Practical Issues in Capital Budgeting

Size: px

Start display at page:

Download "Practical Issues in Capital Budgeting"

Elizabeth Davis
6 years ago
Views:

Practical Issues in Capital Budgeting Note 9 Outline NPV or IRR? The case of multiple IRRs Scale Issue Coping with Uncertainty Capital Rationing Capital Budgeting Practices 1 I. NPV vs.

1 Practical Issues in Capital Budgeting Note 9 Outline NPV or IRR? The case of multiple IRRs Scale Issue Coping with Uncertainty Capital Rationing Capital Budgeting Practices 1 I. NPV vs. IRR NPV or IRR? NPV and IRR will generally give us the same decision Exceptions: the two can give different answers under following situations. Non-conventional cash flows cash flow signs change more than once Mutually exclusive projects Initial investments are substantially different Timing of cash flows is substantially different 2 3 1

2 IRR and Non-conventional Cash Flows Example (non-conventional cash flow) When the cash flows change sign more than once, there is more than one IRR If you have more than one IRR, which one do you use to make your decision? Suppose an investment will cost $90,000 initially and will generate the following cash flows: Year 1: 132,000 Year 2: 100,000 Year 3: -150,000 The required return is 15%. Should we accept or reject the project? 4 5 NPV Profile IRR = 10.11% and 42.66% IRR and Mutually Exclusive Projects Mutually exclusive projects If you choose one, you can t choose the other Intuitively you would use the following decision rules: NPV choose the project with the higher NPV IRR choose the project with the higher IRR 6 7 2

3 Example: Why IRR doesn t work? Example: Why IRR doesn t work? Suppose you consider two investments, which are mutually exclusive and non-duplicative. Which is the better investment? Project A: Invest $100 in time 1 and get $300 in time 2. Project B: Invest $1,000 in time 1 and get $2,000 in time 2. Project A Percent Return Dollar Return Your answer depends on whether you use percentage returns or dollar returns. Project B 8 9 Another Example :Mutually Exclusive Projects NPV Profiles Period Project A Project B IRR 19.43% 22.17% NPV The required return for both projects is 10%. Which project should you accept and why? IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8% Required Rate = 10%

4 Conflicts Between NPV and IRR Then, What about Profitability Index? NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV Profitability index may also lead to incorrect decisions in comparisons of mutually exclusive investments (due to the same reason for the Internal Rate of Return method). IRR is unreliable in the following situations Non-conventional cash flows Mutually exclusive projects Evaluating NPV Estimates II. Coping with Uncertainty Suppose we have an NPV that is positive. Are we ready to go? NPV estimates are just that (point) estimates 14 A positive NPV is a good start now we need to take a closer look Forecasting risk how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk Sources of value why does this project create value? 4

5 Sources of Value Scenario and Sensitivity Analysis In applying the NPV technique, it is always useful to ask: Where does the positive NPV in capital budgeting come from? Some examples how firms create positive NPV. Introduce new ideas and products Apple Corporation Create barrier to entry Microsoft Create product differentiation Mercedes Benz Low (logistics) costs Walmart What happens to the NPV under different cash flow scenarios? At the very least look at: Best case high revenues, low costs Worst case low revenues, high costs Measure of the range of possible outcomes Best case and worst case are not necessarily probable, but they can still be possible 16 Scenario Analysis Sensitivity Analysis Conventional NPV Analysis based only on most probably projections Scenario Net Income Cash Flow NPV IRR Base case 19,800 59,800 15, % An analysis that considers other scenarios Scenario Net Income Cash Flow NPV IRR Base case 19,800 59,800 15, % Worst Case -15,510 24, , % What happens to NPV when we vary one variable at a time This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay to its estimation Best Case 59,730 99, , % 5

6 Sensitivity Analysis for New Project Simulation Analysis Scenario Unit Sales Cash Flow NPV IRR Base case ,800 15, % Worst case ,200-8, % Best case ,400 39, % Simulation is really just an expanded sensitivity and scenario analysis Monte Carlo simulation can estimate thousands of possible outcomes based on conditional probability distributions and constraints for each of the variables The output is a probability distribution for NPV with an estimate of the probability of obtaining a positive net present value The simulation only works as well as the information that is entered and very bad decisions can be made if care is not taken to analyze the interaction between variables Making A Decision Beware Paralysis of Analysis Too much of something is bad At some point you have to make a decision If the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the project If you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project III. Capital Rationing 23 6

