CHAPTER10

TheBasicsofCapitalBudgetingShouldwebuildthisplant?Whatiscapitalbudgeting?Analysisofpotentialadditionstofixedassets.Long-termdecisions;involvelargeexpenditures.Veryimportanttofirm’sfuture.StepstocapitalbudgetingEstimateCFs(inflows&outflows).AssessriskinessofCFs.Determinetheappropriatecostofcapital.FindNPVand/orIRR.AcceptifNPV>0and/orIRR>WACC.Whatisthedifferencebetweenindependentandmutuallyexclusiveprojects?Independentprojects–ifthecashflowsofoneareunaffectedbytheacceptanceoftheother.Mutuallyexclusiveprojects–ifthecashflowsofonecanbeadverselyimpactedbytheacceptanceoftheother.Whatisthedifferencebetweennormalandnonnormalcashflowstreams?Normalcashflowstream–Cost(negativeCF)followedbyaseriesofpositivecashinflows.Onechangeofsigns.Nonnormalcashflowstream–Twoormorechangesofsigns.Mostcommon:Cost(negativeCF),thenstringofpositiveCFs,thencosttocloseproject.Nuclearpowerplant,stripmine,etc.Whatisthepaybackperiod?Thenumberofyearsrequiredtorecoveraproject’scost,or“Howlongdoesittaketogetourmoneyback?”Calculatedbyaddingproject’scashinflowstoitscostuntilthecumulativecashflowfortheprojectturnspositive.CalculatingpaybackPaybackL=2+/=2.375yearsCFt

-1001060100Cumulative-100-900500123=2.4308080-30ProjectLPaybackS=1+/=1.6yearsCFt

-1007010020Cumulative-100020400123=1.6305050-30ProjectSStrengthsandweaknessesofpaybackStrengthsProvidesanindicationofaproject’sriskandliquidity.Easytocalculateandunderstand.WeaknessesIgnoresthetimevalueofmoney.IgnoresCFsoccurringafterthepaybackperiod.DiscountedpaybackperiodUsesdiscountedcashflowsratherthanrawCFs.DiscPaybackL=2+/=2.7yearsCFt-100106080Cumulative-100-90.9118.790123=2.760.11-41.32PVofCFt-1009.0949.5941.3260.1110%NetPresentValue(NPV)SumofthePVsofallcashinflowsandoutflowsofaproject:WhatisProjectL’sNPV?

Year

CFt

PVofCFt 0 -100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPVL= $18.79 NPVS=$19.98SolvingforNPV:

FinancialcalculatorsolutionEnterCFsintothecalculator’sCFLOregister.CF0=-100CF1=10CF2=60CF3=80EnterI/YR=10,pressNPVbuttontogetNPVL=$18.78.RationalefortheNPVmethod

NPV =PVofinflows–Cost =NetgaininwealthIfprojectsareindependent,acceptiftheprojectNPV>0.Ifprojectsaremutuallyexclusive,acceptprojectswiththehighestpositiveNPV,thosethataddthemostvalue.Inthisexample,wouldacceptSifmutuallyexclusive(NPVs>NPVL),andwouldacceptbothifindependent.InternalRateofReturn(IRR)IRRisthediscountratethatforcesPVofinflowsequaltocost,andtheNPV=0:SolvingforIRRwithafinancialcalculator:EnterCFsinCFLOregister.PressIRR;IRRL=18.13%andIRRS=23.56%.Howisaproject’sIRRsimilartoabond’sYTM?Theyarethesamething.Thinkofabondasaproject.TheYTMonthebondwouldbetheIRRofthe“bond”project.EXAMPLE:Supposea10-yearbondwitha9%annualcouponsellsfor$1,134.20.SolveforIRR=YTM=7.08%,theannualreturnforthisproject/bond.RationalefortheIRRmethodIfIRR>WACC,theproject’srateofreturnisgreaterthanitscosts.Thereissomereturnleftovertobooststockholders’returns.IRRAcceptanceCriteriaIfIRR>k,acceptproject.IfIRR<k,rejectproject.Ifprojectsareindependent,acceptbothprojects,asbothIRR>k=10%.Ifprojectsaremutuallyexclusive,acceptS,becauseIRRs>IRRL.NPVProfilesAgraphicalrepresentationofprojectNPVsatvariousdifferentcostsofcapital.

k

NPVL

NPVS 0 $50 $40 5 33 29 10 19 20 15 7 12 20 (4) 5DrawingNPVprofiles-100102030405060510152023.6NPV($)DiscountRate(%)IRRL=18.1%IRRS=23.6%CrossoverPoint=8.7%SL...........ComparingtheNPVandIRRmethodsIfprojectsareindependent,thetwomethodsalwaysleadtothesameaccept/rejectdecisions.Ifprojectsaremutuallyexclusive…Ifk>crossoverpoint,thetwomethodsleadtothesamedecisionandthereisnoconflict.Ifk<crossoverpoint,thetwomethodsleadtodifferentaccept/rejectdecisions.FindingthecrossoverpointFindcashflowdifferencesbetweentheprojectsforeachyear.EnterthesedifferencesinCFLOregister,thenpressIRR.Crossoverrate=8.68%,roundedto8.7%.CansubtractSfromLorviceversa,butbettertohavefirstCFnegative.Ifprofilesdon’tcross,oneprojectdominatestheother.ReasonswhyNPVprofilescrossSize(scale)differences–thesmallerprojectfreesupfundsatt=0forinvestment.Thehighertheopportunitycost,themorevaluablethesefunds,sohighkfavorssmallprojects.Timingdifferences–theprojectwithfasterpaybackprovidesmoreCFinearlyyearsforreinvestment.Ifkishigh,earlyCFespeciallygood,NPVS>NPVL.ReinvestmentrateassumptionsNPVmethodassumesCFsarereinvestedatk,theopportunitycostofcapital.IRRmethodassumesCFsarereinvestedatIRR.AssumingCFsarereinvestedattheopportunitycostofcapitalismorerealistic,soNPVmethodisthebest.NPVmethodshouldbeusedtochoosebetweenmutuallyexclusiveprojects.PerhapsahybridoftheIRRthatassumescostofcapitalreinvestmentisneeded.SincemanagersprefertheIRRtotheNPVmethod,isthereabetterIRRmeasure?Yes,MIRRisthediscountratethatcausesthePVofaproject’sterminalvalue(TV)toequalthePVofcosts.TVisfoundbycompoundinginflowsatWACC.MIRRassumescashflowsarereinvestedattheWACC.CalculatingMIRR66.012.110%10%-100.010.060.080.0012310%PVoutflows-100.0$100MIRR=16.5%158.1TVinflowsMIRRL=16.5%$158.1(1+MIRRL)3=WhyuseMIRRversusIRR?MIRRcorrectlyassumesreinvestmentatopportunitycost=WACC.MIRRalsoavoidstheproblemofmultipleIRRs.Managerslikerateofreturncomparisons,andMIRRisbetterforthisthanIRR.ProjectPhascashflows(in000s):CF0=-$800,CF1=$5,000,andCF2=-$5,000.FindProjectP’sNPVandIRR.EnterCFsintocalculatorCFLOregister.EnterI/YR=10.NPV=-$386.78.IRR=ERROR Why?-8005,000-5,000012k=10%MultipleIRRsNPVProfile450-8000400100IRR2=400%IRR1=25%kNPVWhyaretheremultipleIRRs?Atverylowdiscountrates,theP