VI. Capital Budgeting Under Certainty: Professors Simon Pak and John Zdanowicz

VI.
Capital Budgeting Under Certainty

Textbook Chapters 5 & 6
Professors Simon Pak and John Zdanowicz
Outline
Capital Budgeting Process Estimation of Cash Flows
Accounting Income versus Cash Flow Incremental Analysis: Incremental After Tax Net Cash Flows Investment Characteristics Method of Evaluation: ARR, PB, DCF - NPV, PI, IRR Average Rate of Return, Payback Period NPV vs IRR Independent Projects Mutually Exclusive Projects Independent Projects - Non-conventional CFs NPV vs PI P&Z Electronics P&Z Machine Tool Co. Concrete Mixer Truck
Evaluation Criterior
Comparison of Methods of Evaluation
PROBLEM SOLVING
Long- And Short-lived Equipment: Equivalent Annual Cost (EAC) Inflation and DCF Analysis Capital Rationing Appendix A - More on IRR
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Simon Pak & John Zdanowicz 2000
1. Capital Budgeting Process

Asset Management:
Short-term: Working Capital Management Long-term: Capital Budgeting or Capital Investment
Steps in Capital Budgeting

1. Generate investment proposal
new products or expansion of existing products replacement of equipment or building R&D other - education of management and/or employees
2. Estimate cash flows from the proposed investment 3. Evaluate the cash flows: Accept or Reject
Most firms stops here.
4. Continual Reevaluation:
A rejected project may become acceptable: As the discount rate goes down, the NPV goes up. Cut the losses - develop abandonment criterior in advance Sunk costs are irrelevant in decision making Personal ego to push for project is not value maximizing behavior.
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2. Estimation of Cash Flows

Most difficult and most important in a capital budgeting process To estimate cash flows from a proposed project:
Distinguish between Accounting Income and Cash Flows Use only Incremental After Tax Net Cash Flows Initial Cash Flows Future Cash Flows
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2.1 Accounting Income vs. Cash Flows

Future Income IS NOT EQUAL Future Cash Flow In Finance: focus is on cash
Invest it ; Receive it ; Consume it
In Accounting, objectives are different:

Matching revenues and expenses Other issues: historical cost: depreciation methods inventory valuation - LIFO or FIFO
Cash Flow versus Accounting Income Project Income Statement Revenues (R) Depreciation (D) All other costs (OC) $1,000 $150 $400 NIBT $450 Taxes (T=40%) $180 Project Net Income (PNI) $270 ( = Accounting Income)
Cash Flow = PNI + NoncashExpenses = PNI + Depreciation = $270 + $150 = $420 Alternatively Cash Flow = (R - OC - D) x (1 - T) + D = (R - OC) x (1 - T) + T x D = (1000 - 400) x 0.6 + 0.4 x 150 = $420
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2.2 Incremental Analysis: Incremental After Tax Net Cash Flows

Incremental = Change in CF due to the proposed project
Sales of a new product may be partially offset by a decrease in the sales of the existing product. Equipment Replacement: gains depreciation of the new equipment but loses the depreciation of the old equipment (cost of the new equipment) - (salvage value of the old) Increase In Net Working Capital WorkingCapital = ShortTermAssets - ShortTermLiabilities Short-term Assets = Cash + Accounts receivable +Inventories of raw materials and finished goods Short-term Liabilities = Accounts Payable + Notes payable + Accruals Include working capital effects in the early stages of the project Adjust for changes in net working capital during the life of the project Include recovery of net working capital at the end of the project
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2.2.1 Incremental Analysis - continued

After tax :
Cash Flow:
Only after-tax cash flow can be consumed positive if cash inflow [ or cash outflow \ negative if cash inflow \ or cash outflow [
Net CF: Net out all +s and -s for each time period Time frame: Conclusion: Necessary to obtain
t = 0 : Now t = 1, 2, , n where n = number of years of life of the project

Incremental After Tax Net Cash Flow for each t = 0, 1, 2, , n Important to have a good tax accountant! Any cost already paid or obligated to be paid in the future Not affected by decision to accept or reject project
FORGET SUNK COST!
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2.2.2 Initial Cash Flows

CF0 = - Cost of new investment - Cost of installation + Sale of existing assets if replacement + or - Tax effect of sale of existing assets
If SalePrice < BookValue, tax \ If SalePrice = BookValue, no tax effect If SalePrice > BookValue, tax [ (+) (0) (-)
+ Investment tax credit

Note: Initial investment costs may be spread out over several years.
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2.2.3 Future Cash Flows: CF1, CF2, . . . , CF(n-1), CFn

CFt = + Increase in Revenue (sales) + Decrease in Expense
+ or - Impact of changes in depreciation expenses

