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Original Title: Chapter 6 - Review of Capital Budgeting Techniques- Part 1

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Chapter 6 - Review of Capital Budgeting Techniques- Part 1

Chapter 6 - Review of Capital Budgeting Techniques- Part 1

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Prof. M. Hassanein

Techniques

I have drawn liberally

on chapter Six of

Richard A. Brealey &

Stewart C. Mayers.

Principles of Corporate Finance

9th edition,

Macgraw-Hill- Irwin, 2008.

Professor:

Medhat Hassanein

Than other criteria

Finc 4301

Prof. M. Hassanein

(Capital Budgeting Techniques)

equal-risk, mutually exclusive capital expenditure projects- M and N. The

relevant cash flows for each project are shown in the following table.

The firms cost of capital is 14%.

Project M Project N

$28,500

$27,000

Initial Investment

Year

1

2

3

4

CF(M)

10,000

10,000

10,000

10,000

CF(N)

11,000

10,000

9,000

8,000

a) Payback

b) Net Present Value (NPV)

c) Internal Rate of Return (IRR)

d) Discounted payback period

e) Profitability Index (PI)

f) Modified Internal Rate of Return (MIRR)

g) Select the appropriate project based on the above calculated

investment criteria.

Finc 4301

Prof. M. Hassanein

Payback Period:

Definition: is the amount of time required for the firm to recover its initial investment in a

project, as calculated from cash inflows.

Project M

= 2.85 years

Project N

27,000 21,000 = 6,000

6,000 / 9,000 = 0.67

Payback = 2.67 years

Decision: select the project N since it has a shorter payback period.

Definition:

NPV = Discounted cash flows (DCF) at the weighted average cost of

Capital minus initial investment.

NPV =

CF 1 +

(1+WACC)

NPV = - I +

CF n

n=1

(1+WACC)n

CF2

(1+WACC)2

1. Select the project with NPV > 0

Reject the project with NPV< 0

2. Rank projects according to higher NPV

NPV for project M:

DCF = 10,000 (PVIFA) .14, 4

= 10,000 (2.914)

= $ 29,140

NPV = $29,140 - 28,500

= $ 640

NPV by the financial calculator = $637.1

+.

CFn

(1+WACC)n

Finc 4301

Prof. M. Hassanein

DCF = 11,000 (PVIF)1, .14

7,690

6,075

4,736

$ 28,148

= $1,148

Decision: Select project N because NPVN = $1,148 is greater than NPVM = $640

Definition:

The IRR is the rate of discount which makes NPV = 0

i.e.

N

0 = -I +

CFn

n = 1 (1+IRR) n

IRR for Project M:

0 = -28,500 + 10,000 (PVIFA)4,?

28,500 = 10,000 (PVIFA)4,?

(PVIFA)4,? = 2.850

Use PV of annuity table to search for the rate corresponding to 2.850 and 4 years.

The rate is 15% which is the IRR.

Financial calculator is 15.1%

IRR for Project N:

Search by trial and error. Try 16% to find DCF

11,000 (PVIF) .16,1 = 11,000 (.862) = $9482

+ 10,000 (PVIF) .16,2 = 10,000 (.743) = 7430

+ 9,000 (PVIF) .16,3 = 9,000 (.641) = 5769

+ 8,000 (PVIF) .16,4 = 8,000 (.552) = 4416

DCF = $27,097

NPV = 27,097 27,000

= 97

Therefore the IRR 16 %

Financial calculator is 16.2 %

Decision: Choose project N since:

Finc 4301

Prof. M. Hassanein

IRRN = 16%

Discounted Payback:

Project M:

1- Discount project Ms cash flow at WACC

2- Find the number of years at which the accumulated discounted cash flow = initial

investment.

Year

1

2

3

4

DCF

10,000 (.877) = 8,770

10,000 (.769) = 7,690

10,000 (.675) = 6,750

10,000 (.592) = 5,920

ACC.DCF

8,770

16,460

23,210

29,130

5,290 / 5,920 = .9

Discounted payback for project M = 3.9 years

Project N:

Year

DCF

ACC.DCF

1

2

3

4

9,647

7,690

6,075

4,736

9,647

17,337

23,412

28,148

3,588 / 4,736 = .76

Discounted payback for project N = 3.76 years.

Decision: Select project N since it has shorter discounted payback period.

Finc 4301

Prof. M. Hassanein

PI = NPV / Initial investment

Project

M:

PI = 640 / 28,500

= 0.0224

= 2.24 %

Project

N:

PI = 1,148 / 27,000

= 0.0425

= 4.25 %

Decision rule: The higher the PI, the better is the project.

It means that a highest PI offers the highest NPV per dollar of initial investment.

Therefore, select project N, since PIN > PIM.

Capital Rationing:

Choosing capital investments when financial resources are limited.

The selection criteria is the Profitability Index

Example:

Suppose that a firm is limited to spending $10 million on investment projects. The firm has

three projects and it needs a method of selecting the package of projects that is within its

resources, yet gives the highest net present value.

