Capital Budgeting Review Flashcards

Exam Preparation and Importance of Finals

• Quiz 2 announcement coming soon.

• Final exam is approaching; start reviewing materials from week one.

• Even with passing grades from quizzes and midterms, preparing for the final is crucial.

• Assignments account for 60% of the grade before the final.

• A good grade is a proof that you spent the time, you assert your effort in this university.

• Better grades improve job prospects after graduation.

• Grades demonstrate commitment and achievement to potential employers or government entities.

• A significant number of students feel comfortable with passing grades from assignments and choose not to take the final.

• Better grades are crucial for academic careers or studying overseas.

Introduction to Capital Budgeting (Project Evaluation)

• Capital budgeting, also known as project evaluation, will be covered over four weeks.

• The aim is to learn methods to decide whether a company should undertake a project.

• This involves research, calculation, and method application to make informed decisions.

• The methods learned will be included in the final exam.

• Today's focus: four methods and two project types.

• Key methods: Net Present Value (NPV) and Internal Rate of Return (IRR).

• Simpler methods: Payback and Profitability Index.

• Two project types: Stand-alone/independent projects and mutually exclusive projects.

Capital Budgeting: Core Concepts

• Capital budgeting is the process of deciding whether to undertake a project.

• It involves making an optimal decision on whether a company should take on a project.

• For mutually exclusive projects, it involves selecting one project from several options.

• The purpose of a project is for the firm to earn money.

• Simplified project example: Running a bubble tea shop.

• Inputs: Money outflow for machines, ingredients, employees.

• Outputs: Cash inflows from selling bubble tea.

• The goal is to ensure that cash inflows exceed cash outflows.

• Example: Spending 1,000,000 on a project and earning 1,500,000 in revenue yields a profit of 500,000.

• Projects for big companies can last for thirty years (e.g., BHP).

• Initial investment might be 20,000,000, with revenues coming in the next thirty years.

The Time Value of Money

• It's important to consider the time value of money.

• Future cash flows cannot simply be summed up without discounting.

• Example: Spending \$200 today and receiving \$100 each year for three years.

• Total income: \$300, Profit: \$100.
  *Issue: Ignores the time value of \$100 received in the future.

• The first key part is to deal with the time value of money.

• Expected cash flow analysis is essential.

• Future cash flows need to be discounted back to their present value.

• A discount rate is needed - normally the cost of capital.

Project Cash Flow Overview

• Project cash flow involves initial cash outflows (initial expenditure or cost).

• Predict future cash flows.

• Discount future cash flows back to the present using a discount rate that considers risk levels.

Net Present Value (NPV)

• Estimate all future cash flows (e.g., bubble tea shop earning \$100 revenue each year for three years).

• Use a discount rate to discount all future cash flows back to the present and sum them together.

• Deduct the initial cost from the present value of future cash flows.

• If the result is positive, the project is profitable.

• If the result is negative, the project is not profitable.

• Decision rule: Accept projects with NPV > 0. Indicates adding value to shareholders.

• Mathematically: NPV = \sum{t=1}^{n} \frac{CFt}{(1 + r)^t} - C_0

  • NPV = Net Present Value

  • CF_t = Future Cash Flows

  • t = Period

  • r = Discount Rate

  • C_0 = Initial Cost

• The NPV method directly shows the absolute value that the project is expected to increase for shareholders.

NPV Example: Taking or Leaving Investment

• Independent project for FFF company.

• Project costs \$250,000,000 and generates \$35,000,000 per year, starting at the end of the first year and lasting forever.

• Perpetuity: Cash flow that lasts forever.

• Present value of perpetuity = Cash flow divided by discount rate.
  PV = \frac{Cash Flow}{Discount Rate}

• NPV = PV - Initial Cost

• If the discount rate (r) is 5%:
  NPV = \frac{35,000,000}{0.05} - 250,000,000 = 450,000,000

• As the discount rate increases, the NPV reduces.

• At a discount rate of 14%, NPV equals zero.

• Below 14%, the project should be taken, and above, it should not.

Internal Rate of Return (IRR)

• IRR is the discount rate that makes the NPV equal to zero.

• IRR and NPV use the same formula.

• Formula: 0 = \sum{t=1}^{n} \frac{CFt}{(1 + IRR)^t} - C_0

  • CF_t will be given.

  • Only the IRR needs to be calculated.

• Solving for IRR often requires financial calculators or Excel spreadsheets.

• Decision rule: If IRR > Cost of Capital, accept the project.

• If IRR < Cost of Capital, reject the project.

• If you borrow \$1,000,000 from the bank at 5% interest, you should only invest in a project if it earns more than 5%.

Choosing Between NPV and IRR

• IRR and NPV may provide the same results, but not always.

• The following are three scenarios where the IRR rule might be useless:

  • Delayed Investment

  • Non-existent IRR

  • Multiple IRRs

Delayed Investment

• You are retired as CEO and a publisher offers you \$1,000,000 upfront to write a book.

• It will take three years to write the book.

• You estimate giving up speaking engagements amounting to \$500,000 per year.

• Opportunity cost is 10%.

