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CHAPTER 13
The Basics of Capital Budgeting: Evaluating Cash Flows
Should we build this plant?

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What is capital budgeting?

 Analysis of potential additions to fixed assets.
 Long-term decisions; involve large expenditures.  Very important to firm’s future.

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Steps 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.

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What is the difference between independent and mutually exclusive projects? Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

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An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.

then string of positive CFs. then cost to close project. Nuclear power plant.13 . All rights reserved. One change of signs. strip mine. Nonnormal Cash Flow Project: Two or more changes of signs. Inc. Most common: Cost (negative CF). . Copyright © 2002 Harcourt.6 Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows.

Inc. Copyright © 2002 Harcourt.7 Inflow (+) or Outflow (-) in Year 0 1 + + 2 + + 3 + + + 4 + + + 5 + + N N N NN NN + - + + + + - + - N NN All rights reserved. .13 .

8 What is the payback period? The number of years required to recover a project’s cost. Inc. . All rights reserved.13 . or how long does it take to get the business’s money back? Copyright © 2002 Harcourt.

4 3 80 50 60 100 -30 0 = 2.9 Payback for Project L (Long: Most CFs in out years) 0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 30/80 2 2. Inc.375 years Copyright © 2002 Harcourt. . All rights reserved.13 .

10 Project S (Short: CFs come quickly) 0 CFt -100 1 1.6 2 3 20 40 70 100 50 -30 0 20 Cumulative -100 PaybackS = 1 + 30/50 = 1. Inc.13 . All rights reserved. .6 years Copyright © 2002 Harcourt.

Easy to calculate and understand.13 . All rights reserved. 2. 2. Provides an indication of a project’s risk and liquidity. Ignores CFs occurring after the payback period. . Weaknesses of Payback: 1. Copyright © 2002 Harcourt. Inc.11 Strengths of Payback: 1. Ignores the TVM.

.09 -90. 0 CFt PVCFt -100 -100 10% 1 10 9. + cap.79 Cumulative -100 Discounted = 2 payback + 41. costs in 2. Copyright © 2002 Harcourt.11 18.13 .7 yrs.91 2 60 49.32 3 80 60. All rights reserved.59 -41.7 yrs Recover invest. Inc.11 = 2.32/60.12 Discounted Payback: Uses discounted rather than raw CFs.

t t  0 1  k  n Cost often is CF0 and is negative. CFt NPV   . All rights reserved. Inc. . Copyright © 2002 Harcourt. NPV   t 1 n 1  k  CFt t  CF0 .13 .13 NPV: Sum of the PVs of inflows and outflows.

00 9. . 10% 1 10 2 60 3 80 NPVS = \$19.59 60. All rights reserved.79 = NPVL Copyright © 2002 Harcourt.14 What’s Project L’s NPV? Project L: 0 -100.13 . Inc.09 49.98.11 18.

78 = NPVL All rights reserved. Copyright © 2002 Harcourt. Inc.15 Calculator Solution Enter in CFLO for L: -100 10 60 80 10 CF0 CF1 CF2 CF3 I NPV = 18. .13 .

.13 . Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Inc. Adds most value.Cost = Net gain in wealth. All rights reserved.16 Rationale for the NPV Method NPV = PV inflows . Copyright © 2002 Harcourt.

13 . accept both. All rights reserved.17 Using NPV method. Inc. NPV > 0. Copyright © 2002 Harcourt. .  If S & L are independent. which project(s) should be accepted?  If Projects S and L are mutually exclusive. accept S because NPVs > NPVL .

Copyright © 2002 Harcourt. This is the same as forcing NPV = 0.18 Internal Rate of Return: IRR 0 CF0 Cost 1 CF1 2 CF2 Inflows 3 CF3 IRR is the discount rate that forces PV inflows = cost.13 . . All rights reserved. Inc.

