Capital Budgeting
Evaluating Cash Flows
Week 4-5 Joint MBA - Finance 5000
Webster-SHUFE-2015
Shanghai
How do companies increase value?
• Of course the answer is by
performing better and better
and increase NOPAT
• But at least as important is
that companies make wise
and calculated investments
• Capex is a main cash out for
companies…
• How do they get a feel for if
these investments will create
new additional NOPAT in the
future?
• The answer is: with capital
budgeting!
Invest in China?
We consider different kinds of companies…
• These who have a wide
variety of viable
investments but not
enough money to back
these plans
• These companies that
are phenomenally cash
rich and basically do not
have enough investment
plans to spend all their
money (Microsoft,
Johnson & Johnson…)
Investing to rationalize…
Investing to expand….
New capital projects
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Can be extensions from what the company is
already doing (relatively low risk)
Can be development of entirely new
products/markets (relatively high risk)
Can be major refurbishments of equipment or
maintenance (relatively low risk)
Can be investment in new technologies (high
risk)
Can be replacements of old
equipment/machines
Can be investment in safety, housekeeping,
environment
Investing in warehouse space?
Can be many many other things….
Can be strategic, operational, market oriented
or operations oriented….and vary widely in
risk profile!
The decision rules
• Every investment has a cash
out at the beginning of the
project
• Sometimes the cash payments
are spread over more years
• Sometimes due to the way of
financing the cash out is yearly
over a longer period of time
(leasing)
• The typical model though is:
– Cash Out at the beginning of
the project
– Cash Ins (returns from the
project) in later years
Cash in? Cash out?
Pay Back Period (PBP)
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The PBP tells us after what time the initial
investment has been paid back by the
project:
Say I= -$1000 (t=0)
And in period 1 (t=1) the cash in is $ 500
In t=2
$ 400
In t=3
$ 300
In t=4
$ 100
Then this investment will pay back in 2
years $ 900 and in t=3 $300 so the last
$100 is 0.33 year; in total 2,33 years
Obviously; the shorter pay back an
investment project has the better
This method is hardly used anymore
since it does not take into account the
time value of money…
PBP?
Discounted PBP
• If the project’s cost of capital is
similar to that of the company you
can use the WACC% to discount the
cash inflows of
• t=1 as $500/(1+wacc%)
• t=2 as $400/(1+wacc%)^2
• t=3 as $300/(1+wacc%)^3
• You then can use the same
methodology to find the PBP using
the discounted cash flows…of course
you will find a longer PBP now
• We now have taken into account the
time value of money
• Still this method is not used very
often since there is a better method…
Discounted PBP?
Net Present Value
• The NPV of a project is the
discounted cash flow of all cash
out-and inflows
• So following our example and
assuming the project is average
company risk we discount at the
WACC% (assume 10%)
• The NPV of the project is $ 78.82
• So after covering the cost of
capital the project still generates a
positive cash flow…thus indicating What NPV did Lufthansa calculate?
to add value for the company in
the future…
• Normally the management of the
company will accept to execute
such a project
IRR%
• The Internal Rate of Return will give
you the discount factor at which the
total cash outflows of a project equal
the total inflows over its life
• In other words we now calculate the
yield at which the NPV of the project is
zero!
• After calculating IRR% we can
compare the cost of capital of the
project if IRR%>cost of capital this
project will increase the companies
value…in the other case the project
will not cover the cost of capital and
will not be executed…
IRR%?
Note that sometimes IRR% can
generate more then one result…
• Assume Initial cash
out: $ -1600
• Cash in t=1 is 10,000
• Cash out t=2 is 10,000
• What is IRR% (use
Excel)
• IRR% is 25% and
400%...
year
cash flow
1
2
3
-1600
10000
-10000
IRR%
IRR%
400%
25%
Modified IRR% (MIRR%) is a better
measure…
• We now calculate the
Future Value of all cash
flows except the initial
cash outlay
• We then find the
discount factor (IRR%)
that forces the present
value of the sum of the
future values of the
cash flows to be equal
to the initial cash
outlay…
year
1
2
3
3
4
-1000
500
400
300
100
cash
flo
w
330
484
665.5
FV
-1000
0
MIRR%
0
12.11%
1579.5
0
1579.5
Using Excel…
• You can use Excel
to solve IRR% and
NPV; it’s highly
recommended to
use Excel above a
calculator
year
0
1
2
3
4
cash
flow
-1000
500
400
300
100
IRR%
14.49%
Using Excel
year
cash flow
1
2
3
4
5
-1000
500
400
300
100
Note that since spread sheets calculate with many digits the results
are very precise!
