1. The Basics of Capital Budgeting
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

2. Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Regular Payback Discounted Payback

3. What is capital budgeting?
The process of planning expenditures on assets whose cash flows are expected to extend beyond one year
Analysis of potential additions to fixed assets
Long-term decisions; involve large expenditures
Very important to firm’s future
Important function for financial Mangers
Two major differences than security valuations:
Project created by the firm
Corporation have major influence on the project results
The techniques we will discus are the same ones that are used by many leading companies world wide

4. Types of Capital Budgeting
Replacement
Needed to continue current operation
Cost reduction
Expansion
Existing product or line
New products or markets
Safety or/and environmental project
Other miscellaneous project
Merger

5. Steps to Capital Budgeting
Estimate CFs (inflows & outflows)
The most difficult aspect
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

6. What is the difference between independent & 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 (only one can be accepted)

7. What is the difference between normal & 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. Examples include nuclear power plant, strip mine, etc.

8. Net Present Value (NPV)
Sum of the PVs of all cash inflows and outflows of a project:

9. Example
Projects we’ll examine: CF is the difference between CFL & CFS We’ll use CF later
Cash Flow
Year L S
CF
-100 1 10 70
-60 2 60 50 3 80 20

10. What is Project L’s NPV? WACC = 10% Year CFt PV of CFt - 100 $100.00 1-
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.

11. What is Project S’ NPV? WACC = 10% Year CFt PV of CFt - 100 $100.00 1-
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.

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

13. 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), & accept both if independent

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

15. Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of inflows equal to cost, & the NPV = 0:
It the ”breakeven” characteristic that makes it useful
Solving for IRR with a financial calculator:
Enter CFs in CFLO register.
Press IRR; IRRL = 18.13% & IRRS = 23.56%.
Solving for IRR with Excel:=IRR(CF0:CFn,guess for rate)
Measures the rate of return for the project

16. How is a project’s IRR similar to a bond’s YTM?
They are the same thing
Think of a bond as a project.
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 $1,134.20
Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

17. Example Cash Flow Year Large Small -100,000 -1 1-10 50,000 0.6 I/YR 10
-100,000 -1
1-10
50,000
0.6
I/YR 10
NPV
207,228.36
2.69
IRR
49.1%
59.4%

18. Rationale for the IRR Method
If IRR > WACC, the project’s return exceeds its costs
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

19. NPV Profiles
A graphical representation of project NPVs at various different costs of capital.
WACC
NPV L S
$50
$40 5 33 29 10 19 20 15 7 12
(4)
If WACC = 0, NPV is what?

20. Independent Projects
NPV & IRR always lead to the same accept/reject decision for any given independent project.
r > IRR
and NPV < 0.
Reject.
NPV ($)
r (%)
IRRL = 18.1%
IRR > r
and NPV > 0
Accept.
r = 18.1%
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

21. Mutually Exclusive Projects
If r < 8.7%: NPVL > NPVS IRRS > IRRL
CONFLICT
If r > 8.7%: NPVS > NPVL ,
IRRS > IRRL
NO CONFLICT
r r
NPV %
IRRs
IRRL L S

22. . . . . . . . . . . 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 . . . . .
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 . . . . .

23. Finding the Crossover Rate
Find cash flow differences between the projects. See Slide 11-8.
Enter the CFs in CFj register, then press  IRR. Crossover rate = 8.68%, rounded to 8.7%.
If profiles don’t cross, one project dominates the other.

24. Reasons Why NPV Profiles Cross
Size (scale) differences: the smaller project frees up funds at t = 0 for investment.
The cost of one project is larger
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.
Cash flow for one project come in early years
If WACC is high, early CF especially good, NPVS > NPVL.

25. Comparing the NPV & 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 (No Conflict)
If WACC < crossover rate:
The methods lead to different accept/reject decisions (Conflict)
When Conflict exist, use the NPV

26. Reinvestment Rate Assumptions
NPV method assumes CFs are reinvested at the WACC
IRR method assumes CFs are reinvested at IRR
Overestimate the project true returns
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 & 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

28. Find Project P’s NPV and IRR
Project P has cash flows (in 000s): CF0 = -$800, CF1 = $5,000, and CF2 = -$5,000.
, ,000
WACC = 10%
Enter CFs into calculator CFLO register.
Enter I/YR = 10.
NPV = -$
IRR = ERROR Why?

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

30. 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.

31. When to use the MIRR instead of the IRR? Accept Project P?
When there are nonnormal CFs & 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%.

32. 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
Eliminate the multiple IRR problem

33. Calculating MIRR
66.0
12.1
10%
-100.0
PV outflows
MIRR = 16.5%
158.1
TV inflows
$100
MIRRL = 16.5%
$158.1
(1 + MIRRL)3 = 3 2 1
10.0
60.0
80.0
Excel: =MIRR(CF0:CFn,Finance_rate,Reinvest_rate) We assume that both rates = WACC.

34. Why use MIRR versus IRR?
MIRR assumes reinvestment at the opportunity cost = WACC (Cost of capital)
MIRR also avoids the multiple IRR problem
Eliminated the IRR problems
Managers like rate of return comparisons, and MIRR is better for this than IRR.
Is MIRR better than NPV?

35. What is the payback period?
Number of years required to recover a project’s cost
or “How long does it take to get our money back?”
The length of time require for an investment new revenue to cover its cost
Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive
The shorter the payback the better
This is one of the oldest criteria used to evaluate projects

36. 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
PaybackL = /
= years
PaybackS = years 30 80

37. Strengths & Weaknesses of Payback
Provides an indication of a project’s risk & liquidity
Easy to calculate and understand.
Weaknesses:
Ignores the time value of money
Ignores CFs occurring after the payback period.
No necessary relation between a payback & investor wealth maximization
CFs after the payback period might be too low or too high

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

39. Capital Budget
A firm is considering 2 projects each costing $100 million
Project A has an IRR of 20%; has an NPV of $9 million & 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?

40. Example

41. 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

42. Conclusions on Capital Budgeting Methods
MIRR is better than IRR because of the reinvestment assumption and avoidance of multiple IRRs
Contain information concerning a project’s “Safety margin”
Payback & discounted payback tell us about the project’s risk & 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

43. The end Thank you