LECTURE 9

EBF 2054 Financial ManagementCapital Budgeting

1The Basics of Capital Budgeting

Should we build thisfactory?2Capital Budgeting

3Capital BudgetingDecision to invest in capital - fixed assetsCapital long term assets used in productionBudget- plan with details projected expenditures during future period

Capital Budgeting The process of planning expenditures on assets whose cash flows are expected to extend beyond one year.- long term investment decision.

4What is capital budgeting?Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to firms future.

5Capital Budgeting: The process of planning for purchases of long-term assets.For example: Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide?Will the machine be profitable?Will our firm earn a high rate of return on the investment?

6Decision-making Criteria in Capital BudgetingHow do we decide if a capital investment project should be accepted or rejected?

7The ideal evaluation method should:

a) include all cash flows that occur during the life of the project,b) consider the time value of money, andc) incorporate the required rate of return on the project. Decision-making Criteria in Capital Budgeting83 methods of ranking investmentsPayback methodNet present value (NPV)Internal rate of return (IRR)

1st method not conceptually sound, is often used.2nd & 3rd approaches are more acceptable.Time value of money is used to equate future cash flows to present Cost of capital as basic discount rate

9What 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 cash inflows to its cost until the cumulative cash flow for the project turns positive.

10Payback PeriodHow long will it take for the project to generate enough cash to pay for itself?Payback period = 3.33 years012345867(500) 150 150 150 150 150 150 150 150

11Is a 3.33 year payback period good?Is it acceptable?Firms that use this method will compare the payback calculation to some standard set by the firm.If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision?Accept the project.Payback Period

12Drawbacks of Payback PeriodFirm cutoffs are subjective.Does not consider time value of money.Does not consider any required rate of return.Does not consider all of the projects cash flows.

13Cash flows (of $ 10 000 investment)YearInvestment AInvestment B1500015002500020003500250045005000550010000Initial investment = $10 000

Payback period for:Inv. A (5000+5000)= 2 years

Inv. B(1500+2000+2500) + 4000/5000 1y 2y 3y= 3 years + 0.8 year= 3.8 yearsDrawbacks of Payback PeriodDoes not consider all of the projects cash flows.

14Strengths and weaknesses of paybackStrengthsProvides an indication of a projects risk and liquidity.Easy to calculate and understand.WeaknessesIgnores the time value of money.Ignores CFs occurring after the payback period.

15Discounted PaybackDiscounts the cash flows at the firms required rate of return.Payback period is calculated using these discounted net cash flows.Problems:Cutoffs are still subjective.Still does not examine all cash flows.

Uses discounted cash flows rather than raw CFs.16Example:Discounted payback periodUses discounted cash flows rather than raw CFs.Disc Payback = 2 + / = 2.7 yearsCFt -100 10 60 80Cumulative -100 -90.91 18.79012360.11-41.32PV of CFt -100 9.09 49.5941.3260.1110%

17Other Methods1) Net Present Value (NPV)2) Internal Rate of Return (IRR)

Consider each of these decision-making criteria:All net cash flows.The time value of money.The required rate of return.

18Steps to capital budgeting (NPV & IRR methods)Estimate CFs (inflows & outflows).Assess riskiness of CFs.Determine the appropriate cost of capital.Find NPV and/or IRR.Accept if NPV > 0 and /or IRR > WACC.

19What is the difference between independent and mutually exclusive projects?Independent projects if the cash flows of one are unaffected by the acceptance of the other.

Mutually exclusive projects- if the cash flows of one can be adversely impacted by the acceptance of the other.A set of projects where only one can be accepted.20What 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.

21NPV direct measure of the projects contribution to shareholder wealth.Find PV of each cash flow, including the cost, discounted at projects cost of capitalSum of these discounted cash flows is defined as projects NPV.

Sum of the PVs of all cash inflows and outflows of a project:

Net Present Value (NPV)

22What is Project Ls NPV?(r=10%)Year CFtPV of CFt 0-100 -$100 (initial cost in year 1) 1 10 9.09 2 60 49.59 3 80 60.11 NPV = $18.79* r = cost of capital (WACC) @ discounted rate (i) eg:10%Example: 2 projects long term (L) & short term (S)

23Cash flow time line0 r=10%123

-$1001060 80 (cash flows) 9.09 49.59 60.11 = $18.79 Net present value ,NPV

24Rationale for the NPV methodIf projects are independent, accept if the project NPV > 0.If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value.EG: (NPVA $19.98 and NPVB $18.79 accept A if mutually exclusive (NPVA $19.98 > NPVB $18.79), and accept both if independent. NPV= PV of inflows Cost = Net gain in wealth

25NPV = NPV = - IO FCFt(1 + k)t n

t=1SNet Present Value (NPV)Total PV of the annual net cash flows- the initial outlay26Net Present ValueDecision Rule:

If NPV is positive, accept.If NPV is negative, reject.

