CHAPTER 10 The Basics of Capital Budgeting Omar Al Nasser, Ph.D. FIN

Chapter Outline Net Present Value The Payback Rule The Internal Rate of Return The Profitability Index

Project’s Cash Flows (CF t ) Market interest rates Project’s business risk Market risk aversion Project’s debt/equity capacity Project’s risk-adjusted cost of capital (r) The Big Picture: The Net Present Value of a Project NPV = + + ··· + − Initial cost CF 1 CF 2 CF N (1 + r ) 1 (1 + r) N (1 + r) 2

What is capital budgeting? Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to firm’s future.

Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? –The first step is to estimate the expected future cash flows. –The second step is to estimate the required return for projects of this risk level. –The third step is to find the present value of the cash flows and subtract the initial investment.

NPV Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

Net Present Value Cost often is CF 0 and is negative. NPV = ∑ n t = 0 CF t (1 + r) t. NPV = ∑ n t = 1 CF t (1 + r) t. - CF 0. NPV equal to the PV of future net cash flows, discounted at the cost of capital.

Project Example Information You are looking at a new project and you have estimated the following cash flows: –Year 0:CF = -165,000 –Year 1:CF = 63,120; –Year 2:CF = 70,800; –Year 3:CF = 91,080; Your required return for assets of this risk is 12%.

Computing NPV for the Project Using the formulas: –NPV = 63,120/(1.12) + 70,800/(1.12) ,080/(1.12) 3 – 165,000 = $12, Using the calculator: –CF 0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12, Do we accept or reject the project?

Cash Flows for Franchise L and Franchise S % L’s CFs: % S’s CFs:

What’s Franchise L’s NPV? % L’s CFs: = NPV L NPV S = $19.98.

Calculator Solution: Enter values in CFLO register for L CF 0 CF 1 NPV CF 2 CF 3 I = = NPV L

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.

Using NPV method, which franchise(s) should be accepted? If Franchises S and L are mutually exclusive, accept S because NPV s > NPV L. If S & L are independent, accept both; NPV > 0. NPV is dependent on cost of capital.

What is the payback period? The number of years required for an investment to recover its cost, or how long does it take to get the business’s money back? Computation –Estimate the cash flows –Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Rule – Accept if the payback period is less than some preset limit

Payback for Franchise L = CF t Cumulative Payback L 2+30/80 = years 0 2.4

Payback for Franchise S CF t Cumulative Payback S /50 = 1.6 years =

Strengths and Weaknesses of Payback Strengths: –Provides an indication of a project’s risk and liquidity. –Easy to calculate and understand. Weaknesses: –Ignores CFs occurring after the payback period. –Unlike the NPV, which tells us by how much the project should increase shareholder wealth, the payback tells us when we get our investment back. –No specification of acceptable payback.

Internal Rate of Return This is the most important alternative to NPV It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere. IRR is the discount rate that forces a project’s NPV to equal zero. Decision Rule: Accept the project if the IRR is greater than the required return

Internal Rate of Return IRR: Enter NPV = 0, solve for IRR. = NPV ∑ n t = 0 CF t (1 + r) t.= 0 ∑ n t = 0 CF t (1 + IRR) t.

What’s Franchise L’s IRR? IRR = ? PV 3 PV 2 PV 1 0 = NPV Enter CFs in CFLO, then press IRR: IRR L = 18.13%. IRR S = 23.56%.

Calculator Solution: What’s Franchise L’s IRR? CF 0 CF 1 IRR CF 2 CF 3 = 18.13% = IRR L

Rationale for the IRR Method If IRR > the required return, then the project’s rate of return is greater than its cost– the project expected to earn more than the cost of capital need to finance the project. Example: the required return = 10%, IRR = 15%. So this project adds extra return to shareholders.

Decisions on Franchises S and L per IRR If S and L are independent, accept both: IRR S > r and IRR L > r. If S and L are mutually exclusive, accept S because IRR S > IRR L.

