1. Chapter 11 The Basics of Capital Budgeting
Should we
build this
plant?
 Investment decisions involving fixed assets or capital budgeting
Capital is long-term assets used in production and budget is a plan that outlines the cash flows of the project over a certain period of time
© Cengage Learning
Modified by Dr. Bader Alhashel

2. What is capital budgeting?
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
The techniques we will discus are the same ones that are used by many leading companies world wide

3. Steps to Capital Budgeting
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.
This is very important for firms to do
Their ability to grow and maintain their competitive advantage is by making good capital budgeting decisions to increase their value
What are the type of problems that are considered?
Replacement: needed to continue current operations, Replacement: cost reduction, expansion of existing products or markets, expansion into new products or markets, safety and/or environmental projects, other products (e.g. office buildings, parking lots), mergers

4. 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.
Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.
Give examples on both

5. 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.
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.

6. Net Present Value (NPV)
Sum of the PVs of all cash inflows and outflows of a project:
Measures how much a project contributes to shareholder wealth
NPV is the best measure
Measures how much a project contributes to shareholder wealth
Larger NPV, the more value the project adds to the firm, the higher the stock price
This is why NPV is the best measure
R = WACC n N is the life of the project
CF0 is usually negative. It is the amount of cash investment the firm has to make (e.g. purchasing the equipment)

7. Example Projects we’ll examine: Cash Flow Year L S -100 1 10 70 2 60
-100 1 10 70 2 60 50 3 80 20

8. What is Project L’s NPV? WACC = 10% Excel: =NPV(rate,CF1:CFn) + CF0
Year
CFt
PV of CFt -
100
$100.00 1 10
9.09 2 60
49.59 3 80
60.11
NPVL = $
Excel: =NPV(rate,CF1:CFn) + CF0
Here, CF0 is negative.

9. What is Project S’ NPV? WACC = 10% Excel: =NPV(rate,CF1:CFn) + CF0
Year
CFt
PV of CFt -
100
$100.00 1 70
63.64 2 50
41.32 3 20
15.02
NPVS = $
Excel: =NPV(rate,CF1:CFn) + CF0
Here, CF0 is negative.

10. Solving for NPV: Financial Calculator Solution
Enter CFs into the calculator’s CASH register.
CF0 = -100
CF1 = 10
CF2 = 60
CF3 = 80
Enter I/YR = 10, press NPV button to get NPVL = $18.78.

11. 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.
In this example, accept S if mutually exclusive (NPVS > NPVL), and accept both if independent.

12. Project X is very risky and has an NPV of $3 million
Project X is very risky and has an NPV of $3 million. Project Y is very safe and has an NPV of $2.5 million. They are mutually exclusive and project risk has been properly taken into consideration in the NPV analysis. Which project should be chosen?

13. Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:
Solving for IRR with a financial calculator:
Enter CFs in CASH register.
Press IRR; IRRL = 18.13% and IRRS = 23.56%.
Measures the rate of return for the project

14. 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 and $1,000 par value sells for $1,
Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

15. Rationale for the IRR Method
If IRR > WACC, the project’s return exceeds its costs and there is some return left over to boost stockholders’ returns.
If IRR > WACC, accept project.
If IRR < WACC, reject project.
If projects are independent, accept both projects, as both IRR > WACC = 10%.
If projects are mutually exclusive, accept S, because IRRs > IRRL.

16. NPV Profiles
A graphical representation of project NPVs at various different costs of capital.
If WACC = 0, NPV is what?

17. . . . . . . . . . . Drawing NPV Profiles S L NPV ($) IRRL = 18.1%
-10 10 20 30 40 50 60 5 15
23.6
NPV
($)
Discount Rate (%)
IRRL = 18.1%
IRRS = 23.6%
Crossover Point = 8.7% S L .
The crossover point is the rate (cost of capital) at which the two projects’ have the same NPV. . . . . .
IRR is the point at which the line crosses the horizontal axis
It is a good visualization of the project at different WACCs. Sensitivity analysis. Shows IRR.
The crossover point is the rate (cost of capital) at which the two projects’ NPVs equal
Projects with steeper profiles are more long-term, because they are more sensitive to WACC changes
NPV profiles also help when NPV and IRR are in conflict
If two projects are independent, both NPV and IRR would say go ahead with it
If two projects are mutually exclusive, if WACC is higher that crossover point no conflict between IRR and NPV. If WACC < crossover point, there is a conflict . . . .

18. 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 WACC > crossover rate, the methods lead to the same decision and there is no conflict.
If WACC < crossover rate, the methods lead to different accept/reject decisions.

19. Reasons Why NPV Profiles Cross
Size (scale) differences – the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high WACC favors small projects.
Timing differences – the project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF especially good, NPVS > NPVL.

