# CHAPTER 10

The Basics of Capital Budgeting
Should we build this plant?

10-1

What is capital budgeting?   

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

10-2

Steps to capital budgeting
1. 2. 3. 4. 5.

Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC.

10-3

What is the difference between independent and mutually exclusive projects?   Independent projects if the cash flows of one are unaffected by the acceptance of the other. 10-4 . Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other.

One change of signs. Nonnormal cash flow stream Two or more changes of signs. 10-5 . etc. Most common: Cost (negative CF). Nuclear power plant. then string of positive CFs. then cost to close project. strip mine.What is the difference between normal and nonnormal cash flow streams?   Normal cash flow stream Cost (negative CF) followed by a series of positive cash inflows.

What is the payback period?   The number of years required to recover a project s cost. or How long does it take to get our money back? Calculated by adding project s cash inflows to its cost until the cumulative cash flow for the project turns positive. 10-6 .

6 years 10-7 .6 100 0 2 50 20 = 2.4 100 0 3 80 50 = 2 = 0 -100 -100 + 1 30 / 80 1.Calculating payback Project L CFt Cumulative PaybackL Project S CFt Cumulative PaybackS 0 -100 -100 1 10 -90 2 60 -30 2.375 years 3 20 40 70 -30 = = 1 + 30 / 50 = 1.

Easy to calculate and understand. Ignores the time value of money. 10-8  Weaknesses   . Ignores CFs occurring after the payback period.Strengths and weaknesses of payback  Strengths   Provides an indication of a project s risk and liquidity.

7 years 10-9 CFt PV of CFt Cumulative -100 -100 -100 2 + Disc PaybackL = = 41.11 .59 -41.32 / 60.91 2 60 49.7 3 80 60.79 = 2. 0 10% 1 10 9.32 2.09 -90.Discounted payback period  ses discounted cash flows rather than raw CFs.11 18.

Net Present Value (NPV)  Sum of the PVs of all cash inflows and outflows of a project: CFt NPV ! § t t !0 ( 1  k ) n 10-10 .

What is Project L s NPV? Year 0 1 2 3 CFt -100 10 60 80 NPVL = PV of CFt -\$100 9.98 10-11 .59 60.79 NPVS = \$19.09 49.11 \$18.

press NPV button to get NPVL = \$18. 10-12 .     CF0 CF1 CF2 CF3 = = = = -100 10 60 80  Enter I/YR = 10.Solving for NPV: Financial calculator solution  Enter CFs into the calculator s CFLO register.78.

accept if the project NPV > 0. and would accept both if independent. those that add the most value. 10-13 NPV    . If projects are mutually exclusive.Rationale for the NPV method = PV of inflows Cost = Net gain in wealth If projects are independent. In this example. would accept S if mutually exclusive (NPVs > NPVL). accept projects with the highest positive NPV.

and the NPV = 0: CFt 0!§ t t !0 ( 1  IRR )  n Solving for IRR with a financial calculator:   Enter CFs in CFLO register. Press IRR.13% and IRRS = 23. IRRL = 18.Internal Rate of Return (IRR)  IRR is the discount rate that forces PV of inflows equal to cost. 10-14 .56%.

08%. the annual return for this project/bond.How is a project s IRR similar to a bond s YTM?    They are the same thing. 10-15 .  Solve for IRR = YTM = 7. The YTM on the bond would be the IRR of the bond project. EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for \$1.20.134. Think of a bond as a project.

There is some return left over to boost stockholders returns.Rationale for the IRR method  If IRR > WACC. 10-16 . the project s rate of return is greater than its costs.

IRR Acceptance Criteria   If IRR > k. 10-17   . accept S. If projects are mutually exclusive. accept project. because IRRs > IRRL. reject project. If IRR < k. If projects are independent. as both IRR > k = 10%. accept both projects.

k 0 5 10 15 20 NPVL \$50 33 19 7 (4) NPVS \$40 29 20 12 5 10-18 .NPV Profiles  A graphical representation of project NPVs at various different costs of capital.

30 20 10 0 .1% .7% . .Drawing NPV profiles NPV 60 (\$) 50 . 40 . .6% Discount Rate (%) 10-19 . Crossover Point = 8. . 15 S 5 -10 20 . . 23.6 IRRS = 23. L 10 IRRL = 18.

the two methods lead to different accept/reject decisions. the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive   If k > crossover point. 10-20 .Comparing the NPV and IRR methods   If projects are independent. If k < crossover point. the two methods lead to the same decision and there is no conflict.

Crossover rate = 8. 3. 4.Finding the crossover point 1.7%. Can subtract S from L or vice versa. 10-21 . then press IRR. Find cash flow differences between the projects for each year. Enter these differences in CFLO register. one project dominates the other. If profiles don t cross. 2. but better to have first CF negative.68%. rounded to 8.

10-22 . The higher the opportunity cost. so high k favors small projects. NPVS > NPVL. Timing differences the project with faster payback provides more CF in early years for reinvestment. If k is high. the more valuable these funds. early CF especially good.Reasons why NPV profiles cross   Size (scale) differences the smaller project frees up funds at t = 0 for investment.

Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed. the opportunity cost of capital. NPV method should be used to choose between mutually exclusive projects. IRR method assumes CFs are reinvested at IRR. 10-23 .Reinvestment rate assumptions     NPV method assumes CFs are reinvested at k. Assuming CFs are reinvested at the opportunity cost of capital is more realistic. so NPV method is the best.

MIRR assumes cash flows are reinvested at the WACC. 10-24 .Since managers prefer the IRR to the NPV method. MIRR is the discount rate that causes the PV of a project s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. is there a better IRR measure?   Yes.

0 66.5% 10-25 .0 12.0 10% 3 80.5% 2 60.0 10% MIRR = 16.1 TV inflows -100.Calculating MIRR 0 -100.1 (1 + MIRRL)3 MIRRL = 16.1 158.0 PV outflows \$100 = \$158.0 10% 1 10.

10-26 . Managers like rate of return comparisons. and MIRR is better for this than IRR.Why use MIRR versus IRR?   MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs.

Find Project P s NPV and IRR. Enter I/YR = 10.000     Enter CFs into calculator CFLO register. IRR = ERROR Why? 10-27 .000.Project P has cash flows (in 000s): CF0 = -\$800. CF1 = \$5.78.000. 0 -800 k = 10% 1 5.000 2 -5. NPV = -\$386. and CF2 = -\$5.

Multiple IRRs NPV NPV Profile IRR2 = 400% 450 0 -800 100 IRR1 = 25% 10-28 400 k .

so NPV > 0. In between. the PV of both CF1 and CF2 are low. At very high discount rates. so CF0 dominates and again NPV < 0. so NPV < 0. 10-29 . the PV of CF2 is large & negative. Result: 2 IRRs.Why are there multiple IRRs?     At very low discount rates. the discount rate hits CF2 harder than CF1.

Solving the multiple IRR problem  Using a calculator     Enter CFs as before. 10-30 . use the MIRR. Store a guess for the IRR (try 10%) 10 STO IRR = 25% (the lower IRR) Now guess a larger IRR (try 200%) 200 STO IRR = 400% (the higher IRR) When there are nonnormal CFs and more than one IRR.

MIRR = 5.78 < 0.6%.500.    PV of outflows @ 10% = -\$4.6% < k = 10%.   .2314.When to use the MIRR instead of the IRR? Accept Project P?  When there are nonnormal CFs and more than one IRR.932. NPV = -\$386. TV of inflows @ 10% = \$5. use MIRR. MIRR = 5. 10-31  Do not accept Project P.