361-CH11Concise.ppt

7/30/2019 361-CH11Concise.ppt

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11-1

CHAPTER 11 The Basics of Capital Budgeting

Should webuild this

plant?


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11-2

What is capital budgeting? Analysis of potential additions tofixed assets investment analysis.

Long-term decisions; involve largeexpenditures (see p. 359-360).

Very important to firms future (see

Airbus, Boeing p. 357-358).


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11-3

Steps to capital budgeting1. Estimate CFs (inflows & outflows).2. Assess riskiness of CFs.3. Determine the appropriate cost of capital

(%).4. Find NPV ($), IRR (%) and/or MIRR (%).5. Accept if NPV > 0 and/or IRR > WACC.


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What is the difference betweenindependent and mutually

exclusive projects?Independent projects if the cash flowsof one are unaffected by the acceptanceof the other more than one projectmay be accepted.Mutually exclusive projects if the cashflows of one project can be adverselyimpacted by the acceptance of the other

accept one or the other.


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An Example of MutuallyExclusive Projects

BRIDGE vs. BOAT to getproducts across a river.


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What is the difference between normal

and nonnormal cash flow streams?Normal cash flow stream Cost (negativeCF) followed by a series of positive cash

inflows. One change of signs.Nonnormal cash flow stream Two ormore changes of signs. Most common:Cost (negative CF), then string of positiveCFs, then cost to close project. Nuclearpower plant, strip mine, etc.


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Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN

- + + + + + N- + + + + - NN

- - - + + + N

- - - + + + N

- + + - + - NN


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Net Present Value (NPV)Sum of the PVs of all cash inflows andoutflows of a project:

N

0tt

t

)r1(CF

NPV


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Calculating payback

Payback L = 2 + / = 2.375 years

CF t -100 10 60 100

Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

Payback S = 1 + / = 1.6 years

CF t -100 70 100 20 Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50-30

Project S


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What is Project Ls NPV @ 10%? Year CF t PV of CFt

0 -100 -$100

1 10 9.092 60 49.593 80 60.11

NPVL = $18.79

NPVS = $19.98 @ 10%


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Solving for NPV:

Financial calculator solutionEnter CFs into the calculators CFjregister.

CF0 = -100CF1 = 10CF2 = 60CF

3= 80

Enter I/YR = 10, press NPV button toget NPV L = $18.78.


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Rationale for the NPV methodNPV = PV of inflows Cost= Net gain in wealth

If projects are independent, accept if theproject NPV > 0.If projects are mutually exclusive, acceptprojects with the highest positive NPV,those that add the most value.In this example, accept S if mutuallyexclusive (NPV s > NPV L), and accept both

if independent.


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Internal Rate of Return (IRR)IRR is the discount rate that forces PV of inflowsequal to cost, and the NPV = 0:

Solving for IRR with a financial calculator:Enter CFs in CFj register.Press IRR/YR ; IRR L = 18.13% and IRR S = 23.56%.

N

0tt

t

)IRR 1(CF 0


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How is a projects IRR similar

to a bonds YTM? They are the same thing.Think of a bond as a project. The

YTM on the bond would be the IRR of the bond project. EXAMPLE: Suppose a 10-year bond

with a 9% annual coupon and$1,000 par value sells for $1,134.20.Solve for IRR = YTM = 7.08%, theannual return for this project/bond.


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Bond YTM = IRR

-1134.20 CF j90 CF j9 N j1090 CF jIRR/YR = ? 7.08%

---------------------------------------------------

N I PV PMT FV10 ? (-1134.2) 90 1000

7.08%


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Rationale for the IRR methodIf IRR > WACC, the projects returnexceeds its costs and there is some returnleft over to boost stockholders returns.

If IRR > WACC, accept project.If IRR < WACC, reject project.

If projects are independent, accept bothprojects, as both IRR > WACC = 10%.If projects are mutually exclusive, accept S,because IRR s > IRR L.


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NPV Profiles A graphical representation of project NPVs atvarious different costs of capital.

WACC NPVL NPVS 0 $50 $405 33 29

10 19 2015 7 1220 (4) 5


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Drawing NPV profiles

-10

0

10

20

30

40

50

60

5 10 15 20 23.6

NPV($)

Discount Rate (%)

IRRL = 18.1%

IRRS = 23.6%

Crossover Point = 8.7%

SL

.

.

. ...

..

.. .


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Comparing the NPV and IRR methods

If projects are independent, the twomethods always lead to the same

accept/reject decisions.If projects are mutually exclusive

If WACC > crossover rate, the methodslead to the same decision and there is noconflict.If WACC < crossover rate, the methodslead to different accept/reject decisions.


