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Finance (FNCE 101)
Capital Budgeting (I)
Chapter 9, Part of Chapter 10.6

Professor WANG Rong

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Todays Agenda
Investment criteria:
Net Present Value
Payback Period
Internal Rate of Return (IRR)
Profitability Index (PI)
Comparing projects
Mutually Exclusive (one-time) Projects
Machines of Unequal Lives (EAC) part of
Ch10.6

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Net Present Value
NPV=PV(All Future CFs) Initial Investment




C = Cash Flow (positive or negative), C
0
is usually negative (initial
investment)
t = time period of the investment
r = discount rate, required rate of return, opportunity cost of capital

The NPV rule: Accept a project if NPV > 0.
NPV C
C
r
C
r
C
r
t
t
= +
+
+
+
+ +
+
0
1
1
2
2
1 1 1 ( ) ( )
...
( )
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Net Present Value
Example
You have the opportunity to purchase an office
building. You have a tenant lined up that will
generate $16,000 per year in cash flows for three
years. At the end of three years you anticipate selling
the building for $450,000. If the building is being
offered for sale at a price of $350,000, would you buy
the building? The discount rate is 7%.

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NPV Application - Mutually
Exclusive Projects
Mutually Exclusive Projects
You can only choose one.

Situation: sometimes the firm has several mutually
exclusive projects and all of them have positive NPV,
which one should the firm choose?

The NPV decision rule: choose the project with
highest (and positive) NPV.
(why?)
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Exercise - NPV
Example
Based on NPV, which of the following two
mutually exclusive projects should you choose?



assume 7% discount rate
300 300 300 700
350 350 350 800
3 2 1 0

Slower
Faster
NPV C C C C System
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Payback Period
A projects payback period is the number of years it
takes to repay the initial investment.
Example: What is the payback period of the following
projects?



The payback rule says only accept projects that
payback in the desired time frame.

Year: 0 1 2 3 4
Project A -500 100 200 200 140
Project B -500 100 200 500 140
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Example
The three project below are available. The
company accepts all projects with a 2 year or less
payback period. Show how this decision will
impact our decision.
Project C
0
C
1
C
2
C
3
Payback NPV@10%
A -2000 +1000 +1000 +10000
B -2000 +1000 +1000 0
C -2000 0 +2000 0
Exercise Payback Period
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Payback
What is wrong with the payback rule?
Ignore the time value of money
Ignore all cash flows after the cutoff date

Discounted-payback rule
Discount all future cash flows
Determine how long it takes for the projects
cumulative discounted future cash flows to repay
the initial investment.

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Discounted Payback Period
What is the discounted payback period of the
following project if the cost of capital is 10%?


Year: 0 1 2 3 4
Project A -500 100 200 200 140
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Internal rate of return (IRR)
IRR is the discount rate that makes a projects NPV
equal to zero


How to interpret the IRR?

The IRR rule
Accept a project if its IRR is higher than its required
return (discount rate).

0
) 1 (
...
) 1 ( 1
at
2
2 1
0
=
+
+ +
+
+
+
+ =
T
T
IRR
C
IRR
C
IRR
C
C IRR NPV
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Exercise - Internal Rate of
Return
Example 1
What is the IRR on project A?




Year 0 1 2 3 4
A -200 80 80 80 80
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Advantages of IRR
Easy to understand and communicate

If the IRR is high enough, you may not need
to estimate a required return, which is often a
difficult task.
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Pitfalls of the IRR Non-
Conventional Cash Flows
Non-Conventional Cash Flows
Certain cash flows can generate NPV=0 at two
different discount rates.

Example
Suppose an investment will cost $90,000 initially and will
generate the following cash flows: 132,000 in one year,
100,000 in two years, and -150,000 in three years. The
required return is 15%. What is the IRR of the project?
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Pitfalls of the IRR Non-
Conventional Cash Flows
($10,000.00)
($8,000.00)
($6,000.00)
($4,000.00)
($2,000.00)
$0.00
$2,000.00
$4,000.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate
N
P
V
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Pitfalls of the IRR Non-
Conventional Cash Flows
When does a project have more than one IRR?

A rule of thumb
A project typically has more than one IRR, if its
cash flow stream changes sign more than once.

In the previous example, its cash flows are
-90K, 132K, 100K, -150K.

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Pitfalls of the IRR Mutually
Exclusive Projects
Period Project
A
Project
B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74
The required return
for both projects is
10%.

Which project
should you accept
and why?
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NPV Profiles
($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
$140.00
$160.00
0 0.05 0.1 0.15 0.2 0.25 0.3
Discount Rate
N
P
VA
B
IRR for A = 19.43%
IRR for B = 22.17%
Crossover Point = 11.8%
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Conflicts Between NPV and IRR
Whenever there is a conflict between NPV
and another decision rule, you should always
use NPV. Why?

