Capital Budgeting Process 1. Estimate the cash flows. 2. Assess the riskiness of the cash flows. 3. Determine the appropriate discount rate. 4. Find the PV of the expected cash flows. 5. Accept the project if PV of inflows > costs.

Capital Budgeting 1. Basic Data Expected Net Cash Flow YearProject LProject S 0($100)($100) Evaluation Techniques A. Payback period B. Discounted payback period C. Net present value (NPV) D. Internal rate of return (IRR) E. Modified internal rate of return (MIRR)

Capital Budgeting - Illustration I. Basic Data Expected Net Cash Flow YearProject LProject S 0($100)($100)

Capital Budgeting Weakness of Payback: 1. Ignores the time value of money. This weakness is eliminated with the discounted payback method. 2. Ignores cash flows occurring after the payback period.

Capital Budgeting NPV =  CF t (1+k) Project L: 0 10% NPV L = 18.79NPV S = $19.98 If the projects are independent, accept both. If the projects are mutually exclusive, accept Project S since NPV S > NPV L t

Capital Budgeting IRR =  CF t = $0 = NPV (1+IRR) Project L: 0 IRR = $0 IRR L =18.1% IRR S =23.6% If the projects are independent, accept both because IRR>k. If the projects are mutually exclusive, accept Project S since IRR S > IRR L t

Capital Budgeting Project L: 0 10% MIRR = 16.5% $ $0.00 = NPVTVof inflows PV outflows = $100 TV inflows =$158.10$100= (pvif)

Capital Budgeting - Illustration II. Evaluation Techniques A. Payback period B. Discounted payback period C. Net present value (NPV) D. Internal rate of return (IRR) E. Modified internal rate of return (MIRR)

Capital Budgeting - Payback Period Payback period = Expected number of years required to recover a project’s cost. Project L Expected Net Cash Flow YearAnnualCumulative 0($100)($100) 1 10 (90) 2 60 (30)

Capital Budgeting - Payback Period Payback L = 2 + $30 / $80 years = 2.4 years Payback S = 1.6 years. Weaknesses of Payback: 1. Ignores the time value of money. This weakness is eliminated with the discounted payback period. 2. Ignores cash flows occurring after the payback period.

Capital Budgeting - Net Present Value (NPV) n NPV =  CF t Project L: t=0 (1+k) t 0 10% NPV L = $18.79

Capital Budgeting - Net Present Value (NPV) n NPV =  CF t Project S: t=0 (1+k) t 0 10% NPV S = $19.99

Capital Budgeting - Net Present Value (NPV) NPV S = $19.99 NPV L = $18.79 If the projects are independent, accept both. If the projects are mutually exclusive, accept Project S since NPV S > NPV L. Note: NPV declines as k increases and NPV rises as k decreases.

Internal Rate of Return (IRR) n IRR =  CF t = $0 = NPV Project L: t=0 (1+IRR) t 0 IRR % % % $ 0.01  $0

Internal Rate of Return (IRR) n IRR =  CF t = $0 = NPV Project S: t=0 (1+IRR) t 0 IRR % % % $ 0.00

Internal Rate of Return (IRR) IRR L = 18.13% IRR S = 23.56% If the projects are independent, accept both because IRR > k. If the projects are mutually exclusive, accept Project S since IRR S > IRR L. Note: IRR is independent of the cost of capital.

Capital Budgeting - NPV Profiles k NPV L NPV S 0% $50 $ (4) 5

Modified IRR (MIRR) Project L: 0 10% $ =TV of MIRR=16.5% inflows $ 0.00 = NPV

Modified IRR (MIRR) Project S: 0 10% $ =TV of MIRR=16.9% inflows $ 0.00 = NPV

Modified IRR (MIRR) PV outflows = $100 TV inflows = $ $100 = $ (PVIF MIRR L,3 ) MIRR L = 16.5% MIRR S = 16.9%

Modified IRR (MIRR) Project L: 0 5% $ =TV of MIRR=15.48% inflows $ 0.00 = NPV

Modified IRR (MIRR) Project S: 0 5% $ =TV of MIRR=14.39% inflows $ 0.00 = NPV

Modified IRR (MIRR) MIRR is better than IRR because: 1. MIRR correctly assumes reinvestment at project’s cost of capital. 2. MIRR avoids the problem of multiple IRRs.

NPV Profile: Nonnormal Project P with Multiple IRRs Year Cash Flow (‘000) 0 ($800) 1 5,000 2 (5,000) = -$386,777. Do not accept; NPV < 0. IRR = 25% and 400%. MIRR = 5.6%. Do not accept; MIRR < k.

Debt Bank Equity $100 wacc=10% $120 1 year IRR = 20% $ % 20% wacc = 10% MCC IOS A=20% IF IRR > WACC THEN ACCEPT PROJECT

Debt Bank Equity PV(CASH IN) = 100 = CASH OUTFLOW $100 wacc=10% $110 1 year IRR = 10%

PV(IN) = PV(IN) = 100 PV(OUT) = 100PV(0UT) = 100 NPV = 9.09NPV = 0 CF 0 = -100i=10%CF 0 = -100i=10% CF 1 = 120CF 1 = 110 NPV = 9.09NPV = OUT 100 OUT IN 110 IN YEAR WACC = 10%

IRRNPV CF 0 = -100PV(IN) = CF 1 = 105PV(OUT) = 100 IRR = 5%NPV = CF 0 = -100CF 1 =105 i = 10%NPV = IN 105 WACC = 10% 100 OUT 10%