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Capital Budgeting
Techniques
13b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember? The Different
Methods of Evaluation?
• Payback Period (PBP)
• Internal Rate of Return (IRR)
• Net Present Value (NPV)
• Profitability Index (PI)
Let us use the ‘New Asset’ project
from Chapter 12 (VW13E-13b.xlsx)
13b.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Project Evaluation:
Alternative Methods
We will start with the cash
flows of the project and also
calculate the cumulative
cash flow values.
13b.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember to refer to Excel spreadsheet
IRR: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.
Project Evaluation
13b.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember to refer to Excel spreadsheet
NPV: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.
Project Evaluation
•The Net Present Value (NPV) function is built into
•Excel and we used it in the TVM chapter!
• K31: represents the rate of return investors expect to earn for the
given amount of risk (discount rate)
• $L$25:$L$28: represents the cash flows from period 1 through the
last period (we do NOT use period 0)
• $L$24: We subtract the ICO (or add if we already assigned it a
negative sign as we did in slide 3).
• This is an important “quirk” with the Excel function
13b.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember to refer to Excel spreadsheet
PI: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.
Project Evaluation
13b.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember to refer to Excel spreadsheet
PBP: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.
Project Evaluation
13b.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Asset Replacement?
• Now go back to Chapter 12 and the cash
flows we developed for the ‘Asset
Replacement’ project and calculate the PBP,
IRR, NPV and PI.
• Hint: The answers are shown in ‘VW13E-
13b.xlsx’ file on the ‘Asset Replacement’ tab.
• Given are assumptions, would you want to
replace the project? Why or why not?
13b.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember? Potential Problems
Under Mutual Exclusivity
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
13b.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember?
A. Scale Differences
Compare a small (S) and a
large (L) project.
A. Scale Differences
13b.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember?
B. Cash Flow Pattern
Let us compare a decreasing cash-flow (D)
project and an increasing cash-flow (I) project.
13b.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
B. Cash Flow Pattern
(NOT renewing project)
• Remember that we evaluate the projects based on
maximizing shareholder wealth, but in this case we have an
overriding question – what happens at the end of the first
year if we choose project “Y”?
• We do indeed choose Project “X” (see previous slide)
because the NPV is greatest if, and only if, this is a project
that won’t be repeated or renewed. With the discount rates
we used, X is superior to Y in every scenario shown.
• If this project is repeated, then we need to re-evaluate the
cash flows as follows.
• Again, we can use the functions or ‘Data Tables’ to create
the chart on the previous slide.
13b.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember to refer to Excel spreadsheet
‘VW13E-13b.xlsx’ and the ‘Life2’ tab.
13b.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
B. Cash Flow Pattern
(NOT renewing project)
• Notice on the previous slide that we created the repeated
cash flows for the project assuming no change in cash
flows.
• We are still evaluating projects based on maximizing
shareholder wealth.
• We now choose Project “Y” (see previous slide) because the
NPV is greatest!
• In fact, Y is greatly superior to X in all of the scenarios
shown.
• Again, we can use the functions or ‘Data Tables’ to create
the chart on the previous slide.
13b.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember?
Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for this
capital budgeting period.
13b.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember?
Capital Rationing
We can use the “Solver” Add-in for Excel to find the
optimal mix EASILY!!! First make sure you have it
available on your computer by:
• Click the round Microsoft Office button (upper left corner of
screen) when Excel is open, click “Excel Options” at the
bottom, and then click the “Add-ins” category on the left side.
• In the “Manage” box at the bottom, choose “Excel Add-ins”,
and then click the “Go” button.
• In the pop-up box of Add-ins available, check the “Solver
Add-in” box, and then click OK.
13b.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember?
Available Projects for BW
Project ICO IRR NPV PI
A $ 500 18% $ 50 1.10
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
E 12,500 26 500 1.04
F 15,000 28 21,000 2.40
G 17,500 19 7,500 1.43
H 25,000 15 6,000 1.24
13b.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Rationing
• We are going to use this data that can be found in VW13E-13b.xlsx
or you can enter the data yourself.
• Your data should look something like below in the yellow section.
• The “Yes/No” box is a binary variable that determines if we want to
keep that project as being optimal.
13b.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Rationing
• Let us open
Solver. Click
on the ‘Data’
tab and then in
the ‘Analysis’
ribbon choose
‘Solver’.
• The box
should open
like the
following
example:
13b.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Rationing
• “Set Target
Cell” equal to
the box that
sums the NPVs
and click on the
“Max” option
• In the “By
Changing
Cells” area, set
it to the binary
‘Yes / No’
values (F3:F10
in this case)
13b.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Rationing
• Now we need to
add our
constraints.
• We want the
values of
F3:F10 to be
ONLY a “0” or a
“1” value
• We want G11,
sum of the ICOs
to be $32,500 or
less
13b.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Rationing
Now we solve by clicking the ‘SOLVE’ button! Look, only projects
B, C, D and F are chosen!!