Transcript Chapter 6
Chapter 6: Capital Budgeting: The Basics Objective Explain Capital Budgeting Develop Criteria 1 Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley Chapter 6 Contents • 1 The Nature of Project Analysis • 7 Analyzing Cost-Reducing Projects • 2 Where do Investment Ideas come from? • 8 Projects with Different Lives • 3 The NPV Investment Rule • 9 Ranking Mutually Exclusive Projects • 4 Estimating a Project’s Cash Flows • 5 Cost of Capital • 10 Inflation & Capital Budgeting • 6 Sensitivity Analysis 2 Objectives • To show how to use discounted cash flow analysis to make decisions such as: – Whether to enter a new line of business – Whether to invest in equipment to reduce costs 3 Introduction • Recall the objective of a firm – Maximization of the market value of shareholders’ equity • The theory of how to do this was provided in the prior two chapters – Compute the net present value of the project’s expected cash flows, and undertake only those with positive NPV 4 6.1 The Nature of Project Analysis • Basic unit of analysis – the individual investment project 5 Procedural Outline • Form ideas on how to increase shareholders’ equity • Plan how to implement the ideas • Gather information on timing and magnitude of costs and benefits • Apply NPV criterion 6 Generating a forecast • Information is often biased towards its provider’s goal (agency problem) • There are many ways to implement a goal • Some information is not fully quantifiable • Impact on shareholder wealth difficult to evaluate when cash flows are risky 7 The Nature of Project Analysis • We will postpone discussion of risky cash flows to avoid the complex issue of how they affect shareholder wealth • The criterion used – find the present value of all future cash flows, and subtract the initial investment to obtain the net present value (NPV) 8 6.2 Where do Investment Ideas Come From? – monitor existing & potential customers needs – monitor existing & potential technological capacity of the firm – monitor the competition’s marketing, investment, patents, and technical recruiting – monitor production & distribution functions for revenue enhancement / cost savings – reward employees for innovative ideas 9 6.3 Net Present Value Rule • A project’s net present value is – the amount by which the project is expected to increase the wealth of the firm’s current shareholders • As a criterion – Invest in proposed projects with positive NPV 10 Illustration • The following tables show the computation of NPV – To show the affect of the discount rate, three tables are shown based on different rates 11 NPV of a Project Discout 10% Year 0 1 2 3 4 5 DCF Payback Flow PV Cum_PV -1000 -1000 -1000 450 409 -591 350 289 -302 250 188 -114 150 102 -11 50 31 20 NPV 20 12 Do Project NPV of a Project Discout 15% Year 0 1 2 3 4 5 Flow PV Cum_PV -1000 -1000 -1000 450 391 -609 350 265 -344 250 164 -180 150 86 -94 50 25 -69 NPV -69 13 Don’t Do Project Internal Rate of Return NPV of a Project Discout 11.04% Year 0 1 2 3 4 5 Flow PV Cum_PV -1000 -1000 -1000 450 405 -595 350 284 -311 250 183 -128 150 99 -30 50 30 0 NPV 0 14 Indifferent Common Error • It is a common mistake to start the investment in year 1 rather than year 0 (when this was not intended) – Now is time 0 – Like a child, a project is not one-year old until a year has passed 15 Summary • The discount rate – in the first scenario it was assumed to be 10%, and the resulting NPV was $20 – In the second scenario it was assumed to be 15%, and the NPV was -$69 – In the third scenario, the discount rate that resulted in a zero NPV was found 16 NPV as a Function of Discount Rate 250 200 150 NPV 100 50 0 -50 0% 5% 10% 15% -100 -150 -200 17 Discount Rate 20% 6.4 Depreciation and Cash Flows • It is important to remember that when making financial decisions only timed cash flows are used – depreciation is an expense, but is not a cash expense, and must be