27NPV ExampleSuppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firms required rate of return is 15%.

28NPV Example0 1 2 3 4 5(250,000) 100,000 100,000 100,000 100,000 100,000capital investment costs $250,000annual net cash flows of $100,000 for five years. required rate of return is 15%.29Mathematical Solution:NPV = PMT (PVIFA i, n ) - IONPV = 100,000 (PVIFA .15, 5 ) - 250000 (use PVIFA table) = 100,000 (3.352) 250000 = 335200- 250000 =$85,200OR 1NPV = PMT 1 - (1 + i)n - IO i

1NPV = 100,0000 1 - (1.15 )5 - 250,000 = $335,216 - $250000 .15 = $85,216

NPV = PV of the annual cash flows - initial outflow.Accept @ reject??30Decision Rule:

If NPV is positive, accept.If NPV is negative, reject.

Since the NPV = $85,216, so we should ACCEPT this investment (project)

31Internal Rate of Return (IRR)IRR: The return on the firms invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

32Internal Rate of Return (IRR)NPV = - IO FCFt(1 + k)t n

t=1S n

t=1SIRR: = IO FCFt(1 + IRR)t33Internal Rate of Return (IRR)IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay. n

t=1SIRR: = IO FCFt(1 + IRR)t34Calculating IRRLooking again at our problem:The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.0 1 2 3 4 5(250,000) 100,000 100,000 100,000 100,000 100,00035When, calculate IRR, we let the NPV=0Mathematical Solution:NPV= PMT (PVIFA i, n ) - IO 0 = 100,000 (PVIFA .IRR, 5 ) - 250000 (PVIFA .IRR, 5 ) = 250,000 / 100,000 = 2.5 (use PVIFA table) from PVIFA table, we will get IRR 25 - 30%OR 1NPV= PMT 1 - (1 + i)n - IO i

10 = 100,0000 1 - (1+IRR )5 - 250,000 IRRIRR = 28.65%

36Decision Rule:

If IRR is greater than or equal to the required rate of return, accept.If IRR is less than the required rate of return, reject.Since in this example IRR = 28.65%, the required rate of return is 15%.so, we ACCEPT this investment.

37IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +)Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)

38Multiple IRRThe situation where a project has two or more IRRs.Occurs when the project has nonnormal cash flows.Examples:Normal: - +++++or - - - +++++Nonnormal: - +++++-or - +++ - +++

39ExampleSuppose a firm is considering the development of a strip mine (project P). The mine will cost $ 0.8 million, then it will produce a cash flow of $5 million at the end of year 1. At the end of year 2, the firm must spend $5 million to restore the land to its original condition.cash flow :( - + -)

40NPV Vs IRR, which one is better???NPV method assumes CFs are reinvested at the required rate of return.IRR method assumes CFs are reinvested at IRR.Assuming CFs are reinvested at the opportunity cost of capital (required rate of return ,k) is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects.Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.

Reinvestment rate assumptions41Since managers prefer the IRR to the NPV method, is there a better IRR measure?Yes, Modified Internal Rate of Return (MIRR) discount rate that causes the PV of a projects terminal value (TV) to equal the PV of costs. PV of TV = PV costTV is found by compounding inflows at required rate of return (WACC).

MIRR assumes cash flows are reinvested at the required rate of return (WACC).

42Modified Internal Rate of Return (MIRR)IRR assumes that all cash flows are reinvested at the IRR.MIRR provides a rate of return measure that assumes cash flows are reinvested at the required rate of return, k.

43MIRR Steps:Calculate the PV of the cash outflows.Using the required rate of return,k.Calculate the FV of the cash inflows at the last year of the projects time line. This is called the terminal value (TV).Using the required rate of return.MIRR: the discount rate that equates the PV of the cash outflows with the PV of the terminal value, ie, that makes:PVoutflows = PVinflows

44Calculating MIRR 66.0 12.110%10%-100.0 10.0 60.0 80.00 1 2 310%PV outflows-100.0$100MIRR = 16.5%158.1TV inflowsMIRR = 16.5%$158.1(1 + MIRR)3= 45Calculating MIRR 66.0 12.110%10%-100.0 10.0 60.0 80.00 1 2 310%PV outflows-100.0$100MIRR = 16.5%158.1TV inflowsMIRR = 16.5%$158.1(1 + MIRR)3= 46Why use MIRR versus IRR?MIRR assumes reinvestment at the opportunity cost = WACC. MIRR also avoids the multiple IRR problem.

Managers like rate of return comparisons, and MIRR is better for this than IRR.

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End of LectureThank you for your ATTENTION !48