FNCE10002 Lecture Notes - Lecture 4: Discount Window, Net Present Value, Capital Budgeting
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Capital budgeting involves choosing projects that add value to the firm. The net present value (NPV), internal rate of return (IRR) and payback period methods are the most common approaches to project selection. At its core, capital budgeting is measuring an accounting of costs versus benefits. In a way, all business decisions are a series of capital budgeting decisions. Get it wrong, and you can destroy a company.
The capital budgeting tools help financial managers decide on the desirability of the projects. In the real world, however, managers sometimes will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods.
For example, consider the two mutually exclusive projects below.
Investments | Cost | Cash Flow 1 | Cash Flow 2 |
Project A | $ 50 | $ - | $ 100 |
Project B | $ 50 | $ 50 | $ 25 |
According to the payback period, project B should be selected. Although both projects cost the same, project B has a payback period of one period, while project A will payback in roughly 1.5 periods.
Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20.
This example illustrates the limitations of the payback period method. Even though the payback period method points to project B, the NPV method points to project A since it has more than twice the NPV value to that of project B. Yet the manager may choose project A. Why?
It may be that the project stakeholder is requesting a quicker return in cash.
For this discussion, create an example problem where two (or more) methods contradict each other. What would be the "appropriate" choice (which project would you choose)? In what cases would you not choose the "best" choice?
Scenario Information:
Assume that two gas stations are for sale with the following cash flows; CF1 is the Cash Flow in the first year, and CF2 is the Cash Flow in the second year. This is the time line and data used in calculating the Payback Period, Net Present Value, and Internal Rate of Return. The calculations are done for you. Your task is to select the best project and explain your decision. The methods are presented and the decision each indicates is given below.
Investment | Sales Price | CF1 | CF2 |
Gas Station A | $50,000 | $0 | $100,000 |
Gas Station B | $50,000 | $50,000 | $25,000 |
Three (3) Capital Budgeting Methods are presented:
Payback Period: Gas Station A is paid back in 2 years; CF1 in year 1, and CF2 in year 2. Gas Station B is paid back in one (1) year. According to the payback period, when given the choice between two mutually exclusive projects, the investment paid back in the shortest time is selected.
Net Present Value: Consider the gas station example above under the NPV method, and a discount rate of 10%:
NPVgas station A = $100,000/(1+.10)2 - $50,000 = $32,644
NPVgas station B = $50,000/(1+.10) + $25,000/(1+.10)2 - $50,000 = $16,115
Internal Rate of Return: Assuming 10% is the cost of funds; the IRR for Station A is 41.421%.; for Station B, 36.602.
Summary of the Three (3) Methods:
Gas Station B should be selected, as the investment is returned in 1 period rather than 2 periods required for Gas Station A.
Under the NPV criteria, however, the decision favors gas station A, as it has the higher net present value. NPV is a measure of the value of the investment.
The IRR method favors Gas Station A. as it has a higher return, exceeding the cost of funds (10%) by the highest return.
Your company would like to increase its product lines. Two alternatives are available, a new line of outdoor smokers and a new line of outdoor grills. The two lines are mutually exclusive, meaning that only one of these investment alternatives can be selected. The projected cash flows and their respective probabilities for each alternative are given in the table. There are three possible levels of demand and their corresponding probabilities, which depend on the state of the economy.
Click here to download the table for Investment A.
The two alternatives carry equal risk and should be evaluated at the company's cost of capital. The cost for the new smoker line will be $7,000,000. Also, the company has been guaranteed a buyer for the new line at the end of the fifth year. The buyer has agreed to purchase the new line for $7,900,000. The outdoor grill alternative will cost $3,987,000 and also has a guaranteed buyer, who has agreed to pay $4,000,000 at the end of the fifth year.
Jorge has asked you to provide detailed responses to the following:
Management of Vanda-Laye has determined that the capital structure of the company will involve 30% debt and 70% common equity. This structure will be used to finance all investments by the company. Currently, the company can sell new bonds at par, with a coupon rate of 7%. Any new common stock can be sold for $45, with a required return (or cost) of 15.57%. Using Microsoft Excel, calculate the company's cost of capital to be used in the evaluation of possible investment projects.
For Investment A:
Using Microsoft Excel, create a decision tree. Indicate the various levels of demand and their respective probabilities. Also, include the calculations for the expected cash flows.
Calculate the expected NPV for each alternative. Explain the decision rules for making a selection between the two alternatives on the basis of the expected NPV.
Assuming the two alternatives are mutually exclusive, specify which alternative you would recommend to the company. Explain why.
If the two alternatives were independent of each other, specify which project you would select. Would you accept both projects if funding were available for both? Explain your answer.
Demand | Probability | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
Outdoor Smoker | ||||||
High | 0.2 | $800,000 | $900,000 | $1,000,000 | $1,100,000 | $1,500,000 |
Moderate | 0.6 | $500,000 | $700,000 | $800,000 | $960,000 | $1,240,000 |
Low | 0.2 | $200,000 | $350,000 | $500,000 | $600,000 | $750,000 |
Outdoor Grill | ||||||
High | 0.2 | $600,000 | $750,000 | $850,000 | $975,000 | $5,160,000 |
Moderate | 0.6 | $450,000 | $500,000 | $700,000 | $825,000 | $4,980,000 |
Low | 0.2 | $150,000 | $220,000 | $370,000 | $500,000 | $4,750,000 |