1. 10-1 CHAPTER 10 The Basics of Capital Budgeting

2. 10-2 What is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Capital budgeting is the process of analyzing projects and deciding (1)which are appropriate projects (2) which actually should be purchased.

3. 10-3 What 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. All independent projects can be purchased if all are acceptable. Mutually exclusive projects – if one projects are taken on, the others must be rejected. Only one mutually exclusive project can be purchased even though all are acceptable.

4. 10-4 What 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. No normal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project.

5. 10-5 Capital budgeting decision rules Five methods are used to evaluate projects: (1) Payback (2) Discounted payback (3) Net Present Value (NPV) (4) Internal Rate of Return (IRR) (5) Modified Internal Rate of Return (MIRR) (6) Profitability Index (PI)

6. 10-6 What is the payback period? (Traditional Payback period) The number of years required to recover a project’s cost, or “How long does it take to get our money back?” Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.

7. 10-7 Payback period (uneven cash flows) =(No of years before full recovery of initial investment)+(amount of the initial investment that is unrecovered at the start of the recovery year/total cash flows generated during the recovery year)

8. 10-8 Payback period (for even cashflows)

9. 10-9 Calculating payback Payback L = 2 + / = 2.375 years CF t -100 10 60 100 Cumulative -100 -90 0 50 012 3 = 2.4 3080 -30 Project L Payback S = 1 + / = 1.6 years CF t -100 70 100 20 Cumulative -100 0 20 40 012 3 = 1.6 3050 -30 Project S

10. 10-10 Decision rule:a project is acceptable if PB<N* N* is the recovery period that the firm has determined is appropriate.

11. 10-11 Strengths and weaknesses of payback Strengths Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses Ignores the time value of money. Ignores CFs occurring after the payback period.

12. 10-12 Discounted Pay back Method The length of time it takes for a project’s discounted cashflows to repay the cost of the investment. Decisiobn rule:A project is acceptable if DPB<PROJECTS LIFE. When a projects discounted payback is less than it life,the present value of the future cashflows that the project is expected to generate exceeds the initial cost of the asset-that is NPV>0.

13. 10-13 Discounted payback period Uses discounted cash flows rather than raw CFs. Disc Payback L = 2 + / = 2.7 years CF t -100 10 60 80 Cumulative -100 -90.91 18.79 012 3 = 2.7 60.11 -41.32 PV of CF t -100 9.09 49.59 41.3260.11 10%

14. 10-14 Net Present Value (NPV) NPV = PV of all cash inflows – PV of all cash outflows Net benefit that accrues to the firm if the asset is purchased.Net benefit is NPV

15. 10-15 What is Project L’s NPV? Year CF t PV of CF t 0-100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPV L = $18.79 NPV S = $19.98

16. 10-16 Rationale for the NPV method NPV= PV of inflows – Cost = Net gain in wealth If 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. For example, accept S if mutually exclusive (NPV s > NPV L ), and would accept both if independent.

17. 10-17 Internal Rate of Return (IRR) IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

18. 10-18 How is a project’s IRR similar to a bond’s YTM? They are the same thing. Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project. EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20. Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

19. 10-19 Rationale for the IRR method If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns.

20. 10-20 IRR Acceptance Criteria If IRR > k, accept project. If IRR < k, reject project. If projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept S, because IRR s > IRR L.

21. 10-21 Step 3: Solve Using Mathematical Formula This will require finding the rate at which NPV is equal to zero. We compute the NPV at different rates to determine the range of IRR. This table suggests that IRR is between 15 and 20%. Discount RateComputed NPV 0%$6,990 5%$4,605 10%$2,667 15%$1,075 20%-$245

22. 10-22 Step 4: Analyze The new copying center requires an initial investment of $10,010 and provides future cash flows that offer a return of 19%. Since the firm has decided 15% as the minimum acceptable return, this is a good investment for the firm.

23. 10-23 Interpolation Formula to calculate IRR When there is Unequal Cash Flows IRR = Lowest Discount Rate + [NPV at Lower rate * (Higher Rate - Lower Rate) / (NPV at Lower Rate - NPV at Higher Rate)] Example: Say there are two discount rates for instance 10% & 20% and also let us say NPV at 10% is +29,150 and at 20% is -19,350. IRR = 10% + [ 29,150*(20%- 10%)/(29,150+19,350)] IRR = 16.01%

24. 10-24 NPV Profiles A graphical representation of project NPVs at various different costs of capital. k NPV L NPV S 0$50$40 5 33 29 10 19 20 15 7 12 20 (4) 5

25. 10-25 Drawing NPV profiles -10 0 10 20 30 40 50 60 5 10 152023.6 NPV ($) Discount Rate (%) IRR L = 18.1% IRR S = 23.6% Crossover Point = 8.7% S L...........

26. 10-26 Comparing the NPV and IRR methods If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive … If k > crossover point, the two methods lead to the same decision and there is no conflict. If k < crossover point, the two methods lead to different accept/reject decisions.

27. 10-27 Profitability Index The profitability index (PI) is a cost- benefit ratio equal to the present value of an investment’s future cash flows divided by its initial cost:

28. 10-28 Profitability Index (cont.) Decision Criteria: If PI is greater than one, it indicates that the present value of the investment’s future cash flows exceeds the cost of making the investment and the investment should be accepted. If PI is greater than one, the NPV will be positive. If PI is less than one, the project should be rejected. If PI is less than one, the NPV will be negative.

29. 10-29 Checkpoint 11.3 Calculating the Profitability Index for Project Long Project Long is expected to provide five years of cash inflows and to require an initial investment of $100,000. The discount rate that is appropriate for calculating the PI of Project Long is 17 percent. Is Project Long a good investment opportunity?

30. 10-30 Checkpoint 11.3

31. 10-31 Checkpoint 11.3

32. 10-32 Checkpoint 11.3