the capital budgeting evaluating cash flows

4 B02022 – Chapter 8 -The Criteria of Capital 23/8/2012 What is the difference between independent and mutually exclusive projects?. 16 B02022 – Chapter 8 -The Criteria of Capital 23/

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1 B02022 – Chapter 8 -The Criteria of Capital

Budgeting 23/8/2012

CHAPTER 8 The Capital Budgeting:

Evaluating Cash Flows

8.1 Overview

8.2 Payback Period

8.3 Net Present Value

8.4 Profitability Index

8.5 Internal Rate of Return

Unequal lives

Economic life

Budgeting 23/8/2012

8.1 Overview

Analysis of potential projects

Long-term decisions; involve large expenditures

Very important to firm’s future

23/8/2012

Steps in Capital Budgeting

Estimate cash flows (inflows &

outflows)

Assess risk of cash flows

Determine r = WACC for project

Evaluate cash flows

23/8/2012

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

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Budgeting 23/8/2012

8.2 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?

Budgeting 23/8/2012

Payback for Franchise L (Long: Most CFs in out years)

-100

=

CF t

0

100

2.4

23/8/2012

Franchise S (Short: CFs come

quickly)

-100

CF t

100

0

1.6

=

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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

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Budgeting 23/8/2012

CF t

Discounted

payback 2 + 41.32/60.11 = 2.7 yrs

Discounted Payback: Uses discounted

rather than raw CFs

-100 10%

=

Recover invest + cap costs in 2.7 yrs

Budgeting 23/8/2012

8.3 Net Present Value

23/8/2012

 1  . 0

t t n

t r

CF NPV





NPV: Sum of the PVs of inflows and

outflows

Cost often is CF 0 and is negative

1  0.

1

CF r

CF

n

t







23/8/2012

What’s Franchise L’s NPV?

10%

Project L:

-100.00 9.09 49.59 60.11

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Budgeting 23/8/2012

Calculator Solution

Enter in CFLO for L:

-100

10

60

80

10

CF 0

CF 1

NPV

CF 2

CF 3

Budgeting 23/8/2012

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

23/8/2012

Using NPV method, which franchise(s) should be accepted?

If Franchise S and L are

mutually exclusive, accept S

because NPV s > NPV L

If S & L are independent,

accept both; NPV > 0

23/8/2012

8.4 Profitability Index

Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of

payoff to investment of a proposed project It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment

The ratio is calculated as follows:

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Budgeting 23/8/2012

8.5 Internal Rate of Return

IRR is the discount rate that forces

PV inflows = cost This is the same

as forcing NPV = 0

Budgeting 23/8/2012

0

NPV r

CF

t t n

t









t

n

t t

CF IRR





NPV: Enter r, solve for NPV

IRR: Enter NPV = 0, solve for IRR

23/8/2012

What’s Franchise L’s IRR?

IRR = ?

-100.00

PV 3

PV 2

PV 1

0 = NPV

Enter CFs in CFLO, then press IRR:

IRR L = 18.13% IRR S = 23.56%

23/8/2012

IRR = ?

Find IRR if CFs are constant:

-100

Or, with CFLO, enter CFs and press IRR = 9.70%

3 -100 40 0 9.70%

INPUTS OUTPUT

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Budgeting 23/8/2012

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 stockholders’ returns

Example: WACC = 10%, IRR = 15%

Profitable

Budgeting 23/8/2012

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 IRR S > IRR L

23/8/2012

Construct NPV Profiles

Enter CFs in CFLO and find NPV L and

NPV S at different discount rates:

r

0

5

10

15

20

NPV L

50

33

19

7

NPV S

40

29

20

12

5 (4)

23/8/2012

-10 0 10 20 30 40 50 60

0 5 10 15 20 23.6

NPV ($)

Discount Rate (%) IRR L = 18.1%

IRR S = 23.6%

Crossover Point = 8.7%

r

0

5

10

15

20

NPV L

50

33

19

7 (4)

NPV S

40

29

20

12

5

S L

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Budgeting 23/8/2012

NPV and IRR always lead to the same accept/reject decision for independent projects:

r > IRR and NPV < 0

Reject

NPV ($)

r (%) IRR

IRR > r and NPV > 0 Accept

Budgeting 23/8/2012

Mutually Exclusive Projects

r 8.7 r

NPV

%

IRR S

IRR L

L

S

r < 8.7: NPV L > NPV S , IRR S > IRR L

CONFLICT

r > 8.7: NPV S > NPV L , IRR S > IRR L

NO CONFLICT

23/8/2012

To Find the Crossover Rate

1 Find cash flow differences between the

projects See data at beginning of the

case

2 Enter these differences in CFLO register,

then press IRR Crossover rate = 8.68%,

rounded to 8.7%

3 Can subtract S from L or vice versa, but

better to have first CF negative

4 If profiles don’t cross, one project

dominates the other

23/8/2012

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 payback provides more CF in early years for reinvestment If r is high, early CF especially good, NPV S > NPV L

