Capital Budgeting

Analysis
Part A
Index

0. Introduction: Capital Budgeting and Business Strategy

1. Capital Investment Typology Part A
2. Cash-Flow Definition and Pro-Forma Statements of slides
3. Project Appraisal Methods
4. Impact of Debt on Capital Budgeting Analysis Part B
5. Risk Analysis in Capital Budgeting of slides

2
Capital Budgeting and
Business Valuation
0. Introduction: Capital Budgeting and
Business Strategy
1. Capital Investment Typoloy
2. Cash-Flow Definition and Building Pro-
Forma Statements
3. Project Appraisal Methods
0. Introduction

4
Introduction

•Capital Budgeting Analysis (CBA) is a fundamental tool by which investment

opportunities are screened so as to ensure that the acceptance of a particular project
will be
•a value-creating decision, or
•the best value-creating decision among a set of alternative, mutually exclusive investment
alternatives

•CBA also helps the redefinition or improvement of investments and business models so
as to make them more efficient at generating value

•Guidelines and rules are needed to ensure homogenous CBA practices among
different business units to ensure an overall unbiased capital allocation system

5
Introduction

6
Capital Budgeting and Business Strategy

•Capital Budgeting
Process:

7
Capital Budgeting and Business Strategy

•A Strategic plan (or “Master Plan”) is the grand design of the firm and clearly identifies
the business the firm is in and where it intends to position itself in the future.

•Strategic planning translates the firm’s corporate goal into specific policies and
directions, sets priorities, specifies the structural, strategic and tactical areas of business
development, and guides the planning process in the pursuit of solid objectives.

•A firm’s vision and mission is encapsulated in its strategic planning framework.

8
Capital Budgeting and Business Strategy

•There are feedback loops at different stages, and the feedback to ‘strategic planning’ at
the project evaluation and decision stages – indicated by upward arrows in the Figure
presented earlier – are critically important. This feedback may suggest changes to the
future direction of the firm which may cause changes to the firm’s strategic plan

•Importantly, the ability of an investment proponent to take into account the overall
Strategy of a Firm will not just

• help the firm to help achieve its long term goals, but also

•significantly increases the attractiveness of the proposed project in the eyes of the decision-
maker

9
Capital Budgeting and Business Strategy

10
2. Capital investment typology

Type \ < >

Size of Code X,000€ X,000€ Characteristics
project
Projects whose main objective is a significant
Expansion A A1 A2 increase in the level of activity (production and
sales)
Projects whose main objective is to significantly
alter production conditions or overhead costs with
Efficiency B B1 B2 the purpose of achieving greater economic
efficiency; includes projects aiming at the
protection of future income
Projects whose main purpose is not to increase
Replacement C C1 C2 overall profitability, but to replace productive or
other assets without significantly changing the
overall level of activity and cost efficiency
Projects that pursue objectives other than
increasing the level of activity, achieving costs
Other D D1 D2 efficiencies or the replacement of existing assets.
Includes those projects that are made in order to
comply with legal requirements

11
3. Cash-Flow Definition and Pro-Forma Statements

•Relevant Cash-Flows

•Period for Explicit Cash-Flows Forecasts

•Linking Free Cash-Flows to Pro-Forma Statements

12
Relevant Cash-Flows

“Earnings are a matter of opinion. Cash-Flow is a

matter of fact ”

13
Relevant Cash-Flows

14
Importance of Cash-Flows in Capital Budgeting

•Independence from accounting criteria

•Addresses concern of investors with actual financial flows

•inflows

•outflows

15
Importance of Cash-Flows in Capital Budgeting

16
Relevant Cash-Flows

•Consider only incremental cash-flows arising from the project

•avoid sunk costs (i.e, irreversible costs which do not depend on the acceptance /
rejection of the project)
•consider the opportunity cost (at the best available alternative usage) of assets or
other resources currently being used by the firm or Group (ex. Existing Land or
Buildings)

CFs with project = CFproj

Cash-Flow

} Project CF s= CFproj - CFnoproj

CFs w/o project = CFnoproj

Time 17
Relevant Cash-Flows

•Free Cash-Flows: may be interpreted as

•(1st interpretation) Cash generated by a project before strictly financial flows, such as:
•interest payments
•reimbursement of bank loans or equivalent debt
•dividend payments
•capital increases/repurchase of shares
•acquisition of assets unrelated to the business or of short term financial
investments

