Transcript FM10 Chapter 12

13 - 1
CHAPTER 13
The Basics of Capital Budgeting:
Evaluating Cash Flows
Should we
build this
plant?
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What is capital budgeting?
Analysis of potential additions to
fixed assets.
Long-term decisions; involve large
expenditures.
Very important to firm’s future.
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Steps
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine k = WACC for project.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >
WACC.
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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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An Example of Mutually Exclusive
Projects
BRIDGE vs. BOAT to get
products across a river.
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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.
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Inflow (+) or Outflow (-) in Year
0
1
2
3
4
5
N
-
+
+
+
+
+
N
-
+
+
+
+
-
-
-
-
+
+
+
N
+
+
+
-
-
-
N
-
+
+
-
+
-
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NN
NN
NN
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What is the 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?
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Payback for Project L
(Long: Most CFs in out years)
0
1
CFt
-100
Cumulative -100
PaybackL
= 2
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2
10
-90
+
30/80
2.4
60 100
-30
0
3
80
50
= 2.375 years
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Project S (Short: CFs come quickly)
0
CFt
-100
Cumulative -100
PaybackS
1.6 2
3
70 100 50
20
-30
40
1
0 20
= 1 + 30/50 = 1.6 years
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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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Discounted Payback: Uses discounted
rather than raw CFs.
0
10%
1
2
3
10
60
80
CFt
-100
PVCFt
-100
9.09
49.59
60.11
Cumulative -100
-90.91
-41.32
18.79
Discounted
= 2
payback
+ 41.32/60.11 = 2.7 yrs
Recover invest. + cap. costs in 2.7 yrs.
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NPV: Sum of the PVs of inflows and
outflows.
n
CFt
NPV  
.
t
t  0 1  k 
Cost often is CF0 and is negative.
n
NPV  
t 1
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CFt
1  k 
t
 CF0 .
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What’s Project L’s NPV?
Project L:
0
10%
-100.00
1
2
3
10
60
80
9.09
49.59
60.11
18.79 = NPVL
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NPVS = $19.98.
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Calculator Solution
Enter in CFLO for L:
-100
CF0
10
CF1
60
CF2
80
CF3
10
I
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NPV
= 18.78 = NPVL
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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.
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Using NPV method, which project(s)
should be accepted?
If Projects S and L are mutually
exclusive, accept S because
NPVs > NPVL .
If S & L are independent,
accept both; NPV > 0.
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Internal Rate of Return: IRR
0
1
2
3
CF0
Cost
CF1
CF2
Inflows
CF3
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.
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NPV: Enter k, solve for NPV.
n
CFt
 NPV .

t
t  0 1  k 
IRR: Enter NPV = 0, solve for IRR.
n
CFt
 0.