NPV vs. IRR NPV and IRR will generally give us the same decision Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV because managers find it more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV. However, you should always use NPV as your decision criteria because it selects the project that adds the most to shareholder’s wealth. Whenever there is a conflict between NPV and another decision rule, you should always use NPV

Modified Internal Rate of Return (MIRR) MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found as the sum of the future values of the cash inflows compounded at the firm’s cost of capital. MIRR assumes that all cash flows are reinvested at the firm's cost of capital. Therefore, MIRR more accurately reflects the profitability of a project.

MIRR for Franchise L % L’s CFs:

Franchise L’s Step 1, Find PV of inflows % Project L:

Step 1, Find PV of Inflows First, enter cash inflows in CFLO register: CF 0 = 0, CF 1 = 10, CF 2 = 60, CF 3 = 80 Second, enter I/YR = 10. Third, find PV of inflows: Press NPV =

Step 2, Find FV of Inflows Enter PV = , N = 3, I/YR = 10, PMT = 0. Press FV = = FV of inflows.

Step 3, Find “IRR” of FV of Inflows and PV of Outflows For this problem, there is only one outflow, CF 0 = -100, so the PV of outflows is Enter FV = , PV = -100, PMT = 0, N = 3. Press I/YR = 16.50% = MIRR.

Financial Calculator First, enter cash inflows in CFLO register: CF 0 = 0, CF 1 = 10, CF 2 = 60, CF 3 = 80 Second, enter I = 10. Third, find PV of inflows: Press NPV = Then: Enter PV = , N = 3, I = 10, PMT = 0. Press FV = = FV of inflows. Then: Enter FV = , PV = -100, PMT = 0, N = 3. Press I = 16.50% = MIRR.

Profitability Index The profitability index (PI) is the present value of future cash flows divided by the initial cost. Profitability index is a good tool for ranking projects because it allows you to clearly identify the amount of value created per unit of investment. If PI > 1 then accept the project if PI < 1 then reject the project. The higher the PI, the higher the project’s ranking.

Franchise L’s PV of Future Cash Flows % Project L:

Franchise L’s Profitability Index PI L = PV future CF Initial Cost $ = PI L = $100 PI S = So project L is expected to produce $ for each $1 of investment. A profitability index of implies that for every $1 of investment, we receive $ worth of benefits, so we create an additional $ in value Both projects should be accepted by PI, but project S will be ranked ahead of L because it has a higher PI.

Comprehensive Problem An investment project has the following cash flows: CF0 = -1,000,000; C01 – C08 = 200,000 each If the required rate of return is 12%, what decision should be made using NPV? What decision should be made using IRR?

Excel Example Information You are looking at a new project and you have estimated the following cash flows: –Year 0:CF = -165,000 –Year 1:CF = 63,120; –Year 2:CF = 70,800; –Year 3:CF = 91,080; Your required return for assets of this risk is 12%.

Calculating NPVs with a Spreadsheet Spreadsheets are an excellent way to compute NPVs, especially when you have to compute the cash flows as well. Using the NPV function –The first component is the required return entered as a decimal –The second component is the range of cash flows beginning with year 1 –Subtract the initial investment after computing the NPV –Check your calculations with a hand held calculator to ensure that the formulae have been correctly set up.

Calculating IRRs With a Spreadsheet You start with the cash flows the same as you did for the NPV You use the IRR function –You first enter your range of cash flows, beginning with the initial cash flow –You can enter a guess, but it is not necessary –The default format is a whole percent – you will normally want to increase the decimal places to at least two

Calculating PI With a Spreadsheet The profitability index (PI) is the present value of future cash flows divided by the initial cost. You start with the calculating the PV of future cash flows, then divided by the initial cost. PI = PV future CF Initial Cost

Calculating MIRR With a Spreadsheet  Modified Internal Rate of Return – the cash flow cell range is the same as in the IRR, but both the required rate of return, and the re-investment rate, are entered into the formula.