Inc. CFt  NPV. n . All rights reserved. CFt  0.  t t  0 1  IRR  Copyright © 2002 Harcourt. solve for NPV. solve for IRR.13 .19 NPV: Enter k.  t t  0 1  k  n IRR: Enter NPV = 0.

IRRS = 23. All rights reserved. Inc. . then press IRR: IRRL = 18. Copyright © 2002 Harcourt.13 .13%.00 PV1 PV2 PV3 0 = NPV Enter CFs in CFLO.56%.20 What’s Project L’s IRR? 0 IRR = ? 1 10 2 60 3 80 -100.

All rights reserved.21 Find IRR if CFs are constant: 0 -100 INPUTS OUTPUT 3 N I/YR IRR = ? 1 40 2 40 -100 PV 3 40 40 PMT 0 FV 9. Inc.13 .70%. Copyright © 2002 Harcourt.70% Or. . enter CFs and press IRR = 9. with CFLO.

A bond’s YTM is the IRR if you invest in the bond. A.Q... Copyright © 2002 Harcourt.134.22 0 2 10 .08% (use TVM or CFLO). 90 90 1.090 -1. . All rights reserved.2 IRR = 7. Inc. How is a project’s IRR related to a bond’s YTM? They are the same thing. 1 IRR = ? 13 .

13 . Copyright © 2002 Harcourt.23 Rationale for the IRR Method If IRR > WACC.some return is left over to boost stockholders’ returns. Example: WACC = 10%. then the project’s rate of return is greater than its cost-. . Inc. IRR = 15%. Profitable. All rights reserved.

IRRs > k = 10%.  If S and L are mutually exclusive.25 Decisions on Projects S and L per IRR  If S and L are independent. .13 . All rights reserved. accept both. Copyright © 2002 Harcourt. Inc. accept S because IRRS > IRRL .

NPVL 50 33 19 7 (4) NPVS 40 29 20 12 5 All rights reserved. .26 Construct NPV Profiles Enter CFs in CFLO and find NPVL and NPVS at different discount rates: k 0 5 10 15 20 Copyright © 2002 Harcourt.13 . Inc.

6 Crossover Point = 8. Copyright © 2002 Harcourt.6% Discount Rate (%) IRRL = 18.1% All rights reserved.13 . Inc.7% k 0 5 10 15 20 NPVL 50 33 19 7 (4) NPVS 40 29 20 12 5 S L IRRS = 23.27 NPV (\$) 60 50 40 30 20 10 0 0 -10 5 10 15 20 23. .

k > IRR and NPV < 0.13 . Reject. All rights reserved.28 NPV and IRR always lead to the same accept/reject decision for independent projects: NPV (\$) IRR > k and NPV > 0 Accept. . Inc. k (%) IRR Copyright © 2002 Harcourt.

7: NPVS> NPVL . Copyright © 2002 Harcourt.7 k % IRRL All rights reserved.13 . IRRS > IRRL CONFLICT k > 8.7: NPVL> NPVS .29 Mutually Exclusive Projects NPV L k < 8. . IRRS > IRRL NO CONFLICT S IRRS k 8. Inc.

2. Inc. Copyright © 2002 Harcourt.68%. . rounded to 8.13 . See data at beginning of the case. Can subtract S from L or vice versa. then press IRR. 3. 4. but better to have first CF negative. All rights reserved. Crossover rate = 8.7%. Enter these differences in CFLO register. one project dominates the other.30 To Find the Crossover Rate 1. If profiles don’t cross. Find cash flow differences between the projects.

If k is high. All rights reserved.31 Two Reasons NPV Profiles Cross 1. 2.13 . so high k favors small projects. Smaller project frees up funds at t = 0 for investment. Size (scale) differences. early CF especially good. Copyright © 2002 Harcourt. Timing differences. Project with faster payback provides more CF in early years for reinvestment. NPVS > NPVL. Inc. . the more valuable these funds. The higher the opportunity cost.

