9 - 1 Copyright © 2001 by Harcourt, Inc.All rights reserved. Should we build this plant? CHAPTER 11...

9 - 1

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Should we build thisplant?

CHAPTER 11The Basics of Capital Budgeting

9 - 2


What is capital budgeting?

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to firm’s future.

9 - 3


Steps

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.

3. Determine k = WACC (adj.).

4. Find NPV and/or IRR.

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

9 - 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.

9 - 5


An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.

9 - 6


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.

9 - 7


What is the payback period?

The number of years required to recover a project’s cost,

or how long does it take to get our money back?

9 - 8


Payback for Project L(Long: Large CFs in later years)

10 60

0 1 2 3

-100

=

CFt

Cumulative -100 -90 -30 50

PaybackL 2 + 30/80 = 2.375 years

0100

2.4

80

9 - 9


Project S (Short: CFs come quickly)

70 2050

0 1 2 3

-100CFt

Cumulative -100 -30 20 40

PaybackL 1 + 30/50 = 1.6 years

100

0

1.6

=

9 - 10


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.

9 - 11


.

k1CF

NPV tt

n

0t

NPV: Sum of the PVs of inflows and outflows.

9 - 12


What’s Project L’s NPV?

10 8060

0 1 2 310%

Project L:

-100.00

9.09

49.59

60.1118.79 = NPVL NPVS = $19.98.

9 - 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 ofhigher NPV. Adds most value.

9 - 14


Using NPV method, which project(s) should be accepted?

If Projects S and L are mutually exclusive, accept S because NPVs > NPVL .

If S & L are independent, accept both; NPV > 0.

9 - 15


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.

9 - 16


.NPV

k1CF

tt

n

0t

.0

IRR1CF

tt

n

0t

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

9 - 17


What’s Project 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%.

9 - 18


90 109090

0 1 2 10IRR = ?

Q. How is a project’s IRRrelated to a bond’s YTM?

A. They are the same thing.A bond’s YTM is the IRRif you invest in the bond.

-1134.2

IRR = 7.08% (use TVM or CFLO).

...

9 - 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.

9 - 20


IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.

9 - 21


Decisions on Projects S and L per IRR

If S and L are independent, accept both. IRRs > k = 10%.

If S and L are mutually exclusive, accept S because IRRS > IRRL .

9 - 22


Reasons NPV different from IRR

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 k favors small projects.

2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.

9 - 23


Reinvestment Rate Assumptions

NPV assumes reinvest at k (opportunity cost of capital).

IRR assumes reinvest at IRR.

Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

9 - 24


Managers like rates--prefer IRR to NPV comparisons. Can we give them a

better IRR?

Yes, MIRR is the discount rate thatcauses 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.

9 - 25


MIRR = 16.5%

10.0 80.060.0

0 1 2 310%

66.0 12.1

158.1

MIRR for Project L (k = 10%)

-100.010%

10%

TV inflows-100.0

PV outflowsMIRRL = 16.5%

$100 = $158.1

(1 + MIRRL)3

9 - 26


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.

9 - 1 Copyright © 2001 by Harcourt, Inc.All rights reserved. Should we build this plant? CHAPTER 11...

Documents

Transcript of 9 - 1 Copyright © 2001 by Harcourt, Inc.All rights reserved. Should we build this plant? CHAPTER 11...