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

3. Net Present Value (NPV)
Net Present Value (NPV). Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.

4. If NPV > 0, accept the project If NPV < 0, reject the project
Net Present Value (NPV)
Net Present Value (NPV). Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, indifferent

5. Net Present Value (NPV)

6. Net Present Value (NPV)
Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 9.2

7. Net Present Value (NPV)

8. Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows.
The IRR is the project’s intrinsic rate of return.

9. Capital Budgeting (NPV)
Advantages:
Cash flows rather than profits are analyzed
Recognizes the time value of money
Acceptance criterion is consistent with the goal of maximizing value
Disadvantage:
Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance

10. If IRR > k, accept the project If IRR < k, reject the project
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows.
The IRR is the project’s intrinsic rate of return.
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, indifferent

11. The Internal Rate of Return (IRR)

12. Capital Budgeting (IRR)
Advantages:
Cash flows rather than profits are analyzed
Recognizes the time value of money
Acceptance criterion is consistent with the goal of maximizing value
Disadvantages:
Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance
Difficult to solve for IRR without a financial calculator or spreadsheet

13. NPV versus IRR
When NPV>0, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project.
When IRR>k, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project.
When NPV>0, IRR>k for a project—that is, if a project is acceptable using NPV, it is also acceptable using IRR

14. Net Present Value Profiles

15. IRR and Mutually Exclusive Projects
If you choose one, you can’t choose the other
Example: You can choose to attend graduate school next year at either Harvard or Stanford, but not both
Intuitively you would use the following decision rules:
NPV – choose the project with the higher NPV
IRR – choose the project with the higher IRR

16. Example With Mutually Exclusive Projects
Period
Project A
Project B
-500
-400 1
325 2
200
IRR
19.43%
22.17%
NPV
64.05
60.74
The required return for both projects is 10%.
Which project should you accept and why?

17. NPV profiles

18. Conflicts Between NPV and IRR
NPV directly measures the increase in value to the firm
Whenever there is a conflict between NPV and another decision rule, you should always use NPV
IRR is unreliable in the following situations
Non-conventional cash flows
Mutually exclusive projects

19. To Find the Crossover Rate
Find cash flow differences between the projects. See data at the beginning of the case.
Enter these differences in cash flow register, then press IRR. Crossover rate = 7.2%
Can subtract S from L or vice versa, but easier to have first CF negative
If profiles don’t cross, one project dominates the other.

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

21. Reinvestment Rate Assumptions
NPV assumes reinvesting at r (opportunity cost of capital, WACC).
IRR assumes reinvesting at IRR.
Reinvesting at opportunity cost, r, is more realistic, so NPV method is best.
NPV should be used to choose between mutually exclusive projects if a conflict exists.

22. Multiple IRRS: A Problem With IRR
Normal vs. nonnormal cash flows
Typical cash flow patterns
NPV profile for Project M
Copyright © 2014 by Nelson Education Ltd.

23. Normal vs. Nonnormal Cash Flows
Normal Cash Flow Project:
Cost (negative CF) followed by a series of positive cash inflows
One change of signs
Nonnormal Cash Flow Project:
Two or more changes of signs
Most common: Cost (negative CF), then string of positive CFs, then cost to close project
For example, nuclear power plant or strip mine

24. Conclusions on Capital Budgeting Methods
Quantitative methods provide valuable information, but they should not be used as the sole criteria for accept/reject decisions in capital budgeting process.
NPV is the single most important method showing the absolute profitability.
IRR is ranked second of importance.
Payback is still used significantly among small businesses.

25. Conclusions on Capital Budgeting Methods (cont’d)
Quantitative methods should not be used as a substitute for sound managerial judgment.
In a perfectly competitive economy, projects with high NPV result from some market imperfections only.
Managers should strive to develop nonreplicable sources of competitive advantage.