CHAPTER 11
The Basics of Capital Budgeting
Should we
build this
plant?
10-1
Outline





Payback, Discounted payback
NPV
IRR
NPV vs. IRR
MIRR
10-2
What is capital budgeting?




Capital: long term Budget: financial
plan
Analysis of potential additions to
fixed assets.
Long-term decisions; involve large
expenditures.
Very important to firm’s future.
10-3
Two Projects
(Integrated case p.
385)
Project L
CFt
Project S
CFt
0
1
2
3
-100
10
60
80
0
1
2
3
-100
70
50
20
10-4
What is the difference between
independent and 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.
10-5
What is the payback period?


The number of years required to
recover a project’s cost, or “How long
does it take to get our money back?”
Calculated by adding project’s cash
inflows to its cost until the cumulative
cash flow for the project turns positive.
10-6
Calculating payback
Project L
CFt
Cumulative
PaybackL
Project S
CFt
Cumulative
PaybackS
0
-100
-100
== 2
2
2.4
3
10
-90
60
-30
100
0
80
30 / 80
+
0
1.6
1
-100
-100
== 1
1
70
-30
+
= 2.375 years
2
100 50
0 20
30 / 50
50
3
20
40
= 1.6 years
10-7
Strengths and weaknesses of
payback

Strengths



Provides an indication of a project’s risk
and liquidity.
Easy to calculate and understand.
Weaknesses


Ignores the time value of money.
Ignores CFs occurring after the payback
period.
10-8
Discounted payback period

Uses discounted cash flows rather than
raw CFs.
0
CFt
PV of CFt
Cumulative
10%
-100
-100
-100
Disc PaybackL ==
2
+
1
2
10
9.09
-90.91
60
49.59
-41.32
41.32 / 60.11
2.7 3
80
60.11
18.79
= 2.7 years
10-9
Net Present Value (NPV)

Sum of the PVs of all cash inflows and
outflows of a project:
n
CFt
NPV  
t
t 0 ( 1  r )
10-10
What is Project L’s NPV?
Year
0
1
2
3
CFt
-100
10
60
80
NPVL =
PV of CFt
-$100
9.09
49.59
60.11
$18.79
NPVS = $19.98
10-11
Solving for NPV:
Financial calculator solution

Enter CFs into the calculator’s CFLO
register.





CF0
CF1
CF2
CF3
=
=
=
=
-100
10
60
80
Enter I/YR = 10, press NPV button to
get NPVL = $18.78.
10-12
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, would accept S if
mutually exclusive (NPVs > NPVL), and
would accept both if independent.
10-13
Internal Rate of Return (IRR)


IRR is the actual return of a project
IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:
CFt
0
t
t 0 ( 1  IRR )
n

Solving for IRR with a financial calculator:


Enter CFs in CFLO register.
Press IRR; IRRL = 18.13% and IRRS = 23.56%.
10-14
How is a project’s IRR similar to a
bond’s YTM?



They are the same thing.
Think of a bond as a project. The
YTM on the bond would be the IRR
of the “bond” project.
EXAMPLE: Suppose a 10-year bond
with a 9% annual coupon sells for
$1,134.20.

Solve for IRR = YTM = 7.08%, the
annual return for this project/bond.
10-15
Rationale for the IRR method

If IRR > WACC, the project’s rate of
return is greater than its costs.
There is some return left over to
boost stockholders’ returns.
10-16
IRR Acceptance Criteria




If IRR > k, accept project.
If IRR < k, reject project.
If projects are independent, accept
both projects, as both IRR > k =
10%.
If projects are mutually exclusive,
accept S, because IRRs > IRRL.
10-17
NPV vs. IRR

NPV and IRR, what are they?



Do NPV and IRP conflict?
Examples of conflicts


Value vs. Return; $ vs. %
CFs, and NPV profile
Then, which one?

Simple example
10-18
NPV Profiles

A graphical representation of project NPVs at
various different costs of capital.
k
0
5
10
15
20
NPVL
$50
33
19
7
(4)
NPVS
$40
29
20
12
5
10-19
Drawing NPV profiles
NPV 60
($)
.
40 .
50
30
.
.
20
Crossover Point = 8.7%
.
10
IRRL = 18.1%
L
..
0
5
-10
10
15
S
.
.
20
.
IRRS = 23.6%
Discount Rate (%)
23.6
10-20
Comparing the NPV and IRR
methods


IRR remains constant when discount
rate changes
NPV decreases when discount rate
increases
10-21
Comparing the NPV and IRR
methods


If projects are independent, the two
methods always lead to the same
accept/reject decisions.
If projects are mutually exclusive …


If r > crossover point, the two methods
lead to the same decision and there is no
conflict.
If r < crossover point, the two methods
lead to different accept/reject decisions.
10-22
Finding the crossover point
1.
2.
3.
NPVl=NPVs
Find cash flow differences between
the projects for each year.
Enter these differences in CF register,
then press IRR. Crossover rate =
8.68%.
10-23
NPV vs. IRR

Size (scale) differences –



Timing differences –




$1 investment, 100% IRR
$1000 invest, 50% IRR
$1M, 30% IRR, 1 year
$1M, 29% IRR, 2 years
If we use IRR, we suppose we can invest
$999 somewhere else at 100% return; or
1M for the 2nd year at 30% return.
Not realistic! NPV is better, or we should
modify IRR
10-24
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.
10-25
Calculating MIRR
0
10%
-100.0
1
2
3
10.0
60.0
80.0
66.0
12.1
10%
10%
MIRR = 16.5%
-100.0
PV outflows
$100 =
$158.1
(1 + MIRRL)3
158.1
TV inflows
MIRRL = 16.5%
10-26