The Basics of Capital Budgeting Evaluating Cash FlowsCHAPTE.docx

The Basics of Capital Budgeting:
Evaluating Cash Flows
CHAPTER 10
© 2020 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.
Topics
Overview and “vocabulary”
Methods
NPV
IRR, MIRR
Profitability Index
Payback, discounted payback
Unequal lives
Economic life
Optimal capital budget
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The Big Picture:
The Net Present Value of a Project

classroom use.
What is capital budgeting?
Analysis of potential projects.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
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Steps in Capital Budgeting
Estimate cash flows (inflows & outflows).
Assess risk of cash flows.
Determine r = WACC for project.
Evaluate cash flows.
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Capital Budgeting Project Categories
Replacement to continue profitable operations
Replacement to reduce costs
Expansion of existing products or markets
Expansion into new products/markets
Contraction decisions
Safety and/or environmental projects
Mergers
Other

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Independent versus 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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Cash Flows for Franchises L and S
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NPV: Sum of the PVs of All Cash Flows

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What’s Franchise L’s NPV?
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Calculator
Solution
: Enter Values in CFLO Register for L
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Rationale for the NPV Method
NPV = PV inflows – Cost
This is net gain in wealth, so accept project if NPV > 0.
Choose between mutually exclusive projects on basis of higher

positive NPV. Adds most value.
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Using the NPV measure, which franchise(s) should be accepted?
If Franchises S and L are mutually exclusive, accept S because
NPVs > NPVL.
If S & L are independent, accept both; NPV > 0.
NPV is dependent on cost of capital.
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Internal Rate of Return: IRR
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.

classroom use.
NPV: Enter r, solve for NPV.
classroom use.
IRR: Enter NPV = 0, Solve for IRR
IRR is an estimate of the project’s rate of return, so it is
comparable to the YTM on a bond.

classroom use.
What’s Franchise L’s IRR?
classroom use.
How is the IRR on a project related to the yield to maturity
(YTM) on a bond?
IRR: The discount rate that forces the present value of a
project’s expected future cash flows to equal the initial cash
flow.
YTM: The discount rate that forces the present value of a
bondscash flows (i.e., coupons and maturity value) to equal the
price of the bond.

classroom use.
Finding IRR if CFs are Constant (Use the Excel RATE function
as though the project were a bond.)
IRR = RATE(3,40,100) = 9.7%
Alternatively:
classroom use.
Rationale for the IRR Method
If IRR > r, then the project’s rate of return is greater than its
cost-- some return is left over to boost stockholders’ returns.
Example:
r= 10%, IRR = 15%.
So this project adds extra return to shareholders.

classroom use.
Decisions on Franchises S and L per IRR
If S and L are independent, accept both: IRRS > r and IRRL >
r.
If S and L are mutually exclusive, accept S because IRRS >
IRRL.
IRR is not dependent on the cost of capital used.
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Construct NPV Profiles
Enter CFs in CFLO and find NPVL and NPVS at different
discount rates: rNPVLNPVS 05040 5332910192015 71220
(4) 5

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NPV Profile
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NPV and IRR: No conflict for independent projects.
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Mutually Exclusive Projects

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To Find the Crossover Rate
Find 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 and consistently, but easier
to have first CF negative.
If profiles don’t cross, one project dominates the other.
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Two Reasons NPV Profiles Cross
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.
Timing differences. Project with faster payback provides more
CF in early years for reinvestment. If r is high, early CF

especially good, NPVS > NPVL.
classroom use.
Modified Internal Rate of Return (MIRR)
MIRR is the discount rate that 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.
classroom use.
MIRR for Franchise L (r = 10%) using the Excel RATE
function.ABCD1r = 10%2YearYearYearYear301234(100)10
60 80 56MIRR =MIRR(A4:D4,B4,B4)7MIRR =16.50%

classroom use.
Alternative Method to Find MIRR for Franchise L: First, find
PV and TV (r = 10%).
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Second, find discount rate that equates PV and TV.
classroom use.
To find MIRR with financial calculator:

(1 of 2)
Step 1, Find PV of inflows
First, enter cash inflows in CFLO register:
CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80
Second, enter I/YR = 10.
Third, find PV of inflows: Press NPV = 118.78
Step 2, Find TV of PV of inflows from Step 1.
Enter PV = -118.78, N = 3, I/YR = 10, PMT = 0.
Press FV = 158.10 = FV of inflows.
classroom use.
To find MIRR with financial calculator:
(2 of 2)
Step 3, Find PV of outflows.
For this problem, there is only one outflow:
CF0 = -100, so the PV of outflows is -100.
For other problems there may be negative cash flows for several
years, and you must find the present value for all negative cash
flows.
Step 4, Find “IRR” of TV of inflows and PV of outflows.

