This document provides an overview of capital budgeting techniques including NPV, IRR, MIRR, payback period, and profitability index. It discusses evaluating independent and mutually exclusive projects, dealing with normal and non-normal cash flows, and economic versus physical project life. Key points covered include using NPV profiles to evaluate projects, handling multiple IRRs, and putting projects on a common basis for comparison using techniques like replication chains.
The presentation slide is on stock valuation. We have tried to present the various techniques to stock valuation under which different methods are discussed with illustrations. Key concepts:
Zero Growth Model
Balance sheet Technique
Constant Growth Model
Two-stage growth Model
Feel Free to comment.
Understand the role that financial institutions play in managerial
finance. Contrast the functions of financial institutions and financial markets.
Describe the differences between the capital markets and the
money markets.Discuss business taxes and their importance in financial decisions.
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall.
time value of money
,
concept of time value of money
,
significance of time value of money
,
present value vs future value
,
solve for the present value
,
simple vs compound interest rate
,
nominal vs effective annual interest rates
,
future value of a lump sum
,
solve for the future value
,
present value of a lump sum
,
types of annuity
,
future value of an annuity
The presentation slide is on stock valuation. We have tried to present the various techniques to stock valuation under which different methods are discussed with illustrations. Key concepts:
Zero Growth Model
Balance sheet Technique
Constant Growth Model
Two-stage growth Model
Feel Free to comment.
Understand the role that financial institutions play in managerial
finance. Contrast the functions of financial institutions and financial markets.
Describe the differences between the capital markets and the
money markets.Discuss business taxes and their importance in financial decisions.
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall.
time value of money
,
concept of time value of money
,
significance of time value of money
,
present value vs future value
,
solve for the present value
,
simple vs compound interest rate
,
nominal vs effective annual interest rates
,
future value of a lump sum
,
solve for the future value
,
present value of a lump sum
,
types of annuity
,
future value of an annuity
ChapterTool KitChapter 10112018 The Basics of Capital BudgetingJinElias52
ChapterTool KitChapter 1011/20/18 The Basics of Capital Budgeting: Evaluating Cash Flows10-1 An Overview of Capital BudgetingCapital budgeting is the process of analyzing projects and deciding which ones to accept.10-2 The First Step in Project AnalysisThe capital budgeting process begins with estimating a project's expected cash flows. We explain this in the next chapter.The next step is to put the estimated cash flows and other inputs (primarily the project's cost of capital) on a time line, as shown below. The figure below also reports evaluation measures, which we explain in the next sections.Figure 10-1Cash Flows and Selected Evaluation Measures for Projects S and L (Millions of Dollars)Panel A: Inputs for Project Cash Flows and Cost of Capital, rINPUTS:r =10%Initial Cost and Expected Cash FlowsYear01234Project S−$10,000$5,300$4,300$1,874$1,500Project L−$10,000$1,600$2,364$2,469$8,400Panel B: Summary of Selected Evaluation MeasuresProject SProject LNet present value, NPV$804.38$1,000.57Internal rate of return, IRR14.7%13.5%Modified IRR, MIRR12.1%12.7%Profitability index, PI1.081.10Payback2.213.42Discounted payback3.213.83Note: Numbers in the figure are shown as rounded values for clarity in reporting. However unrounded values are used for all calculations.10-3 Net Present Value (NPV)To calculate the NPV, we find the present value of the individual cash flows and then sum those discounted cash flows. The sum is the value the project adds to or subtracts from shareholder wealth.Figure 10-2Finding the NPV for Projects S and L (Millions of Dollars)INPUTS:r =10%Initial Cost and Expected Cash FlowsYear01234Project S−$10,000$5,300$4,300$1,874$1,5004,818←← ↵ ↓ ↓ ↓3,554← ← ← ← ← ← ←← ↵ ↓ ↓1,408← ← ← ← ← ← ← ← ← ← ← ← ←← ↵ ↓1,025← ← ← ← ← ← ← ← ← ← ← ← ← ← ← ← ← ← ←← ↵NPVS = $804Long way:
Sum the PVs of the CFs to find NPVInitial Cost and Expected Cash FlowsYear01234Project L−$10,000$1,600$2,364$2,469$8,400NPVL = $1,001Short way: Use Excel's NPV function.
=NPV(B47,C59:F59)+B59Note: Numbers in the figure are shown as rounded values for clarity in reporting. However unrounded values are used for all calculations.10-4 Internal Rate of Return (IRR)The internal rate of return is defined as the discount rate that equates the present value of a project's cash inflows to its outflows. In other words, the internal rate of return is the interest rate that forces NPV to zero. The calculation for IRR can be tedious, but Excel provides an IRR function that merely requires you to access the function and enter the array of cash flows. The IRRs for Project S and L are shown below, along with the data entry for Project S.Figure 10-3Finding the IRR for Projects S and L (Millions of Dollars)INPUTS:Initial Cost and Expected Cash FlowsYear01234Project S−$10,000$5,300$4,300$1,874$1,5004,621.33←← ↵ ↓ ↓ ↓3,269.26← ← ← ← ← ← ...