excluded – the tax benefit of depreciation, however, is a cash flow, and must be included 18 Working Capital & Cash Flows • Some cash flows do not occur on the income statement, but involve timing – working capital additions and reductions are cash flows – at the end of a project, the sum of the nominal changes in working capital is zero 19 Accruals & Deferrals • Take extra care if you are provided with net income information by an accountant – the flows forming net income may include • accruals • deferrals – these are typically small, and may sometimes be ignored 20 Incremental Cash Flows • Only the incremental cash flows should form part of an investment decision – Evaluate the projected cash flows, by (category and) timing, both with and without the project, and find the difference – This difference is a collection of timed cash flows, and this is what affects the wealth of the shareholders 21 Illustration: Cannibalism • A proposed project will generate $10,000 in revenue, but will causes another product line to lose $3,000 in revenues • The incremental cash flow is only $7,000 22 Illustration: Prior Expenses • R&D expenses are $10,000 to-date for your project, and you plan to spend another $20,000, making $30,000 in all – The $10,000 is a sunk cost. The decision whether to undertake the project will not change this expenditure – Only the $20,000 is an incremental cost, and the $10,000 should be excluded 23 Sunk Costs • Shareholders are interested in the timing and magnitude of cash flows – From an investor’s vantage, a project gives rise to an alternative cash flow – If (alternative cash flows) - (original cash flows) is valuable to shareholders, do project – A sunk cost has no impact on future cash flows: it is irrelevant to shareholders 24 Illustration: Underutilized Resources • A project uses an existing (non-cancelable) leased warehouse with a remaining life of 20 years, and total annual rent of $100,000 • The warehouse is projected to remain 50% utilized, unless your project is undertaken • The lease prohibits sub-leasing • The current project is making a loss • Your project will use 25% of the warehouse • What should the project be charged? 25 Proposed Solution 1 • The original project currently using the warehouse is making a loss: – “Charge the full $100,000 /year so the company can recover the very real warehousing costs.” 26 Proposed Solution 2 • Half the warehouse is available: – “The project should be charged the full $50,000 /year if it needs to use it. A portion of the warehousing costs will not be charged-out otherwise.” 27 Proposed Solution 3 • The project should be charged for its share of the used space: – “Charge $33,333 /year.” 28 Proposed Solution 4 • The project is going to use only 25% of the space. – “Charge $25,000 /year.” 29 Proposed Solution 5 • The charge should be proportioned according to revenues generated by each project--that is fair, isn’t it? – “The old project’s revenues = $9,000,000, and the new project has projected revenues = $1,000,000, so the charge is 10%, or $10,000/year.” 30 Proposed Solution 6 • There is a suitable new (smaller) warehouse available on the market for $27,000 /year. – “Charge the project the market rate of the space, $27,000.” 31 Proposed Solution 7 • The original lease was entered into when warehouse space was cheap, but now space is twice what it was: – “The market value of the leased warehouse is now $200,000, and the project should take its proper share of that amount.” 32 Proposed Solution 8 • This is a new project, so give it a sporting chance: – “The project should be charged nothing.” 