked for this information
by banks before getting loans.
3. Problem: Ignores the time value of money.
CAPITAL INVESTMENT
DECISION RULES
D. NPV Profile
1. To create a profile, calculate net present value at
different discount rates.
2. The rate for a zero NPV is the IRR for the project.
E. Problem of Multiple IRR
1. When signs change more than once.
2. Cartesian Rule of Signs; number if solutions.
CAPITAL INVESTMENT
DECISION RULES
F. Modified Internal Rate of Return
1. The NPV and IRR models assume that ATCF are
reinvested at the WACC or the IRR, respectively.
2. A problem with the IRR is that it may be unattainable
over the long run.
3. The MIRR is that rate which takes the terminal value
(TV) of the reinvested cash flows and computes the
discount rate that makes the TV equal to the initial
outlay. See text for MIRR model example.
HOMEWORK CHAPTER 11
A. Self-test: ST-1, parts b, c, e, g
B. Questions: 11-4, 11-7, 11-9
C. Problems: 11-1, 11-2, 11-4, 11-13
Re 11-13: How do the timing and magnitudes of
future cash flows influence the IRR? MIRR?