18
Relevant Cash-Flows

•Free Cash-Flows: may also be interpreted as

•(2nd interpretation, equivalent to the first one):

•Cash generated by an integrally equity funded project, as available to be returned
to shareholders

•(3rd interpretation, equivalent to the previous ones):

•Cash generated by a project as potentially available to compensate all the funding
of the project (equity as well as debt)

19
Relevant Cash-Flows

20
Free Cash-Flows (or FCFF-Free Cash Flows to Firm)

•Logic:

•determination of cash-flow available for all those who funded the project (by means of equity
or debt) and not only for shareholders

•calculation of total project value (value of equity+debt)

•total project value = value of project equity (+) value of project debt

21
Free Cash-Flow
Free Cash Flow :
+Earnings before tax and interest (EBIT)
-Taxes on EBIT
=Net Operational Earnings after Taxes
+ Depreciation
+ Other Costs that are not cash expenditure
= Gross Cash Flow
- Increase in Inventory
- Increase in Accounts Receivable
+ Increase in Accounts Payable (does not include short term loans)
- Investment in Fixed Assets
- Acquisition of other operating assets
= Free Cash Flow (sources)

22
Free Cash-Flow

Financing Flow:
+ Financial charges (net of financial income)
- tax savings from financial charges
- Increase in short term loans
- Increase in medium or long term Loans
- Equity share issues
+ Paid dividends
+ Repurchase of shares
+ Increase in available cash and in short term financial investments
+ Increase in assets unrelated to the business
= Free Cash-Flow (applications)

23
Free Cash-Flows

Corporate tax savings from interest paid

Current Dividends
Corporate and Stock
Assets Equity
Taxes Repurchases
+ Fixed (Shareholders)
Over EBIT Assets S
(State) - Current
€ Free € Liabilities
(except
Cash- Flow Debt) Debt
(Banks and
A equivalent)
D Interest and Debt repayments
(minus tax savings from interest)
24
Free Cash-Flow

25
Impact of inflation

•Real CF (at constant prices) versus nominal CF (current prices)

•real discount rate versus nominal
•Kn = nominal discount rate
•Ki = inflation rate
•Kr = real discount rate
(1+Kn) = (1+Ki ) (1 + Kr)
Kn = (1+ Ki) (1+Kr) -1
Kn = Ki + Kr + Kr . Ki

•Different inflation rates per category of costs and income

26
Impact of inflation

•Suppose you invest in an asset yielding 8% interest and that inflation next
year will be 6%
•Investment: 10.000
•Return: 10.800
•Nominal rate: 8%
•How much does the return represent in terms of purchasing power?
•10.800/1.06=10.188
•hence, the real gain is 10.188, corresponding to a 1.88% real rate
•Note that even when the nominal rate is known, the real rate generally is not.

27
Impact of inflation

•If the discount rate is nominal, cash-flows should be estimated in nominal terms
•The effects of inflation on sales and on costs may be different
•Depreciation is constant even under inflation (except where revaluation of assets
at the inflation rate is allowed)
•Practical rule
•Nominal Cash-flow ------> nominal rate
•Real Cash-flow -----> real rate

28
Impact of inflation

•Example:
•A company expects the following cash-flows in real terms:
•CF0: -100
•CF1: +35
•CF2: +50
•CF3: +30
•nominal cost of capital: 15%
•Inflation rate : 10%

Compute “NPV”, the sum of all cash-flows discounted at the cost of capital

29
Impact of inflation

•Solution
•Alternative 1: Restate cash-flows to nominal terms and discount at the nominal rate (15%)
Year 1: 35  11
. = 38.5
Year 2: 50  1.12 = 60.5
Year 3: 30  1.13 = 39.93
38.5 60.5 39.93
NPV = −100 + + + = 5.48
(1 + 15%) (1 + 15%) 2 (1 + 15%) 3

•Alternative 2: Restate the cost of capital to a real rate

1 + nominal rate
real rate = −1
1 + inflation rate
1 + 15%
real rate = − 1 = 4.(54)%
1 + 10%
35 50 30
NPV = −100 + + + = 5.48
(1 + 4.(54)%) (1 + 4.(54)%) 2
(1 + 4.(54)%) 3

