Topics

 Methods
 Net Present Value
 Internal Rate of Return, Multiple internal
Rate of Return
 Profitability Index
 Payback, discounted payback
 Unequal lives
 Economic life
 Optimal capital budget
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 Calculation of Future Value &
Present Value
FV = P (1+r)n
FV =100(1.10)2 = 100 x 1.21 = 121
PV = FV / (1+r)n
PV = 121/(1.1)2 = 121/1.21 = 100

Investors are ultimately concerned with what they can buy.

Nomnal Rate 15.50%

Inflation Rate 5%

1) Present Value Rs. 100 2) Nominal Rate 15.50%

A product you can buy for Rs. 5 after one year 100 X 15.5% = 15.5 = 115.5
So you can buy 20 units now after one year the price 5 x 1.05 =5.25
20 Units to Buy (115.5/5.25) 22

2
 Real Rate
115.5/1.05 = 110

110 – 100 = 10 Inflation Adjusted

3
 Irving Fisher Formula

1+R = (1+r)(1+h)

1+15.5%= (1 +r)(1+0.05)

(1 + r) = 1.155/1.05 = 1.1

r = 0.1 or 10%
R=Nominal Rate
r=Real Rate
h=Inflation Rate
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 The Big Picture:
The Net Present Value of a Project

Project’s Cash Flows

(CFt)

CF1 CF2 CFN

NPV = + + ··· + − Initial cost
(1 + r )1 (1 + r)2 (1 + r)N

Market Project’s
interest rates debt/equity capacity
Project’s risk-adjusted
cost of capital
(r)
Market Project’s
risk aversion business risk
VALUE of ASSET TODAY

 Sum of Present Values of future Cash

Flows (CFs)

6
 Capital Budgeting

 Is to a company what buying stocks or

bonds is to individuals:
 An investment decision where each want a
return > cost.
 CFs are key for each.

7
 Cap. Budgeting & CFs
COMPANY INDIVIDUAL
 CFs  CFs

 generated by a project &  generated by stocks or

returned to company. bonds & returned to
individual > costs.

8
 Cap Budgeting
Evaluation Methods
 Payback
 Discounted Payback
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Modified Internal Rate of Return (MIRR)
 Profitability Index (PI)
 Equivalent Annual Annuity (EAA)
 Replacement Chain
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What is capital budgeting?
 Analysis of potential projects.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.

10
 Steps in Capital Budgeting
 Estimate cash flows (inflows & outflows).
 Assess risk of cash flows.
 Determine appropriate discount rate (r =
WACC) for project.
 Evaluate cash flows. (Find NPV or IRR
etc.).
 Make Accept/Reject Decision.

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Capital Budgeting Project
Categories
1. Replacement to continue profitable
operations
2. Replacement to reduce costs
3. Expansion of existing products or markets
4. Expansion into new products/markets
5. Contraction decisions
6. Safety and/or environmental projects
7. Mergers
8. Other
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Normal vs. Non-normal Cash
Flows
 Normal Cash Flow Project:
 Cost (negative CF) followed by a series of positive
cash inflows.
 One change of signs.
 Non-normal Cash Flow Project:
 Two or more changes of signs.
 Most common: Cost (negative CF), then string of
positive CFs, then cost to close project.
 For example, nuclear power plant or strip mine.

13
Inflow (+) or Outflow (-) in
Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN

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 Cash Flows for Franchises
L and S

0 1 2 3
L’s CFs: 10%

-100.00 10 60 80

0 1 2 3
S’s CFs: 10%

-100.00 70 50 20

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 Expected Net Cash Flows
Year Project L Project S
 0 <$100>  <$100>

 1 10  70
 2 60  50
 3 80  20

16
What is the payback period?
 The number of years required to
recover a project’s cost.

 OR how long does it take to get the

business’s money back?

17
 Payback for Franchise L

0 1 2 2.4 3

CFt -100 10 60 80
Cumulative -100 -90 -30 0 50

PaybackL = 2 + $30/$80 = 2.375 years

18
 Payback for Franchise S

0 1 1.6 2 3

CFt -100 70 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + $30/$50 = 1.6 years

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 Strengths and Weaknesses of
Payback
 Strengths:
 Provides an indication of a project’s risk and
liquidity.
 Easy to calculate and understand.
 Weaknesses:
 Ignores the Time Value of Money.
 Ignores CFs occurring after payback period.
 No specification of acceptable payback.
 CFs uniform??
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 Discounted Payback: Uses
Discounted 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

Recover investment + capital costs in 2.7 yrs.

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NPV: Sum of the PVs of All
Cash Flows
N CFt
NPV = Σ
(1 + r)t
t=0

Cost often is CF0 and is negative.

N CFt
NPV = Σ – CF0
(1 + r)t
t=1
22
 What’s Franchise L’s NPV?

0 1 2 3
L’s CFs: 10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
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 Rationale for the NPV Method
 NPV = PV inflows – Cost

 This is net gain in wealth, so accept project if

NPV > 0.

 Choose between mutually exclusive projects

on basis of higher positive NPV. Adds most
value.
 Risk Adjustment: higher risk, higher cost of
cap, lower NPV. 24
Using NPV method, which
franchise(s) should be accepted?

 If Franchises S and L are mutually

exclusive, accept S because NPVs
> NPVL.
 If S & L are independent, accept
both; NPV > 0.
 NPV is dependent on cost of capital.

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 Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = PV costs. Same
as i that creates NPV= 0.
::i.e., project’s breakeven interest rate.
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