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Payback/Discounted Payback: - Irr - Mirr - Benefit Cost Ratio (BCR)
Payback/Discounted Payback: - Irr - Mirr - Benefit Cost Ratio (BCR)
Budgeting
• Payback/Discounted Payback
• IRR
• MIRR
• Benefit Cost Ratio (BCR)
• NPV (DCF)
– FCF: Free cash flow
– FTE: Flow to equity
– APV: Adjusted present value
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Payback Rule
2
The Payback Rule
Time
0 1 2 3 4
$-600
Time
0 1 2 3 4
$-600
8
IRR Rule
• Accept the project if the IRR is greater than
the required rate of return. Otherwise, reject
the project.
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IRR Rule and Unconventional
Cash Flows
• Unconventional cash flows: A negative cash
flow after a positive one.
11
Mutually Exclusive
• Taking one project means another is not taken
• The highest IRR may not have the highest NPV
12
Mutually Exclusive Cash Flows
Period Proj. A Proj. B Incremental
(A - B)
0 -500 -400 -100
1 325 325 0
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NPV Profiles of Mutually
Exclusive Projects
$150.00
$130.00
$110.00
$90.00
$70.00
Crossover Rate = 11.8
$50.00
$30.00 IRRB=22.17
$10.00
($10.00)
0 5 10 15 20 25
($30.00)
($50.00)
Project A Project B IRRA=19.43
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Reinvestment Rate Assumption
• During the life of a project, what are the
investment assumptions of the intermediate
cash flows?
• Implicitly the PV oriented methods assume
that the cash flows can be reinvested at r.
• Is this reasonable?
– NPV
– IRR
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Modified IRR (MIRR)
• Solves the PV (outflows)
T
Ct
if Ct 0
t 0 (1 r )
t
reinvestment rate
400
problem PV (outflows) 0
400
(1.12)
• Example: A project’s
cash flows are -400, T
FV (inf lows) Ct (1 r )T t if Ct 0
325 and 200. t 0
• Note:
– re (e=equity) is the same as rS (S=stock)
– rd (d=debt) is the same as rB (B=bond)
18
Compare Methods
• FCF
– Very strict assumptions of constant proportion capital structure (from
WACC)
– Can adjust r if risk or capital structure is different from existing firm
– Tax debt shield must be cD (for WACC(adjusted))
• FTE
– Probability of payments to other finance sources, i.e. debt holders
• Option to default usually not considered so FTE value is usually low
– Difficult to extrapolate entire firm value
• APV
– Flexible and works well for changing capital structure
– Usually will need an estimate of unlevered r
• Potential for estimation error depending on NPV of financing
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Relevant Cash Flows
•Incremental cash flows: Only the incremental portion
of any flow is relevant
20
Relevant Cash Flows?
•Sunk Costs
—No
•Opportunity Costs
—Yes
•Side Effects (Erosion)
—Yes
•Net Working Capital
—Yes
•Value of cash flow volatility change
—Yes
•Financing Costs
—No (there are some methods where this is relevant)
•Allocated Overhead Costs
―No
25
Capital Rationing
• NPV>0 then accept, is based on unlimited capital
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You have $500,000 to spend
Project Investment NPV PI
• Project B, $200,000
• Project D, $250,000
• Project C, $50,000 (partial investment)
– Alternative:
NPV=3,200,000, 4 year EAC 1
3,200,000 = 1 -
life 0.12 (1 + 0.12 )4
• Which process is better?
EAC 1,053,550
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Biases
• Systematic deviation from the actual value
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Cognitive Bias
• When conscious beliefs do not reflect the
information
– Easy to recall/available information is used
– Adjustment and anchoring
– Representative
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Motivational Bias
• Statements do not reflect beliefs
– Dishonesty
– Greed
– Asymmetric Reward
– Brown-nosing
– Fear
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Managing Bias
• Recognize it!
• Keep going back to the economics
• Sensitivity analysis
• Information management
• Check and recheck assumptions
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