30
Period for Explicit Cash-Flow Forecasts

•Unless particular circumstances apply:

•Expansion Projects (type A); generally at least 5 years, followed by either

•Perpetuity
•Residual book value of assets
•Both (ex. to analyse the maximum of the two)

•Efficiency and Replacement Projects (types B and C): generally about 5 years, followed
by residual value of liquidated assets at the end of the project

•Other Projects (type D): usually up to 3 years, but fully covering the initial investment
period

31
Building Pro-Forma Statements

Sales

Inventories
Operating Plan

Production and Supplies

Overhead and Other Costs

Cost of Goods Sold

Proforma Income Statement

Investment Plan
Capex Plan

Proforma Cash-Flow Proforma Balance

Financial Plan Financing Plan
Statement Sheet

32
Building Pro-Forma Statements

•Simple Example:

Data:

Year 0 1 2 3
EBIT 50 100 150
Depreciation 20 20 30
Corporate Taxes over EBIT 0 0 0
Receivables at year-end 100 120 130
Payables at year-end 50 70 70
Stocks at year-end 80 80 90
Capital Expenditures 500 100
100% Equity-Financing, k=10%

33
Building Pro-Forma Statements

Pro-Forma FCF

Year 0 1 2 3
EBIT after Taxes 50 100 150
Depreciation 20 20 30
Ch. in Receivables 100 20 10
Ch. in Payables 50 20 0
Ch. in Stocks 80 0 10
Capital Expenditures 500 0 100 0
FCF -500 -60 20 160
External Capital -500 -60 0 0
Ch. in Cash 0 0 20 160
FCF -500 -60 20 160

34
Building Pro-Forma Statements

Pro-Forma Balance Sheets

Year 0 1 2 3
Gross Fixed Assets 500 500 600 600
Accum. Depreciation 0 -20 -40 -70
Net Fixed Assets 500 480 560 530
Receivables 0 100 120 130
Stocks 0 80 80 90
Cash 0 0 20 180
Total Net Assets 500 660 780 930
External Capital 500 560 560 560
Undistributed profits 50 150
Net Profits 50 100 150
Payables 50 70 70
Total Equity+Liabilities 500 660 780 930

35
3. Project Appraisal Methods

•Pay-Back Period
•non-adjusted
•adjusted

•NPV-Net Present Value

•Profitability Index

•IRR-Internal Rate of Return

•non-adjusted
•adjusted

36
Pay-Back Period
•Number of periods needed to reimburse all the capital invested in a project
•Example
Year (t) Expected Cash-Flows Expected Cash-Flows
Project S Project L
0 -1000 -1000
1 500 100
2 400 300
3 300 400
4 100 600

Year (t) Accumulated Accumulated

Expected Cash-Flows Expected Cash-Flows
Project S Project L
0 -1000 -1000
1 -500 -900
2 -100 -600
3 200 -200
4 300 400

•Pay-Back (assuming linearity of Cash-Flows throughout each year)

•Project S: 2+100/300=2.33 years

•Project L: 3+200/600=3.33 years

37
Adjusted Pay-Back Period

•Takes into consideration the time value of money

•In other words,

•What is the number of periods needed to reimburse all the capital AND ensuring the
appropriate return to the providers of capital?

38
Adjusted Pay-Back Period

•Example
•Suppose that in the above example the cost of capital is 10%
Year (t) Expected Discounted Expected Discounted
Cash-Flows Cash-Flows
Project S Project L
0 -1000 -1000
1 455 91
2 331 248
3 225 301
4 68 410

Year (t) Accumulated Accumulated

Expected Discounted Expected Discounted
Cash-Flows Cash-Flows
Project S Project L
0 -1000 -1000
1 -545 -909
2 -214 -661
3 11 -360
4 79 50

•Adjusted Pay-Back Period

•Project S: 2+214/225=2.95 years
•Project L: 3+360/410=3.88 years

39
Problems with Pay-Back

• Non-adjusted Pay-Back does not consider the cost of capital

• Both Pay-Backs do not consider cash-flows after the reimbursement of the capital

• The Pay-Back may lead to the preference of short-run projects and the refusal of
more long-term ones (even if these are more profitable)

• Is a quick pay-back a desirable thing on its own?