Non cash charges Depreciation expenses [ means tax shield Must net lost depreciation in a replacement project
Operating expenses, labor, raw material, etc. Administrative expenses
- Change in working capital requirements in the particular year - Change in taxes CFn = Same as above + Salvage value of assets - Removal cost
*
(environmental issue, cleaning up sites) Depending upon specific project, many other CFs may need to be considered.
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3. Evaluation Criterior
Once CFs, incremental after tax net CF, are determined, an investment project can be evaluated. Investment Characteristics will be important in later discussions.
Cash flow characteristics: Pattern of positive CFs and negative CFs Conventional case: s r r r . . . r Non-conventional case: s r s r r s . . . s r
change in signs of CFs over time - complicates analysis
Types of Investment Independent projects: The evaluation of a project is independent of any other projects, i.e., A or B or Both in accept-reject decision Mutually exclusive projects:
Only one project can be accepted, i.e., A or B, but not Both: gas heater or oil heater Capital Constraint: Example: Up to $1 million available for investment. This means that not all the good projects can be accepted.
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3.1. Methods of Evaluation

Five methods of evaluation:
Average Rate of Return (ARR) Payback Period (PB) Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR)
NPV, PI, and IRR use Discount Cash Flow (DCF) technique. For each one of the five methods, we will discuss:
The way each measure is calculated The way each measure is used Advantages Disadvantages
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3.2. Average Rate of Return (ARR), Book R of R

Average Annual Profit After Tax 1. ARR Average Investment 2. How to Apply:
Establish a Required ARR. Rank, Accept or Reject a project by comparing to the reqd ARR 3. Advantage: Simple to calculate based on accounting income (readily available information)
4. Disadvantages:
Ignores Cash Flows by using Accounting income Ignores Time Value of Money by using Average Income
Example 1: Projects A and B both cost $9,000 and have a 3 year project life. Compare the two project using ARR criterior. Project A Project B Period Net Income Net CF Net Income Net CF 1 $3,000 $6,000 $1,000 $4,000 2 $2,000 $5,000 $2,000 $5,000 3 $1,000 $4,000 $3,000 $6,000 AvgInv = (9000+6000+3000+0)/4 = 4500 ARRA = ARRB = 2000/4500 = 44.44% However, A is preferable B because PV(CF A) > PVCFB)
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3.3. Payback Period (PB)

1. PB = number of years required to recover the initial investment
Example: Uneven Cash flows Even Cash Flows CF0 = - 10,000 ( - 10,000) CF0 = - 18,000 CF1 = + 4,000 ( - 6,000) CF1 ~ CF5 = + 5,600 CF2 = + 5,000 ( - 1,000) PB = 18,000/ 5,600 = 3.2 years CF3 = + 4,000 ( + 3,000) PB = 2 years + 1,000/4,000 = 2.25 years
2. How to Apply:
Establish a maximum acceptable payback period. Rank by payback period. Accept (or Reject) a project with a PB shorter(or longer) than the maximum acceptable PB
3. Advantage:
Simple to calculate Uses CFs Maybe useful if liquidity is a problem Maybe useful as supplement to other evaluation methods
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3.3.1. Payback Period (PB) - continued 4. Disadvantages: (i) Ignores CFs after the PB period.
Project Cost = $10,000 Period CFA CFB 1 $5,000 $5,000 2 $3,000 $3,000 3 $2,000 $2,000 4 $1,000 $1,000,000 5 $0 $2,000 PBA = PBB = 3 yrs. However, CFB is better than CFA
(ii) Does not take into account time value of money

Project Cost = $10,000 Period CFA CFB 1 $5,000 $2,000 2 $3,000 $3,000 3 $2,000 $5,000 4 $2,000 $2,000 PBA = PBB = 3 yrs. However, CF A is better than CF B
Payback period: may be viewed as a constraint to be satisfied, rather than a measure of profitability to be maximized.
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3.4. Discount Cash Flow Techniques

The remaining three method of evaluation uses DCF techniques
Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR)
All three methods require a discount rate, k = i + q

Discount rate, k, may be determined centrally in an organization Different division within a same organization may use different discount rate depending upon the level of risk (Risk Premium: q ).
In this section the following project example will be used:

Discount rate = 10% CF0 = - $18,000 CF1, CF2, . . . , CF5 = $5,600
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3.4.1. Net Present Value (NPV) Method

Calculate NPV of a project
NPV = PV (CFs from t= 0 to N)
tN CF0 CFN CFt CF1 NPV (1 k ) 0 (1 k ) (1 k ) N t 0 (1 k )t
Often: NPV = PV (CFs from t= 1 to N) - Cost(t=0)
How to use NPV?

Accept the project if NPV > 0, reject if NPV < 0 If NPV = 0, the project earns k on the investment Projects can be ranked by NPV
Example:
discount rate k= 10% t CFt PVIF PV 0 -$18,000 1 -$18,000 1 ~ 5 $5,600 3.7908 $21,228 NPV = $3,228 Accept the project since NPV > 0
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3.4.2. Profitability Index (PI)

PV PV of Future Benefits PI CF0 Cost
How to use PI:
Accept a project if PI > 1 Accept a project if PI = 1 (makes required return) Reject a project if PI < 1
Example:
Note:
CF0 = - $18,000 PV(CF1 ~ CF5) = $21,228 Therefore, PI = 21,228 / 18,000 = 1.18