 Reinvest at opportunity cost. Copyright © 2002 Harcourt.13 . k. NPV should be used to choose between mutually exclusive projects. so NPV method is best.  IRR assumes reinvest at IRR. is more realistic. All rights reserved. . Inc.32 Reinvestment Rate Assumptions  NPV assumes reinvest at k (opportunity cost of capital).

TV is found by compounding inflows at WACC.13 . Copyright © 2002 Harcourt. Inc. MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. . MIRR assumes cash inflows are reinvested at WACC. All rights reserved. Thus. Can we give them a better IRR? Yes.33 Managers like rates--prefer IRR to NPV comparisons.

0 10% MIRR = 16.5% Copyright © 2002 Harcourt.13 . Inc.0 66.1 \$100 = (1+MIRRL)3 MIRRL = 16.34 MIRR for Project L (k = 10%) 0 10% 1 10.1 158.0 10% 3 80.0 12.0 -100. .1 TV inflows -100.5% 2 60. All rights reserved.0 PV outflows \$158.

Enter FV = 158. PV = -100. Copyright © 2002 Harcourt. Press I = 16. I = 10. CF3 = 80 I = 10 NPV = 118. Enter PV = -118.10 = FV of inflows.13 .78 = PV of inflows. N = 3. PMT = 0.10.78. enter in CFLO: CF0 = 0. .35 To find TV with 10B. CF1 = 10.50% = MIRR. PMT = 0. CF2 = 60. N = 3. Press FV = 158. All rights reserved. Inc.

Managers like rate of return comparisons. and MIRR is better for this than IRR.13 . . Copyright © 2002 Harcourt.36 Why use MIRR versus IRR? MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. All rights reserved. Inc.

78 IRR = ERROR. enter I = 10.000 2 -5.13 . NPV = -386. All rights reserved. . Inc.37 Pavilion Project: NPV and IRR? 0 -800 k = 10% 1 5. Why? Copyright © 2002 Harcourt.000 Enter CFs in CFLO.

Inc.38 We got IRR = ERROR because there are 2 IRRs.13 . 400 k -800 Copyright © 2002 Harcourt. Nonnormal CFs--two sign changes. . Here’s a picture: NPV NPV Profile IRR2 = 400% 450 0 100 IRR1 = 25% All rights reserved.

so NPV < 0.13 . 3. Result: 2 IRRs.39 Logic of Multiple IRRs 1. the discount rate hits CF2 harder than CF1. All rights reserved. so CF0 dominates and again NPV < 0. the PV of both CF1 and CF2 are low. the PV of CF2 is large & negative. At very high discount rates. Copyright © 2002 Harcourt. 4. In between. 2. At very low discount rates. so NPV > 0. Inc. .

All rights reserved. Enter a “guess” as to IRR by storing the guess.13 .40 Could find IRR with calculator: 1. 2. say. Inc. Enter CFs as before. Try 10%: 10 STO IRR = 25% = lower IRR Now guess large IRR. . 200: 200 STO IRR = 400% = upper IRR Copyright © 2002 Harcourt.

231.000.40.13 .6% Copyright © 2002 Harcourt. Inc.000 2 -5.000.500.000 1 5. use MIRR: 0 -800.00. . TV inflows @ 10% = 5.000.932. MIRR = 5.000 PV outflows @ 10% = -4. All rights reserved.41 When there are nonnormal CFs and more than one IRR.

Reject because MIRR = 5. Copyright © 2002 Harcourt. Inc. NPV will be negative: NPV = -\$386. . if MIRR < k.13 . Also.6% < k = 10%. All rights reserved.42 Accept Project P? NO.777.

60 33.5 Copyright © 2002 Harcourt.5 33. Which is better? (000s) 0 1 2 3 4 Project S: (100) 60 Project L: (100) 33.5 33. .43 S and L are mutually exclusive and will be repeated. k = 10%.5 All rights reserved.13 . Inc.

