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11 - 1Chapter 11: Capital Budgeting: Decision Criterian Overview and “vocabulary”n Methods l Payback, discounted payback l NPV l IRR, MIRR l Profitability Indexn Unequal livesn Economic life
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11 - 2 What is capital budgeting?n Analysis of potential projects.n Long-term decisions; involve large expenditures.n Very important to firm’s future.
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11 - 3 Steps in Capital Budgetingn Estimate cash flows (inflows & outflows).n Assess risk of cash flows.n Determine r = WACC for project.n Evaluate cash flows.
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11 - 4 What is the difference between independent and mutually exclusive projects?Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.
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11 - 5 What is the payback period?The number of years required torecover a project’s cost,or how long does it take to get thebusiness’s money back?
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11 - 6 Payback for Franchise L (Long: Most CFs in out years) 0 1 2 2.4 3CFt -100 10 60 100 80Cumulative -100 -90 -30 0 50PaybackL = 2 + 30/80 = 2.375 years
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11 - 8Strengths of Payback:1. Provides an indication of a project’s risk and liquidity.2. Easy to calculate and understand.Weaknesses of Payback:1. Ignores the TVM.2. Ignores CFs occurring after the payback period.
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11 - 10NPV: Sum of the PVs of inflows and outflows. n CFt NPV = ∑ t . t =0 ( + r ) 1 Cost often is CF0 and is negative. n CFt NPV = ∑ t − CF0 . t =1 ( + r ) 1
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11 - 12 Calculator SolutionEnter in CFLO for L:-100 CF0 10 CF1 60 CF2 80 CF3 10 I NPV = 18.78 = NPVL
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11 - 13Rationale for the NPV MethodNPV = PV inflows - Cost = Net gain in wealth.Accept project if NPV > 0.Choose between mutuallyexclusive projects on basis ofhigher NPV. Adds most value.
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11 - 14Using NPV method, which franchise(s) should be accepted? n If Franchise S and L are mutually exclusive, accept S because NPVs > NPVL . n If S & L are independent, accept both; NPV > 0.
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11 - 15 Internal Rate of Return: IRR 0 1 2 3CF0 CF1 CF2 CF3Cost InflowsIRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.
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11 - 16NPV: Enter r, solve for NPV. n CFt ∑ (1 + r )t = NPV . t =0IRR: Enter NPV = 0, solve for IRR. n CFt ∑ t = 0. t = 0 (1 + IRR)
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11 - 18Find IRR if CFs are constant: 0 1 2 3 IRR = ?-100 40 40 40INPUTS 3 -100 40 0 N I/YR PV PMT FVOUTPUT 9.70%Or, with CFLO, enter CFs and pressIRR = 9.70%.
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11 - 19 Rationale for the IRR MethodIf IRR > WACC, then the project’srate of return is greater than itscost-- some return is left over toboost stockholders’ returns.Example: WACC = 10%, IRR = 15%. Profitable.
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11 - 20Decisions on Projects S and L per IRRn If S and L are independent, accept both. IRRs > r = 10%.n If S and L are mutually exclusive, accept S because IRRS > IRRL .
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11 - 21 Construct NPV ProfilesEnter CFs in CFLO and find NPVL andNPVS at different discount rates: r NPVL NPVS 0 50 40 5 33 29 10 19 20 15 7 12 20 (4) 5
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11 - 23NPV and IRR always lead to the sameaccept/reject decision for independentprojects:NPV ($) IRR > r r > IRR and NPV > 0 and NPV < 0. Accept. Reject. r (%) IRR
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11 - 24 Mutually Exclusive ProjectsNPV r < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT L r > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT S IRRS r 8.7 r % IRRL
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11 - 25 To Find the Crossover Rate1. Find cash flow differences between the projects. See data at beginning of the case.2. Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%.3. Can subtract S from L or vice versa, but better to have first CF negative.4. If profiles don’t cross, one project dominates the other.
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11 - 26 Two Reasons NPV Profiles Cross1. Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects.2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPVS > NPVL.
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11 - 27 Reinvestment Rate Assumptionsn NPV assumes reinvest at r (opportunity cost of capital).n IRR assumes reinvest at IRR.n Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
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11 - 28Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?Yes, MIRR is the discount rate whichcauses the PV of a project’s terminalvalue (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.Thus, MIRR assumes cash inflows arereinvested at WACC.