PI is also called Benefit-Cost Ratio When costs are spread over for more than one period, then the cost is the PV of all cash outflows. PI may alternatively defined as (NPV/Cost). In this case, PI will simply be reduced by 1.
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3.4.3. Internal Rate of Return (IRR)

IRR = The discount rate that makes NPV = 0.
Can not be calculated directly. Only by trial and error.
Example 1:
Try k= 15% t CFt PVIF PV 0 -$18,000 1 -$18,000 1~5 $5,600 3.3522 $18,772 NPV = $772 Try k= 20% t CFt PVIF PV 0 -$18,000 1 -$18,000 1~5 $5,600 2.9906 $16,747 NPV = -$1,253 Try k= 17% t CFt PVIF PV 0 -$18,000 1 -$18,000 1~5 $5,600 3.1993 $17,916 NPV = -$84
trial 1 2 3 4 N
k 10% 15% 20% 17% ?
NPV + $ 3,228 + $ 772 - $1,253 - $ 84 .. 0
IRR must be between 16% and 17% The true value is 16.80% when calculated with a calculator
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3.4.3a. IRR Calculation with TI BA-II Plus

Example1: IRR Computation
CF0 = 18000, CF1 ~ CF5 = 5,600 CF 2nd 18000 [CLR Work] CF0 = No. in mem Start CF worksheet CF0 = 0.00 Clear CF memory CF0 C01 -18,000 0.00 CF0 = -18,000 CF(t=0 ) = - 18,000 C01 = 5,600.00 CF(t=1 ) = 5,600 F01 = 1.00 F01 = 5.00 CF repeats 5 times IRR= IRR= 0.00 16.80 Answer 0.00 exit CF work sheet
+/[ENTER]
x
5600 5
[ENTER]
x
[ENTER] IRR CPT 2nd [QUIT]
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3.4.3b. IRR Calculation with TI BA-II Plus

Example 2. Calculate IRR.
A project has the following CFs: CF0 = -$10 million; CF1 = $2 m; CF2 = $ 4 m; CF3 - CF6 = $ 3 m; CF7 = $ 2 m; CF8 = $ 4 m Calculate IRR. Answer using TI II Plus calculator CF, 2nd, CLR Work, 10000000, +/-, ENTER, \, 2000000, ENTER, \, \, 4000000, ENTER, \, \, 3000000, ENTER, \, 4, ENTER, \, 2000000, ENTER, \, \, 4000000, ENTER, IRR, CPT Ans: IRR= 24.23%.
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3.4.3b. How to Use IRR

Discount Rate, k
USE OF IRR METHOD Accept if IRR >= k, (cost of capital) Reject if IRR < k, (cost of capital) Rank by IRR k, risk adjusted cost of capital: No clear cut way of determination. Risk is estimated.
k=10%
B
Risk
Assuming the required rate, or discount rate adjusted for the risk level of projects A and B is 10%: Accept the project A : IRRA > k =10% Reject the project B : IRRB < k =10%
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4. Comparison: ARR and PB Period

Average Rate of Return and Payback Period
Often used due to simplicity Poor measure of profitability because CFs and TVM are not employed ARR - Accounting income is used, not CFs PB - Ignores CFs after the payback period Can be used as back up if other methods rank similarly Accuracy of NPV calculation of a project depends upon the accuracy of CF forecast. A project with NPV > 0 is more easily acceptable if it has a shorter PB period.
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4.1. NPV vs IRR - Independent Projects

Both NPV and IRR give the same answer when evaluating an independent project.
NPV Profile of a project as a function of k
Sum of all CFs

IRR1 >= k1 : Accept NPV1 > 0 : Accept NPV1
IRR1
k1
ACCEPT: Positive NPV for k < IRR1
discount rate k (%) opportunity cost of capital
REJECT: Negative NPV for k > IRR1
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4.1.1. NPV vs IRR: Mutually Exclusive Projects

Mutually Exclusive Projects: C and D discount rate k= 8% (opportunity cost of capital) Project C Project D t CFt PVIF PV t CFt PVIF PV 0 -$155.22 1.0000 -$155.22 0 -$155.22 1.0000 -$155.22 1 $100.00 0.9259 $92.59 1 $0.00 0.9259 $0.00 2 $0.00 0.8573 $0.00 2 $0.00 0.8573 $0.00 3 $100.00 0.7938 $79.38 3 $221.00 0.7938 $175.44 NPV = $16.76 NPV = $20.22 IRR = 14.00% IRR = 12.50%
NPV method: Pick the project D since NPVD > NPVC IRR method: Pick the project C since IRRC > IRRD
NPVD NPVC IRR D 8% 12.5% 14% IRR C
discount rate k (%)
NPV and IRR can give a conflicting choice. NPV is more realistic given opportunity cost of capital.
NPVD> NPVC
NPVC> NPVD
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4.1.2. NPV vs IRR
Non-conventional Cash Flows Independent Projects
Non-conventional cash flows: Conventional case: s r r r . . . r Non-conventional case: s r s r r s . . . s Non-conventional CFs can result in multiple IRR values.
For more details, see Appendix A
Change in signs of CFs over time - complicates analysis
Example: Should you accept a project with the following cash flows? CF0= -1,600, CF1= +10,000, CF2= -10,000 ? Assume k=20% ANS:
With trial and error method, we find IRR = 25% and 400% . Since both IRR > k, the project should be accepted. But wrong. NPV = - 211.11, at k = 20% . Therefore, the NPV rule indicates rejecting the project.
Given k=20%, borrow $1,600 at t=0 for one year and invest the amount. At t=1, your net CF = 10,000 - 1,600 x (1+0.2) = + $8,080 Deposit $8,080 at t=1 for one year @20% At t=2, your net CF= 8,080 x (1+0.2) - 10,000 = - $304 [ = FV(NPV), net loss!]
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4.1.2. Conclusion on NPV vs IRR