000 2 10 4.000 60. Need to perform common life analysis.000 33. . Inc. Copyright © 2002 Harcourt.500 4 10 6.13 . But is L better? Can’t say yet.190 NPVL > NPVS. All rights reserved.44 CF0 CF1 Nj I NPV S -100.132 L -100.

 Can use either replacement chain or equivalent annual annuity analysis to make decision. Inc.45  Note that Project S could be repeated after 2 years to generate additional profits. Copyright © 2002 Harcourt. .13 . All rights reserved.

46 Replacement Chain Approach (000s) Project S with Replication: 0 1 2 3 4 Project S: (100) 60 (100) 60 60 (100) (40) 60 60 60 60 NPV = \$7.13 . All rights reserved.547. Copyright © 2002 Harcourt. . Inc.

Inc.190.415 7. All rights reserved. use NPVs: 0 4. Copyright © 2002 Harcourt.547 1 10% 2 4. .132 3 4 Compare to Project L NPV = \$6.47 Or.132 3.13 .

13 . Now choose L.48 If the cost to repeat S in two years rises to \$105. . All rights reserved. Copyright © 2002 Harcourt.415 < NPVL = \$6. Inc.190.000. which is best? (000s) 0 1 2 3 4 Project S: (100) 60 60 (105) (45) 60 60 NPVS = \$3.

the machinery will have positive salvage value. Year 0 1 2 3 CF (\$5.000 3.49 Consider another project with a 3-year life.13 .000) 2. If terminated prior to Year 3.750 Salvage Value \$5.000 0 All rights reserved. Inc.100 2. .100 2. Copyright © 2002 Harcourt.000 1.

1 2. .2 2 2 4 3 1. No termination 0 (5) 1 2. Terminate 1 year (5) Copyright © 2002 Harcourt. Inc.50 CFs Under Each Alternative (000s) 1. All rights reserved.75 2.13 .1 5. Terminate 2 years (5) 3.

Inc. what is the project’s optimal. or economic life? NPV(no) = -\$123. Copyright © 2002 Harcourt. NPV(2) = \$215.13 . NPV(1) = -\$273.51 Assuming a 10% cost of capital. . All rights reserved.

52 Conclusions  The project is acceptable only if operated for 2 years. .  A project’s engineering life does not always equal its economic life. Copyright © 2002 Harcourt.13 . All rights reserved. Inc.

All rights reserved.  Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects: An increasing marginal cost of capital.13 .53 Choosing the Optimal Capital Budget  Finance theory says to accept all positive NPV projects. Inc. Capital rationing Copyright © 2002 Harcourt. .

All rights reserved.13 . which increase the cost of capital.) Copyright © 2002 Harcourt.. Inc. . (More. which drives up the cost of capital..54 Increasing Marginal Cost of Capital  Externally raised capital can have large flotation costs.  Investors often perceive large capital budgets as being risky.

Copyright © 2002 Harcourt.13 . then the NPV of all projects should be estimated using this higher marginal cost of capital. Inc.55  If external funds will be raised. All rights reserved. .

.56 Capital Rationing  Capital rationing occurs when a company chooses not to fund all positive NPV projects. . (More.13 .) Copyright © 2002 Harcourt.. All rights reserved.  The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year. Inc.

All rights reserved.) Copyright © 2002 Harcourt.. (More. flotation costs) and the indirect costs of issuing new capital.57 Reason: Companies want to avoid the direct costs (i.e. .13 . Inc.. Solution: Increase the cost of capital by enough to reflect all of these costs.. and then accept all projects that still have a positive NPV with the higher cost of capital.

. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing. Inc. All rights reserved.58 Reason: Companies don’t have enough managerial..13 . marketing.) Copyright © 2002 Harcourt. (More. or engineering staff to implement all positive NPV projects..

Copyright © 2002 Harcourt. so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted. . Inc. Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project. All rights reserved.13 .59 Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates.