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TheBasicsofCapitalBudgetingNetPresentValue(NPV)InternalRateofReturn(IRR)ModifiedInternalRateofReturn(MIRR)RegularPaybackDiscountedPaybackChapter1111-1TheBasicsofCapitalBudgetinWhatiscapitalbudgeting?Analysisofpotentialadditionstofixedassets.Long-termdecisions;involvelargeexpenditures.Veryimportanttofirm’sfuture.11-2Whatiscapitalbudgeting?AnalStepstoCapitalBudgetingEstimateCFs(inflows&outflows).AssessriskinessofCFs.Determinetheappropriatecostofcapital.FindNPVand/orIRR.AcceptifNPV>0and/orIRR>WACC.11-3StepstoCapitalBudgetingEstiWhatisthedifferencebetweenindependentandmutuallyexclusiveprojects?Independentprojects:ifthecashflowsofoneareunaffectedbytheacceptanceoftheother.Mutuallyexclusiveprojects:ifthecashflowsofonecanbeadverselyimpactedbytheacceptanceoftheother.11-4WhatisthedifferencebetweenWhatisthedifferencebetweennormalandnonnormalcashflowstreams?Normalcashflowstream:Cost(negativeCF)followedbyaseriesofpositivecashinflows.Onechangeofsigns.Nonnormalcashflowstream:Twoormorechangesofsigns.Mostcommon:Cost(negativeCF),thenstringofpositiveCFs,thencosttocloseproject.Examplesincludenuclearpowerplant,stripmine,etc.11-5WhatisthedifferencebetweenNetPresentValue(NPV)SumofthePVsofallcashinflowsandoutflowsofaproject:11-6NetPresentValue(NPV)SumofExampleProjectswe’llexamine:CFisthedifferencebetweenCFLandCFS.We’lluseCFlater.CashFlowYearLSCF0 -100 -100 01 10 70 -602 60 50 103 80 20 6011-7ExampleProjectswe’llexamine:WhatisProjectL’sNPV?WACC=10%11-8YearCFtPVofCFt0-100-$100.001109.0926049.5938060.11NPVL=$18.79Excel:=NPV(rate,CF1:CFn)+CF0Here,CF0isnegative.WhatisProjectL’sNPV?WACC=WhatisProjectS’NPV?WACC=10%11-9YearCFtPVofCFt0-100-$100.0017063.6425041.3232015.02NPVS=$19.98Excel:=NPV(rate,CF1:CFn)+CF0Here,CF0isnegative.WhatisProjectS’NPV?WACC=SolvingforNPV:
FinancialCalculatorSolutionEnterCFsintothecalculator’sCFLOregister.CF0=-100CF1=10CF2=60CF3=80EnterI/YR=10,pressNPVbuttontogetNPVL=$18.78.11-10SolvingforNPV:
FinancialCalRationalefortheNPVMethod NPV =PVofinflows–Cost =NetgaininwealthIfprojectsareindependent,acceptiftheprojectNPV>0.Ifprojectsaremutuallyexclusive,acceptprojectswiththehighestpositiveNPV,thosethataddthemostvalue.Inthisexample,acceptSifmutuallyexclusive(NPVS>NPVL),andacceptbothifindependent.11-11RationalefortheNPVMethod IRRisthediscountratethatforcesPVofinflowsequaltocost,andtheNPV=0:SolvingforIRRwithafinancialcalculator:EnterCFsinCFLOregister.PressIRR;IRRL=18.13%and
IRRS=23.56%.SolvingforIRRwithExcel: =IRR(CF0:CFn,guessforrate)InternalRateofReturn(IRR)11-12IRRisthediscountratethatHowisaproject’sIRRsimilartoabond’sYTM?Theyarethesamething.Thinkofabondasaproject.TheYTMonthebondwouldbetheIRRofthe“bond”project.EXAMPLE:Supposea10-yearbondwitha9%annualcouponand$1,000parvaluesellsfor$1,134.20.SolveforIRR=YTM=7.08%,theannualreturnforthisproject/bond.11-13Howisaproject’sIRRsimilarRationalefortheIRRMethodIfIRR>WACC,theproject’sreturnexceedsitscostsandthereissomereturnleftovertobooststockholders’returns.
IfIRR>WACC,acceptproject. IfIRR<WACC,rejectproject.Ifprojectsareindependent,acceptbothprojects,asbothIRR>WACC=10%.Ifprojectsaremutuallyexclusive,acceptS,becauseIRRs>IRRL.11-14RationalefortheIRRMethodIfNPVProfilesAgraphicalrepresentationofprojectNPVsatvariousdifferentcostsofcapital.
11-15WACC
NPVL
NPVS
0
$50
$40
5
33
29
10
19
20
15
7
12
20
(4)
5
NPVProfilesAgraphicalrepresIndependentProjectsNPVandIRRalwaysleadtothesameaccept/rejectdecisionforanygivenindependentproject.r>IRRandNPV<0.Reject.NPV($)r(%)IRRL=18.1%IRR>randNPV>0Accept.r=18.1%11-16IndependentProjectsNPVandIRMutuallyExclusiveProjectsIfr<8.7%:NPVL>NPVS
IRRS>IRRL CONFLICTIfr>8.7%: NPVS>NPVL, IRRS>IRRL NOCONFLICTr8.7rNPV%IRRsIRRLLS11-17MutuallyExclusiveProjectsIfFindingtheCrossoverRateFindcashflowdifferencesbetweentheprojects.SeeSlide11-7.EntertheCFsinCFjregister,thenpress
IRR.Crossoverrate=8.68%,roundedto8.7%.Ifprofilesdon’tcross,oneprojectdominatestheother.11-18FindingtheCrossoverRateFindReasonsWhyNPVProfilesCrossSize(scale)differences:thesmallerprojectfreesupfundsatt=0forinvestment.Thehighertheopportunitycost,themorevaluablethesefunds,soahighWACCfavorssmallprojects.Timingdifferences:theprojectwithfasterpaybackprovidesmoreCFinearlyyearsforreinvestment.IfWACCishigh,earlyCFespeciallygood,NPVS>NPVL.11-19ReasonsWhyNPVProfilesCrossReinvestmentRateAssumptionsNPVmethodassumesCFsarereinvestedattheWACC.IRRmethodassumesCFsarereinvestedatIRR.AssumingCFsarereinvestedattheopportunitycostofcapitalismorerealistic,soNPVmethodisthebest.NPVmethodshouldbeusedtochoosebetweenmutuallyexclusiveprojects.PerhapsahybridoftheIRRthatassumescostofcapitalreinvestmentisneeded.11-20ReinvestmentRateAssumptionsNSincemanagersprefertheIRRtotheNPVmethod,isthereabetterIRRmeasure?Yes,MIRRisthediscountratethatcausesthePVofaproject’sterminalvalue(TV)toequalthePVofcosts.TVisfoundbycompoundinginflowsatWACC.MIRRassumescashflowsarereinvestedattheWACC.11-21SincemanagersprefertheIRRCalculatingMIRRExcel:=MIRR(CF0:CFn,Finance_rate,Reinvest_rate)Weassumethatbothrates=WACC.11-22
66.012.110%10%-100.0010%PVoutflows-100.0MIRR=16.5%158.1TVinflows$100MIRRL=16.5%$158.1(1+MIRRL)3=
32110.060.080.0CalculatingMIRRExcel:=MIRR(WhyuseMIRRversusIRR?MIRRassumesreinvestmentattheopportunitycost=WACC.MIRRalsoavoidsthemultipleIRRproblem.Managerslikerateofreturncomparisons,andMIRRisbetterforthisthanIRR.11-23WhyuseMIRRversusIRR?MIRRaWhatisthepaybackperiod?Thenumberofyearsrequiredtorecoveraproject’scost,or“Howlongdoesittaketogetourmoneyback?”Calculatedbyaddingproject’scashinflowstoitscostuntilthecumulativecashflowfortheprojectturnspositive.11-24Whatisthepaybackperiod?TheCalculatingPayback11-25PaybackL =2+/ =2.375yearsPaybackS =1.600years3080CFtCumulative0123-30ProjectL’sPaybackCalculation-10050-9080-1006010CalculatingPayback11-25PaybacStrengthsandWeaknessesofPaybackStrengthsProvidesanindicationofaproject’sriskandliquidity.Easytocalculateandunderstand.WeaknessesIgnoresthetimevalueofmoney.IgnoresCFsoccurringafterthepaybackperiod.11-26StrengthsandWeaknessesofPaDiscountedPaybackPeriodUsesdiscountedcashflowsratherthanrawCFs.11-27DiscPaybackL=2+/=2.7years41.3260.11CFtCumulative0123-41.32-10018.79-90.9180-100601010%PVofCFt-1009.0949.5960.11DiscountedPaybackPeriodUsesFindProjectP’sNPVandIRREnterCFsintocalculatorCFLOregister.EnterI/YR=10.NPV=-$386.78.IRR=ERROR Why?11-28-8005,000-5,000012WACC=10%ProjectPhascashflows(in000s):CF0=-$800,CF1=$5,000,andCF2=-$5,000.FindProjectP’sNPVandIRREnMultipleIRRs11-29450-8000400100IRR2=400%IRR1=25%WACCNPVMultipleIRRs11-29450-80004001WhyaretheremultipleIRRs?Atverylowdiscountrates,thePVofCF2islargeandnegative,soNPV<0.Atveryhighdiscountrates,thePVofbothCF1andCF2arelow,soCF0dominatesandagainNPV<0.Inbetween,thediscountratehitsCF2harderthanCF1,soNPV>0.Result:2IRRs.11-30WhyaretheremultipleIRRs?AtWhentousetheMIRRinsteadoftheIRR?AcceptProjectP?WhentherearenonnormalCFsandmorethanoneIRR,useMIRR.PVofoutflows@10%=-$4,932.2314.TVofinflows@10%=$5,500.MIRR=5.6%.DonotacceptProjectP.NPV=-$386.78<0.MIRR=5.6%<WACC=10%.11-31WhentousetheMIRRinsteadoTheBasicsofCapitalBudgetingNetPresentValue(NPV)InternalRateofReturn(IRR)ModifiedInternalRateofReturn(MIRR)RegularPaybackDiscountedPaybackChapter1111-32TheBasicsofCapitalBudgetinWhatiscapitalbudgeting?Analysisofpotentialadditionstofixedassets.Long-termdecisions;involvelargeexpenditures.Veryimportanttofirm’sfuture.11-33Whatiscapitalbudgeting?AnalStepstoCapitalBudgetingEstimateCFs(inflows&outflows).AssessriskinessofCFs.Determinetheappropriatecostofcapital.FindNPVand/orIRR.AcceptifNPV>0and/orIRR>WACC.11-34StepstoCapitalBudgetingEstiWhatisthedifferencebetweenindependentandmutuallyexclusiveprojects?Independentprojects:ifthecashflowsofoneareunaffectedbytheacceptanceoftheother.Mutuallyexclusiveprojects:ifthecashflowsofonecanbeadverselyimpactedbytheacceptanceoftheother.11-35WhatisthedifferencebetweenWhatisthedifferencebetweennormalandnonnormalcashflowstreams?Normalcashflowstream:Cost(negativeCF)followedbyaseriesofpositivecashinflows.Onechangeofsigns.Nonnormalcashflowstream:Twoormorechangesofsigns.Mostcommon:Cost(negativeCF),thenstringofpositiveCFs,thencosttocloseproject.Examplesincludenuclearpowerplant,stripmine,etc.11-36WhatisthedifferencebetweenNetPresentValue(NPV)SumofthePVsofallcashinflowsandoutflowsofaproject:11-37NetPresentValue(NPV)SumofExampleProjectswe’llexamine:CFisthedifferencebetweenCFLandCFS.We’lluseCFlater.CashFlowYearLSCF0 -100 -100 01 10 70 -602 60 50 103 80 20 6011-38ExampleProjectswe’llexamine:WhatisProjectL’sNPV?WACC=10%11-39YearCFtPVofCFt0-100-$100.001109.0926049.5938060.11NPVL=$18.79Excel:=NPV(rate,CF1:CFn)+CF0Here,CF0isnegative.WhatisProjectL’sNPV?WACC=WhatisProjectS’NPV?WACC=10%11-40YearCFtPVofCFt0-100-$100.0017063.6425041.3232015.02NPVS=$19.98Excel:=NPV(rate,CF1:CFn)+CF0Here,CF0isnegative.WhatisProjectS’NPV?WACC=SolvingforNPV:
FinancialCalculatorSolutionEnterCFsintothecalculator’sCFLOregister.CF0=-100CF1=10CF2=60CF3=80EnterI/YR=10,pressNPVbuttontogetNPVL=$18.78.11-41SolvingforNPV:
FinancialCalRationalefortheNPVMethod NPV =PVofinflows–Cost =NetgaininwealthIfprojectsareindependent,acceptiftheprojectNPV>0.Ifprojectsaremutuallyexclusive,acceptprojectswiththehighestpositiveNPV,thosethataddthemostvalue.Inthisexample,acceptSifmutuallyexclusive(NPVS>NPVL),andacceptbothifindependent.11-42RationalefortheNPVMethod IRRisthediscountratethatforcesPVofinflowsequaltocost,andtheNPV=0:SolvingforIRRwithafinancialcalculator:EnterCFsinCFLOregister.PressIRR;IRRL=18.13%and
IRRS=23.56%.SolvingforIRRwithExcel: =IRR(CF0:CFn,guessforrate)InternalRateofReturn(IRR)11-43IRRisthediscountratethatHowisaproject’sIRRsimilartoabond’sYTM?Theyarethesamething.Thinkofabondasaproject.TheYTMonthebondwouldbetheIRRofthe“bond”project.EXAMPLE:Supposea10-yearbondwitha9%annualcouponand$1,000parvaluesellsfor$1,134.20.SolveforIRR=YTM=7.08%,theannualreturnforthisproject/bond.11-44Howisaproject’sIRRsimilarRationalefortheIRRMethodIfIRR>WACC,theproject’sreturnexceedsitscostsandthereissomereturnleftovertobooststockholders’returns.
