Cameron School of Business
UNIVERSITY OF NORTH CAROLINA WILMINGTON
FIN 335, Chapter 8 and
Capital Budgeting
Edward Graham
Professor of Finance
Department of Economics and Finance
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Continuing your Introduction to Finance
Recalling the Broad Introduction to Finance
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I.
The Three Primary Duties of the Financial Manager
II.
Capital Budgeting and Financial Decision-making: The
Capital Budgeting Decision-making Criteria
An Introduction to Finance
What is finance?
• Finance is the study of the art and the science of money
management; it is based on the Latin root finis,
meaning the end. In managing ours or our firm’s money,
we consider historical outcomes or “endings,”
and we propose future results as a function of decisions
made today. Those outcomes or results are
typically portrayed using financial statements.
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I.
The Three Primary Duties of the
Financial Manager
Whether managing monies for the home, or for the firm, our
duties are met with decisions framed by the same general
principles. These principles instruct us in making three main
types of decisions as we perform those three primary duties:
•The capital budgeting decision
•The capital structure decision
•The working capital decision
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The Capital Budgeting Decision
With the capital budgeting decision, the financial manager
decides where best to deploy monies long-term. The
purchase of a new delivery truck or a new warehouse
is a capital budgeting decision; the payment of a utility
bill is not.
With the making of this decision, we consider three features
of the cash flows deriving from the decision:
• The size of the cash flows
• The timing of the cash flows
• The risk of the cash flows
We review a couple examples of capital budgeting decisions.
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The Capital Structure Decision
With the capital structure decision, the financial manager decides
from where best to acquire monies long-term. The purchase of that
new delivery truck with cash or with a loan from GMAC or Ford
Motor Credit is a capital structure decision; the use of long-term
borrowing to fund a franchise purchase is another.
Perhaps most importantly, the decision to fund a firm’s growth with
equity - such as with funds invested by the firm’s founders, angel
investors, venture capitalists or public stock offerings – or debt, is
a critical capital structure choice. Two features of this choice bear
mentioning:
• The risk of the debt
• The loss of control and reduced potential cash flows to the
founders with an equity or stock sale
We expand our review with a few capital structure decisions.
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The Working Capital Decision
With the working capital decision, current assets and current
liabilities become the focus of the financial manager.
Such items as cash balances, accounts receivable, inventory levels
and short-term accruals (such as prepaid rent or utilities) are
included among the short-term assets that comprise one
component of working capital.
Also with the working capital decision, we concern ourselves with
short-term obligations such as accounts payable to vendors,
and other debt that is expected to be paid off within one year.
Net working capital is a meaningful outcome of the working capital
decision-making matrix. Net working capital is merely the
difference between current assets and current liabilities.
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II.
The Capital Budgeting Choice: Capital
Budgeting Decision-making Criteria
Recall the definition of a capital budgeting choice; we are
deploying firm resources long-term towards the
maximization of shareholder wealth.
How do we know when we are doing that?
We use your text and four new tools to assist us:
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The Net Present Value or NPV rule in Section 8.1
The Payback rule in Section 8.2
The Internal Rate of Return or IRR rule in Section 8.4
The Profitability Index in Section 8.5
Capital Budgeting Decision-making
A great summary of the four “new tools’ is given in Table 8.6
of your text (p.244)
As well, problems 18-22 in your BA II Plus Review Sheet on
pages 28 and 29 of your course packet will assist you.
Those problems introduce us to the ideas below.
• First, the NPV rule (pages 224-228)
The NPV = PV (Inflows) – PV (Outflows or Cost)
We accept “deals” where the NPV > 0, and
We reject deals where the NPV < 0.
We illustrate all these new rules by example
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Capital Budgeting Decision-making
We are considering a new gym and health plan for our
employees. We have conducted a study and affirmed that
the new gym and plan will save us $35,000 per year, in
reduced absenteeism and turnover, and will cost us
$200,000 to put into place. Should we make this investment?
We “know” that 8 times 35,000 is more than 200,0000, but is
it “enough” more? That is where the NPV criteria assists. If a
reasonable time value of money (or cost of capital, as we will
learn in later lessons) for this investment is 8%, we can treat
the 35,000 per year as an annuity, and discover it has a PV
of $201,132. Our NPV becomes $1,132. That is greater than
zero, so we “accept” this deal.
But, what if our time value of money (or required return, in
this case) is greater than 8%? Or the cash flows are
irregular? Then what?
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Capital Budgeting Decision-making
So, what if our time value of money (or required return, in
this case) is greater than 8%? Or the cash flows are
irregular? Then what?
Our calculators assist us. We can easily compute “new”
PV’s with differing required returns or I/Y’s. But, with
irregular cash flows, and with all subsequent capital
budgeting choices, we use a different set of
applications. We use the cash flow or CF keys.
