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CAPITAL
Should we
BUDGETING build this
plant?
Topic Overview
Project Types
Capital Budgeting Decision Criteria
Payback Period
Discounted Payback Period
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return
(MIRR)
Learning Objectives
Normal Project:
Cost (negative CF) followed by a series of
positive cash inflows. One change of
signs.
Non-normal Project:
Two or more changes of signs.
Most common: Cost (negative CF), then
string of positive CFs, then cost to close
project.
Nuclear power plant, strip mine.
Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
Value Additivity Principle
0 1 2 2.4 3
0 1 1.6 2 3
Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
Discounted Payback: Uses discounted
rather than raw CFs.
0 1 2 3
10%
CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs
Project L:
0 1 2 3
10%
-100.00 10 60 80
9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
Rationale for the NPV Method
0 1 2 3
IRR
Discount Rate
What’s Franchise L’s IRR?
0 1 2 3
IRR = ?
-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Use IRR function in excel
IRRL = 18.13%. IRRS = 23.56%.
Find IRR if CFs are constant:
0 1 2 3
IRR = ?
-100 40 40 40
IRR = 9.70%.
Rationale for the IRR Method
r (%)
IRR
Construct NPV Profiles
r NPVL NPVS
0 50 40
5 33 29
10 19 20
15 7 12
20 (4) 5
NPV ($) r NPVL NPVS
60
0 50 40
50 5 33 29
Crossover 10 19 20
40
Point = 8.7% 15 7 12
30 (4) 5
20
20 S
IRRS = 23.6%
10 L
0 Discount Rate (%)
0 5 10 15 20 23.6
-10
IRRL = 18.1%
Mutually Exclusive Projects
S IRRS
r 8.7 r %
IRRL
Determining NPV/IRR Conflict Range
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
Pavilion Project: NPV and IRR?
0 1 2
r = 10%
NPV = -386.78
IRR = ERROR. Why?
The IRR is incorrect because there
are 2 IRRs. Nonnormal CFs--two sign
changes. Here’s a picture:
IRR2 = 400%
450
0 r
100 400
IRR1 = 25%
-800
Logic of Multiple IRRs
0 1 2
-5 30 -30
FV (INFLOWS) PV (OUTFLOWS)
-5 0 5
30 33
-30 0 24.79338843
TV 33 NPV (INFLOWS) 29.79338843
MIRR 5.24%
Accept Project P?
0 1 2 3 4
Project S:
(100) 60 60
Project L:
(100) 33.5 33.5 33.5 33.5
S L
CF0 -100,000 -100,000
CF1 60,000 33,500
Nj 2 4
I 10 10
0 1 2 3 4
Franchise S:
(100) 60 60
(100) 60 60
(100) 60 (40) 60 60
NPV = $7,547.
Or, use NPVs:
0 1 2 3 4
4,132 4,132
3,415 10%
7,547
0 1 2 3 4
Franchise S:
(100) 60 60
(105) 60 60
(45)
NPVS = $3,415 < NPVL = $6,190.
Now choose L.
Consider another project with a 3-year
life. If terminated prior to Year 3, the
machinery will have positive salvage
value.
0 1 2 3
1. No termination (5) 2.1 2 1.75
2. Terminate 2 years (5) 2.1 4
3. Terminate 1 year (5) 5.2
Assuming a 10% cost of capital, what is
the project’s optimal, or economic life?
NPV(no) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
Conclusions
Annuity Factor
1
1 -
(1 + r)t
AF
r
Choosing the Optimal Capital Budget