33 Warehouse Illustration • The solution in this case is proposed solution # 8, (but for another reason): The project should be charged nothing – The warehouse expenditure will occur whether the project is done or not. It is therefore not an incremental cash flow – With different facts (alternative usage or lease re-negotiation) the answer would be different 34 6.5 The Cost of Capital • When determining the cost of capital – the risk of the project is, in general, different from the risk of existing projects – only the market-related risk is relevant – only the risk from a project’s cash flows is relevant (not that of financing instruments) 35 Computing the Average Cost of Capital of a Corporation • Determine the return to security holders of each class of security issued • Determine the market value of each class of the company’s securities, and compute the weight of each • After adjusting for tax, compute the weighted sum of returns 36 Average Cost of Capital: Example with 3-Securities • Let • ke be the return on equity • kd be the return on debt • kp be the return on preferred • Ve be the market value of issued equity • Vd be the Market value of issued bonds • Vp be the market value of issued preferred • t be the tax rate 37 Average Cost of Capital: Example with 3-Securities • k = ke * Ve + kp * Vp + kd * Vd* (1 - t) • The average cost of capital is also the cost of capital for each of the firms business divisions weighted according to their market value 38 6.6 Sensitivity Analysis Using Spreadsheets • Will the project still be economical if some of the underlying variables are inaccurate? – Spreadsheets are an excellent tool for exploring the influence of estimation errors on financial decisions 39 Base Case • The following is an embedded Excel worksheet for the cash flow of a firm – It is generally a good practice to divide the worksheet into two segments, one containing only data, and the other containing only formulae – This practice increases flexibility & reduces the chance of error – It is also a good practice to name variables using Insert:Name:Create in Excel 40 Tax rate Unit sales in year 1 Sales growth rate Unit price Unit Price Growth Fixed Start Fixed Growth Variable pcent Depreciation schedule Start working capt Investment schedule Capital movements sch Dividend Working Cap Sch Year CF Forecast Sales revenue Expenses Fixed Costs (cash) Variable costs Depreciation Operating Profit Taxes Net Profit Operating CF Working cap move Investment in P&E Invest CF Net CF PV(NCF) 40.00% $4,000 0.00% $5,000 0.00% 3,100,000 0.00% 75.00% 400,000 2,200,000 2,800,000 0 1,000,000 2,200,000 0 2200 2,800 5,000 -5,000 -5000 NPV = 1236 1 2 3 4 5 6 7 20,000 20,000 20,000 20,000 20,000 20,000 20,000 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 0 1,300 1130 0 0 1,300 983 0 0 1,300 855 0 0 1,300 743 0 0 1,300 646 0 0 1,300 562 3,100 15,000 400 1,500 600 900 1,300 -2,200 0 -2,200 3,500 1316 41 A Modified Scenario – In this case the cash is piling up (Watch out for IRS penalties in this case!) – The assumption is now made that sales units grow by +2%, unit prices by -3%, and fixed costs by +8% (No, Victor: Fixed costs may vary with time. Yes, Valerie: Fixed costs do not vary with sales.) – Assume a dividend of $1,000,000/year 42 Assumptions Cost of capital Tax rate Unit sales in year 1 Sales growth rate Unit price Unit Price Growth Fixed Start Fixed Growth Variable pcent Depreciation schedule Start working capt Investment schedule Capital movements sch Dividend Working Cap Sch Year CF Forecast Sales revenue Expenses Fixed Costs (cash) Variable costs Depreciation Operating Profit Taxes Net Profit Operating CF Working cap move Investment in P&E Invest CF Net CF PV(NCF) (Table in $'000) 15.00% 40.00% $4,000 2.00% $5,000 -3.00% 3,100,000 8.00% 75.00% 400,000 2,200,000 2,800,000 0 1,000,000 2,200,000 0 2200 2,800 5,000 -5,000 -5000 NPV = -797 1 2 3 4 5 6 7 20,000 19,788 19,578 19,371 19,165 18,962 18,761 3,100 15,000 400 1,500 600 900 1,300 3,348 14,841 400 1,199 480 719 1,119 3,616 14,684 400 879 351 527 927 3,905 14,528 400 538 215 323 723 4,218 14,374 400 174 70 104 504 4,555 14,222 400 -214 -86 -129 271 0 1,300 1130 0 0 1,119 846 0 0 927 610 0 0 723 413 0 0 