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ch 11 Capital budgeting
1. Chapter 11
The Basics of Capital
B dgeting
1
Budgeting:
Evaluating Cash Flows
Topics
Overview and “vocabulary”Overview and vocabulary
Methods
NPV
IRR, MIRR
Profitability Index
2
Payback, discounted payback
Unequal lives
Economic life
2. What is capital budgeting?
Analysis of potential projectsAnalysis of potential projects.
Long-term decisions; involve large
expenditures.
Very important to firm’s future.
3
Steps in Capital Budgeting
Estimate cash flows (inflows &Estimate cash flows (inflows &
outflows).
Assess risk of cash flows.
Determine r = WACC for project.
Evaluate cash flows
4
Evaluate cash flows.
3. Independent versus Mutually
Exclusive Projects
Projects are: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
t f th th
5
acceptance of the other.
Cash Flows for Franchise L
and Franchise S
10 8060
0 1 2 3
10%L’s CFs:
-100.00
0 1 2 3
6
70 2050
10%S’s CFs:
-100.00
4. NPV: Sum of the PVs of all
cash flows.
n CF
Cost often is CF0 and is negative.
NPV =∑
n
t = 0
CFt
(1 + r)t
.
7
NPV =∑
n
t = 1
CFt
(1 + r)t
. - CF0 .
What’s Franchise L’s NPV?
10 8060
0 1 2 3
10%L’s CFs:
-100.00
9.09
8
49.59
60.11
18.79 = NPVL NPVS = $19.98.
5. Calculator Solution: Enter
values in CFLO register for L.
-100
10
60
CF0
CF1
CF2
9
80
10 NPV
CF3
I = 18.78 = NPVL
Rationale for the NPV Method
NPV = PV inflows – CostNPV = PV inflows – Cost
This is net gain in wealth, so accept
project if NPV > 0.
10
Choose between mutually exclusive
projects on basis of higher NPV. Adds
most value.
6. Using NPV method, which
franchise(s) should be accepted?
If Franchise S and L are mutuallyIf Franchise S and L are mutually
exclusive, accept S because NPVs >
NPVL .
If S & L are independent, accept both;
NPV > 0.
11
Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3
Cost Inflows
12
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.
7. NPV: Enter r, solve for NPV.
n CF
IRR: Enter NPV = 0 solve for IRR
= NPV∑
n
t = 0
CFt
(1 + r)t
.
13
IRR: Enter NPV 0, solve for IRR.
= 0∑
n
t = 0
CFt
(1 + IRR)t
.
What’s Franchise L’s IRR?
10 8060
0 1 2 3
IRR = ?
-100.00
PV2
PV1
14
PV3
0 = NPV Enter CFs in CFLO, then press
IRR: IRRL = 18.13%. IRRS =
23.56%.
8. Find IRR if CFs are constant:
40 4040
0 1 2 3
-100
3 -100 40 0
N I/YR PV PMT FV
INPUTS
15
Or, with CFLO, enter CFs and press
IRR = 9.70%.
9.70%
N I/YR PV PMT FV
OUTPUT
Rationale for the IRR Method
If IRR > WACC then the project’s rateIf IRR > WACC, then the project s rate
of return is greater than its cost-- some
return is left over to boost stockholders’
returns.
E l
16
Example:
WACC = 10%, IRR = 15%.
So this project adds extra return to
shareholders.
9. Decisions on Projects S and L
per IRR
If S and L are independent acceptIf S and L are independent, accept
both: IRRS > r and IRRL > r.
If S and L are mutually exclusive,
accept S because IRRS > IRRL .
17
accept S because IRRS > IRRL .
Construct NPV Profiles
Enter CFs in CFLO and find NPV andEnter CFs in CFLO and find NPVL and
NPVS at different discount rates:
r NPVL NPVS
0 50 40
18
5 33 29
10 19 20
15 7 12
20 (4) 5
10. NPV Profile
50 L
20
30
40
50
NPV($)
IRR 23 6%
Crossover
Point = 8.7%
S
L
19
-10
0
10
0 5 10 15 20 23.6
Discount rate r (%) IRRL = 18.1%
IRRS = 23.6%
NPV and IRR: No conflict for
independent projects.
r > IRR
and NPV < 0.
Reject.
NPV ($)
IRR > r
and NPV > 0
Accept.
20
r (%)
IRR
11. Mutually Exclusive Projects
NPV
L
r < 8.7: NPVL> NPVS , IRRS > IRRL
CONFLICT
r > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
21
8.7 %
IRRS
IRRL
S
To Find the Crossover Rate
Find cash flow differences between theFind cash flow differences between the
projects. See data at beginning of the case.