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11 - 30To find TV with 10B, enter in CFLO:CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80I = 10NPV = 118.78 = PV of inflows.Enter PV = -118.78, N = 3, I = 10, PMT = 0.Press FV = 158.10 = FV of inflows.Enter FV = 158.10, PV = -100, PMT = 0,N = 3.Press I = 16.50% = MIRR.
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11 - 31 Why use MIRR versus IRR?MIRR correctly assumes reinvestmentat opportunity cost = WACC. MIRRalso avoids the problem of multipleIRRs.Managers like rate of returncomparisons, and MIRR is better forthis than IRR.
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11 - 32Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs.Nonnormal Cash Flow 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.
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11 - 36 Logic of Multiple IRRs1. At very low discount rates, the PV of CF2 is large & negative, so NPV < 0.2. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0.3. In between, the discount rate hits CF2 harder than CF1, so NPV > 0.4. Result: 2 IRRs.
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11 - 37Could find IRR with calculator:1. Enter CFs as before.2. Enter a “guess” as to IRR by storing the guess. Try 10%: 10 STO IRR = 25% = lower IRR Now guess large IRR, say, 200: 200 STO IRR = 400% = upper IRR
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11 - 38 When there are nonnormal CFs and more than one IRR, use MIRR: 0 1 2-800,000 5,000,000 -5,000,000 PV outflows @ 10% = -4,932,231.40. TV inflows @ 10% = 5,500,000.00. MIRR = 5.6%
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11 - 39 Accept Project P?NO. Reject because MIRR =5.6% < r = 10%.Also, if MIRR < r, NPV will benegative: NPV = -$386,777.
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11 - 40 S and L are mutually exclusive and will be repeated. r = 10%. Which is better? (000s) 0 1 2 3 4Project S:(100) 60 60Project L:(100) 33.5 33.5 33.5 33.5
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11 - 41 S LCF0 -100,000 -100,000CF1 60,000 33,500Nj 2 4I 10 10NPV 4,132 6,190NPVL > NPVS. But is L better?Can’t say yet. Need to performcommon life analysis.
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11 - 42n Note that Project S could be repeated after 2 years to generate additional profits.n Can use either replacement chain or equivalent annual annuity analysis to make decision.
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11 - 44 Or, use NPVs: 0 1 2 3 44,132 4,1323,415 10%7,547 Compare to Franchise L NPV = $6,190.
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11 - 45If the cost to repeat S in two years rises to $105,000, which is best? (000s) 0 1 2 3 4Franchise S:(100) 60 60 (105) 60 60 (45) NPVS = $3,415 < NPVL = $6,190. Now choose L.
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11 - 46Consider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage value. Year CF Salvage Value 0 ($5,000) $5,000 1 2,100 3,100 2 2,000 2,000 3 1,750 0
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11 - 47 CFs Under Each Alternative (000s) 0 1 2 31. No termination (5) 2.1 2 1.752. Terminate 2 years (5) 2.1 43. Terminate 1 year (5) 5.2
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11 - 48Assuming a 10% cost of capital, what isthe project’s optimal, or economic life? NPV(no) = -$123. NPV(2) = $215. NPV(1) = -$273.
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11 - 49 Conclusionsn The project is acceptable only if operated for 2 years.n A project’s engineering life does not always equal its economic life.
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11 - 50Choosing the Optimal Capital Budgetn Finance theory says to accept all positive NPV projects.n Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects: l An increasing marginal cost of capital. l Capital rationing
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11 - 51 Increasing Marginal Cost of Capitaln Externally raised capital can have large flotation costs, which increase the cost of capital.n Investors often perceive large capital budgets as being risky, which drives up the cost of capital. (More...)
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11 - 52n If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
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11 - 53 Capital Rationingn Capital rationing occurs when a company chooses not to fund all positive NPV projects.n The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year. (More...)
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11 - 54Reason: Companies want to avoid thedirect costs (i.e., flotation costs) andthe indirect costs of issuing newcapital.Solution: Increase the cost of capitalby enough to reflect all of these costs,and then accept all projects that stillhave a positive NPV with the highercost of capital. (More...)
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11 - 55Reason: Companies don’t haveenough managerial, marketing, orengineering staff to implement allpositive NPV projects.Solution: Use linear programming tomaximize NPV subject to notexceeding the constraints on staffing. (More...)
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11 - 56Reason: Companies believe that theproject’s managers forecastunreasonably high cash flow estimates,so companies “filter” out the worstprojects by limiting the total amount ofprojects that can be accepted.Solution: Implement a post-auditprocess and tie the managers’compensation to the subsequentperformance of the project.
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