CONCLUSION on NPV vs IRR:
IRR can lead you into a wrong decision for Projects with non-conventional CFs Mutually exclusive projects At the end of the day, we are interested In a dollar measure of profitability Not in the profitability per dollar of investment
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4.2. NPV vs PI
On Accept/Reject decision for Independent Projects:
Both NPV and PI give same answer.
For Mutually Exclusive Projects:

Mutually Exclusive Projects Proj. A Proj. B PV $20,000 $8,000 CF0 $15,000 $5,000 NPV $5,000 $3,000 PI = PV/CF0 1.33 1.60
NPV: Choose A (absolute $ amount) PI: Choose B (relative measure)
NPV is better than PI for share holder wealth maximization
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5. P&Z Electronics
P&Z Electronics has two mutually exclusive investments under consideration. Each project is to produce incremental cost savings for 7 years. The required rate of return for P&Z is 14% . Determine for each project: (1) the payback period (2) the net present value. Which project should you choose and why? Assume the accelerated cost recovery system (ACRS) for depreciation for a 5-year property class. The corporate tax rate is 40%.
P&Z Electronics
Investment Project A Project B $28,000 $20,000
Period 1 2 3 4 5 6 7
Cost Savings Project A Project B $8,000 $5,000 $8,000 $5,000 $8,000 $6,000 $8,000 $6,000 $8,000 $7,000 $8,000 $7,000 $8,000 $7,000
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5a. Projects A & B - Cash Flows

Investment $28,000 5-year Depreciation Schedule Year Rate Deprec 1 20.00% $5,600 2 32.00% $8,960 3 19.20% $5,376 4 11.52% $3,226 5 11.52% $3,226 6 5.76% $1,613 100% $28,000 Investment $20,000 5-year Depreciation Schedule Year Rate Deprec 1 20.00% $4,000 2 32.00% $6,400 3 19.20% $3,840 4 11.52% $2,304 5 11.52% $2,304 6 5.76% $1,152 100% $20,000
Project A Cash Flows Savings Deprec Taxable Year (1) (2) Income (3) 0 -$28,000 1 $8,000 $5,600 $2,400 2 $8,000 $8,960 -$960 3 $8,000 $5,376 $2,624 4 $8,000 $3,226 $4,774 5 $8,000 $3,226 $4,774 6 $8,000 $1,613 $6,387 7 $8,000 $0 $8,000 Project B Cash Flows Savings Deprec Taxable Year (1) (2) Income (3) 0 -$20,000 1 $5,000 $4,000 $1,000 2 $5,000 $6,400 -$1,400 3 $6,000 $3,840 $2,160 4 $6,000 $2,304 $3,696 5 $7,000 $2,304 $4,696 6 $7,000 $1,152 $5,848 7 $7,000 $0 $7,000
Tax (4) $960 -$384 $1,050 $1,910 $1,910 $2,555 $3,200
Cash Flow (1) - (4) -$28,000 $7,040 $8,384 $6,950 $6,090 $6,090 $5,445 $4,800 Cash Flow (1) - (4) -$20,000 $4,600 $5,560 $5,136 $4,522 $5,122 $4,661 $4,200
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Tax (4) $400 -$560 $864 $1,478 $1,878 $2,339 $2,800
5b. Projects A & B - Payback Periods

Payback Periods Year CF for A 0 -$28,000 1 $7,040 2 $8,384 3 $6,950 4 $6,090 5 $6,090 6 $5,445 7 $4,800 Amount NotPaidBack -$28,000 -$20,960 -$12,576 -$5,626 $465 CF for B -$20,000 $4,600 $5,560 $5,136 $4,522 $5,122 $4,661 $4,200 3.92 yrs 4.04 yrs Amount NotPaidBack -$20,000 -$15,400 -$9,840 -$4,704 -$182 $4,939
PB Period A = 3 + 5626 / 6090= PB Period B = 4 + 182 / 5122=
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5c. Projects A & B - NPV

Net Present Value k= 14% Year PVIF CF for A PVA CF for B NPVB 0 1.0000 -$28,000 -$28,000 -$20,000 -$20,000 1 0.8772 $7,040 $6,175 $4,600 $4,035 2 0.7695 $8,384 $6,451 $5,560 $4,278 3 0.6750 $6,950 $4,691 $5,136 $3,467 4 0.5921 $6,090 $3,606 $4,522 $2,677 5 0.5194 $6,090 $3,163 $5,122 $2,660 6 0.4556 $5,445 $2,481 $4,661 $2,123 7 0.3996 $4,800 $1,918 $4,200 $1,678 NPVA $486 NPVB $919
NPV Project A $486 Project B $919 NPV rule: Choose B PB rule: Choose A Which one?
Payback 3.92 yrs 4.04 yrs
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6. P&Z Machine Tool Co.