40
Net Present Value

•Steps
• Discount all Free Cash-Flows of a project, including those that correspond to the initial
capital outflows and negative operating cash-flows
• Sum all the discounted Cash-Flows, which will give us the Net Present Value (NPV)
• If the NPV is positive (negative), then the project is acceptable (to be refused)
•Formally,

FCFt = Free Cash - Flow at period t (t = 0,1,.. n)

k t = Cost of capital at time t (t = 0,1,... n)
NPV = Net Present Value
n
FCFt
NPV = 
t =0 (1 + k t ) t

41
Meaning of NPV

•If a project is implement with an expected NPV of, say, 1500, this means that
• the project will enable the full reimbursement of the capital invested

• the project will ensure that all providers of capital get the minimum required rate of
return (considering a normal risk premium)

• the project will generate a rate of return for equity-holders in excess of the rate
they demand, which translated into a permanent increase in the present value of
their wealth by the amount of 1500 (the NPV)

• in other words, the project generates a surplus for shareholders, with a present
value of 1500.

• if the total capital that shareholders invested in the project has a present value of
3000, then this means that the expected market value of their investment is 4500
(=3000+1500) if they were the sell the project in the open market

42
NPV and the Value of a Firm

•Suppose an investment in the creation of a new firm 100% financed by Equity

•V0= Total Value of the firm at time 0 (100%Equity)
•k= Cost of Equity (required return by shareholders)
•NPV0=Net Present Value (at time 0)

n n
FCFt FCFt
NPV0 =  = FCF +  =
t = 0 (1 + k ) t =1 (1 + k )
t 0 t

= -Initial Investment + V0
Thus
V0 = Initial Investment + NPV

Note that NPV is the present value (PV) of expected cash-flows from time 0 to n,
whereas V, the value of the project (or firm), is the PV of expected cash-flows
from time 1 (not zero) to n
43
Example of NPV Computation

−1000 500 400 300 100

NPVS = 0
+ 1
+ 2
+ 3
+ =
11
. 11
. 11
. 11
. . 4
11
= −1000 + 454.55 + 330.58 + 225.39 + 68.3 = 78.82
Similarly,
NPVL = 49.18

•Expected Market Value of S (assuming 100% financed by equity holders):

•MV of S=1000+78.82=1078.82

•Expected Market Value of L (assuming 100% financed by equity holders):

•MV of L=1000+49.18=1049.18

44
How Many Periods?

•Answer:
•Depends on the type of project:

• If it is, for instance, a finite concession (like car parking or mobile phones), the
concession period should be utilised; same for investment in equipment with a limited
useful life

• if no finite period of useful life is anticipated, the number of years to use should be
such that a “cruise speed” is achieved (this may take 5, 10 or more years)

• A terminal value after the explicitly forecasted period could reflect

• a perpetuity of cash-flows
• a liquidation value of the business
• a residual accounting book value of assets
• a multiple of EBITDA (ex. 6 or 8) or book value of equity (ex. 0.5 or 1.5)
corresponding to “normal values” observed in the stock market for similar
projects

45
Profitability Index
•Measures the relation between the PV of positive cash-flows to the PV of all capital invested
in the project

CIFt = Cash - Inflows at time t

(i.e., positive Free Cash - Flows)
COFt = Cash - Outflows at time t
(i.e., negative Free Cash - Flows)
n
CIFt
t = 0 (1 + k )
t
PI = n
COFt
t = 0 (1 + k )
t

•Example
•Project S: PI=1078.82/1000=1.079
•Project L: PI=1.049

46
Internal Rate of Return (IRR)

•Measures the maximum rate of return to all providers of capital, assuming that
all cash-flows are reinvested at the same return yielded by the project
•Formally,
IRR → results from solving the following equation:
n
FCFt

t =0 (1 + IRR ) t
=0

•This may be interpreted as the required return on capital for which the project
would yield a zero NPV

•Example:
•Project S: IRR=14.5%
•Project L: IRR=11.8%

47
Problems with IRR

•Reinvestment rate assumption

•better to assume a reinvestment at a rate equal to the cost of capital

•Yields the same decision as the NPV rule for independent projects, but
•May yield the wrong decision if the projects are mutually exclusive (see following slides)
•Better to use the NPV rule in the presence of mutually exclusive projects

48
Problems with IRR

•Assumption about reinvestment rate of return:

•Note that from the IRR definition it follows that

-CF0 = CF 1 + CF 2 + . . .+ CF n
( 1 + IRR ) 1 ( 1 + IRR ) 2 ( 1 + IRR ) n

Multiplying both sides by ( 1 + IRR ) n , we have

-CF0 ( 1 + IRR ) n = CF 1 ( 1 + IRR ) n −1 + CF 2 ( 1 + IRR ) n − 2 + . . . + CF n −1 ( 1 + IRR ) 1 + CF n

49
Problems with IRR

•Therefore, saying that the capital invested in the project (CF0) is remunerated at
the IRR carries an implicit assumption that all the project’s cash flows will be
reinvested at the IRR itself!

•Would that be reasonable?

50
Problems with IRR

•Assumption about reinvestment rate in the NPV method:

-CF0 + NPV = CF1 + CF 2 + ...+ CF n

(1 + k ) 1 (1 + k ) 2 (1 + k ) n

Multiplying both sides by (1 + k ) n , we have:

-CF0 + NPV (1 + k ) n = CF1(1 + k ) n−1 + CF 2 (1 + k ) n−2 + ...+ CF n−1(1 + k ) 1 + CF n

51
Problems with IRR

•Therefore, in the NPV the implicit assumption is that cash flows are reinvested at
the cost of capital

•Which of the two assumptions (in the IRR or in the NPV method) is more realistic?

52
Problems with IRR

•How can the IRR cash-flow reinvestment problem be solved?

• Assume reinvestment at the cost of capital, leading to the so called adjusted IRR (Modified
Internal Rate of Return or MIRR)

•The adjusted IRR is the IRR arising from the comparison between:
• Investiment cash-flow (or the present value of negative cash-flows),
and
• The capitalization of operating cash-flows (or the positive cash flows) to
the project’s terminal year

53
Adjusted IRR - Example

•Modified (or Adjusted) IRR of S (MIRR):

•Investment Cash-flow : 1000
•Operating Cash-flows capitalized to the terminal year (year 4):

500 ( 1 + 10%) 3 + 400 ( 1 + 10%) 2 + 300 ( 1 + 10%) 1 + 100 = 1 ,579 .5

Therefore,
1000 ( 1 + MIRR) 4 = 1 ,579 .5

( 41 )
→ MIRR = 1579 .5 − 1 = 12 .10627%( < 14 .5% = simple IRR )
1000

54
Problems with IRR

•Multiple IRRs

•Note that the IRR results from solving a polynomial equation of degree n

CF1 CF2 CFn

− CF0 = + +...+
(1 + TIR) 1
(1 + TIR) 2
(1 + TIR) n

1 1
or, making x = , ou TIR = − 1
(1 + TIR ) x

CF0 = CF1 x + CF2 x 2 +...+ CFn x n

•... This should have at least one root but may have up to a maximum of n roots (or solutions)

55
Multiple IRRs

•Example
CF0 = −1.6
CF1 = 10
CF2 = −10
-1.6 10 −10
0 = + +
(1 + IRR ) 0
(1 + IRR ) 1
(1 + IRR ) 2
Solutions: IRR = 25% or 400%

•Note that using NPV (k=10%) there would be no ambiguity:

•NPV=-0.77

56
Multiple IRRs

•What to do if there is more than one solution to the IRR equation?

• Use MIRR!

•In the previous example:

Capitalized value of operating cash flows

10 (1 + 10%) − 10 = 1
1 (1)
MIRR= (
'
) 2 − 1 = − 20 .94%
1.6

57
Comparing NPV and IRR

•The two provide the same decision when dealing with one independent project

•IRR may lead to wrong decisions when dealing with mutually exclusive projects

58
Comparing NPV and IRR

NPV Curves

600
400
200
NPV

Project S
0
Project L
0,00
0,03
0,06
0,09
0,12
0,15
0,18
0,21
0,24
0,27
0,30
0,33
0,36
-200
-400
-600
Cost of Capital

59
Desirable features of an assessment criterion

•It should take into account all of the project’s cash flows

•It should take into account the time value of money

•When used to select one of two or more mutually exclusive projects, it should
select the one maximizing shareholder wealth

60
Comparing NPV and IRR

•Why might NPV curves intersect each other in the case of alternative projects?

