PowerPoint to accompany Chapter Capital Budgeting Techniques Learning Goals:        Understand the role of capital budgeting techniques in the capital budgeting process Calculate, interpret and evaluate the payback period Calculate, interpret and evaluate net present value (NPV) Calculate, interpret and evaluate internal rate of return (IRR) Use NPV profiles to compare NPV and IRR techniques Discuss NPV and IRR in terms of conflicting rankings and the strengths/weaknesses of each approach Calculate, interpret and evaluate other capital budgeting techniques Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Net Present Value  Regarded as a sophisticated capital budgeting technique, due to its explicit consideration of the time value of money  Calculated by: NPV = Present Value Of - Initial Investment Net Cash Inflows n NPV = ∑ (CFt × PVIFr ,t ) − CF0 t =1 [Equation 9.1a] Where: CF0 = Project’s initial investment CFt = Net cash inflows for year t r = the firm’s cost of capital Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Net Present Value  Decision criteria:  Accept if NPV > $0  Reject if NPV < $0 If the NPV is greater than $0, the firm will earn a return greater than its cost of capital Using the Bennett Company data from Table 9.1, if the firm has a cost of capital of 10%, the NPV’s of projects A & B can be calculated as follows: Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Net Present Value Project A: NPV = Initial Investment - PVAn = - $42,000 + ($14,000 x 3.7908) = $11,071.20 Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Net Present Value Project B: NPV = Initial Investment - PVn = - $42,000 + ($28,000 x 0.9091 ) + ($12,000 x 0.8264 ) + ($10,000 x 0.7513 ) + ($10,000 x 0.6830) + ($10,000 x 0.6209) = $10,923.60 Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Internal Rate Of Return • Regarded as a sophisticated capital budgeting technique for evaluating investments • More difficult than NPV to calculate by hand • The discount rate that equates the PV of net cash inflows with the initial investment in the project • Therefore equating the NPV of the investment opportunity with $0 Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Internal Rate Of Return  Calculated by: NPV = $0 = CFt ∑ (1 + IRR) t − CF0 t =1 n [Equation 9.2] Where: CF0 = Project’s initial investment CFt = Net cash inflows for year t t = Year t  Requires a trial and error approach, substituting different discount rates until the equation balances Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Internal Rate Of Return  Decision criteria: • Accept if IRR > Cost Of Capital • Reject if IRR < Cost Of Capital Using the Bennett Company data from Table 9.1, if the firm has a cost of capital of 10%, the IRR of projects A & B can be calculated as follows: Project A:  Financial Calculator: CF0 = -42,000, CF1 = $14,000, n = IRR = 19.9% Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Internal Rate Of Return Project B:  Financial Calculator: CF0 = -45,000, CF1 = $28,000, CF2 = $12,000, CF3 = $10,000, n = IRR = 21.7% Based on IRR project B is most preferable as it will provide the highest return on the investment  Formula: If calculating IRR manually we substitute different interest rates into the equation using the cash flows given until the equation balances Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Ranking & Conflicting Rankings  Ranking is necessary when:    Projects are mutually exclusive Capital rationing is necessary Conflicting rankings arise due to differences in cash flow:  Timing  Magnitude Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Which Is Better – NPV Or IRR?  On a theoretical basis NPV is preferred as: • • avoids possibility of time consuming multiple IRR’s •  it assumes intermediate flows are reinvested at the firm’s cost of capital it directly reflects the actual project return On a practical basis, many financial managers prefer IRR because: • •  it works with rates of return not dollars NPV does not measure benefits relative to the amount invested Most organisations use both Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition ... Group Pty Ltd) – 97 81442518 193 / Gitman et al / Principles of Managerial Finance / 6th edition Net Present Value Project B: NPV = Initial Investment - PVn = - $42,000 + ($28,000 x 0 .90 91 ) + ($12,000... + ($10,000 x 0.6830) + ($10,000 x 0.62 09) = $10 ,92 3.60 Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 97 81442518 193 / Gitman et al / Principles of Managerial... Ltd) – 97 81442518 193 / Gitman et al / Principles of Managerial Finance / 6th edition Internal Rate Of Return  Decision criteria: • Accept if IRR > Cost Of Capital • Reject if IRR < Cost Of Capital