504 251 0 0 271 117 4,919 14,071 400 -629 -252 -377 23 -2,200 0 -2,200 2,223 836 43 Additional Scenarios • The following graphs are variations of from the basic model constructed by changing one variable at a time: 44 Assumptions Cost of capital Tax rate Unit sales in year 1 Sales growth rate Unit price Unit Price Growth Fixed Start Fixed Growth Variable pcent Depreciation schedule Start working capt Investment schedule Capital movements sch Dividend Working Cap Sch Year CF Forecast Sales revenue Expenses Fixed Costs (cash) Variable costs Depreciation Operating Profit Taxes Net Profit Operating CF Working cap move Investment in P&E Invest CF Net CF PV(NCF) (Table in $'000) 25.00% 40.00% $4,000 0.00% $5,000 0.00% 3,100,000 0.00% 75.00% 400,000 2,200,000 2,800,000 0 1,000,000 2,200,000 0 2200 2,800 5,000 -5,000 -5000 Was 15% NPV = -429 1 2 3 4 5 6 7 20,000 20,000 20,000 20,000 20,000 20,000 20,000 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 3,100 15,000 400 1,500 600 900 1,300 0 1,300 1040 0 0 1,300 832 0 0 1,300 532 0 0 1,300 426 0 0 1,300 341 3,100 15,000 400 1,500 600 900 1,300 -2,200 0 -2,200 3,500 734 0 0 1,300 66645 Assumptions Cost of capital Tax rate Unit sales in year 1 Sales growth rate Unit price Unit Price Growth Fixed Start Fixed Growth Variable pcent Depreciation schedule Start working capt Investment schedule Capital movements sch Dividend Working Cap Sch Year CF Forecast Sales revenue Expenses Fixed Costs (cash) Variable costs Depreciation Operating Profit Taxes Net Profit Operating CF Working cap move Investment in P&E Invest CF Net CF PV(NCF) (Table in $'000) 15.00% 30.00% $4,000 0.00% $5,000 0.00% 3,100,000 0.00% 75.00% 400,000 2,200,000 2,800,000 0 1,000,000 2,200,000 0 2200 2,800 5,000 -5,000 -5000 Was 40% NPV = 1860 1 2 3 4 5 6 7 20,000 20,000 20,000 20,000 20,000 20,000 20,000 3,100 15,000 400 1,500 450 1,050 1,450 3,100 15,000 400 1,500 450 1,050 1,450 3,100 15,000 400 1,500 450 1,050 1,450 3,100 15,000 400 1,500 450 1,050 1,450 3,100 15,000 400 1,500 450 1,050 1,450 3,100 15,000 400 1,500 450 1,050 1,450 0 1,450 1261 0 0 1,450 1096 0 0 1,450 953 0 0 1,450 829 0 0 1,450 721 0 0 1,450 627 3,100 15,000 400 1,500 450 1,050 1,450 -2,200 0 -2,200 3,650 1372 46 Assumptions Cost of capital Tax rate Unit sales in year 1 Sales growth rate Unit price Unit Price Growth Fixed Start Fixed Growth Variable pcent Depreciation schedule Start working capt Investment schedule Capital movements sch Dividend Working Cap Sch Year CF Forecast Sales revenue Expenses Fixed Costs (cash) Variable costs Depreciation Operating Profit Taxes Net Profit Operating CF Working cap move Investment in P&E Invest CF Net CF PV(NCF) (Table in $'000) 15.00% 40.00% $4,000 5.00% $5,000 0.00% 3,100,000 0.00% 75.00% 400,000 2,200,000 2,800,000 0 1,000,000 2,200,000 0 2200 2,800 5,000 -5,000 -5000 Was 0% NPV = 2885 1 2 3 4 5 6 7 20,000 21,000 22,050 23,153 24,310 25,526 26,802 3,100 15,000 400 1,500 600 900 1,300 3,100 15,750 400 1,750 700 1,050 1,450 3,100 16,538 400 2,013 805 1,208 1,608 3,100 17,364 400 2,288 915 1,373 1,773 3,100 18,233 400 2,578 1,031 1,547 1,947 3,100 19,144 400 2,881 1,153 1,729 2,129 0 1,300 1130 0 0 1,450 1096 0 0 1,608 1057 0 0 1,773 1014 0 0 1,947 968 0 0 2,129 920 3,100 20,101 400 3,200 1,280 1,920 2,320 -2,200 0 -2,200 4,520 1699 47 Assumptions Cost of capital Tax rate Unit sales in year 1 Sales growth rate Unit price Unit Price Growth Fixed Start Fixed Growth Variable pcent Depreciation schedule Start working capt Investment schedule Capital movements sch Dividend Working Cap Sch Year CF Forecast Sales revenue Expenses Fixed Costs (cash) Variable costs Depreciation Operating Profit Taxes Net Profit Operating CF Working cap move Investment in P&E Invest CF Net CF PV(NCF) (Table in $'000) 15.00% 40.00% $4,000 0.00% $5,000 0.00% 3,100,000 0.00% 85.00% 400,000 2,200,000 2,800,000 0 1,000,000 2,200,000 0 2200 2,800 5,000 -5,000 -5000 Was 75% NPV = -3757 1 2 3 4 5 6 7 20,000 20,000 20,000 20,000 20,000 20,000 20,000 3,100 17,000 400 -500 -200 -300 100 3,100 17,000 400 -500 -200 -300 100 3,100 17,000 400 -500 -200 -300 100 3,100 17,000 400 -500 -200 -300 100 3,100 17,000 400 -500 -200 -300 100 3,100 17,000 400 -500 -200 -300 100 0 100 87 0 0 100 76 0 0 100 66 0 0 100 57 0 0 100 50 0 0 100 43 3,100 17,000 400 -500 -200 -300 100 -2,200 0 -2,200 2,300 865 48 Assumptions Cost of capital Tax rate Unit sales in year 1 Sales growth rate Unit price Unit Price Growth Fixed Start Fixed Growth Variable pcent Depreciation schedule Start working capt Investment schedule Capital movements sch Dividend Working Cap Sch Year CF Forecast Sales revenue Expenses Fixed Costs (cash) Variable costs Depreciation Operating Profit Taxes Net Profit Operating CF Working cap move Investment in P&E Invest CF Net CF PV(NCF) (Table in $'000) 15.00% 40.00% $4,000 0.00% $5,000 0.00% 3,500,000 0.00% 75.00% 400,000 2,200,000 2,800,000 0 1,000,000 2,200,000 0 2200 2,800 5,000 -5,000 -5000 Was $3,100,000 NPV = 237 1 2 3 4 5 6 7 20,000 20,000 20,000 20,000 20,000 20,000 20,000 3,500 15,000 400 1,100 440 660 1,060 3,500 15,000 400 1,100 440 660 1,060 3,500 15,000 400 1,100 440 660 1,060 3,500 15,000 400 1,100 440 660 1,060 3,500 15,000 400 1,100 440 660 1,060 3,500 15,000 400 1,100 440 660 1,060 0 1,060 922 0 0 1,060 802 0 0 1,060 697 0 0 1,060 606 0 0 1,060 527 0 0 1,060 458 3,500 15,000 400 1,100 440 660 1,060 -2,200 0 -2,200 3,260 1226 49 Consequences – Notice that the reduced long-term viability of the product, together with the dividend for demands, will cause: – a cash flow crisis early in year 5, – negative accounting profits in year 6, – and a serious negative operating cash flow in year 8 when the tax benefits of depreciation are finally consumed. 50 Graphs – Graphs are a useful supplement to spreadsheets as they may illustrate behavior of the model to continuing changes in a selected independent variable – The following graphs explore a model 51 Table 6.4 Project Sensitivity to Sales Volume Sales Units 2000 3000 3604 4000 5000 6000 Net CF Operations 200000 550000 1003009 1300000 2050000 2800000 52 NPV Project 5005022 1884708 0 1235607 4355922 7476237 NPV v. Discount Rate $7,000 $6,000 $5,000 NPV $000 $4,000 $3,000 $2,000 $1,000 $0 0% 5% 10% 15% 20% 25% 30% $1,000 $2,000 $3,000 Rate 53 35% 40% 45% 50% Sensitivity of Project to Sale Volume $3,000,000 Net CF from Operations $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 $0 $2,000 $2,500 $3,000 $3,500 $4,000 $4,500 $500,000 Sales (Units) 54 $5,000 $5,500 $6,000 NPV Project $10,000,000 $8,000,000 $6,000,000 NPV $4,000,000 $2,000,000 $0 2000 2500 3000 3500 4000 4500 $2,000,000 $4,000,000 $6,000,000 Sales (Units) 55 5000 5500 6000 Spreadsheet Planning Conclusions: • Spreadsheets permit management to explore perturbations caused by randomness in the model’s inputs – This should lead to management correctly prioritizing time to the variables of the model – Management will recognize dangers sooner, and will create contingency plans to avoid their worst consequences 56 6.7 Break-Even and Indifference Points • Break-even point is number of sales resulting in a NPV = 0 • IRR is discount rate resulting in NPV = 0 • Price B/E is unit price resulting in NPV= 0 • Payback period is the project life resulting in NPV = 0 57 6.8 Projects with Different Lives • When do you replace a sales car? – As a car ages • its resale price decreases • the annual repair bills increase • sales people become discontented – people who live in their cars demand reliability – customers are influenced by sales people’s cars – a nice car is part of their unofficial remuneration 58 Data Collection • A car uses about the same amount of oil, gasoline, cleaning, tire usage, et cetera, no matter how old it is – This data need not be collected, because we are interested only in incremental cash flows • assume that the degree of tires wear is compensated by a credit on sale 59 Data Collection • In order to simplify this example, it will be assumed that all cash flows are in real terms • Assumed that the required rate of return on cars is a real 10% (Excited already?) 