P&Z Machine Tool Co. is considering the purchase of a new drill press to replace the one currently being used. The present machine is expected to last another seven years and have no salvage value. The drill press in current use as a book value of $7,000 and can be sold today for $4,000. P&Z pays $5,000 a year maintenance on the press. The new drill press will cost $15,000; is expected to last 7 years at which time it will be sold for $1,000. The maintenance cost on the new machine is expected to be $1,500 a year. P&Z depreciate its assets on the straight line basis and pays taxes at the rate of 40%. 1) What is the initial cash outlay associated with the new machine? 2) What is the additional cash flow expected to be produced by the new machine for the years 1-7 ? 3) What is the average rate of return? 4) What is the payback period? 5) What the the NPV assuming a discount rate of 20% ? 6) What is the profitability index assuming a discount rate of 20% ? 7) What is the internal rate of return?
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6a P&Z Machine Tool Co. - solution

1) CF0 = Cost + Salvage + TaxSaving TaxSaving = (BookValue - SalePrice) x TaxRate = (7,000 - 4,000) x 0.4 = 1,200 Thus, CF0 = - 15,000 + 4,000 + 1,200 = - 9.800 2) Cash Flows Year 1 thru Year 7: Changes in Depreciation & Income Depreciation on New Machine = (15,000 - 1,000) / 7 = $2,000/yr Depreciation on Old Machine = (7,000 - 0) / 7 = $1,000/yr Change in Depreciation = $1,000/yr Year 1 thru Year 6 Cash savings: Maintenance on Old - New = 5,000 - 1,500 Change in depreciation expense Change in taxable income Change in tax @40% Change in net income Change in CF (add back Change in depreciation, 1,000) Year 7 Change in CF + Salvage Value = 2,500 + 1,000
= 3,500 = - 1,000 = 2,500 = - 1,000 = 1,500 = + 2,500 = + 3,500

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6b P&Z Machine Tool Co. - Solution

3) Average Rate of Return: ARR = (AverageAnnualChangeInNetIncome) / (AverageInvestment) = 1,500/ ((15,000+1,000)/2) = 1,500 / 8,000 = 18.75% 4) Payback period: Year 1: 9,800 - 2,500 = 7,300 Year 2: 7,300 - 2,500 = 4,800 Year 3: 4,800 - 2,500 = 2,300 Year 4: 2,300 / 2,500 = 0.92 yrs. Payback period = 3 + 0.92 = 3.92 years 5) NPV = - $ 509 : The project should be rejected!
Year 0 1-6 7
Discount Rate 20% CFs PVIF PV -$9,800 1.0000 -$9,800 $2,500 3.3255 $8,314 $3,500 0.2791 $977 NPV = -$509
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6c P&Z Machine Tool Co. - Solution

6) Profitability Index: CF0 = - $9.800 PV(CF1, CF2, . . . , CF7) = 8,314 + 977 = $ 9,291 PI = PV(CF1, CF2, . . . , CF7 / CF0 = 9291/9800 = 0.95 Since PI < 1, the project should be REJECTED! 7) IRR
Answer using TI BA-II Plus calculator
CF, 2nd, CLR Work, 9800, +/-, ENTER, \, 2500, ENTER, \, 6, ENTER,\, 3500, ENTER, IRR, CPT Ans: IRR= 18.15%.
Since IRR = 18.15% is less than the discount rate of 20%, the project should be rejected !
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7. Concrete Mixer Truck

The City of Miami must replace a number of its concrete mixer trucks with new trucks. It has received several bids and has evaluated closely the performance characteristics of the various trucks. The Patterbilt truck, which costs $74,000 is top-of-the-line equipment. It has a life of 8 years assuming that the engine is rebuilt in the fifth year. Maintenance costs of $2,000 a year are expected in the first 4 years, followed by total maintenance and rebuilding costs of $13,000 in the fifth year. During the last 3 years, maintenance costs are expected to be $4,000 a year. At the end of 8 years, the truck will have an estimated scrap value of $9,000. A bid from Bulldog Trucks, Inc., is for $59,000 a truck. The maintenance costs are expected to be $3,000 in year 1. This amount is expected to increase by $1,500 a year through the eighth year. In year 4 the engine will need to be rebuilt, and this will cost the city $15,000 in addition to maintenance costs in that year. At the end of 8 years the Bulldog truck will have an estimated scrap value of $5,000. continued . . .
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7. Concrete Mixer Truck continued