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Budgeting 23/8/2012

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

Budgeting 23/8/2012

Managers like 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

23/8/2012

MIRR = 16.5%

10%

66.0 12.1 158.1

MIRR for Franchise L (r = 10%)

-100.0

10%

TV inflows -100.0

PV outflows

MIRR L = 16.5%

$100 = $158.1

(1+MIRR L ) 3

23/8/2012

To find TV with 10B, enter in CFLO:

I = 10 NPV = 118.78 = PV of inflows

Enter PV = -118.78, N = 3, I = 10, PMT = 0 Press FV = 158.10 = FV of inflows

Enter FV = 158.10, PV = -100, PMT = 0,

N = 3

Press I = 16.50% = MIRR

CF 0 = 0, CF 1 = 10, CF 2 = 60, CF 3 = 80

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Budgeting 23/8/2012

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

Budgeting 23/8/2012

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

23/8/2012

Inflow (+) or Outflow (-) in Year

23/8/2012

Pavilion Project: NPV and IRR?

r = 10%

-800

Enter CFs in CFLO, enter I = 10

NPV = -386.78 IRR = ERROR Why?

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Budgeting 23/8/2012

We got IRR = ERROR because

there are 2 IRRs Nonnormal

CFs—two sign changes

Here’s a picture:

NPV Profile

450

-800

0

400

100

IRR 2 = 400%

IRR 1 = 25%

r NPV

Budgeting 23/8/2012

Logic of Multiple IRRs

1 At very low discount rates, the PV of

CF 2 is large & negative, so NPV < 0

2 At very high discount rates, the PV of both CF 1 and CF 2 are low, so CF 0 dominates and again NPV < 0

3 In between, the discount rate hits CF 2 harder than CF 1 , so NPV > 0

4 Result: 2 IRRs

23/8/2012

Could find IRR with calculator:

1 Enter CFs as before

2 Enter a “guess” as to IRR by

storing the guess Try 10%:

IRR = 25% = lower IRR

Now guess large IRR, say, 200:

IRR = 400% = upper IRR

23/8/2012

When there are nonnormal CFs and more than one IRR, use MIRR:

PV outflows @ 10% = -4,932,231.40

TV inflows @ 10% = 5,500,000.00

MIRR = 5.6%

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Budgeting 23/8/2012

Accept Project P?

NO Reject because MIRR =

5.6% < r = 10%

Also, if MIRR < r, NPV will be

negative: NPV = -$386,777

Budgeting 23/8/2012

S and L are mutually exclusive and will be repeated r = 10% Which is better? (000s)

Project S:

(100) Project L:

(100)

60

33.5

60

33.5 33.5 33.5

23/8/2012

S L

CF 1 60,000 33,500

NPV 4,132 6,190

NPV L > NPV S But is L better?

Can’t say yet Need to perform

common life analysis

23/8/2012

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 make decision

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Budgeting 23/8/2012

Franchise S with Replication:

NPV = $7,547

Replacement Chain Approach (000s)

Franchise S:

(100)

60

60 (100) (40)

60

Budgeting 23/8/2012

Compare to Franchise L NPV =

$6,190

Or, use NPVs:

4,132 3,415 7,547

4,132 10%

23/8/2012

If the cost to repeat S in two years rises to $105,000, which is best? (000s)

NPV S = $3,415 < NPV L = $6,190

Now choose L

Franchise S:

(100)

60 60

(105) (45)

23/8/2012

Year

0

1

2

3

CF ($5,000) 2,100 2,000 1,750

Salvage Value $5,000 3,100 2,000

0

Consider another project with

a 3-year life If terminated prior

to Year 3, the machinery will have positive salvage value

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Budgeting 23/8/2012

1.75

1 No termination

2 Terminate 2 years

3 Terminate 1 year

(5) (5) (5)

2.1 2.1 5.2

2

4

CFs Under Each Alternative (000s)

Budgeting 23/8/2012

NPV (no) = -$123

NPV (2) = $215

NPV (1) = -$273

Assuming a 10% cost of capital, what is the project’s optimal, or economic life?

23/8/2012

The project is acceptable only if

operated for 2 years

A project’s engineering life does not

always equal its economic life

Conclusions

23/8/2012

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

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Budgeting 23/8/2012

Increasing Marginal Cost

of Capital

Externally raised capital can have

large flotation costs, which increase

the cost of capital

Investors often perceive large capital

budgets as being risky, which drives

up the cost of capital

(More )

Budgeting 23/8/2012

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

23/8/2012

Capital Rationing

Capital rationing occurs when a

company chooses not to fund all

positive NPV projects

The company typically sets an

upper limit on the total amount

of capital expenditures that it will

make in the upcoming year

(More )

23/8/2012

direct costs (i.e., flotation costs) and the indirect costs of issuing new capital

Solution : Increase the cost of capital

by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital

(More )

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Budgeting 23/8/2012

enough managerial, marketing, or

engineering staff to implement all

positive NPV projects

maximize NPV subject to not

exceeding the constraints on staffing

(More )

Budgeting 23/8/2012

project’s managers forecast unreasonably high cash flow estimates,

so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted

process and tie the managers’

compensation to the subsequent performance of the project

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