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1. Estimate the cash flows. 2. Assess the riskiness of the cash flows. 3. Determine the appropriate discount rate. 4. Find the PV of the expected cash flows. 5. Accept the project if PV of inflows > costs.

**Capital Budgeting 1. Basic Data
**

Expected Net Cash Flow Year Project L Project S 0 ($100) ($100) 1 10 70 2 60 50 3 80 20

2. Evaluation Techniques A. Payback period B. Discounted payback period C. Net present value (NPV) D. Internal rate of return (IRR) E. Modified internal rate of return (MIRR)

Capital Budgeting . Basic Data Expected Net Cash Flow Year Project L Project S 0 ($100) ($100) 1 10 70 2 60 50 3 80 20 .Illustration I.

Ignores cash flows occurring after the payback period.Capital Budgeting Weakness of Payback: 1. This weakness is eliminated with the discounted payback method. . Ignores the time value of money. 2.

Capital Budgeting NPV = 7 Project L: 0 10% 1 -100.09 49.79 CFt t (1+k) 2 60 3 80 NPVS = $19.00 10 9.11 NPVL= 18. If the projects are mutually exclusive.98 If the projects are independent. accept both. accept Project S since NPVS > NPVL .59 60.

06 = $0 IRRL=18. accept Project S since IRRS > IRRL .47 43.02 48.Capital Budgeting IRR = Project L: CFt 7 (1+IRR)= t $0 = NPV 3 80 0 IRR 1 2 60 -100.00 10 8. If the projects are mutually exclusive.6% If the projects are independent.57 0. accept both because IRR>k.1% IRRS=23.

Project L: 0 10% 1 -100.10 100.00 = NPV PV outflows = $100 TV inflows =$158.10 $158.00 10 Capital Budgeting 2 60 3 80.00 12.00 MIRR = 16.10 (pvif) .5% $0.00 66.10 TVof inflows $100=158.

Net present value (NPV) D.Illustration II. Internal rate of return (IRR) E. Evaluation Techniques A. Payback period B.Capital Budgeting . Modified internal rate of return (MIRR) . Discounted payback period C.

Capital Budgeting .Payback Period Payback period = Expected number of years required to recover a project¶s cost. Project L Expected Net Cash Flow Year Annual Cumulative 0 ($100) ($100) 1 10 (90) 2 60 (30) 3 80 50 .

Capital Budgeting . Ignores cash flows occurring after the payback period. 2.4 years PaybackS= 1. Ignores the time value of money.6 years. This weakness is eliminated with the discounted payback period. .Payback Period PaybackL= 2 + $30 / $80 years = 2. Weaknesses of Payback: 1.

00 10 60 9.59 60.Capital Budgeting .79 n 3 80 .Net Present Value (NPV) CFt NPV = 7 Project L: t=0 (1+k)t 0 10% 1 2 -100.09 49.11 NPVL= $18.

32 15.03 NPVS= $19.Capital Budgeting .Net Present Value (NPV) CFt NPV = 7 Project S: t=0 (1+k)t 0 10% 1 2 -100.64 41.00 70 50 63.99 n 3 20 .

99 NPVL= $18. If the projects are mutually exclusive. Note: NPV declines as k increases and NPV rises as k decreases. accept both.Net Present Value (NPV) NPVS = $19.Capital Budgeting . .79 If the projects are independent. accept Project S since NPVS > NPVL.

Internal Rate of Return (IRR) n CFt = $0 = NPV IRR = 7 Project L: t=0 (1+IRR)t 0 IRR 1 2 3 -100.13% 43.13% 48.13% $ 0.00 18.01 } $0 .47 18.54 18.00 10 60 80 8.

00 .00 70 50 20 56.Internal Rate of Return (IRR) n CFt = $0 = NPV IRR = 7 t Project S: t=0 (1+IRR) 0 IRR 1 2 3 -100.56% $ 0.60 23.56% 32.56% 10.75 23.65 23.

accept Project S since IRRS > IRRL. accept both because IRR > k. If the projects are mutually exclusive.56% If the projects are independent.Internal Rate of Return (IRR) IRRL = 18.13% IRRS = 23. Note: IRR is independent of the cost of capital. .

Capital Budgeting .NPV Profiles k NPVL NPVS 0% $50 $40 5 33 29 10 19 20 15 7 12 20 (4) 5 .

00 MIRR=16.5% inflows $ 0.10 =TV of 100.00 12.00 66.Modified IRR (MIRR) Project L: 0 10% 1 -100 10 3 80.10 $158.00 = NPV 2 60 .

00 84.70 =TV of 100.00 MIRR=16.9% inflows $ 0.00 55.00 = NPV 2 50 .70 $159.Modified IRR (MIRR) Project S: 0 10% 1 -100 70 3 20.

3) MIRRL = 16.Modified IRR (MIRR) PV outflows = $100 TV inflows = $158.5% MIRRS = 16.10 $100 = $158.10 (PVIFMIRRL.9% .

00 63.03 $154.00 = NPV 2 60 .48% inflows $ 0.Modified IRR (MIRR) Project L: 0 5% 1 -100 10 3 80.00 MIRR=15.03 =TV of 100.00 11.

00 MIRR=14.39% inflows $ 0.50 77.Modified IRR (MIRR) Project S: 0 5% 1 -100 70 3 20.18 $149.00 = NPV 2 50 .68 =TV of 100.00 52.

MIRR correctly assumes reinvestment at project¶s cost of capital. 2. . MIRR avoids the problem of multiple IRRs.Modified IRR (MIRR) MIRR is better than IRR because: 1.

Do not accept. . IRR = 25% and 400%. NPV < 0.000) NPV @10% = -$386.777.NPV Profile: Nonnormal Project P with Multiple IRRs Year 0 1 2 Cash Flow (µ000) ($800) 5. Do not accept.000 (5.6%. MIRR < k. MIRR = 5.

Debt Equity % $120 $100 wacc=10% Bank $100 1 year IRR = 20% 20% A=20% wacc = 10% 0 100 IOS MCC $ IF IRR > WACC THEN ACCEPT PROJECT .

Debt Equity $110 $100 wacc=10% Bank $100 1 year IRR = 10% PV(CASH IN) = 100 = CASH OUTFLOW .

09 CF0= -100 i=10% CF1= 120 NPV = 9.09 PV(IN) = 100 PV(0UT) = 100 NPV =0 CF0= -100 i=10% CF1= 110 NPV = 0 .IN 120 1 YEAR WACC = 10% 100 OUT 100 OUT 1 YEAR WACC = 10% IN 110 PV(IN) = 109.09 PV(OUT) = 100 NPV = 9.

55 .55 CF0 = -100 CF1=105 i = 10% NPV = -4.45 PV(OUT) = 100 NPV = -4.10% IN 105 WACC = 10% 100 OUT IRR CF0 = -100 CF1 = 105 IRR = 5% NPV PV(IN) = 95.

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