The last bidder, Best Tractor and Trailer Company, has agreed to sell trucks at $44,000 each. Maintenance costs in the first 4 years are expected to be $4,000 the first year and to increase by $1,000 a year. For the citys purpose, the truck has a life of only 4 years. At that time, it can be traded in for a new Best Truck, which is expected to cost $52,000. The likely trade-in value of the old truck is $15,000. During years 5 through 7 the second truck is expected to have maintenance costs of $5,000 in year 5, and these are expected to increase by $1,000 each year. At the end of 8 years, the second truck is expected to have a resale value or salvage value of $18,000. 1) If the opportunity cost of funds for the city is 8%, which bid should the city accept? Ignore tax considerations, as the city pays no taxes.
2) If its opportunity cost were 15%, would your answer change?
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7a Concrete Mixer Truck with k = 8%

k = 8% Patterbilt Time PVIF CF PV 0 1.0000 -$74,000 -$74,000 1 0.9259 -$2,000 -$1,852 2 0.8573 -$2,000 -$1,715 3 0.7938 -$2,000 -$1,588 4 0.7350 -$2,000 -$1,470 5 0.6806 -$13,000 -$8,848 6 0.6302 -$4,000 -$2,521 7 0.5835 -$4,000 -$2,334 8 0.5403 $5,000 $2,701 Present Value -$91,625
CF8 = -4,000+9,000=5,000
Bulldog Best CF PV CF PV -$59,000 -$59,000 -$44,000 -$44,000 -$3,000 -$2,778 -$4,000 -$3,704 -$4,500 -$3,858 -$5,000 -$4,287 -$6,000 -$4,763 -$6,000 -$4,763 -$22,500 -$16,538 -$44,000 -$32,341 -$9,000 -$6,125 -$5,000 -$3,403 -$10,500 -$6,617 -$6,000 -$3,781 -$12,000 -$7,002 -$7,000 -$4,084 -$8,500 -$4,592 $10,000 $5,403 -$111,273 -$94,960
CF4 = -7,500 - 15,000 CF8 = -13,500 + 5,000 CF4 = - 52K + 15K - 7K = - 44,000 CF8 = - 8K + 18K = 10,000
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7b Concrete Mixer Truck with k = 15%

k = 15% Patterbilt Time PVIF CF PV 0 1.0000 -$74,000 -$74,000 1 0.8696 -$2,000 -$1,739 2 0.7561 -$2,000 -$1,512 3 0.6575 -$2,000 -$1,315 4 0.5718 -$2,000 -$1,144 5 0.4972 -$13,000 -$6,463 6 0.4323 -$4,000 -$1,729 7 0.3759 -$4,000 -$1,504 8 0.3269 $5,000 $1,635 Present Value -$87,772
CF8 = -4,000+9,000=5,000
Bulldog Best CF PV CF PV -$59,000 -$59,000 -$44,000 -$44,000 -$3,000 -$2,609 -$4,000 -$3,478 -$4,500 -$3,403 -$5,000 -$3,781 -$6,000 -$3,945 -$6,000 -$3,945 -$22,500 -$12,864 -$44,000 -$25,157 -$9,000 -$4,475 -$5,000 -$2,486 -$10,500 -$4,539 -$6,000 -$2,594 -$12,000 -$4,511 -$7,000 -$2,632 -$8,500 -$2,779 $10,000 $3,269 -$98,125 -$84,804
CF4 = -7,500 - 15,000 CF8 = -13,500 + 5,000 CF4 = - 52K + 15K - 7K = - 44,000 CF8 = - 8K + 18K = 10,000
IV - 39
Choosing Between Long- And Short-lived Equipment: Equivalent Annual Cost (EAC)
Two Machines Have Same Functionality

Ignore Revenue Side Choose Between Them On the Basis Of Cost
Have To Be Replaced At the End Of Their Economic Life

Machine A Has 3-year Life Machine B Has 2-year Life
Following Are Costs In Todays Dollars

Use Real Discount Rate Of 6%
Copyright 1996 by The McGraw-Hill Companies, Inc
IV - 40
8.2 Long- Versus Short-lived Equipment

Year: A B 0 15 10 COSTS 1 2 5 5 6 6 3 5 PV @ 6% 28.37 21.00
Machine B Has Lower NPV But Shorter Life Has To Be Replaced one Year Earlier Convert To Costs Per Year Fair Rental Payment Equivalent Annual Cost (EAC) Equivalent annual cost of A =28.37/(3-year annuity factor) = 28.37/2.673 = 10.61 Equivalent annual cost of B =21.00/(2-year annuity factor) = 21/1.834 = 11.45
Annual Cost Of A Is Less Than That Of B

IV - 41
Inflation and DCF Analysis

Nominal CFs discounted by nominal discount rates both nominal cash flows and nominal discount rates include expected inflation
PV of Nominal cash flows
PV of Real cash flows

Real CFs discounted by real discount rates both cash flows and discount rates exclude inflation effects
Nominal cash flows discounted at the nominal rate are equal to real cash flows discounted at the real rate because both methods measure $NOW
IV - 43
9.1 Nominal vs. Real Cash Flows

CNOMINAL : Nominal Cash Flow in N - periods CREAL : Real Cash Flow in N - periods CNOMINAL CREAL (1 IEXPECTED ) in one period CNOMINAL CREAL (1 IEXPECTED )N in N - periods
Using the Fisher Equation for N Periods
1 rNOMINAL N (1 rREAL )N (1 IEXPECTED )N

