1. The Basics of Capital Budgeting: Investment Criteria and
Evaluating Cash Flows
Should we
build this
plant?

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

3. Steps
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine r = WACC for project.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.

4. Incremental Cash Flows
Cash flows matter—not accounting earnings.
Sunk costs don’t matter.
Incremental cash flows matter. (with or without the project)
Opportunity costs matter.
Be cautious about Fixed OH allocation
Side effects like erosion matter.
Taxes matter: we want incremental after-tax cash flows.
Inflation matters.

5. Cash Flows—Not Accounting Earnings
Consider depreciation expense.
You never write a cheque made out to “depreciation”.
Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.

6. Incremental Cash Flows
Sunk costs are not relevant
Just because “we have come this far” does not mean that we should continue to throw good money after old.
Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed.
When I was an undergrad at the University of Missouri-Rolla, a good friend of mine abandoned college three credit hours shy of graduation. Really. Entreaties from his friends and parents regarding how far he had come and how hard he had worked could not change Louis’ mind. That was all a sunk cost to Louis. He already had a job and didn’t value the degree as much as the incremental work of an easy three-hour required class called ET-10 engineering drafting. Fifteen years later, he still has a good job, a great wife and two charming daughters. Louis taught me a lot about sunk costs.

7. Incremental Cash Flows
Side effects matter.
Erosion; If our new product causes existing customers to demand less of current products, we need to recognize that.
When I was an undergrad at the University of Missouri-Rolla, a good friend of mine abandoned college three credit hours shy of graduation. Really. Entreaties from his friends and parents regarding how far he had come and how hard he had worked could not change Louis’ mind. That was all a sunk cost to Louis. He already had a job and didn’t value the degree as much as the incremental work of an easy three-hour required class called ET-10 engineering drafting. Fifteen years later, he still has a good job, a great wife and two charming daughters. Louis taught me a lot about sunk costs.

8. Estimating Cash Flows Cash Flows from Operations Recall that:
Operating Cash Flow = EBIT – Taxes + Depreciation
Net Capital Spending
Don’t forget salvage value (after tax, of course).
Changes in Net Working Capital
Recall that when the project winds down, we enjoy a return of net working capital.

9. What is the difference between independent and 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.

10. An Example of Mutually Exclusive Projects
BRIDGE vs. BOAT to get
products across a river.

11. 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.
Nuclear power plant, strip mine.

12. Inflow (+) or Outflow (-) in Year1 2 3 4 5 N NN - + + + + + N - + + + + - NN - - - + + + N + + + - - - N - + + - + - NN

13. The Average Accounting Return Rule
Another attractive but fatally flawed approach.
Ranking Criteria and Minimum Acceptance Criteria set by management
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on boor values, not cash flows and market values
Advantages:
The accounting information is usually available
Easy to calculate

14. 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?

15. Payback for Project L (Long: Most CFs in out years)1 2
2.4 3
CFt
-100 10 60
100 80
Cumulative
-100
-90
-30 50
Payback L =
2 + 30/ = years

16. Project S (Short: CFs come quicrly)1
1.6 2 3
CFt
-100 70
100 50 20
Cumulative
-100
-30 20 40
Payback S =
/50 = years

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

18. Discounted Payback: Uses discounted rather than raw CFs.1 2 3
10%
CFt
-100 10 60 80
PVCFt
-100
9.09
49.59
60.11
Cumulative
-100
-90.91
-41.32
18.79
Discounted
payback =
/ = yrs
Recover invest. + cap. costs in 2.7 yrs.

19. NPV: Sum of the PVs of inflows and outflows.
Cost often is CF0 and is negative.

20. What’s Project L’s NPV? Project L: 1 2 3 10% -100.00 10 60 80 9.091 2 3
10% 10 60 80
9.09
49.59
60.11
= NPVL
NPVS = $19.98.

21. Rationale for the NPV Method
NPV = PV inflows - Cost
= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually
exclusive projects on basis of
higher NPV. Adds most value.

22. Using NPV method, which project(s) should be accepted?
If Projects S and L are mutually exclusive, accept S because NPVs > NPVL .
If S & L are independent, accept both; NPV > 0.

23. Internal Rate of Return: IRR1 2 3
CF0
CF1
CF2
CF3
Cost
Inflows
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.

24. NPV: Enter r, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.

25. Enter CFs in CFLO, then press IRR: IRRL = 18.13%. IRRS = 23.56%.
What’s Project L’s IRR? 1 2 3
IRR = ? 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRL = 18.13%.
IRRS = 23.56%.

