The document discusses various capital budgeting techniques for evaluating investment projects, including payback period, net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and profitability index. It provides examples of calculating these metrics for projects and outlines the appropriate methods for analyzing independent vs. mutually exclusive projects. It also discusses how to handle non-normal cash flows and determine the economic life of a project.
This slide set is a work in progress and is embedded in my Principles of Finance course that I teach to computer scientists and engineers.
http://awesome.weebly.com/
Chapter 5, Problem 12 with Solution. From Essentials of Investments by Bodie, Kane and Marcus, 8th edition. Sharpe Ratios, return and standard deviaion, CAL line.
This slide set is a work in progress and is embedded in my Principles of Finance course that I teach to computer scientists and engineers.
http://awesome.weebly.com/
Chapter 5, Problem 12 with Solution. From Essentials of Investments by Bodie, Kane and Marcus, 8th edition. Sharpe Ratios, return and standard deviaion, CAL line.
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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1. 10 - 1
Chapter 10:
The Basics of Capital Budgeting:
Evaluating Cash Flows
Overview and “vocabulary”
Methods
Payback, discounted payback
NPV
IRR, MIRR
Profitability Index
Unequal lives
Economic life
2. 10 - 2
What is capital budgeting?
Analysis of potential projects.
Long-term decisions; involve large
expenditures.
Very important to firm’s future.
3. 10 - 3
Steps in Capital Budgeting
Estimate cash flows (inflows &
outflows).
Assess risk of cash flows.
Determine r = WACC for project.
Evaluate cash flows.
4. 10 - 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.
5. 10 - 5
What is the payback period?
The number of years required to
recover a project’s cost,
or how long does it take to get the
business’s money back?
6. 10 - 6
Payback for Franchise L
(Long: Most CFs in out years)
10 8060
0 1 2 3
-100
=
CFt
Cumulative -100 -90 -30 50
PaybackL 2 + 30/80 = 2.375 years
0
100
2.4
8. 10 - 8
Strengths 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.
10. 10 - 10
( )
.
10
t
t
n
t r
CF
NPV
+
= ∑=
NPV: Sum of the PVs of inflows and
outflows.
Cost often is CF0 and is negative.
( )
.
1
0
1
CF
r
CF
NPV t
t
n
t
−
+
= ∑=
12. 10 - 12
Calculator Solution
Enter in CFLO for L:
-100
10
60
80
10
CF0
CF1
NPV
CF2
CF3
I = 18.78 = NPVL
13. 10 - 13
Rationale for the NPV Method
NPV = PV inflows - Cost
= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually
exclusive projects on basis of
higher NPV. Adds most value.
14. 10 - 14
Using NPV method, which franchise(s)
should be accepted?
If Franchise S and L are
mutually exclusive, accept S
because NPVs > NPVL .
If S & L are independent,
accept both; NPV > 0.
15. 10 - 15
Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3
Cost Inflows
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.
16. 10 - 16
( )
.
10
NPV
r
CF
t
t
n
t
=
+
∑=
( )t
n
t
t
CF
IRR=
∑
+
=
0 1
0.
NPV: Enter r, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
18. 10 - 18
40 4040
0 1 2 3
IRR = ?
Find IRR if CFs are constant:
-100
Or, with CFLO, enter CFs and press
IRR = 9.70%.
3 -100 40 0
9.70%
N I/YR PV PMT FV
INPUTS
OUTPUT
19. 10 - 19
Rationale for the IRR Method
If IRR > WACC, then the project’s
rate of return is greater than its
cost-- some return is left over to
boost stockholders’ returns.
Example: WACC = 10%, IRR = 15%.
Profitable.
20. 10 - 20
Decisions on Projects S and L per IRR
If S and L are independent, accept
both. IRRs > r = 10%.
If S and L are mutually exclusive,
accept S because IRRS > IRRL .
21. 10 - 21
Construct NPV Profiles
Enter CFs in CFLO and find NPVL and
NPVS at different discount rates:
r
0
5
10
15
20
NPVL
50
33
19
7
NPVS
40
29
20
12
5(4)
23. 10 - 23
NPV and IRR always lead to the same
accept/reject decision for independent
projects:
r > IRR
and NPV < 0.
Reject.
NPV ($)
r (%)
IRR
IRR > r
and NPV > 0
Accept.