Enter FV = 158.10, PV = -100, PMT = 0, N = 3.
Press I/YR = 16.50% = MIRR.
classroom use.
Profitability Index
The profitability index (PI) is the present value of future cash
flows divided by the initial cost.
It measures the “bang for the buck.”
classroom use.
Franchise L’s PV of Future Cash Flows

classroom use.
Franchise L’s Profitability Index
classroom use.
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?
classroom use.
Payback for Franchise L

classroom use.
Payback for Franchise S
classroom use.
Strengths and Weaknesses of Payback
Strengths:
Provides an indication of a project’s risk and liquidity.
Easy to calculate and understand.
Weaknesses:
Ignores the TVM.
Ignores CFs occurring after the payback period.
No specification of acceptable payback.

classroom use.
Discounted Payback: Uses Discounted CFs
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Normal vs. Nonnormal Cash Flows
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.

For example, nuclear power plant or strip mine.
classroom use.
Inflow (+) or Outflow (-) in Year012345NNN-+++++N-++++-
NN---+++N+++---N-++-+-NN
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Pavilion Project: NPV and IRR?
Enter CFs in CFLO, enter I/YR = 10.
NPV = -386,777
IRR = ERROR. Why?

classroom use.
Nonnormal CFs—Two Sign Changes, Two IRRs
classroom use.
Logic of Multiple IRRs
At 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.
In between, the discount rate hits CF2 harder than CF1, so NPV
> 0.
Result: 2 IRRs.

classroom use.
Finding Multiple IRRs with Calculator
1. Enter CFs as before.
2. Enter a “guess” as to IRR by storing the guess. Try 10%:
10STO
IRR = 25% = lower IRR
(See next slide for upper IRR)
classroom use.
Finding Upper IRR with Calculator
Now guess large IRR, say, 200:
200STO
IRR = 400% = upper IRR

classroom use.
When there are nonnormal CFs and more than one IRR, use
MIRR.
classroom use.
Accept Project P?
NO. Reject because
MIRR = 5.6% < r = 10%.
Also, if MIRR < r, NPV will be negative: NPV = -$386,777.

classroom use.
Projects T (for two years) and F (for four years) are mutually
exclusive and will be repeated; r = 10%.
0
1
2
3
4
T: -100
F: -100
60
33.5
60
33.5
33.5

33.5
Note: CFs shown in $ Thousands
classroom use.
NPVF > NPVT, but which is better? T can be repeated! T
FCF0-100-100CF1 60 33.5NJ24I/YR1010NPV4.1326.190
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Equivalent Annual Annuity Approach (EAA)
Convert the PV into a stream of annuity payments with the same
PV.
T: N=2, I/YR=10, PV=-4.132, FV = 0. Solve for PMT = EAAT
= $2.38.
F: N=4, I/YR=10, PV=-6.190, FV = 0. Solve for PMT = EAAF =
$1.95.
T has higher EAA, so it is a better project.
classroom use.
Replacement Chain
Note that Project T could be repeated after 2 years to generate
additional profits.
Use replacement chain to put on common life.

