The Basics of Capital

Budgeting

CHAPTER 10

10-1
 An Overview of Capital Budgeting

• Analysis of potential additions to fixed

assets.
• Long-term decisions; involve large
expenditures.
• Very important to firm’s future.

10-2
 An Overview of Capital Budgeting
• Replacement needed to continue profitable
operations.
• Replacement to reduce costs.
• Expansion of existing products or markets.
• Expansion into new products or markets.
• Contraction decisions.
• Safety and/or environmental projects.
• Others e.g., new office building etc.
• Mergers.
10-3
 Steps to capital budgeting

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital
based on project risk.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.

10-4
 Capital Budgeting Methods
The following procedures have been established
for screening projects and deciding which to
accept or reject
1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Modified Internal Rate of Return (MIRR)
4. Profitability Index (PI)
5. Regular Payback
6. Discounted Payback
10-5
 Different Types Of Projects
• Independent projects – A project whose
acceptance (or rejection) does not prevent the
acceptance of other projects under
consideration.
• Dependent (or contingent) projects - A
project whose acceptance depends on the
acceptance of one or more other projects.
• Mutually exclusive projects – A project
whose acceptance precludes the acceptance of
one or more alternative projects. 10-6
 Ranking Problems
• When two or more investment proposals are
mutually exclusive, ranking proposals on the
basis of the IRR, NPV, and PI methods may
give contradictory results due to:
 Scale of investment: Costs of projects differ.
 Cash flow pattern: Timing of cash flows
differs. For example, the cash flows of one
project increase over time whereas those of
another decrease.
 Project life: Projects have unequal useful
lives. 10-7
 Normal Vs. Non-normal Cash Flow Streams

• Normal cash flow stream – Cost (negative CF)

followed by a series of positive cash inflows.
One change of signs.
• Non-normal cash flow stream – Two or more
changes of signs. Most common: Cost (negative
CF), then string of positive CFs, then cost to
closed project. Nuclear power plant, strip mine,
etc.
10-8
 Net Present Value (NPV)

  

• Sum of the PVs of all cash inflows and

outflows of a project.
• NPV = - $10,000 + + + + = $804.38
million
 Rationale for the NPV method

NPV = PV of inflows – Cost

= Net gain in wealth
• If projects are independent, accept if the
project NPV > 0.
• If projects are mutually exclusive, accept
projects with the highest positive NPV,
those that add the most value.

10-10
 Internal Rate of Return (IRR)
• IRR is the discount rate for which PV of
cash inflows equal to project cost, and the
NPV = 0:

• Project IRR is similar to YTM for Bonds!

• Solving for IRR with Excel.

 Rationale for the IRR method

• If IRR > WACC, the project’s rate of

return is greater than its costs.

• There is some return left over to boost

stockholders’ returns.

10-12
 IRR Acceptance Criteria

• If IRR > r, accept project.

• If IRR < r, reject project.
• If projects are independent, accept projects,
for which IRR > r.
• If projects are mutually exclusive, accept the
project with highest IRR.

10-13
 NPV Profiles

A graphical representation of project

NPVs at various different costs of
capital.

10-14
 Multiple IRRs

NPV NPV Profile

IRR2 = 400%
450
0 r
100 400

IRR1 = 25%
-800

10-15
 Crossover Conflict
 CONFLICT: If WACC is to LEFT of
crossover rate,
NPVL > NPVS, but IRRs > IRRL.
NPV 60  NO CONFLICT: If WACC is to RIGHT of
($)
50 .L the crossover rate.
40 .
S . Crossover Point = 9.5%
30 .
20 . IRRL = 18.1%

.. IRRS = 23.6%
10
. .
0 . Cost of Capital (%)
5 10 15 20 23.6
-10
10-16
 Reasons why NPV profiles cross

• Size (scale) differences – the smaller project frees

up funds earlier for investment. The higher the
opportunity cost, the more valuable these funds, so
high r favors small projects.
• Timing differences – the project with faster
payback provides more CF in early years for
reinvestment. If “r” is high, early CF is especially
good.

10-17
 Reinvestment rate assumptions

• NPV method assumes CFs are reinvested at

r, the opportunity cost of capital.
• IRR method assumes CFs are reinvested at
IRR.
• Assuming CFs are reinvested at the
opportunity cost of capital is more realistic,
so NPV method is the best. NPV method
should be used to choose between mutually
exclusive projects.

10-18
 Modified Internal Rate Of Return (MIRR)

• IRR is based on the assumption that projects’ cash

flows can be reinvested at the IRR. This assumption
is usually wrong.
• The IRR overstates the expected return for the
accepted projects as the cash flows cannot generally
be reinvested at IRR.
• The Modified Internal Rate (MIRR) is similar to
regular IRR, except it is based on the assumption that
cash flows are reinvested at WACC (or some more
reasonable rate).
10-19
 Calculating MIRR
0 1 2 3 4
WACC = 10%

-$10,000 $5,300 $4,300 $1,874 $1,500

$2,061
$5,203
$7,054
MIRR = 12.15%
- $10,000 $15,819

$15,819 TV inflows =
PV outflows $10,000 = FV of CFs @ WACC
(1 + MIRR)4

MIRR = 12.15%
10-20
 Why use MIRR instead of IRR?

• MIRR correctly assumes reinvestment at

opportunity cost = WACC. MIRR also avoids the
problem of multiple IRRs.
• Managers like rate of return comparisons, and
MIRR is better for this than IRR.

10-21
 Profitability Index (PI)

• Primarily used for ranking projects / capital

rationing.
• NPV, IRR, MIRR, and PI methods will always lead
to the same accept/ reject decisions for normal,
independent projects.
• However, these methods can give conflicting
rankings for mutually exclusive projects, if the
projects differ in size or in the timing of cash flows.
10-22
 Payback / Discounted payback period

• The number of years required to recover

cost of project, or “How long does it take to
get your money back?”
• Calculated by adding project’s cash inflows
(or discounted cash flows) to its cost until
the cumulative cash flow for the project
turns positive.
10-23
 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 the payback
period.
10-24
 List of problems

10-8 to 10-13
(leftover is assignment)

10-25