1 Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows

2 Topics Overview and “vocabulary” Methods NPV IRR, MIRR Payback, discounted payback

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

4 Steps in Capital Budgeting Estimate cash flows (inflows & outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows.

5 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.

6 What does this represent? = ∑ n t = 0 CF t (1 + r) t

7 NPV: Sum of the PVs of all cash flows. 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.

8 Cash Flows for Franchise L and Franchise S % L’s CFs: % S’s CFs: -100

9 What’s Franchise L’s NPV? % L’s CFs: -100 = NPV L NPV S = $19.98.

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

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

12 Rationale for the NPV Method NPV = PV inflows – Cost This is net gain in wealth, so accept project if NPV > 0. Choose between mutuallyexclusive projects on basis of higher NPV. Adds most value.

13 Using NPV method, which franchise(s) should be accepted? If Franchise S and L are mutually exclusive, accept S because NPV s > NPV L. If S & L are independent, accept both; NPV > 0.

14 Internal Rate of Return: IRR 0123 CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

15 NPV: Enter r, solve for NPV. 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.

16 What’s Franchise L’s IRR? IRR = ? -100 PV 3 PV 2 PV 1 0 = NPV Enter Cash Flows in CF, then press IRR:

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

Find IRR if CFs are constant:

Or, with CF, enter CFs and press IRR = 9.70% % NI/YRPVPMT INPUTS OUTPUT Find IRR if CFs are constant:

20 Decisions on Projects S and L per IRR IRR S = 18% IRR L = 23% WACC = 10% If S and L are independent, what to do? If S and L are mutually exclusive, what to do?

21 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%. So this project adds extra return to shareholders.

22 Reinvestment Rate Assumptions NPV assumes reinvest at r (opportunity cost of capital). IRR assumes reinvest CFs 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.

23 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 by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC.

% % TV inflows -100 PV outflows MIRR for Franchise L: First, find PV and TV (r = 10%)

25 Second, find discount rate that equates PV and TV MIRR = 16.5% TV inflows PV outflows MIRR L = 16.5% $100 = $158.1 (1+MIRR L ) 3

26 To find TV with calculator: Step 1, find PV of Inflows First, enter cash inflows in CF register: CF 0 = 0, CF 1 = 10, CF 2 = 60, CF 3 = 80 Second, enter I = 10. Third, find PV of inflows: Press NPV =

27 Step 2, find TV of inflows. Enter PV = , N = 3, I = 10 CPT FV = = FV of inflows.

28 Step 3, find PV of outflows. For this problem, there is only one outflow, CF 0 = -100, so the PV of outflows is -100.

29 Step 4, find “IRR” of TV of inflows and PV of outflows. Enter FV = , PV = -100, N = 3. CPT I = 16.50% = MIRR.

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.

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

32 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?

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

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

35 Strengths and Weaknesses of Payback Strengths: Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses: Ignores the TVM. Ignores CFs occurring after the payback period.

CF t Cumulative Discounted payback /60.11 = 2.7 yrs PVCF t % = Recover invest. + cap. costs in 2.7 yrs. Discounted Payback: Uses discounted rather than raw CFs.