•projects may have different sensitivities to the discount rate; this is in turn associated with

•differences in dimension (or scale) between projects

•differences in the time profile of cash-flows

61
Differences in Scale

•Mutually exclusive projects often differ in terms of scale

•Example
•Suppose there are two projects to exploit a mine which will operate just for 1 year
(assume it is a 1 year concession). The cost of capital is 10% for both projects and there
are two scale possibilities (regarding voth investment and operating net earnings):
•Hypothesis S (from “Small"), whose cash-flows (in thousand euros) are
•Year 0 = - 1000
•Year 1= 1280
•Hypothesis L (from “Large") whose cash-flows (in thousand euros) are
•Year 0 = - 5000
•Year 1 = 6000

62
Differences in Scale

•NPVS = -1000+ 1280/1.1. = 163.636

•NPVL = -5000+6000/1.1 = 454.545

•On the other hand,

•IRRS ---» -1000+1280/(1+IRRS) = 0 ---» IRRS = 28%

•IRRL ---» -5000+6000/(1+IRRL) = = ----» IRRL = 20%

•Therefore, NPVL  NPVS but IRRL<IRRS (there is a conflict between the two
decision criteria).

63
Differences in Scale

•How to solve the conflict between NPV and IRR?

•Assuming the cost of capital is constant (10%) and that an unlimited a

•mount of funds could be raised at that rate, then the answer would be to invest in
L, the project showing the higher NPV.

•Note that the differencial bewteen the two projects may be observed by
considering the "differencial project" (a so called project ). I.e., project L may be
broken into two, one being project S and the other, . Then:

(Thousand euros)
Project Cost NPV
L 5000 454.545
S 1000 163.636
 4000 290.909

64
Differences in Scale

•Funding availability being unlimited (and the cost of capital constant), then, since
project  shows a positive NPV, it should be accepted, which corresponds to
accepting L.

•Since the IRR criterion would select S to the detriment of L, we conclude the NPV
criterion is more correct.

65
Differences in Scale

NPV Curves

1500

1000

500 Project S
NPV

0 Project L
0,00
0,03
0,06
0,09
0,12
0,15
0,18
0,21
0,24
0,27
0,30
0,33
0,36
-500

-1000
Cost of Capital (%)

66
Differences in the Time Profile of Cash-Flows

•Conflicts between the IRR and the NPV may also occur due to differences in
the projects cash-flows, even when the investiment costs are exactly the same.
•Example:
•Suppose you have a forest project, where there are two hypotheses (identical 10% cost
of capital):
•Project ST (“Short-Term”) = cut all the forest wood within one year. Cash-flows will
be:
•Year 0= - 1000
•Year 1= 1280
•Project LT (“Long-Term”)= wait for 10 years before you cut all the wood. Cash-
flows will be:
•Year 0 = -1000
•Year 10 = 4046

67
Differences in the Time Profile of Cash-Flows

•NPVST = -1000+1280/1.1=163.636
•NPVLT= -1000+4046/1.1^10 = 559.908

•IRRST=28%
•IRRLT=15%

•Once more there is a conflict between the criteria, which can be illustrated by the
behaviour of the two projects’ NPV curves:

68
Differences in the Time Profile of Cash-Flows

NPV Curves

4000
3000
2000
Project ST
NPV

1000
Project LT
0
0,00
0,04

0,08
0,12
0,16
0,20
0,24

0,28
0,32
0,36
-1000
-2000
Cost of Capital (%)

69
Differences in the Time Profile of Cash-Flows

•We could follow a reasoning similar to the one developed regarding the
differences in scale of two projects.

•Note that project ST yields a cash-flow of 1280 at the end of year 1, whilst
project LT yields a cash-flow of 4046 at the end of year 10.

•If we accept ST, we shall have a cash-flow of 1280 in year 1. But if we accept
LT, we shall be giving up ST and its year 1 cash flow, which is no less than
investing in that year so as to obtain 4046 in year 10.

70
Differences in the Time Profile of Cash-Flows

•Therefore, in this case project  has a cost of 1280 in year 1 and a cash-flow of
4046 in year 10, generating a NPV of

•NPV  = -1280/1.1+4046/1.1^10=396.272

•If we accept ST, we sall be rejecting LT, in spite of its positive NPV. Since we
would then be giving up an increase in value of 396.772, we should instead accept
LT, against the conclusion of criterion IRR.