7 Special Cases(2): Capital Rationing Capital rationing occurs when a firm or division has limited resources Soft rationing the limited resources are temporary, often self-imposed Hard rationing capital will never be available for this project The profitability index is a useful tool when a manager is faced with soft rationing Large LNG projects like the ones proposed for B.C. require capital investments in the $40 billion to $50 billion range. Faced with weak oil prices and shrinking revenue, there are fears that companies like Petronas and Shell (NYSE:RDB.B) will postpone their investments in B.C. and wait for a recovery in oil prices. The big challenge is the capital rationing that is going on in the industry because the broader oil and gas industry is in distress, Hemmingsen said. 25 Capital Rationing: Steps Example: The management of ZYX Corp. set a ceiling in this year s capital expenditures at $300,000. All of the following six investment projects are available for investments for ZYX. Which one(s) should ZYX accept? Step. 1: Estimate the profitability index of each investment project in consideration Step 2: If PI<0 for an investment, then exclude it Step 3: Sort the investments that survived in step 2 by PI (from largest to smallest) Step 4: Accept investments starting from the one with the highest PI until there is no more investment capital left Investment Initial Cost PV(Future CF) A 50,000 40,000 B 80, ,000 C 40,000 80,000 D 80,000 95,000 E 100, ,000 F 50,000 55,

8 Capital Rationing: Example Capital Rationing: Example PV(Future Investment Initial Cost NPV PI CF) A 50,000 40,000-10, B 80, ,000 25, C 40,000 80,000 40, D 80,000 95,000 15, E 100, ,000 50, F 50,000 55,000 5, Project Initial Cost PV (Future CF) NPV PI Cum. Capital Invested Cum. NPV C 40,000 80,000 40, ,000 40,000 E 100, ,000 50, ,000 90,000 B 80, ,000 25, , ,000 D 80,000 95,000 15, , ,000 F 50,000 55,000 5, , ,000 A 50,000 40,000-10, , , IV. Capital Budgeting Practices Capital Budgeting In Practice We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria But should be well aware of the pitfalls of the IRR. Payback is a commonly used secondary investment criteria

Example: Capital Budgeting in Practice Example: Capital Budgeting in Practice Using a 10% discount rate for an initial 15 yearmine life and a copper price of $1.

Using copper prices of $2.00/lb and $3.00/lb, the NPVs increase to $527 million and $1,075 million respectively and the IRRs increase significantly to 46% and 76% respectively.

9 Example: Capital Budgeting in Practice Example: Capital Budgeting in Practice Using a 10% discount rate for an initial 15 yearmine life and a copper price of $1.20 per pound, the feasibility study demonstrates a Net Present Value ("NPV") of $89 million and a robust Internal Rate of Return ("IRR") of 17%, with a payback period of 6.6 years. Using copper prices of $2.00/lb and $3.00/lb, the NPVs increase to $527 million and $1,075 million respectively and the IRRs increase significantly to 46% and 76% respectively Capital Budgeting Practices of Fortune 1000 Journal of Business and Management Vol. 8 (2002) Capital Budgeting Practices of Fortune 1000 CEOs use multiple capital budgeting tools NPV and IRR dominate the other rules Usage Frequency NPV > IRR >>> PB > DPB >> PI > ARR > MIRR Investment Size and Capital Budgeting Tools NPV is used for investments of all sizes. But it is always the way to go particularly for large-scale investments PB is popular with small scale investments PI is used more for mid size investments

10 P 의원 " 경부운하보고서는정치공작용 " H 당의원 6 명건교부방문 [ 연합뉴스 ] 2007 년 08 월 02 일 ( 목 ) ( 서울 = 연합뉴스 ) H 당공작정치저지범국민투쟁위원회는 2 일건설교통부를방문, 경부운하재검토보고서를작성한것은 L 전서울시장측을음해하려는의도가있다고주장했다. 그러나 1998 년국토연구원의보고서는 " 화물물동량과투입공사비를기준으로경부노선전체의경제성을검토한결과노선전체로는 NPV( 순현재가치 ), B/C( 비용편익비율 ) 등에서타당성이없는것으로판단된다 " 고돼있는것으로확인됐다. Gyeongbu Channel (Seoul Busan) Discount Rate Cost-Benefit Analysis PV (Future Benefits) Costs NPV (unit: million won) B/C (PI) 8% 1,341,786 1,415,026-73, % 1,056,318 1,140,172-83, % 845, ,778-85, Korea Water Resources Corporation 37 Garbage In. Garbage Out

Chapter 7. Net Present Value and Other Investment Rules

Chapter 7. Net Present Value and Other Investment Rules Chapter 7 Net Present Value and Other Investment Rules Be able to compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their shortcomings Be