IfIRR>WACC,acceptproject. IfIRR<WACC,rejectproject.Ifprojectsareindependent,acceptbothprojects,asbothIRR>WACC=10%.Ifprojectsaremutuallyexclusive,acceptS,becauseIRRs>IRRL.11-45RationalefortheIRRMethodIfNPVProfilesAgraphicalrepresentationofprojectNPVsatvariousdifferentcostsofcapital.
11-46WACC
NPVL
NPVS
0
$50
$40
5
33
29
10
19
20
15
7
12
20
(4)
5
NPVProfilesAgraphicalrepresIndependentProjectsNPVandIRRalwaysleadtothesameaccept/rejectdecisionforanygivenindependentproject.r>IRRandNPV<0.Reject.NPV($)r(%)IRRL=18.1%IRR>randNPV>0Accept.r=18.1%11-47IndependentProjectsNPVandIRMutuallyExclusiveProjectsIfr<8.7%:NPVL>NPVS
IRRS>IRRL CONFLICTIfr>8.7%: NPVS>NPVL, IRRS>IRRL NOCONFLICTr8.7rNPV%IRRsIRRLLS11-48MutuallyExclusiveProjectsIfFindingtheCrossoverRateFindcashflowdifferencesbetweentheprojects.SeeSlide11-7.EntertheCFsinCFjregister,thenpress
IRR.Crossoverrate=8.68%,roundedto8.7%.Ifprofilesdon’tcross,oneprojectdominatestheother.11-49FindingtheCrossoverRateFindReasonsWhyNPVProfilesCrossSize(scale)differences:thesmallerprojectfreesupfundsatt=0forinvestment.Thehighertheopportunitycost,themorevaluablethesefunds,soahighWACCfavorssmallprojects.Timingdifferences:theprojectwithfasterpaybackprovidesmoreCFinearlyyearsforreinvestment.IfWACCishigh,earlyCFespeciallygood,NPVS>NPVL.11-50ReasonsWhyNPVProfilesCrossReinvestmentRateAssumptionsNPVmethodassumesCFsarereinvestedattheWACC.IRRmethodassumesCFsarereinvestedatIRR.AssumingCFsarereinvestedattheopportunitycostofcapitalismorerealistic,soNPVmethodisthebest.NPVmethodshouldbeusedtochoosebetweenmutuallyexclusiveprojects.PerhapsahybridoftheIRRthatassumescostofcapitalreinvestmentisneeded.11-51ReinvestmentRateAssumptionsNSincemanagersprefertheIRRtotheNPVmethod,isthereabetterIRRmeasure?Yes,MIRRisthediscountratethatcausesthePVofaproject’sterminalvalue(TV)toequalthePVofcosts.TVisfoundbycompoundinginflowsatWACC.MIRRassumescashflowsarereinvestedattheWACC.11-52SincemanagersprefertheIRRCalculatingMIRRExcel:=MIRR(CF0:CFn,Finance_rate,Reinvest_rate)Weassumethatbothrates=WACC.11-53
66.012.110%10%-100.0010%PVoutflows-100.0MIRR=16.5%158.1TVinflows$100MIRRL=16.5%$158.1(1+MIRRL)3=
32110.060.080.0CalculatingMIRRExcel:=MIRR(WhyuseMIRRversusIRR?MIRRassumesreinvestmentattheopportunitycost=WACC.MIRRalsoavoidsthemultipleIRRproblem.Managerslikerateofreturncomparisons,andMIRRisbetterforthisthanIRR.11-54WhyuseMIRRversusIRR?MIRRaWhatisthepaybackperiod?Thenumberofyearsrequiredtorecoveraproject’scost,or“Howlongdoesittaketogetourmoneyback?”Calculatedbyaddingproject’scashinflowstoitscostuntilthecumulativecashflowfortheprojectturnspositive.11-55Whatisthepaybackperiod?TheCalculatingPayback11-56PaybackL =2+/ =2.375yearsPaybackS =1.600years3080CFtCumulative0123-30ProjectL’sPaybackCalcu
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