CNOMINAL CREAL (1 IEXPECTED ) CREAL N N N N (1 rNOMINAL ) (1 rREAL ) (1 IEXPECTED ) (1 rREAL )
N
IV - 44
10. Capital Rationing

Shareholders are interested in the absolute amount of money.
NPV rule is better than PI or IRR rules NPV rule often picks a larger investment project even though IRR or PI may be lower. NPV rule assumes the firm can invest as much as it wants to.
Capital Rationing
It occurs when the firm has a limitations on the capital it can invest Capital Rationing can be now and/or in the future It means not all the positive NPV projects will be undertaken
Under Capital Rationing

What should be the investment decision rule? Maximize NPV subject to the capital constraint on all the investments How to identify the investment projects? Use Profitability Index with trial and error in simple cases Use Linear Programming or Integer Programming in general cases
IV - 45
10.1Example of Capital Rationing

0 1 2 NPV @ 10% A -10 +30 +5 21 B -5 +5 +20 16 C -5 +5 +15 12 Limited $10 million capital Firm can invest in project A or (projects B and C) Individually, B and C have lower NPV Taken together, B and C have higher NPV Choose projects that offer highest Benefits or NPV per dollar invested
IV - 46
10.2Use Profitability Index in A Simple Case
Present Value of Benefits Profitability Index Initial Investment

rRank projects in terms of declining PI rContinue making investments until capital exhausted rAccept projects B and C
Investment PV(CF1,CF2) 5 21 5 17 10 31 PI 4.2 3.4 3.1 NPV 16 12 21
IV - 47
10.3 Limitations In Use Of Profitability Index Capital constraints in more than one period
Project A B C D CF0 -10 -5 -5 0 CF1 30 5 5 -40 CF2 PV(benefits) 5 31 20 21 15 17 60 50 PI 3.1 4.2 3.4 1.4
Example: firm can raise $10 million in each of years 0 and 1
NPV @10% 21 16 12 13
If we accept projects B and C, based on PI, we cannot accept project D Better to accept project A in period 0
Allows us to accept project D in period 1
IV - 48
10.4 Wrong Applications of PI

PI cannot be used whenever there is any constraints in choice of projects, other than capital rationing in one period Capital rationing in multiple periods Mutually exclusive projects One project depends on another
Use of PI may be reasonable if we dont have a good idea of future capital availability or investment opportunities Alternatively, we may need linear programming or Integer Programming
IV - 49
10.5Types of Capital Rationing

Soft Rationing: Internally Imposed Constraint
Capital Rationing at the Division Level: To Force Divisions to Prioritize Among the Investment Opportunities Capital Rationing at the Corporate Level: to Limit Corporate Growth Due to Limited Management Resources
Hard Rationing: Externally Imposed Constraint

Capital Markets Imperfections Shareholders may not want to Issue additional stocks to maintain the control of the company Lenders may not provide funding for a new positive NPV Project Because of Poor Financial Condition of Existing Projects of Firm
IV - 50
11. Appendix A: More on IRR - A Positively Sloped NPV

Consider the following two Projects:
Investing Project
C0 = -$1,000 C1 = $1,200 NPV at various opportunity CC's k NPV 0% $200 5% $142.86 10% $90.91 15% $43.48 20% $0.00 25% -$40.00
Borrowing Project
C0 = $1,000 C1 = -$1,200 NPV at various opportunity CC's k NPV 0% -$200 5% -$142.86 10% -$90.91 15% -$43.48 20% $0.00 25% $40.00
$200
The Investing Project
IRR=20%
- $40
25% Reject the project because NPV<0 k > IRR The Borrowing Project IRR=20%
IRR Rule: If NPV is downward sloping, accept projects when k < IRR If NPV is upward sloping, accept projects when k > IRR
$40 25% Accept the project because NPV>0 k > IRR

IV - 51
- $200
11.1 Appendix A : More on IRR - Multiple IRRs

Consider the following Project with CFs changing signs:
Project With Negative CF later
C0 = -$1,000 C1 = $1,200 C2 = $1,500 C3 = -$1,750 Clean-up Cost NPV at various opportunity CC's k NPV 0.0% -$50 5.0% -$8.31 6.4% $0.00 10.0% $15.78 15.0% $27.04 20.0% $28.94 25.0% $24.00 30.0% $14.11 35.2% $0.00 40.0% -$15.31 45.0% -$33.01
$40 $30 $20 $10 $0 -$10 -$20 -$30REJECT -$40 -$50 -$60 10% 20% 30% 40% 50%
DCF: Net Present Value

