chapter 11: capital budgeting: decision criteria
DESCRIPTION
Chapter 11: Capital Budgeting: Decision Criteria. Overview and “vocabulary” Methods Payback, discounted payback NPV IRR, MIRR Profitability Index Unequal lives Economic life. Steps in Capital Budgeting. Estimate cash flows (inflows & outflows). Assess risk of cash flows. - PowerPoint PPT PresentationTRANSCRIPT
![Page 1: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/1.jpg)
11 - 1
Chapter 11: Capital Budgeting: Decision Criteria
Overview and “vocabulary”Methods
Payback, discounted paybackNPVIRR, MIRRProfitability Index
Unequal livesEconomic life
![Page 2: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/2.jpg)
11 - 2
Steps in Capital Budgeting
Estimate cash flows (inflows & outflows).
Assess risk of cash flows.Determine r = WACC for project.Evaluate cash flows.
![Page 3: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/3.jpg)
11 - 3
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.
![Page 4: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/4.jpg)
11 - 4
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?
![Page 5: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/5.jpg)
11 - 5
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
0100
2.4
![Page 6: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/6.jpg)
11 - 6
Franchise S (Short: CFs come quickly)
70 2050
0 1 2 3
-100CFt
Cumulative -100 -30 20 40
PaybackS 1 + 30/50 = 1.6 years
100
0
1.6
=
![Page 7: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/7.jpg)
11 - 7
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.
![Page 8: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/8.jpg)
11 - 8
10 8060
0 1 2 3
CFt
Cumulative -100 -90.91 -41.32 18.79Discountedpayback 2 + 41.32/60.11 = 2.7 yrs
Discounted Payback: Uses discountedrather than raw CFs.
PVCFt -100
-100
10%
9.09 49.59 60.11
=
Recover invest. + cap. costs in 2.7 yrs.
![Page 9: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/9.jpg)
11 - 9
.
10t
tn
t rCFNPV
NPV: Sum of the PVs of inflows and outflows.
Cost often is CF0 and is negative.
.
1 01
CFr
CFNPV tt
n
t
![Page 10: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/10.jpg)
11 - 10
What’s Franchise L’s NPV?
10 8060
0 1 2 310%
Project L:
-100.00
9.0949.5960.1118.79 = NPVL NPVS = $19.98.
![Page 11: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/11.jpg)
11 - 11
Calculator Solution
Enter in CFLO for L:
-100
10
60
80
10
CF0
CF1
NPV
CF2
CF3
I = 18.78 = NPVL
![Page 12: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/12.jpg)
11 - 12
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 ofhigher NPV. Adds most value.
![Page 13: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/13.jpg)
11 - 13
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.
![Page 14: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/14.jpg)
11 - 14
Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3
Cost Inflows
IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.
![Page 15: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/15.jpg)
11 - 15
.
10
NPVr
CFt
tn
t
t
n tt
CFIRR
0 1
0.
NPV: Enter r, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
![Page 16: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/16.jpg)
11 - 16
What’s Franchise L’s IRR?
10 8060
0 1 2 3IRR = ?
-100.00
PV3
PV2
PV1
0 = NPV
Enter CFs in CFLO, then press IRR:IRRL = 18.13%. IRRS = 23.56%.
![Page 17: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/17.jpg)
11 - 17
40 40 40
0 1 2 3IRR = ?
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
![Page 18: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/18.jpg)
11 - 18
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.
![Page 19: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/19.jpg)
11 - 19
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 .
![Page 20: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/20.jpg)
11 - 20
Construct NPV Profiles
Enter CFs in CFLO and find NPVL andNPVS at different discount rates:
r 05
101520
NPVL
50 3319
7
NPVS
402920125 (4)
![Page 21: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/21.jpg)
11 - 21
-10
0
10
20
30
40
50
60
0 5 10 15 20 23.6
NPV ($)
Discount Rate (%)
IRRL = 18.1%
IRRS = 23.6%
Crossover Point = 8.7%
r 05
101520
NPVL
503319
7(4)
NPVS
402920125
S
L
![Page 22: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/22.jpg)
11 - 22NPV and IRR always lead to the same accept/reject decision for independent projects:
r > IRRand NPV < 0.
Reject.
NPV ($)
r (%)IRR
IRR > rand NPV > 0
Accept.
![Page 23: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/23.jpg)
11 - 23
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
![Page 24: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/24.jpg)
11 - 24
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.
![Page 25: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/25.jpg)
11 - 25
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.
![Page 26: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/26.jpg)
11 - 26
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.
![Page 27: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/27.jpg)
11 - 27
Managers 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 are reinvested at WACC.
![Page 28: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/28.jpg)
11 - 28
MIRR = 16.5%
10.0 80.060.0
0 1 2 310%
66.0 12.1158.1
MIRR for Franchise L (r = 10%)
-100.010%
10%
TV inflows-100.0PV outflows
MIRRL = 16.5%
$100 = $158.1(1+MIRRL)3
![Page 29: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/29.jpg)
11 - 29
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
![Page 30: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/30.jpg)
11 - 30
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.
![Page 31: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/31.jpg)
11 - 31
Normal Cash Flow Project:Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.
Nonnormal Cash Flow Project:Two or more changes of signs.Most common: Cost (negativeCF), then string of positive CFs,then cost to close project.Nuclear power plant, strip mine.
![Page 32: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/32.jpg)
11 - 32
Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
![Page 33: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/33.jpg)
11 - 33
Pavilion Project: NPV and IRR?
5,000 -5,000
0 1 2r = 10%
-800
Enter CFs in CFLO, enter I = 10.NPV = -386.78IRR = ERROR. Why?
![Page 34: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/34.jpg)
11 - 34We got IRR = ERROR because there are 2 IRRs. Nonnormal CFs--two signchanges. Here’s a picture:
NPV Profile
450
-800
0400100
IRR2 = 400%
IRR1 = 25%
r
NPV
![Page 35: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/35.jpg)
11 - 35
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.
![Page 36: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/36.jpg)
11 - 36Could 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 IRRNow guess large IRR, say, 200:200 STO
IRR = 400% = upper IRR
![Page 37: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/37.jpg)
11 - 37
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%
![Page 38: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/38.jpg)
11 - 38
Accept Project P?
NO. Reject because MIRR = 5.6% < r = 10%.
Also, if MIRR < r, NPV will be negative: NPV = -$386,777.
![Page 39: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/39.jpg)
11 - 39
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
![Page 40: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/40.jpg)
11 - 40
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...)
![Page 41: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/41.jpg)
11 - 41
If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
![Page 42: Chapter 11: Capital Budgeting: Decision Criteria](https://reader036.vdocument.in/reader036/viewer/2022062521/56814a54550346895db776fc/html5/thumbnails/42.jpg)
11 - 42
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...)