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Reasons why NPV profiles cross

Size (scale) differences the smallerproject frees up funds at t = 0 for

investment. The higher the opportunitycost, the more valuable these funds, so ahigh WACC favors small projects.Timing differences the project with fasterpayback provides more CF in early yearsfor reinvestment. If WACC is high, early CFespecially good, NPV S > NPV L.


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Reinvestment rate assumptionsNPV method assumes CFs are reinvestedat the WACC.IRR method assumes CFs are reinvestedat IRR.

Assuming CFs are reinvested at theopportunity cost of capital is morerealistic, so NPV method is the best. NPV

method should be used to choosebetween mutually exclusive projects.Perhaps a hybrid of the IRR that assumescost of capital reinvestment is needed.


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Since managers prefer the IRR to the NPVmethod, is there a better IRR measure?

Yes, MIRR is the discount rate thatcauses the PV of a projects terminalvalue (TV) to equal the PV of costs. TVis found by compounding inflows atWACC.

MIRR assumes cash flows arereinvested at the WACC.


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Calculating MIRR

66.012.1

10%10%

-100.0 10.0 60.0 80.0

0 1 2 310%

PV outflows

-100.0 $100

MIRR = 16.5% 158.1

TV inflows

MIRRL = 16.5%

$158.1(1 + MIRR L)3

=


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Calculator Solution for MIRR

1. Solve for PV of future CFs, using thereinvestment rate to discount

(set CF 0 = 0)2. Solve for the FV of these CFs (usingreinvestment rate) = Terminal Value =

Future Value (FV)3. Use CF0 as PV, N = # years, Terminal Value as FV, solve for I/YR = MIRR


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Keystrokes for MIRR

CF j = 0, 10, 60, 80

I = 10%, solve for NPV = $118.78

PV = 118.78, n = 3, solve for FV = -158.10

PV = 100, solve for I/YR = 16.50% = MIRR


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Keystrokes for MIRR, p. 372

CF j = 0, 500, 400, 300, 100

I = 10%, solve for NPV = $1078.82

PV = 1078.82, n = 4, solve for FV = -1579.50

PV = 1000, solve for I/YR = 12.11% = MIRR


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Why use MIRR versus IRR?

MIRR assumes reinvestment at theopportunity cost = WACC. MIRR alsoavoids the multiple IRR problem.Managers like rate of returncomparisons, and MIRR is better for

this than IRR.


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What is the payback period?

The number of years required torecover a projects cost, or How longdoes it take to get our money back? Calculated by adding projects cashinflows to its cost until the cumulative

cash flow for the project turns positive.


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Calculating payback

Payback L = 2 + / = 2.375 years

CF t -100 10 60 100

Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

Payback S = 1 + / = 1.6 years

CF t -100 70 100 20 Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50-30

Project S


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Strengths and weaknesses of payback

StrengthsProvides an indication of a projects risk and liquidity.Easy to calculate and understand.

Weaknesses

Ignores the time value of money.Ignores CFs occurring after the payback period.


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Discounted payback period

Uses discounted cash flows rather thanraw CFs.

Disc Payback L = 2 + / = 2.7 years

CF t -100 10 60 80

Cumulative -100 -90.91 18.79

0 1 2 3

=

60.11

-41.32

PV of CF t -100 9.09 49.59

41.32 60.11

10%


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Project P has cash flows (in 000s): CF 0 =-$0.8 million, CF 1 = $5 million, and CF 2 =

-$5 million. Find Project Ps NPV and IRR.

Enter CFs into calculator CFLO register.

Enter I/YR = 10.NPV = -$386.78.IRR = ERROR Why?

-800 5,000 -5,000

0 1 2WACC = 10%


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Multiple IRRs

450

-800

0 400100

IRR2 = 400%

IRR1 = 25%

WACC

NPV


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Why are there multiple IRRs?

At very low discount rates, the PV of CF 2 islarge & negative, so NPV < 0.

At very high discount rates, the PV of bothCF1 and CF 2 are low, so CF 0 dominates andagain NPV < 0.In between, the discount rate hits CF 2 harder than CF 1, so NPV > 0.Result: 2 IRRs.


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When to use the MIRR insteadof the IRR? Accept Project P?

When there are nonnormal CFs andmore than one IRR, use MIRR.

PV of outflows @ 10% = -$4,932.2314.TV of inflows @ 10% = $5,500.MIRR = 5.6%.

Do not accept Project P.NPV = -$386.78 < 0.MIRR = 5.6% < WACC = 10%.

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361-CH11Concise.ppt