20. Reinvestment Rate Assumptions
NPV method assumes CFs are reinvested at the WACC.
IRR method assumes CFs are reinvested at IRR.
Assuming CFs are reinvested at the opportunity cost of capital 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.
It is more reasonable to expect reinvestment at WACC since a firm would not accept anything below WACC and even if it has projects with R > WACC, this is a more conservative assumption
IRR’s assumption is a very strong one and most likely not possible for the firm to achieve. Therefore, IRR leads to an overstatement of the firm’s total return on the project

21. Problem 11-12

22. Problem 11-18

23. Since managers prefer the IRR to the NPV method, is there a better IRR measure?
Yes, MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC.
MIRR assumes cash flows are reinvested at the WACC.

24. Calculating MIRR 66.0 12.1 -100.0 $100 158.1 MIRRL = 16.5% $158.1
10%
-100.0
PV outflows
$100
MIRR = 16.5%
158.1
TV inflows
MIRRL = 16.5%
$158.1
(1 + MIRRL)3 = 3 2 1
10.0
60.0
80.0

25. Why 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.
Is MIRR better than NPV?
For independent projects, IRR, MIRR, and NPV reach the same accept/reject decision
For mutually exclusive projects, conflicts may arise and therefore use NPV

26. Is MIRR better than NPV?
For independent projects, IRR, MIRR, and NPV reach the same accept/reject decision
For mutually exclusive projects, conflicts may arise and therefore use NPV

27. What is the 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.
This is one of the oldest criteria used to evaluate projects
The shorter the payback the better

28. Calculating Payback Project L’s Payback Calculation CFt Cumulative 1 21 2 3
-30
Project L’s Payback Calculation
-100 50
-90 80 60 10 30 80
PaybackL = /
= years
PaybackS = years

29. Strengths and Weaknesses of Payback
Provides an indication of a project’s risk and liquidity.
The shorter the project’s payback period, the greater it’s liquidity and the lower its risk
Easy to calculate and understand.
Weaknesses
Ignores the time value of money.
Ignores CFs occurring after the payback period.
Does not provide information on wealth creation or rate of return of the project.
CFs after the payback period might be too low or too high
The shorter the project’s payback period, the greater it’s liquidity and the lower its risk

30. Discounted Payback Period
Uses discounted cash flows rather than raw CFs.
Still ignores CFs beyond payback period
No indication of what is a good payback number?
CFt
Cumulative 1 2 3
-41.32
-100
18.79
-90.91 80 60 10
10%
PV of CFt
9.09
49.59
60.11
Still ignores CFs beyond payback period
No indication of what is a good payback number?
41.32
60.11
Disc PaybackL = / = 2.7 years

31. A firm has a $100 million capital budget
A firm has a $100 million capital budget. It is considering two projects each costing $100 million. Project A has an IRR of 20%; has an NPV of $9 million; and will be terminated after 1 year at a profit of $20 million, resulting in an immediate increase in EPS. Project B which cannot be postponed has an IRR of 30% and an NPV of $50 million. However, the firm’s short-run EPS will be reduced if it accepts project B because no revenue will be generated for several years.
Should the short-run effects on EPS influence the choice between the two projects?
How might situations like this influence a firm’s decision to use payback?

32. Find Project P’s NPV and IRR.
Enter CFs into calculator CFLO register.
Enter I/YR = 10.
NPV = -$
IRR = ERROR Why?
Project P has cash flows (in 000s):
CF0 = -$0.8 million, CF1 = $5 million, and CF2 = -$5 million.
, ,000
WACC = 10%

33. Multiple IRRs
450
-800
400
100
IRR2 = 400%
IRR1 = 25%
WACC
NPV

34. Why are there multiple IRRs?
At very low discount rates, the PV of CF2 is large and negative, so NPV < 0.
At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0.
In between, the discount rate hits CF2 harder than CF1, so NPV > 0.
Result: 2 IRRs.

35. When to use the MIRR instead of the IRR? Accept Project P?
When there are nonnormal CFs and more than one IRR, use MIRR.
PV of 10% = -$4,
TV of 10% = $5,500.
MIRR = 5.6%.
Do not accept Project P.
NPV = -$ < 0.
MIRR = 5.6% < WACC = 10%.

36. Problem 11-6

37. Problem 11-21

38. Conclusions on Capital Budgeting Methods
Five criteria have been presented:
NPV
IRR
MIRR
Payback Period
Discounted Payback Period
NPV measures wealth creation
IRR measures rate of return (or profitability)
IRR & MIRR also tell me if I have a margin of error, how high IRR is relative to WACC. NPV doesn’t

39. Conclusions on Capital Budgeting Methods
NPV is the best meathod
MIRR is better than IRR because of the reinvestment assumption and avoidance of multiple IRRs
Payback and discounted payback tell us about the project’s risk and liquidity
Every measures tells a set of information that is useful.
Use all measures
In practice IRR is the mostly used but NPV is gaining traction