• Cash Flow: \$1,000,000 now, but losing \$500,000 per year for three years.

• IRR = 23.38%

• NPV:
  NPV = 1,000,000 - \frac{500,000}{(1 + 0.1)^1} - \frac{500,000}{(1 + 0.1)^2} - \frac{500,000}{(1 + 0.1)^3} = -243,000

• IRR suggests taking the project, but NPV suggests rejecting it.

• Key: The cash flows sign different is sometimes conflict with NPV, it’s a delayed investment.

• If this happens you should use NPV because IRR looks at rates, which can be misleading, whereas NPV looks at absolute numbers.

Non-Existent IRR

• A publisher increases advance to \$750,000 in addition to \1,000,000 when the book is published in four years.

• No IRR exists.

• The project is good, and no matter which IRR you choose, it won't affect the NPV, it won't equal to 0.

Multiple IRRs

• Suppose an agent informs the publisher that it needs to sweeten the deal. So the agent asks the publisher to offer additional 550 advance and \$1,000,000 in four years when the book is published.

• Even if additional advances being paid, NPV indicates not to take the deal as it is still a negative amount.

• NPV is still negative, indicating you shouldn't do it. IRR will generate two answers.

• Possible IRRs: 7% and 33%.

• Cannot make a decision based on IRR.

• Remember that, when we say a conventional cash flow, that means the future cash flow side remains the same.

• If the sign changes for the future cash flows more than once, then you will have more than one IRR.

• If the signs change, and if that happens, you cannot rely on IRR.

Summary: NPV vs. IRR

• If a conflict between NPV and IRR, use NPV.

• Two major scenarios that will make you have a tricky IRR calculations:

  • Non-conventional cash flow

  • Mutually exclusive projects

Advantages and Disadvantages of IRR

• Compared to NPV, IRR is intuitively appealing and easy to understand.

• Easy to communicate.

• Drawbacks of IRR:

  • Can't be used for mutually exclusive projects.

  • If cash flows are non-conventional, there will be multiple or non-IRRs.

Advantages of NPV

• Takes into account the time value of money.

• Shows the value directly.

• It doesn't matter what the cash flow looks like, you can still get the correct answer.

Payback Rule

• How long it takes to earn enough cash inflows to cover the initial investment.

• Decision rule: Compare the calculated payback period to a predetermined cutoff point.

• Major Drawbacks:

  • Ignore the time value of money.

  • The cutoff point is arbitrary.

  • Ignores cash flows beyond the payback period.

• Example: Bubble tea shop costs \$200 to set up and earns \$100 per year.

• Payback period is two years.

• Drawback: predetermined cutoff point, you literally can choose which is best for you.

• For the calculation you can't always get the integral number about the payback. What if you're gonna use half of the year's money to cover your rest of the course, then you're gonna calculate it.

• Calculation: so your initial course is \$165,000 and these are your future cash flows, is you need at least a 2 years whole year to cover part of it, and the year 3 you have much more than that.

Advantages and Disadvantages of Payback Rule

• Advantages:

  • Easy to understand.

• Disadvantages:

  • Ignores the time value of money.

  • Arbitrary cutoff point.

  • Ignores cash flows beyond the payback period.

  • Biased against long-term projects.

Usefulness of Payback Rule

• Useful for companies that need to ensure the survival.

• Help to know how soon you can get the cash back.

Profitability Index (PI)

• Like a shadow of NPV.

• Compares the present value of future cash flows to the initial cost.

• Formula: PI = \frac{\sum{t=1}^{n} \frac{CFt}{(1 + r)^t}}{C_0}

  • PI = Profitability Index

  • CF_t = Future Cash Flows

  • r = Discount Rate

  • C_0 = Initial Cost

• Decision rule: If PI > 1, accept the project.

Independent vs. Mutually Exclusive Projects

• Independent: Whether to conduct project A is irrelevant to other projects.

• Mutually Exclusive: Only one project can be chosen (e.g., choosing between Microsoft Windows or Apple OS).

• Basic idea, always stick to the NPV because NPV tells you what tells you how much value gonna the project gonna provide for you.

• Problem with the IRR is to not use the IRR rule to pick the mutually exclusive projects.

Limitations of IRR in Mutually Exclusive Projects

*Differences in Timing: Differences in risk. It is generally seems more attractive for the SAFE project.

• Return Rate: Does not represent the absolute amount.

• Smaller numbers are more vulnerable as everything becomes based on rates.

• IRR can be distorted by the scale of the initial investment.

• Differences in is going to distort the actual meaning scale. The level, the magnitude of the initial investment.
  *Scale: The major part scale, what's more important?

• The $2,100,000 is what shareholders obviously want is an absolute amount.
  *IRR seems the preferred those larger amount of cash inflows happens at the early time because the reason is just maths, you will get a higher rate, but this is a minor issue given all our current examples.

Excel for IRR Calculation

• Using Excel to calculate IRR can save time.

• Call the function: =IRR(values, [guess])
  *If the formula is conventional, done.
  *You can create those tiny little templates for yourself.
  *The unconventional Cash Flow: the IRR and show you what's unconventional. Give you what a negative.