Enter these differences in CFLO register, then
press IRR. Crossover rate = 8.68%, rounded
to 8.7%.
Can subtract S from L or vice versa, but
22
easier to have first CF negative.
If profiles don’t cross, one project dominates
the other.
12. Two Reasons NPV Profiles
Cross
Size (scale) differences Smaller project freesSize (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.
Timing differences. Project with faster
payback provides more CF in early years for
23
payback provides more CF in early years for
reinvestment. If r is high, early CF especially
good, NPVS > NPVL.
Reinvestment Rate
Assumptions
NPV assumes reinvest at r (opportunityNPV assumes reinvest at r (opportunity
cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, r, is more
realistic, so NPV method is best. NPV
24
realistic, so NPV method is best. NPV
should be used to choose between
mutually exclusive projects.
13. Modified Internal Rate of
Return (MIRR)
MIRR is the discount rate whichMIRR is the discount rate which
causes the PV of a project’s terminal
value (TV) to equal the PV of costs.
TV is found by compounding inflows at
WACC.
25
Thus, MIRR assumes cash inflows are
reinvested at WACC.
MIRR for Franchise L: First,
find PV and TV (r = 10%)
10.0 80.060.0
0 1 2 3
10%
66.0
-100.0
10%
26
12.1
158.1
10%
TV inflows
-100.0
PV outflows
14. Second, find discount rate that
equates PV and TV
MIRR = 16.5%
158.1
0 1 2 3
-100.0
TV inflowsPV outflows
27
TV inflowsPV outflows
MIRRL = 16.5%
$100 = $158.1
(1+MIRRL)3
Why use MIRR versus IRR?
MIRR correctly assumes reinvestment atMIRR 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
28
p ,
than IRR.
15. Normal vs. Nonnormal Cash
Flows
Normal Cash Flow Project:Normal 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
29
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.
Inflow (+) or Outflow (-) in
Year
0 1 2 3 4 5 N NN0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
30
+ + + - - - N
- + + - + - NN
16. Pavilion Project: NPV and IRR?
5,000 -5,000
0 1 2
r = 10%
-800
Enter CFs in CFLO enter I = 10
31
Enter CFs in CFLO, enter I = 10.
NPV = -386.78
IRR = ERROR. Why?
Nonnormal CFs--two sign
changes, two IRRs.
NPV Profile
450
IRR2 = 400%
NPV
32
-800
0
400100
IRR1 = 25%
r
17. Logic of Multiple IRRs
At very low discount rates the PV ofAt very low discount rates, the PV of
CF2 is large & negative, so NPV < 0.
At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
I b t th di t t hit CF
33
In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
Result: 2 IRRs.
Finding Multiple IRRs with
Calculator
1. Enter CFs as before.
2. Enter a “guess” as to IRR by
storing the guess. Try 10%:
34
10 STO
IRR = 25% = lower IRR
(See next slide for upper IRR)
18. Finding Upper IRR with
Calculator
Now guess large IRR, say, 200:
200 STO
IRR = 400% = upper IRR
35
When there are nonnormal CFs and
more than one IRR, use MIRR:
0 1 2
-800,000 5,000,000 -5,000,000
PV tfl @ 10% 4 932 231 40
36
PV outflows @ 10% = -4,932,231.40.
TV inflows @ 10% = 5,500,000.00.
MIRR = 5.6%
19. Accept Project P?
NO Reject because MIRR = 5 6% < rNO. Reject because MIRR = 5.6% < r
= 10%.
Also, if MIRR < r, NPV will be negative:
NPV = -$386,777.
37
NPV $386,777.
Profitability Index
The profitability index (PI) is theThe profitability index (PI) is the
present value of future cash flows
divided by the initial cost.
It measures the “bang for the buck.”
38
21. What is the payback period?
The number of years required toThe number of years required to
recover a project’s cost,
or how long does it take to get the
business’s money back?
41
business s money back?
Payback for Franchise L
10 8060
0 1 2 3
-100CFt
Cumulative -100 -90 -30 500
2.4
42
=PaybackL 2 + 30/80 = 2.375 years
22. Payback for Franchise S
70 2050
0 1 2 3
-100CFt
1.6
43
Cumulative -100 -30 20 40
PaybackS 1 + 30/50 = 1.6 years
0
=
Strengths and Weaknesses of
Payback
Strengths:Strengths:
Provides an indication of a project’s risk
and liquidity.
Easy to calculate and understand.
Weaknesses:
44
Ignores the TVM.
Ignores CFs occurring after the payback
period.
23. Discounted Payback: Uses
discounted rather than raw CFs.