IRR is unreliable in the following situations
Non-conventional cash flows
Mutually exclusive projects
Assume reinvestment rates = IRR
Reading: IRR - A Cautionary Tale
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Use financial calculators to
find NPV and IRR - 1
Example 1: Calculate the NPV and the IRR of the following
project. The discount rate is 10%.



Using the calculator:
CF; 2
nd
CLR Work;
CF
0
= -350,000; C01 = 16,000; F01 = 1; C02 = 16,000;
F02 = 1; C03 = 466,000; F03 = 1;
NPV; I = 10; CPT = ?
IRR CPT = ?


CF0 CF1 CF2 CF3
-350,000 16,000 16,000 466,000
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Use financial calculators to
find NPV and IRR - 2
Example 2: Calculate the NPV and the IRR of the following
project. The discount rate is 10%.



Using the calculator:
CF; 2
nd
CLR Work;
CF
0
= -50,000; C01 = 20,000; F01 = 2;C02=30,000;
F02=2
NPV; I = 10; CPT = ?
IRR CPT = ?
CF0 CF1 CF2 CF3 CF4
-50,000 20,000 20,000 30,000 30,000
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Again, in the exams
Always show the equations of calculating NPV
and IRR.

Its more important to understand the meaning
behind the formula than press the buttons!


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Profitability Index
Profitability index (PI)
= PV (All future cash flows) /initial investment
Example: Calculate the PI @10%





A profitability index of 1.1 implies that for every $1
of investment, we create an additional $0.10 in
value.
Project C0 C1 C2 PV(CFs) PI
A -10 +30 +5
B -5 +5 +20
C -5 +5 +15
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Profitability Index
Flashback: Managers maximize shareholder value
by undertaking all projects with + NPV
Capital Rationing Problem: When the capital is
limited, firms sometimes can not undertake all such
projects.
Solution:
Select the subset of projects that fits the
companys budget and have the highest total
NPV.
PI helps us to find those projects.

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Profitability Index
Example 1
Suppose that a firm is limited to invest $10 million today.
There are three projects available, all of which have a
10% opportunity cost of capital. Which project(s) should
the firm invest in? Cash Flows ($ millions)

Project C0 C1 C2 PV(CFs) NPV PI
A -10 +30 +5
B -5 +5 +20
C -5 +5 +15
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Profitability Index
Example 2
Suppose that a firm is limited to invest $50 million today.
Which project(s) should the firm invest in? Cash Flows
($ millions)

Project C0 NPV PI
A -30 2.3 1.08
B -12.5 2.2 1.18
C -50 4.7 1.09
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Profitability Index
Pitfalls of the PI may lead to wrong decision on
mutually exclusive projects.
Example:

Cash Flows, $
Project C
0
C
1
IRR NPV @
10%
Profitability
Index
A -10 20
B -20 35
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Mutually Exclusive Projects
Question: How to choose from mutually exclusive (one-
time) projects?
NPV rule
IRR rule
Payback period rule
Profitability Index

What should we do if four rules do not agree with
each other?
Solution: select the project with the largest NPV.
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How to Choose Machines with
Unequal Lives
Suppose you are trying to decide which printing
machine to buy for the SMU Student News Paper.
Machine 1 has an NPV of 110 and will last 4 years.
Machine 2 has an NPV of 157 and will last 7 years.
The 2 options have unequal lives. Therefore,
assume theyll be replaced indefinitely.
The appropriate discount rate is 12%.
Which machine should you buy?
Can you compare NPVs?
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How to Choose Machines with
Unequal Lives
To compare two projects that have unequal lives and
will be replaced indefinitely, we compute the
equivalent annual cash flows for the two alternatives
to make them comparable.

Equivalent Annual Cost (EAC):
The annualized NPV of a machine (project) that equal
to the cost of buying and operating a machine over the
machines economic life.
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Equivalent Annual Cost
KEY: To annualize NPV, you must determine the
annuity that gives you the equivalent NPV.

RECALL:



ANSWER: Find the cash flow CF
1
of the annuity.
( )
1
0
1
1
1
n
CF
PVA
r
r
(
=
(
+
(

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Equivalent Annual Cost
EAC of machine 1:



EAC of machine 2:



Which one should we choose?
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Steps to Compare Machines
with Unequal Lives
1. Get NPVs of each machine.

2. Calculate the annual cost of each machine by computing EAC.
Annuity whose NPV is the same as the NPV of the
machine.
Solve for the annuity payment CF
1
(which is your cost).

3. Compare the costs of the two. Take the one with lower cost.
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Exercise - The Replacement
Decision
Example:
You are operating an old machine that will last 2 more years.
It costs $12,000 per year to operate. You can replace it now
with a new machine, which costs $25,000 but is much more
efficient ($8,000 per year in operating costs) and will last for
5 years. Should you replace now or wait two more years?
The opportunity cost of capital is 6 percent.

Hint: Determine the EAC of the new machine.
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Capital Budgeting Techniques
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Homework Assignments
Problems are posted at eLearn.

Next Class
Capital budgeting (II)
Chapter 10 Project Cash Flows

No class next week Happy Chinese New
Year!

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