60 Data Collection • Sales people use the Bdella Sedan. • The market prices for new and used Bdellas is given on the next slide • The expected annual maintenance charges by year are also given • Intangible losses have been listed 61 Schedule of Bdella Price & Maint Age 0 1 2 3 4 5 6 7 8 9 10 Discount Price Maint Intang 20,000 0 16,000 0 1,000 12,800 1,000 800 10,240 1,100 0 8,192 1,210 -500 4,096 1,331 -600 2,048 1,464 -840 1,024 1,611 -1,176 512 1,772 -1,646 256 1,949 -2,305 128 2,144 -3,227 5.00% 62 Car Replacement • First compute the NPV of – purchasing in year 0, and selling in year 1, – purchasing in year 0, and selling in year 2, –… – purchasing in year 0, and selling in year 10 • These figures are shown in col. PV_Proj 63 Schedule of Bdella Price & Maint Age 0 1 2 3 4 5 6 7 8 9 10 Discount Price Maint Intang PV_Price PV_Maint PV_Intang PV_Proj 20,000 0 20,000 16,000 0 1,000 15,238 0 952 -3,810 12,800 1,000 800 11,610 907 726 -7,619 10,240 1,100 0 8,846 950 0 -11,334 8,192 1,210 -500 6,740 995 -411 -14,846 4,096 1,331 -600 3,209 1,043 -470 -19,890 2,048 1,464 -840 1,528 1,093 -627 -23,290 1,024 1,611 -1,176 728 1,145 -836 -26,071 512 1,772 -1,646 347 1,199 -1,114 -28,766 256 1,949 -2,305 165 1,256 -1,486 -31,689 128 2,144 -3,227 79 1,316 -1,981 -35,073 5.00% 64 Interpretation • We see that the incremental cost of replacing the car every year is $3810, replacing it every two years is $7,619… • You are not yet tempted to select “replace every year” because this option does not provide a Bdella Sedan after the 1st year, while replace after 2-years does 65 Additional Analysis • The analysis so far does not provide for a replacement car. • The simplest way to do this is to replace each project with an identical project forever • We have the perpetuity equation for this 66 Additional Analysis • Take the two year problem as an example • The NPV is discounted to year 0, the 1st replacement NPV is discounted to year 2, the 2nd to year 4, … for ever • This is a perpetuity due, with interest (1.05)2 - 1 = 10.25% 67 Schedule of Bdella Price & Maint Age 0 1 2 3 4 5 6 7 8 9 10 Discount Price Maint Intang PV_Price PV_Maint PV_Intang PV_Proj Rate PV_Infinity Ann_Equ 20,000 0 20,000 16,000 0 1,000 15,238 0 952 -3,810 5.00% -80,000 -3,810 12,800 1,000 800 11,610 907 726 -7,619 10.25% -81,951 -3,902 10,240 1,100 0 8,846 950 0 -11,334 15.76% -83,236 -3,964 8,192 1,210 -500 6,740 995 -411 -14,846 21.55% -83,738 -3,988 4,096 1,331 -600 3,209 1,043 -470 -19,890 27.63% -91,881 -4,375 2,048 1,464 -840 1,528 1,093 -627 -23,290 34.01% -91,771 -4,370 1,024 1,611 -1,176 728 1,145 -836 -26,071 40.71% -90,112 -4,291 512 1,772 -1,646 347 1,199 -1,114 -28,766 47.75% -89,013 -4,239 256 1,949 -2,305 165 1,256 -1,486 -31,689 55.13% -89,167 -4,246 128 2,144 -3,227 79 1,316 -1,981 -35,073 62.89% -90,841 -4,326 5.00% 68 Conclusion • Replacing the car every year is the best scenario, but, watch out for an agency problem. Without the intangibles the answer is to keep the car as long as possible • The Bdella Sedan is like a Volvo on Geritol: it doesn't know when to die 69 6.9 Ranking Mutually Exclusive Projects • Using the NPV method, you are unlikely to encounter any serious problems – Some managers, particularly those with an engineering background, prefer to use the IRR method • The IRR method may be made to give the correct answer, but this requires considerable skill. Avoid it (unless your boss engineer) 70 6.10 Inflation and Capital Budgeting • When computing NPV – Use the nominal cost of capital to discount nominal cash flows • (Nominal cash flows are rarely constant) – Use the real cost of capital to discount real cash flows 71