10 8060
0 1 2 3
CFt
PVCFt -100
-100
10%
9.09 49.59 60.11
45
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback 2 + 41.32/60.11 = 2.7 yrs=
Recover invest. + cap. costs in 2.7 yrs.
S and L are mutually exclusive
and will be repeated. r = 10%.
0 1 2 3 4
Project S:
(100) 60 60
46
(100)
Project L:
(100) 33.5 33.5 33.5 33.5
Note: CFs shown in $ Thousands
24. NPVL > NPVS. But is L better?
S LS L
CF0 -100 -100
CF1 60 33
NJ 2 4
47
NJ 2 4
I 10 10
NPV 4.132 6.190
Equivalent Annual Annuity
Approach (EAA)
Convert the PV into a stream of annuityConvert the PV into a stream of annuity
payments with the same PV.
S: N=2, I/YR=10, PV=-4.132, FV = 0.
Solve for PMT = EAAS = $2.38.
L: N=4, I/YR=10, PV=-6.190, FV = 0.
S l f PMT EAA $1 95
48
Solve for PMT = EAAL = $1.95.
S has higher EAA, so it is a better
project.
25. Put Projects on Common Basis
Note that Project S could be repeatedNote that Project S could be repeated
after 2 years to generate additional
profits.
Use replacement chain to put on
common life.
N t i l t l it
49
Note: equivalent annual annuity
analysis is alternative method, shown in
Tool Kit and Web Extension.
Replacement Chain Approach (000s).
Franchise S with Replication:
0 1 2 3 4
Franchise S:
(100) 60 60
(100) 60 60
50
NPV = $7,547.
(100) 60
(100)
(40)
60
60
60
60
26. Or, use NPVs:
0 1 2 3 4
4,132
3,415
7 547
4,132
10%
51
Compare to Franchise L NPV =
$6,190.
Compare to Franchise L NPV =
$6,190.
7,547
Suppose cost to repeat S in two
years rises to $105,000.
0 1 2 3 4
Franchise S:
(100) 60 60
(105) 60 60
52
NPVS = $3,415 < NPVL = $6,190.
Now choose L.
NPVS = $3,415 < NPVL = $6,190.
Now choose L.
(105)
(45)
60 60
27. Economic Life versus Physical
Life
Consider another project with a 3-yearConsider another project with a 3-year
life.
If terminated prior to Year 3, the
machinery will have positive salvage
value.
Sh ld l t f th f ll
53
Should you always operate for the full
physical life?
See next slide for cash flows.
Economic Life versus Physical
Life (Continued)
Year CF Salvage ValueYear CF Salvage Value
0 ($5000) $5000
1 2,100 3,100
54
2 2,000 2,000
3 1,750 0
28. CFs Under Each Alternative
(000s)
0 1 2 30 1 2 3
1. No termination (5) 2.1 2 1.75
2. Terminate 2 years (5) 2.1 4
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3. Terminate 1 year (5) 5.2
NPVs under Alternative Lives (Cost of
capital = 10%)
NPV(3) = $123NPV(3) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
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29. Conclusions
The project is acceptable only ifThe project is acceptable only if
operated for 2 years.
A project’s engineering life does not
always equal its economic life.
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Choosing the Optimal Capital
Budget
Finance theory says to accept allFinance theory says to accept all
positive NPV projects.
Two problems can occur when there is
not enough internally generated cash to
fund all positive NPV projects:
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p p j
An increasing marginal cost of capital.
Capital rationing
30. Increasing Marginal Cost of
Capital
Externally raised capital can have largeExternally raised capital can have large
flotation costs, which increase the cost
of capital.
Investors often perceive large capital
budgets as being risky, which drives up
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g g y, p
the cost of capital.
(More...)
If external funds will be raised then theIf 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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31. Capital Rationing
Capital rationing occurs when aCapital rationing occurs when a
company chooses not to fund all
positive NPV projects.
The company typically sets an upper
limit on the total amount of capital
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p
expenditures that it will make in the
upcoming year.
(More...)
Reason: Companies want to avoid theReason: Companies want to avoid the
direct costs (i.e., flotation costs) and
the indirect costs of issuing new capital.
Solution: Increase the cost of capital
by enough to reflect all of these costs,
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y g ,
and then accept all projects that still
have a positive NPV with the higher
cost of capital. (More...)
32. Reason: Companies don’t have enoughReason: Companies don t have enough
managerial, marketing, or engineering
staff to implement all positive NPV
projects.
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Solution: Use linear programming to
maximize NPV subject to not exceeding
the constraints on staffing. (More...)
Reason: Companies believe that the project’sReason: Companies believe that the project s
managers forecast unreasonably high cash
flow estimates, so companies “filter” out the
worst projects by limiting the total amount of
projects that can be accepted.
Solution: Implement a post-audit process
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Solution: Implement a post audit process
and tie the managers’ compensation to the
subsequent performance of the project.