71
NPV Curves Intersection Point

•It can be seen as the IRR of the diferential project ()

•Example: in the case of projects S and L the diferential cash-flows are

•Year 0: -5000 - (-1000)=-4000
•Year 1: 6000 - (1280) = 4720

•Note that if k (the rate of return on reinvested cash-flows) is less than 18%, the
differential project is profitable; if k=18%, the differential project’s NPV is 0. If
k>18%, NPV<0, meaning that project P ought to be preferred.

4720
TIR → −4000 + =0
(1 + TIR )
TIR = 18%

72
Sensitivity of NPV to the Cost of Capital

•Remember that the NPV is given by

CF1 CF2 CF3 CFn

NPV = CF0 + + + +...+
(1 + k )1 (1 + k ) 2 (1 + k ) 3 (1 + k ) n

•Note that
• The denominators of the terms in the equation above increase with k and t
• The increase is exponential, i.e.
• the effect of a larger k is larger if t is large

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Sensitivity of NPV to the Cost of Capital

•Example:
•Present value of 100 due in 1 year, with k=5%: 95.24

•Present value of 100 due in 1 year, with k=10%: 90.91

•hence, the percent reduction of the present value of 100 when k goes from 5% to 10%
is -4.5%

•Present value of 100 due in 10 years, with k=5%: 61.39

•Present value of 100 due in 10 years, with k=10%: 38.55

•hence, the percent reduction of the present value of 100 when k goes from 5% to 10% is
-37.2%

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Sensitivity of NPV to the Cost of Capital

•Therefore, if most of a project’s cash-flows occur in its early years, it will be less
sensitive to changes in the discount rate

•And its NPV curve will show a not so steep slope (e.g. project ST)

•If, however, most of a project’s cash-flows occur in later years, it will be more
sensitive to changes in the discount rate

•And its NPV curve will show a steeper slope (e.g. project LT)

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Comparing NPV and PI

•Example of projects S and L

•According to NPV: choose L (NPV of 464.545 versus S’s NPV of 163.636)

•According to PI: project S is chosen (PI of 1.16=1163.636/1000 versus L’s PI of

1.09=5454.545/5000)

•How to opt between NPV’s and PI’s different conclusions?

•Again, only NPV garantees the maximization of shareholder wealth in the face of
alternative projects; therefore, L ought to be chosen.

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The problem of interest rates’ time structure

•The consideration of a single, constant discount rate was a simplification

•Normally different interest rates will be considered for different time periods

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The problem of interest rates’ time structure

•When in the presence of time-changing cost of capital, NPV becomes:

FCF1 FCF2 FCFn

NPV = FCF0 + + +...
(1 + k1 ) (1 + k1 )(1 + k 2 ) n

 (1 + k
j =1
j )

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The problem of interest rates’ time structure

•Implications for the IRR method:

• It is difficult to interpret the IRR in the context of different short and long term interest rates

• Compare IRR to what?

• The IRR is a single rate and corresponds to an average “internal”

return, to be compared with a cost of capital corresponding to a
complex average of future rates, varying per period

• ... It is much simpler to use the NPV method

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The problem of interest rates’ time structure

• Example:

Period 0 1 2 3 4
FCF -100 10 20 40 60
k 8% 12% 9% 6%
IRR 8,79%
geom.average of k : ((1+8%)(1+12%)(1+9%)(1+6%))^(1/4)-1= 8,73%
Period 0 1 2 3 4
FCF -100 10 20 40 60
Disc Factor 1 1,080 1,2096 1,318464 1,397572
Disc FCF -100,00 9,26 16,53 30,34 42,93
NPV -0,94
IRR > geom average of k, but NPV<0?

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The problem of interest rates’ time structure

• Example (cont.):

Calculation of an “average” cost of capital comparable to the IRR:

Period 0 1 2 3 4
FCF-NPV -99,06 10 20 40 60
Disc Factor 1 1,080 1,210 1,318 1,398
Disc FCF -99,06 9,26 16,53 30,34 42,93
NPV 0,00
“IRR" 9,12%
As “IRR“ = “average” CC = 9,12% > Project IRR, refuse
Hence, the geometrical average of k cannot be used to
compare to the IRR!!

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