24. 10 - 24
Mutually Exclusive Projects
r 8.7 r
NPV
%
IRRS
IRRL
L
S
r < 8.7: NPVL> NPVS , IRRS > IRRL
CONFLICT
r > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
25. 10 - 25
To Find the Crossover Rate
1. 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.
26. 10 - 26
Two Reasons NPV Profiles Cross
1. 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.
27. 10 - 27
Reinvestment Rate Assumptions
NPV 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 should be used to choose
between mutually exclusive projects.
28. 10 - 28
Managers like rates--prefer IRR to NPV
comparisons. Can we give them a
better IRR?
Yes, MIRR 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.
Thus, MIRR assumes cash inflows are
reinvested at WACC.
30. 10 - 30
To find TV with 10B, enter in CFLO:
I =
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.
CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80
31. 10 - 31
Why use MIRR versus 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.
32. 10 - 32
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.
Most common: Cost (negative
CF), then string of positive CFs,
then cost to close project.
Nuclear power plant, strip mine.
33. 10 - 33
Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
34. 10 - 34
Pavilion Project: NPV and IRR?
5,000 -5,000
0 1 2
r = 10%
-800
Enter CFs in CFLO, enter I = 10.
NPV = -386.78
IRR = ERROR. Why?
35. 10 - 35
We got IRR = ERROR because there
are 2 IRRs. Nonnormal CFs--two sign
changes. Here’s a picture:
NPV Profile
450
-800
0
400100
IRR2 = 400%
IRR1 = 25%
r
NPV
36. 10 - 36
Logic of Multiple IRRs
1. 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.
37. 10 - 37
Could 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
38. 10 - 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%
39. 10 - 39
Accept Project P?
NO. Reject because MIRR =
5.6% < r = 10%.
Also, if MIRR < r, NPV will be
negative: NPV = -$386,777.
40. 10 - 40
S and L are mutually exclusive and
will be repeated. r = 10%. Which is
better? (000s)
0 1 2 3 4
Project S:
(100)
Project L:
(100)
60
33.5
60
33.5 33.5 33.5
41. 10 - 41
S L
CF0 -100,000 -100,000
CF1 60,000 33,500
Nj 2 4
I 10 10
NPV 4,132 6,190
NPVL > NPVS. But is L better?
Can’t say yet. Need to perform
common life analysis.
42. 10 - 42
Note that Project S could be
repeated after 2 years to generate
additional profits.
Can use either replacement chain
or equivalent annual annuity
analysis to make decision.
44. 10 - 44
Compare to Franchise L NPV =
$6,190.
Or, use NPVs:
0 1 2 3 4
4,132
3,415
7,547
4,132
10%
45. 10 - 45
If the cost to repeat S in two years
rises to $105,000, which is best? (000s)
NPVS = $3,415 < NPVL = $6,190.
Now choose L.
0 1 2 3 4
Franchise S:
(100) 60 60
(105)
(45)
60 60
47. 10 - 47
1.751. No termination
2. Terminate 2 years
3. Terminate 1 year
(5)
(5)
(5)
2.1
2.1
5.2
2
4
0 1 2 3
CFs Under Each Alternative (000s)
48. 10 - 48
NPV(no) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
Assuming a 10% cost of capital, what is
the project’s optimal, or economic life?
49. 10 - 49
The project is acceptable only if
operated for 2 years.
A project’s engineering life does not
always equal its economic life.
Conclusions
50. 10 - 50
Choosing the Optimal Capital Budget
Finance 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:
An increasing marginal cost of
capital.
Capital rationing
51. 10 - 51
Increasing Marginal Cost of Capital
Externally 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 the cost of capital.
(More...)
52. 10 - 52
If external funds will be raised, then
the NPV of all projects should be
estimated using this higher marginal
cost of capital.
53. 10 - 53
Capital Rationing
Capital 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 expenditures that it will
make in the upcoming year.
(More...)
54. 10 - 54
Reason: 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,
and then accept all projects that still
have a positive NPV with the higher
cost of capital.
(More...)
55. 10 - 55
Reason: Companies don’t have
enough managerial, marketing, or
engineering staff to implement all
positive NPV projects.
Solution: Use linear programming to
maximize NPV subject to not
exceeding the constraints on staffing.
(More...)
56. 10 - 56
Reason: 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 and tie the managers’
compensation to the subsequent
performance of the project.