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Replacement Chain Approach: F with Replication ($ thousands)
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Or, Use NPVs
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Suppose the cost to repeat T in two years rises to $105,000?

classroom use.
Economic Life versus Physical Life (1 of 2)
Consider another project with a 3-year life.
If terminated prior to Year 3, the machinery will have positive
salvage value.
Should you always operate for the full physical life?
See next slide for cash flows.
classroom use.
Economic Life versus Physical Life (2 of 2)YearCFSalvage
Value0-$5,000$5,0001 2,100 3,1002 2,000 2,0003 1,750
0

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CFs Under Each Alternative (000s)Years: 01231. No
termination-52.121.752. Terminate 2 years-52.143. Terminate 1
year-55.2
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NPVs under Alternative Lives
(Cost of Capital = 10%)
NPV(3 years)= -$123.
NPV(2 years)= $215.
NPV(1 year)= -$273.
classroom use.
Conclusions

The project is acceptable only if operated for 2 years.
A project’s engineering life does not always equal its economic
life.
classroom use.
(
)
N
t
t
t0
CF
NPV
1r
=
=
+
å
(

)
N
t
t
t0
CF
0
1IRR
=
=
+
å
L
L
S
PV future CF$118.79
PI
Initial cost$100
PI 1.1879
PI 1.1998
==
=
=

Grading for this assignment will be based on answer quality,
logic / organization of the paper, and language and writing
skills, using the following rubric.
Points: 280
Assignment 2: Investment Risk Management
Criteria
Unacceptable
Below 60% F
Meets Minimum Expectations
60-69% D
Fair
70-79% C
Proficient
80-89% B
Exemplary
90-100% A
1. Assess the factors that contributed to the financial failure of
the firm, indicating how management failed to manage the risk
related to each factor. Make a recommendation for how firms
should manage these types of risks in the future. Provide

support for your recommendation.
Weight: 15%
Did not submit or incompletely assessed the factors that
contributed to the financial failure of the firm, indicating how
management failed to manage the risk related to each factor; did
not submit or incompletely made a recommendation for how
firms should manage these types of risks in the future; did not
submit or incompletely provided support for your
recommendation.
Insufficiently assessed the factors that contributed to the
financial failure of the firm, indicating how management failed
to manage the risk related to each factor; insufficiently made a
recommendation for how firms should manage these types of
risks in the future; insufficiently provided support for your
recommendation.
Partially assessed the factors that contributed to the financial
failure of the firm, indicating how management failed to manage
the risk related to each factor; partially made a recommendation
for how firms should manage these types of risks in the future;
partially provided support for your recommendation.
Satisfactorily assessed the factors that contributed to the
financial failure of the firm, indicating how management failed
to manage the risk related to each factor; satisfactorily made a
risks in the future; satisfactorily provided support for your

recommendation.
Thoroughly assessed the factors that contributed to the financial
failure of the firm, indicating how management failed to manage
the risk related to each factor; thoroughly made a
risks in the future; thoroughly provided support for your
recommendation.
2. Assess the sufficiency of risk management techniques used
by financial institutions today indicating whether or not you
believe the risk is appropriately managed to avoid a subsequent
financial crisis. Provide support for your position.
Weight: 15%
Did not submit or incompletely assessed the sufficiency of risk
management techniques used by financial institutions today,
indicating whether or not you believe the risk is appropriately
managed to avoid a subsequent financial crisis; did not submit
or incompletely provided support for your position.
Insufficiently assessed the sufficiency of risk management
techniques used by financial institutions today, indicating
whether or not you believe the risk is appropriately managed to
avoid a subsequent financial crisis; insufficiently provided
support for your position.
Partially assessed the sufficiency of risk management

avoid a subsequent financial crisis; partially provided support
for your position.
Satisfactorily assessed the sufficiency of risk management
avoid a subsequent financial crisis; satisfactorily provided
support for your position.
Thoroughly assessed the sufficiency of risk management
avoid a subsequent financial crisis; thoroughly provided support
for your position.
3. Evaluate management’s role within a financial investment
firm for establishing proper risk management procedures for
high-risk investments and the appropriate level of
accountability for portfolio performance. Determine the
consequences that should be enacted when Financial Firm
Management fails to perform their fiduciary obligation to
investors, indicating how these consequences should be
implemented. Provide support for your response.
Weight: 20%
Did not submit or incompletely evaluated management’s role
within a financial investment firm for establishing proper risk
management procedures for high-risk investments and the
appropriate level of accountability for portfolio performance;