Thusly:
Observe the calculator application for cash flows.
Remember always to begin cash flow analyses by
hitting 2nd, CLR WORK after you hit the CF key.
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Capital Budgeting Decision-making
The NPV rule anticipates the IRR rule in Section 8.4 of your text.
We accept deals where the IRR > required return.
The IRR is that discount rate that forces the NPV to zero. With
equal-sized cash flows or annuities, the IRR is simply the I/Y.
With irregular cash flows, we must use the CF keys to “discover”
the IRR. We “know” the IRR in the first example with even
$35,000 annual cash flows for 8 years is over 8%, as our NPV >
0. If the IRR > Required Return, then the NPV must be > 0.
A graphical illustration, as on page 236 of your text, illustrates this
premise.
Using the CF keys, IRR = 8.149% in the first example, as also I/Y =
8.149%.
With irregular cash flows, the IRR changes, but with a
changing required return, the IRR is unchanged. The IRR is
not impacted by the required return!
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Capital Budgeting Decision-making
We examine the relationship between NPV and IRR with another
set of prospective cash flows. Suppose a project will cost us
$165,000 and throw off cash flows of $63,120 the first year, $70,800
the second and $91,080 the third. What is its IRR, and what is its
NPV at a discount rate of 16%? The graph below portrays the
NPV/IRR dynamic. The IRR occurs, of course, where the NPV = 0.
70,000
60,000
50,000
NPV
40,000
30,000
20,000
10,000
0
-10,000 0
0.02 0.04 0.06 0.08
0.1
0.12 0.14 0.16 0.18
-20,000
Discount Rate
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0.2
0.22
Capital Budgeting Decision-making
Advantages and disadvantages of the NPV and IRR rules
are given in your text and condensed in Table 8.6.
For the NPV rule, its greatest drawback is its complexity.
For the IRR rule, it is elegant, and widely used, but with
mutually exclusive projects, it can be misleading. An
example? Suppose you are choosing between two new
delivery trucks. The first costs $10,000 and provides
cash flows of $7,000 the first year, and $5,000 each of
the second and third years, yielding an IRR of 34.68%.
A second newer truck costs $20,000 and generates
cash flows of $12,000 the first year, $10,000 the second
and $8,000 the third. This represents an IRR of 25.34%
But, do we choose the first truck? Think about it…..
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Capital Budgeting Decision-making
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•
Recall the mutually exclusive decision of buying one used truck or one
newer one. The old truck generated an IRR of 34.68%, the new one an
IRR of 25.34%. But, if our cost of capital or required return is 10%, our
NPV is $4,252 for the older truck, and $5,184 for the newer one.
•
Confirm the IRR and NPV calculations.
•
We choose the newer one, maximizing our wealth (and share price,
indirectly) though it generates the lower IRR. That is a disadvantage of
the IRR rule, it breaks down with those mutually exclusive buddies.
•
With mutually exclusive projects, use the NPV rule.
•
And, if the signs of your cash flows change more than once – if the
cash flows are “unconventional,” you cannot dependably use the IRR
rule, either. Multiple IRR’s are possible, depending on the number of
“sign changes’ attaching to a given deal.
Capital Budgeting Decision-making
•
The third rule we review is the payback rule in Section 8.2 pages 228232, where a deal is accepted if the payback < some required payback
period.
•
With an annuity, the payback period (PP) is simply equal to the cost of
a project divided by the annual flows; using our original set of “simpler”
cash flows:
PP = Cost/Annual flows = 200,000/35,000 = 5.7 years
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•
Assuming our maximum allowable period for payback is 6 years, we
would accept this project. Were our maximum allowable period
something less than 5.7 years (or 5.714 years to be more exact!), than
we would reject the project.
•
Unequal cash flows are handled as with the example in class.
Capital Budgeting Decision-making
•
The final rule we consider is the profitability index (PI) from page 242.
The PI is simply a metric contrasting the present value of a project’s
cash flows with its costs.
•
PI = PV (Inflows)/PV (Outflows)
•
The PI is larger the greater a project’s IRR. For the original set of cash
flows, at a discount rate of 8%, the PV of the health plan’s cash flows
(the numerator of the PI function above) was just over $201,000. (Cost
plus the NPV). The cost or denominator was $200,000. The PI is
around 1.006. ($201,132/$200,000)
•
The PI reveals a project’s “bang for the buck.” If we cannot do all
positive NPV deals, we rank them by PI, and invest in them ‘til we are
out of money. That maximizes the total possible NPV out of a given pot
of invest-able capital.
The four new rules are used in concert, by the firm and its
financial managers, to optimize the results of the capital
budgeting decision-making process.
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