IRR1
IRR2
ACCEPT
REJECT
IRR Rule: If DCF is positively sloping at IRR1, accept the project when k > IRR1 If DCF is negatively sloping at IRR2, accept the project when k < IRR2
IV - 52
11.2 WARNING on IRR vs Opportunity Cost of Capital Distinguish between IRR and opportunity cost of capital
Both appear as discount rates in NPV formula.
IRR is a measure of profitability, depends on amount and timing of cash flows Opportunity cost of capital measures what we could earn by investing in financial assets of similar risk
Set by capital markets It is a cost of financing the project It provides us with a minimum acceptable level of profitability
IV - 53
11.3 Can IRR Rule be used for Mutually Exclusive Projects? Project CF0 CF1 IRR(%) E -10,000 +20,000 +100 F -20,000 +35,000 +75 Project E manually controlled machine Project F computer controlled machine
HIGHER NPV PREFERRED MACHINE BUT LOWER IRR!
NPV@10% +8,182 +11,818
We can accept only one project

We are choosing between alternative ways of doing the same thing We need one fork lift truck
What should be the criterion in choosing between alternative projects? IRR rule can give wrong answer !
IV - 54
11.3a IRR Rule Vs. Mutually Exclusive Projects
Salvage IRR rule by considering IRR on the incremental project
Accept project E
First analyze smaller project E
Should I make the incremental investment to go from project E to project F?

Accept incremental project (F - E)
IRR of 50% > 10% cost of capital
IRR of 100% > 10% cost of capital At the least, project E is acceptable
Incremental Cash Flows 0 1 IRR(%) F-E -10,000 +15,000 +50
NPV@10% +3,636
But we know that project E is acceptable Choose project F We could have chosen project F at the start by noting that it has the higher NPV
IV - 55
11.3b IRR rule vs. MUTUALLY EXCLUSIVE PROJECTS
A small project with a very high IRR
may have a smaller NPV

than a large project with a smaller IRR
IV - 56
11.4 DISCOUNTED PAYBACK RULE

Calculate length of time until the sum of the discounted cash flows is equal to the initial investment Accept project if it is less than some cutoff value Discounted-payback rule asks how long will it be until the project has a positive NPV
No longer gives equal weight to all cash flows before payback date but still ignores cash flows after the cutoff date
Cannot be used for ranking projects
IV - 57

VI. Capital Budgeting Under Certainty: Professors Simon Pak and John Zdanowicz

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VI. Capital Budgeting Under Certainty: Professors Simon Pak and John Zdanowicz

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VI.

Capital Budgeting Under Certainty

Professors Simon Pak and John Zdanowicz

Comparison of Methods of Evaluation

Simon Pak & John Zdanowicz 2000

1. Capital Budgeting Process

Steps in Capital Budgeting

2. Estimation of Cash Flows

Simon Pak & John Zdanowicz 2000

2.1 Accounting Income vs. Cash Flows

In Accounting, objectives are different:

2.2 Incremental Analysis: Incremental After Tax Net Cash Flows

Simon Pak & John Zdanowicz 2000

2.2.1 Incremental Analysis - continued

t = 0 : Now t = 1, 2, , n where n = number of years of life of the project

FORGET SUNK COST!

Simon Pak & John Zdanowicz 2000

2.2.2 Initial Cash Flows

+ Investment tax credit

Simon Pak & John Zdanowicz 2000

2.2.3 Future Cash Flows: CF1, CF2, . . . , CF(n-1), CFn

+ or - Impact of changes in depreciation expenses

Operating expenses, labor, raw material, etc. Administrative expenses

Simon Pak & John Zdanowicz 2000

Simon Pak & John Zdanowicz 2000

3.1. Methods of Evaluation

Simon Pak & John Zdanowicz 2000

3.2. Average Rate of Return (ARR), Book R of R

Simon Pak & John Zdanowicz 2000

3.3. Payback Period (PB)

(ii) Does not take into account time value of money

Simon Pak & John Zdanowicz 2000

3.4. Discount Cash Flow Techniques

All three methods require a discount rate, k = i + q

In this section the following project example will be used:

Simon Pak & John Zdanowicz 2000

3.4.1. Net Present Value (NPV) Method

Often: NPV = PV (CFs from t= 1 to N) - Cost(t=0)

How to use NPV?

Simon Pak & John Zdanowicz 2000

3.4.2. Profitability Index (PI)

CF0 = - $18,000 PV(CF1 ~ CF5) = $21,228 Therefore, PI = 21,228 / 18,000 = 1.18

Simon Pak & John Zdanowicz 2000

3.4.3. Internal Rate of Return (IRR)

k 10% 15% 20% 17% ?

NPV + $ 3,228 + $ 772 - $1,253 - $ 84 .. 0

3.4.3a. IRR Calculation with TI BA-II Plus

[ENTER] IRR CPT 2nd [QUIT]

Simon Pak & John Zdanowicz 2000

3.4.3b. IRR Calculation with TI BA-II Plus

3.4.3b. How to Use IRR

Simon Pak & John Zdanowicz 2000

4. Comparison: ARR and PB Period

Simon Pak & John Zdanowicz 2000

4.1. NPV vs IRR - Independent Projects

Sum of all CFs

discount rate k (%) opportunity cost of capital

REJECT: Negative NPV for k > IRR1

Simon Pak & John Zdanowicz 2000

4.1.1. NPV vs IRR: Mutually Exclusive Projects

NPVD NPVC IRR D 8% 12.5% 14% IRR C

discount rate k (%)