26. 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 stocrholders’ returns.
Example: WACC = 10%, IRR = 15%.
Profitable.

27. IRR Acceptance Criteria
If IRR > r, accept project.
If IRR < r, reject project.

28. Decisions on Projects S and L per IRR
If S and L are independent, accept both. IRRs > r = 10%.
If S and L are mutually exclusive, accept S because IRRS > IRRL .

29. Construct NPV Profiles
Enter CFs in and find NPVL and
NPVS at different discount rates: r 5 10 15 20
NPVL 50 33 19 7
NPVS 40 29 20 12 5
(4)

30. NPV ($) Discount Rate (%) r 5 10 15 20 NPVL 50 33 19 7 (4) NPVS 40 295 10 15 20
NPVL 50 33 19 7
(4)
NPVS 40 29 20 12 5
Crossover
Point = 8.7% S
IRRS = 23.6% L
Discount Rate (%)
IRRL = 18.1%

31. NPV and IRR always lead to the same accept/reject decision for independent projects:
IRR > r
and NPV > 0
Accept.
r > IRR
and NPV < 0.
Reject.
r (%)
IRR

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

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

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

35. Managers lire rates--prefer IRR to NPV comparisons
Managers lire rates--prefer IRR to NPV comparisons. Can we give them a better IRR?
Yes, 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.

36. MIRR for Project L (r = 10%)1 2 3
10%
-100.0
10.0
60.0
80.0
10%
66.0
12.1
10%
MIRR = 16.5%
158.1
$100 =
$158.1
(1+MIRRL)3
-100.0
TV inflows
PV outflows
MIRRL = 16.5%

37. 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.

38. When there are nonnormal CFs and more than one IRR, use MIRR:1 2
-800,000
5,000,000
-5,000,000
PV 10% = -4,932,
TV 10% = 5,500,
MIRR = 5.6%

39. Accept Project P?
NO. Reject because MIRR = 5.6% < r = 10%.
Also, if MIRR < r, NPV will be negative: NPV = -$386,777.

40. S and L are mutually exclusive and will be repeated. r = 10%
S and L are mutually exclusive and will be repeated. r = 10%. Which is better? (000s) 1 2 3 4
Project S:
(100)
Project L: 60
33.5 60
33.5
33.5
33.5

41. S L
CF , ,000
CF , ,500 Nj I
NPV , ,190
NPVL > NPVS. But is L better?
Can’t say yet. Need to perform common life analysis.

42. Note that Project S could be repeated after 2 years to generate additional profits.
Can use either replacement chain or equivalent annual annuity analysis to mare decision.

43. Project S with Replication:
Replacement Chain Approach (000s)
Project S with Replication: 1 2 3 4
Project S:
(100) 60 60
(100)
(40) 60 60
NPV = $7,547.

44. Or, use NPVs: 1 2 3 4
4,132
3,415
7,547
4,132
10%
Compare to Project L NPV = $6,190.

45. If the cost to repeat S in two years rises to $105,000, which is best
If the cost to repeat S in two years rises to $105,000, which is best? (000s) 1 2 3 4
Project S:
(100) 60 60
(105)
(45) 60 60
NPVS = $3,415 < NPVL = $6,190.
Now choose L.

46. Consider another project with a 3-year life
Consider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage value.
Year 1 2 3 CF
($5,000)
2,100
2,000
1,750
Salvage Value
$5,000
3,100
2,000

47. CFs Under Each Alternative (000s)1 2 3
1. No termination
2. Terminate 2 years
3. Terminate 1 year
(5)
2.1
5.2 2 4
1.75

48. Assuming a 10% cost of capital, what is the project’s optimal, or economic life?
NPV(no) = -$123.
NPV(2) = $215.
NPV(1) = -$273.

49. Conclusions
The project is acceptable only if operated for 2 years.
A project’s engineering life does not always equal its economic life.

50. Choosing the Optimal Capital Budget
Finance theory says to accept all positive NPV projects.
Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:
An increasing marginal cost of capital.
Capital rationing

51. If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.

52. Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150

53. Example of Investment Rules
Project A Project B
CF0 -$ $150.00
PV0 of CF1-3 $ $240.80
NPV = $41.92 $90.80
IRR = %, 100% %
PI =

54. Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?

55. The Good-Buy Project Appraisal