NPV cash in
$1,078.82
NPV cash out
($1,000)
NET NPV
$78.82
So what to use ?
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Despite the academic preference to use NPV
business people do prefer IRR%
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More advanced capital budgeting departments
use MIRR%
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A Modified IRR% (page 520 textbook)
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The Modified IRR% assumes that all cash ins
during the project’s life can be reinvested at the
Cost of Capital (WACC%)
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The MIRR% is the % that makes the NPV of all
cash outs (discounted at WACC%) equal to the
NPV of the Future Value (at the end of the
project at WACC%)
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So now we take an extra step…
Wonder what MIRR% is?
Example MIRR%
• Project cash flows:
»
»
»
»
»
T0=-1000
T1=+500
T2=+400
T3=+300
T4=+100
• Calculate the FV of all positive CF’s at the end of project
(end of year 4) at WACC% (assume 10%)
• You will find $ 1,579.50
• What IRR% will make this equal to the sum of the NPV of
all cash outs ($ 1000)
• (M)IRR%= 12.1%
Test the answer with Excel;
Demo Project (note that you can enter different rates in Excel for
discounting and reinvesting (we assume both are 10%
T0 (cash out)
-1000
T1
500
T2
400
T3
300
T4
100
IRR%
14.49%
MIRR%
12.11%
MIRR%
• So the MIRR% assumes that
cash flows from the project
will generate the WACC%
(and not the IRR%)
• It also finds a unique
solution in case cash flows
alternate during the project
(from positive to negative to
positive etc.)
• We illustrate one more
example in case of
alternating cash flows
Great Wall Street ?
Example MIRR%
• Project cash flows:
»
»
»
»
»
T0=-1000
T1=+1500
T2=-400
T3=+300
T4=-100
• Calculate the FV of all positive CF’s at the end of project
(end of year 4) at WACC% (assume 10%) you will find $
2326.50
• You will find $ What IRR% will make this equal to the
sum of the NPV of all cash outs (sum of NPV of all cash
outs at 10% is $ 1398.88) (M)IRR%= 13.56%)
Excel can do it instantly…
Demo Project
-1000
1500
-400
300
-100
IRR%
32.61%
MIRR%
13.56%
Calculations in Excel…
CF's
FV
$1,500.00
$1,996.50
$300.00
$330.00
$2,326.50
NPV
-$1,000.00
-$1,000.00
-$400.00
-$330.58
-$100.00
-$68.30
-$1,398.88
FV/NPV
1.6631164
1.1356138
MIRR%
13.56%
Companies compare
• Projects risks
• Projects NPV’s
• Projects (M)IRR’s
OR
• And based on their total assessment of the
investment (including imponderables) make
final choices for executing selected projects
Finally companies use
• Profitability Index (PI): The
Present Value of future
cash flows/Initial cash
outflow
• Any index above 1 shows
that the sum of future (PV)
cash flows is higher then
the initial cash outlay…
• In our example the PI is:
PV(cash flows)/Initial cash
outflow= $ 1078,82/$1000=
1.079
Airbus A 380
The better performer…
Disney Hong Kong…
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$ 3.5 bln USD project
5.6M visitors first year
Ticket price RMB 300
Will it pay off?
Assignment: Investment Proposal
You are business unit manager of the company you selected
Currently you see a large investment opportunity in China (yes!)
However you will have to convince your Board of investing $ 150 Mln. (no small money)
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Your Board is very strict on large Capex and you will need to make a formal investment proposal
consisting of:
– Description of the investment you want to do in China
– Motivation of this investment
– Strategic Context of the investment
– Timing
– Risks and uncertainties (is this the first investment in China?)
– Cost Savings, and/or extra sales revenues and profit development
– Working capital impact
– Maintenance capex in the future
– Currency and Macro-economic environment
– Cash flows
– WACC% of your company and the cost of capital of this investment
BOEING 7E7
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The nicer toy…
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Consider a worst case scenario and a base case scenario
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Now calculate: PBP, discounted PBP, NPV, IRR%, MIRR%, PI for both the base case and the worst case
Finalize with a formal request to the Board based on your calculations for approval of your Capex
Make it look professional; amateur work will be “returned to sender” in professional companies!