The three projects are as follows:

Project

Initial investment

A

-10

B

-5

C

-5

Calculate PI for each project

Cash Flows

C1

C2

30

5

5

($ millions)

NPV at 10%

5

20

15

21

16

12

Project

Initial Investment

PI

Rank by PI

A

B

C

$ 10

5

5

2.1

3.2

2.4

Third

First

Second

Finc 4301

Prof. M. Hassanein

There are two propositions regarding the IRR criteria

Preposition one:

There is an important assumption behind the IRR selection or ranking criteria. This assumption

is that the generated cash flow from any selected or ranked project will be reinvested at the

project's IRR.

If the firm cannot reinvest the generated cash flow at the project's IRR, for example, it can only

at the WACC, therefore the project's IRR will not be the calculated IRR; it will certainly be

less than this IRR.

Example: Project N has an IRR = 16 %

Assume one of two assumptions:

1- The firm is able to reinvest the cash flow generated by this project at

16%

2- The firm is not able to reinvest the cash flow of project N at 16 %,

rather at WACC = 14 %

Find the IRR of each one of the two assumptions.

To find the IRR under the first assumption i.e.: the reinvestment rate is the calculated IRR

which is the 16 %, follow the following steps:

Step one:

Find the sum of the future value of the project's generated cash flow at the end of its economic

life (N) at the IRR.

Project N:

Year

1

Cash flow

$ 11,000

Fv of cash flow at 16 %

11,000 (FVIF) 3, .16 = 11,000 (1.561) = 17,171

10,000

9,000

8,000

= 8,000

Step two:

Find the rate of discount which equates the sum of the discounted future cash flow obtained

from step one with the initial investment of project N.

27,000

= 0.5Search in the present value table for the rate of discount

corresponding to the factor 0.550 at the 4 year row.

The rate is 16 %

7

Finc 4301

Prof. M. Hassanein

Find the IRR under the second assumption i.e.: the firm does not have investment opportunities

to reinvest the generated cash flow at the IRR = 16 %, rather it can reinvest this cash flow at

the WACC, which is its opportunity cost i.e.: 14 %

Step one:

Repeat the same step one as before, but the rate at which the generated cash flow will be

compounded is the WACC = 14 %

Years

Cash flow

$ 11,000

10,000

9,000

8,000

= 8,000

Step Two:

Repeat the same step two as before i.e. find the rate of discount which equates the sum of the

discounted future cash flow obtained from step one with the initial investment of the project.

27,000 = 47,562 (PVIF) 4,?

(PVIF) 4,? = 27,000 / 47,562

= 0.5677

The rate is 15%

Or by financial calculator = 15.2%

You can see that the internal rate of return of project N is not 16%, it is 15%. The reason is that

the firm reinvestment rate is not 16%, it is its WACC = 14%. This is a very reasonable

assumption, and it makes the NPV method more superior to the IRR. As you know NPV

discounts cash flows at WACC.

The 15% calculated by steps one and two under assumption (2) i.e. the reinvestment rate is the

WACC is called the Modified Internal Rate of Return (MIRR).

How do you calculate the MIRR?

Step one:

Find the sum of the future value of the project's generated cash flow at the end of its economic

life (N), using the weighted Average Cost of Capital (WACC) as the compounding rate.

Step two:

Then, the MIRR is the rate of discount which equates the sum of the discounted cash flow

obtained from step one with the initial investment of the project.

Finc 4301

Prof. M. Hassanein

Example:

MIRR for project M.

(FVA) 4, .14 = 10000 (FVIFA) 4, .14

= 10,000(4.921)

= $49,210

28,500 = 49,210 (PVIF)4,?

By the financial calculator: MIRR= 14.63% and not IRR= 15.1%

Decision rule: Select the project with the highest Modified IRR.

Therefore select project N since MIRRN = 15 % which is greater than

MIRRM = 14.63 %

Preposition two: (The Multiple IRR Paradox)

If the expected cash flows of a project double the change of the negative sign then it is more

than likely that the solution for IRR will result in multiple of IRRs.

Example: Suppose that the cash flow of a Mining Project is as follows:

NCF ($)

0

-1,000

1

800

2

150

3

150

4

150

5

150

6

-150

Then

NPV = $ 74.87

If we calculate IRR by using certain type of financial calculator, you will find that this cash

flow has two IRRs. One IRR = 15.2 %, and the second IRR = -50 %.

The IRR fails in this case as a method of project selection or ranking.

However, you can find the MIRR for this project as follows:

MIRR

PV = -150 (PVIF)6, .10

= -150 (.564)

= -84.6

Add to initial investment

-1000 84.6 = $ -1084.6

FV of cash flow

800 (FVIF)5,.10 = 800 (1.611) = 1,288.8

+ 150 (FVIFA)4,.10 (FVIF)1,.10

= 765.8

Finc 4301

Prof. M. Hassanein

= $ 2,054.6

1084.6 = 2,054.6 (PVIF)6,?

(PVIF)6,? = 1084.6 / 2,054.6

= .5279

MIRR 11 %

Financial calculator

11.23 %

OR

FV of cash flow at 10%

2054.6

- 150.0

1904.6

PV = 1000

1000 = 1904.6 (PVIF) 6,?

MIRR= 11.34%

10

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