The Basics of Capital Budgeting:
Evaluating Cash Flows
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NET PRESENT VALUE (NPV)
INTERNAL RATE OF RETURN (IRR)
MODIFIED INTERNAL RATE OF RETURN (MIRR)
NET PRESENT VALUE (NPV) PROFILE
PROFITABILITY INDEX
REGULAR PAYBACK
DISCOUNTED PAYBACK
NET PRESENT VALUE (NPV)
NET PRESENT VALUE (NPV)
The net present value (NPV),
defined as the present value of
a project’s cash inflows minus
the present value of its costs,
tells us how much the project
contributes to shareholder
wealth.
Note: the
larger the
NPV, the more value
the project adds and
thus the higher the
stock’s price.
NET PRESENT VALUE (NPV)
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CF = cash flow
CF0 = initial investment
CFt is the expected net cash flow at Time t
r is the project’s risk-adjusted cost of capital (or WACC)
N is its life
NET PRESENT VALUE (NPV)
INTERNAL RATE OF RETURN (IRR)
INTERNAL RATE OF RETURN (IRR)
A project’s IRR is the discount rate that forces the PV of the inflows to equal the initial
cost (or to equal the PVs of all the costs if costs are incurred over several years). This is
equivalent to forcing the NPV to equal zero.
➔ The IRR is an estimate of the project’s rate of return, and it is comparable to the
YTM on a bond.
INTERNAL RATE OF RETURN (IRR)
MODIFIED INTERNAL RATE OF
RETURN (MRR)
MODIFIED INTERNAL RATE OF RETURN
It is similar to the regular
IRR, except it is based on
the assumption that cash
flows are reinvested at the
WACC (or some other
explicit rate if that is a more
reasonable assumption).
NET PRESENT VALUE (NPV) PROFILE
NPV PROFILE
NPV PROFILE
The NPVs vary depending on the actual cost of capital—the higher the cost of
capital, the lower the NPV.
PROFITABILITY INDEX (PI)
PROFITABILITY INDEX
The profitability Index is calculation determined by dividing the present value of future
cash flow by the initial investment in a project. Here, CFt represents the expected future
cash flows and CF0 represents the initial cost. The PI shows the relative profitability of
any project, or the present value per dollar of initial cost.
PAYBACK
DISCOUNTED PAYBACK
Payback Period
NPV and IRR are the most commonly used methods today, but historically the
first selection criterion was the payback period, defined as the number of years
required to recover the funds invested in a project from its operating cash flows.
Payback Period
The shorter the
payback, the better
the project.
● Discounted Payback Period
DISCOUNTED PAYBACK
where
cash
flows
are
discounted at the WACC and
then those discounted cash
flows are used to find the
payback.
Note: that the payback is a
“break-even” calculation in
the sense that if cash flows
come in at the expected rate,
then the project will at least
break even.
THANK YOU!
Chapter 11
Cash Flow
Estimation and
Risk Analysis
Cash Flow versus Accounting Income
Free Cash Flow is cash flow that is
available for distribution to investors.
Note!
Capital budgeting
decisions must be
based on cash flows,
not accounting
income.
Refer to chapter 2 figure 9
Incremental Cash Flows
the difference between the cash flows the firm will
have if it implements the project versus the cash
flows it will have if it rejects the project.
Note!
Only incremental cash
flows are relevant.
11.2 Analysis of an
Expansion Project
Cash Flow Projections:
Base Case
11.2 Analysis of an Expansion Project
Cash Flow Projections: Base Case
Depreciation
is calculated as the annual rate allowed by the IRS
multiplied by the project’s depreciable cost basis.
Taxation of Salvage
The after-tax salvage value depends on the price at which GPC can
sell the equipment and on the book value of the equipment (i.e., the
original basis less all previous depreciation charges).
THANK YOU!
R I S K A N A LY S I S I N
C A P I TA L
BUDGETING
1. Stand-alone risk is a project’s risk assuming (a) that it is the firm’s only asset and (b) that each of the firm’s
stockholders holds only that one stock in his portfolio. Stand-alone risk is based on uncertainty about the
project’s expected cash flows. It is important to remember that stand-alone risk ignores diversification by
both the firm and its stockholders.
2. Within-firm risk (also called corporate risk) is a project’s risk to the corpo- ration itself. Within-firm risk
recognizes that the project is only one asset
in the firm’s portfolio of projects; hence some of its risk is eliminated by diversification within the firm.
However, within-firm risk ignores diversification by the firm’s stockholders. Within-firm risk is measured by
the project’s impact on uncertainty about the firm’s future total cash flows.
3. Market risk (also called beta risk) is the risk of the project as seen by a well- diversified stockholder who
recognizes (a) that the project is only one of the firm’s projects and (b) that the firm’s stock is but one of
her stocks. The project’s market risk is measured by its effect on the firm’s beta coefficient.