t
t  0 1  IRR
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What’s Project L’s IRR?
0
IRR = ?
-100.00
PV1
1
2
3
10
60
80
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
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Find IRR if CFs are constant:
0
IRR = ?
-100
INPUTS
1
2
3
40
40
40
3
N
OUTPUT
I/YR
-100
40
0
PV
PMT
FV
9.70%
Or, with CFLO, enter CFs and press
IRR = 9.70%.
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How is a project’s IRR
related to a bond’s YTM?
They are the same thing.
A bond’s YTM is the IRR
if you invest in the bond.
Q.
A.
0
1
2
IRR = ?
-1,134.2
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10
...
90
90
1,090
IRR = 7.08% (use TVM or CFLO).
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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.
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IRR Acceptance Criteria
If IRR > k, accept project.
If IRR < k, reject project.
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Decisions on Projects S and L per IRR
If S and L are independent, accept
both. IRRs > k = 10%.
If S and L are mutually exclusive,
accept S because IRRS > IRRL .
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Construct NPV Profiles
Enter CFs in CFLO and find NPVL and
NPVS at different discount rates:
k
0
5
10
15
20
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NPVL
50
33
19
7
(4)
NPVS
40
29
20
12
5
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NPV ($)
k
0
5
10
60
50
Crossover
Point = 8.7%
40
15
20
30
20
NPVL
50
33
19
7
(4)
NPVS
40
29
20
12
5
S
10
IRRS = 23.6%
L
Discount Rate (%)
0
0
5
10
-10
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15
20
23.6
IRRL = 18.1%
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NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > k
and NPV > 0
Accept.
k > IRR
and NPV < 0.
Reject.
k (%)
IRR
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Mutually Exclusive Projects
k < 8.7: NPVL> NPVS , IRRS > IRRL
CONFLICT
k > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
NPV
L
S
k
8.7
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k
IRRS
%
IRRL
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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.
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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 k favors small projects.
2. Timing differences. Project with faster
payback provides more CF in early
years for reinvestment. If k is high,
early CF especially good, NPVS > NPVL.
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Reinvestment Rate Assumptions
NPV assumes reinvest at k
(opportunity cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, k, is
more realistic, so NPV method is
best. NPV should be used to choose
between mutually exclusive projects.
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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.
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MIRR for Project L (k = 10%)
0
1
2
3
10.0
60.0
80.0
10%
-100.0
10%
10%
MIRR =
16.5%
-100.0
PV outflows
$158.1
$100 =
(1+MIRRL)3
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66.0
12.1
158.1
TV inflows
MIRRL = 16.5%
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To find TV with 10B, enter in CFLO:
CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80
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.
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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.
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Pavilion Project: NPV and IRR?
0
k = 10%
-800
1
2
5,000
-5,000
Enter CFs in CFLO, enter I = 10.
NPV = -386.78
IRR = ERROR. Why?
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We got IRR = ERROR because there
are 2 IRRs. Nonnormal CFs--two sign
changes. Here’s a picture:
NPV Profile
NPV
IRR2 = 400%
450
0
-800
100
400
k
IRR1 = 25%
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Logic of Multiple IRRs
1. At very low discount rates, the PV of
CF2 is large & negative, so NPV < 0.
2. At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
3. In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
4. Result: 2 IRRs.
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Could find IRR with calculator:
1. Enter CFs as before.
2. Enter a “guess” as to IRR by
storing the guess. Try 10%:
10
STO
IRR = 25% = lower IRR
Now guess large IRR, say, 200:
200
STO
IRR = 400% = upper IRR
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When there are nonnormal CFs and
more than one IRR, use MIRR:
0
-800,000
1
5,000,000
2
-5,000,000
PV outflows @ 10% = -4,932,231.40.
TV inflows @ 10% = 5,500,000.00.
MIRR = 5.6%
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Accept Project P?
NO. Reject because MIRR =
5.6% < k = 10%.
Also, if MIRR < k, NPV will be
negative: NPV = -$386,777.
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S and L are mutually exclusive and
will be repeated. k = 10%. Which is
better? (000s)
0
1
2
Project S:
(100)
60
60
Project L:
(100)
33.5
33.5
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3
4
33.5
33.5
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CF0
CF1
Nj
I
NPV
S
-100,000
60,000
2
10
L
-100,000
33,500
4
10
4,132
6,190
NPVL > NPVS. But is L better?
Can’t say yet. Need to perform
common life analysis.
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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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13 - 46
Replacement Chain Approach (000s)
Project S with Replication:
0
1
Project S:
(100)
60
(100)
60
2
3
4
60
(100)
(40)
60
60
60
60
NPV = $7,547.
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13 - 47
Or, use NPVs:
0
4,132
3,415
7,547
1
10%
2
3
4
4,132
Compare to Project L NPV = $6,190.
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If the cost to repeat S in two years rises
to $105,000, which is best? (000s)
0
1
Project S:
(100)
60
2
3
4
60
(105)
(45)
60
60
NPVS = $3,415 < NPVL = $6,190.
Now choose L.
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13 - 49
Consider another project with a 3-year
life. If terminated prior to Year 3, the
machinery will have positive salvage
value.
Year
0
1
2
3
CF
($5,000)
2,100
2,000
1,750
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Salvage Value
$5,000
3,100
2,000
0
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CFs Under Each Alternative (000s)
0
(5)
1
2.1
2
2
2. Terminate 2 years (5)
2.1
4
3. Terminate 1 year
5.2
1. No termination
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(5)
3
1.75
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Assuming a 10% cost of capital, what is
the project’s optimal, or economic life?
NPV(no) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
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Conclusions
The project is acceptable only if
operated for 2 years.
A project’s engineering life does not
always equal its economic life.
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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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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...)
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If external funds will be raised, then
the NPV of all projects should be
estimated using this higher marginal
cost of capital.
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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...)
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Reason: Companies want to avoid the
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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Reason: Companies don’t have
enough managerial, marketing, or
engineering staff to implement all
positive NPV projects.
Solution: Use linear programming to
maximize NPV subject to not
exceeding the constraints on staffing.
(More...)
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Reason: Companies believe that the
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.
Solution: Implement a post-audit
process and tie the managers’
compensation to the subsequent
performance of the project.
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