No Slide Title
Download
Report
Transcript No Slide Title
11 - 1
CHAPTER 11
The Basics of Capital Budgeting
Should we
build this
plant?
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 2
What is capital budgeting?
Analysis of potential additions to
fixed assets.
Long-term decisions; involve large
expenditures.
Very important to firm’s future.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 3
Steps
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine k = WACC (adj.).
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >
WACC.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 4
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 5
An Example of Mutually Exclusive
Projects
BRIDGE vs. BOAT to get
products across a river.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 6
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 7
Inflow (+) or Outflow (-) in Year
0
1
2
3
4
5
N
-
+
+
+
+
+
N
-
+
+
+
+
-
-
-
-
+
+
+
N
+
+
+
-
-
-
N
-
+
+
-
+
-
Copyright © 2001 by Harcourt, Inc.
NN
NN
NN
All rights reserved.
11 - 8
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?
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 9
Payback for Project L
(Long: Large CFs in later years)
0
1
CFt
-100
Cumulative -100
PaybackL
= 2
Copyright © 2001 by Harcourt, Inc.
2
10
-90
+
30/80
2.4
60 100
-30
0
3
80
50
= 2.375 years
All rights reserved.
11 - 10
Project S (Short: CFs come quickly)
0
CFt
-100
Cumulative -100
PaybackL
1.6 2
3
70 100 50
20
-30
40
1
0 20
= 1 + 30/50 = 1.6 years
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 11
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 12
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 years
Recover invest. + cap. costs in 2.7 years.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 13
NPV: Sum of the PVs of inflows and
outflows.
CFt
NPV
t .
t 0 1 k
n
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 14
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
Copyright © 2001 by Harcourt, Inc.
NPVS = $19.98.
All rights reserved.
11 - 15
Calculator Solution
Enter in CFLO for L:
-100
CF0
10
CF1
60
CF2
80
CF3
10
I
Copyright © 2001 by Harcourt, Inc.
NPV
= 18.78 = NPVL
All rights reserved.
11 - 16
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 17
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 18
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 19
NPV: Enter k, solve for NPV.
CFt
t NPV .
t 0 1 k
n
IRR: Enter NPV = 0, solve for IRR.
CFt
t 0.
t 0 1 IRR
n
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 20
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%.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 21
Find IRR if CFs are constant:
0
IRR = ?
-100
INPUTS
2
3
40
40
40
3
N
OUTPUT
1
I/YR
-100
40
0
PV
PMT
FV
9.70%
Or, with CFLO, enter CFs and press
IRR = 9.70%.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 22
Q.
A.
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.
0
1
2
IRR = ?
-1134.2
10
...
90
90
1090
IRR = 7.08% (use TVM or CFLO).
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 23
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 24
IRR Acceptance Criteria
If IRR > k, accept project.
If IRR < k, reject project.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 25
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 .
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 26
Construct NPV Profiles
Enter CFs in CFLO and find NPVL and
NPVS at different discount rates:
k
0
5
10
15
20
Copyright © 2001 by Harcourt, Inc.
NPVL
50
33
19
7
(4
(4)
NPVS
40
29
20
12
5
All rights reserved.
11 - 27
NPV ($)
k
0
5
10
60
.
40 .
50
30
.
.
Crossover
Point = 8.7%
.
20
10
L
.
.
0
5
-10
10
15
15
20
NPVL
50
33
19
7
(4)
NPVS
40
29
20
12
5
S
.
.20
IRRS = 23.6%
.
Discount Rate (%)
23.6
IRRL = 18.1%
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 28
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
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 29
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
k
Copyright © 2001 by Harcourt, Inc.
IRRS
%
IRRL
All rights reserved.
11 - 30
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 31
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 32
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 33
Managers like rates--prefer IRR to NPV
comparisons. Can we give them a
better IRR?
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.
Thus, MIRR assumes cash inflows are
reinvested at WACC.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 34
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
66.0
12.1
158.1
TV inflows
MIRRL = 16.5%
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 35
To find TV with HP 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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 36
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 37
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?
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 38
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%
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 39
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.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 40
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
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 41
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%
Copyright © 2001 by Harcourt, Inc.
All rights reserved.
11 - 42
Accept Project P?
NO. Reject because MIRR =
5.6% < k = 10%.
Also, if MIRR < k, NPV will be
negative: NPV = -$386,777.
Copyright © 2001 by Harcourt, Inc.
All rights reserved.