10 capital budgeting

8/4/2019 10 Capital Budgeting

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The Basics of Capital Budgeting

Should webuild this

plant?


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10-1

What is capital budgeting?Analysis of potential additions to

fixed assets.

Long-term decisions; involve largeexpenditures.

Very important to firms future.


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10-2

Steps to capital budgeting1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.

3. Determine the appropriate cost of capital.

4. Find NPV and/or IRR.

5. Accept if NPV > 0 and/or IRR > WACC.


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10-3

What is the difference betweenindependent and mutually exclusive

projects?

Independent projects if the cash flows of oneare unaffected by the acceptance of the other.

Mutually exclusive projects if the cash flowsof one can be adversely impacted by theacceptance of the other.


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10-4

What is the difference between normal

and nonnormal cash flow streams? Normal cash flow stream Cost (negative CF)

followed by a series of positive cash inflows.

One change of signs. Nonnormal cash flow stream 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, etc.


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10-5

What is the payback period? The number of years required to

recover a projects cost, or How long

does 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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10-6

Calculating payback

PaybackL = 2 + / = 2.375 years

CFt -100 10 60 100

Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

PaybackS = 1 + / = 1.6 years

CFt -100 70 100 20Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50

-30

Project S


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10-7

Strengths and weaknesses of

payback Strengths

Provides 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 paybackperiod.


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10-8

Discounted payback period Uses discounted cash flows rather than

raw CFs.

Disc PaybackL = 2 + / = 2.7 years

CFt -100 10 60 80

Cumulative -100 -90.91 18.79

0 1 2 3

=

2.7

60.11

-41.32

PV of CFt -100 9.09 49.59

41.32 60.11

10%


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10-9

Net Present Value (NPV) Sum of the PVs of all cash inflows and

outflows of a project:

n

0tt

t

)k1(

CFNPV


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10-10

What is Project Ls NPV?Year CFt PV of CFt

0 -100 -$100

1 10 9.09

2 60 49.59

3 80 60.11

NPVL = $18.79

NPVS = $19.98


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10-11

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, would accept S ifmutually exclusive (NPVs > NPVL), and

would accept both if independent.


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10-12

Internal Rate of Return (IRR) IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:

n

0tt

t

)IRR1(

CF0


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10-13

Rationale for the IRR method If IRR > WACC, the projects rate of

return is greater than its costs.

There is some return left over toboost stockholders returns.


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10-14

IRR Acceptance Criteria If IRR > k, accept project.

If IRR < k, reject project.

If projects are independent, acceptboth projects, as both IRR > k =

10%. If projects are mutually exclusive,

accept S, because IRRs > IRRL.


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10-15

NPV Profiles

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

k NPVL NPVS0 $50 $405 33 29

10 19 2015 7 1220 (4) 5


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10-16

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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10-17

Comparing the NPV and IRRmethods

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

accept/reject decisions. If projects are mutually exclusive

If k > crossover point, the two methods lead tothe same decision and there is no conflict.

If k < crossover point, the two methods lead todifferent accept/reject decisions.

Ifprofiles dont cross, one project dominates the

other.


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10-18

Reinvestment rate assumptions

NPV method assumes CFs are reinvestedat k, the opportunity cost of capital.

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 assumes

cost of capital reinvestment is needed.


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10-19

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 terminal

value (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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10-20

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 + MIRRL)

3=


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10-21

Why use MIRR versus IRR?

MIRR correctly assumes reinvestmentat opportunity cost = WACC. MIRR

also avoids the problem of multipleIRRs.

Managers like rate of return

comparisons, and MIRR is better forthis than IRR.


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10-22

Project P has cash flows (in 000s): CF0 =-$800, CF1 = $5,000, and CF2 = -$5,000.

Find Project Ps NPV and IRR.

NPV = -$386.78.

IRR = 25% & 400%

-800 5,000 -5,000

0 1 2k = 10%


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10-23

Multiple IRRs

NPV Profile

450

-800

0 400100

IRR2 = 400%

IRR1 = 25%

k

NPV

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