did not submit or incompletely determined the consequences
that should be enacted when Financial Firm Management fails
to perform their fiduciary obligation to investors, indicating
how these consequences should be implemented; did not submit
or incompletely provided support for your response.
Insufficiently evaluated management’s role within a financial
investment firm for establishing proper risk management
procedures for high-risk investments and the appropriate level
of accountability for portfolio performance; insufficiently
determined the consequences that should be enacted when
Financial Firm Management fails to perform their fiduciary
obligation to investors, indicating how these consequences
should be implemented; insufficiently provided support for your
response.
Partially evaluated management’s role within a financial
of accountability for portfolio performance; partially
should be implemented; partially provided support for your
response.
Satisfactorily evaluated management’s role within a financial

of accountability for portfolio performance; satisfactorily
should be implemented; satisfactorily provided support for your
response.
Thoroughly evaluated management’s role within a financial
of accountability for portfolio performance; thoroughly
should be implemented; thoroughly provided support for your
response.
4. Given the recent debt crisis within the EURO zone of Europe,
analyze the impact to the performance of foreign markets and
recommend a strategy for financial firms to minimize
investment risk in these markets. Provide support for your
recommendation.
Weight: 15%
Did not submit or incompletely analyzed the impact to the
performance of foreign markets and did not submit or
incompletely recommended a strategy for financial firms to

minimize investment risk in these markets; did not submit or
incompletely provided support for your recommendation.
Insufficiently analyzed the impact to the performance of foreign
markets and insufficiently recommended a strategy for financial
firms to minimize investment risk in these markets;
insufficiently provided support for your recommendation.
Partially analyzed the impact to the performance of foreign
markets and partially recommended a strategy for financial
firms to minimize investment risk in these markets; partially
provided support for your recommendation.
Satisfactorily analyzed the impact to the performance of foreign
markets and satisfactorily recommended a strategy for financial
firms to minimize investment risk in these markets;
satisfactorily provided support for your recommendation.
Thoroughly analyzed the impact to the performance of foreign
markets and thoroughly recommended a strategy for financial
firms to minimize investment risk in these markets; thoroughly
provided support for your recommendation.
5. Evaluate the role of the Federal government, if any, related to
the regulation of investments by financial institutions, including
the scope of the role, the authority and enforcement capability
within the regulatory agency, the benefits, and consequences of
regulation. Predict how the regulatory environment may change
over the next five (5) years. Provide support for your
prediction.

Weight: 20%
Did not submit or incompletely evaluated the role of the Federal
government, if any, related to the regulation of investments by
financial institutions, including the scope of the role, the
authority and enforcement capability within the regulatory
agency, the benefits, and consequences of regulation; did not
submit or incompletely predicted how the regulatory
environment may change over the next five (5) years; did not
submit or incompletely provided support for your prediction.
Insufficiently evaluated the role of the Federal government, if
any, related to the regulation of investments by financial
institutions, including the scope of the role, the authority and
enforcement capability within the regulatory agency, the
benefits, and consequences of regulation; insufficiently
predicted how the regulatory environment may change over the
next five (5) years; insufficiently provided support for your
prediction.
Partially evaluated the role of the Federal government, if any,
related to the regulation of investments by financial institutions,
including the scope of the role, the authority and enforcement
capability within the regulatory agency, the benefits, and
consequences of regulation; partially predicted how the
regulatory environment may change over the next five (5) years;
partially provided support for your prediction.
Satisfactorily evaluated the role of the Federal government, if

benefits, and consequences of regulation; satisfactorily
predicted how the regulatory environment may change over the
next five (5) years; satisfactorily provided support for your
prediction.
Thoroughly evaluated the role of the Federal government, if
benefits, and consequences of regulation; thoroughly predicted
how the regulatory environment may change over the next five
(5) years; thoroughly provided support for your prediction.
6. 5 references
Weight: 5%
No references provided
Does not meet the required number of references; all references
poor quality choices.
Does not meet the required number of references; some
references poor quality choices.
Meets number of required references; all references high quality
choices.
Exceeds number of required references; all references high
quality choices.

7. Clarity, writing mechanics, and formatting requirements
Weight: 10%
More than 8 errors present
7-8 errors present
5-6 errors present
3-4 errors present
0-2 errors present

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