The Basics of Capital Budgeting

Capital Budgeting
The process of planning expenditures on assets whose cash flows are expected to extend beyond one year Involves making long-term decisions, and involves large expenditures Extremely important to a firms future

Some Projects that can be decided through Capital Budgeting

Replacement Decisions
Maintenance (replace damaged equipment) Cost Reduction Decisions (replace serviceable but obsolete equipment to lower costs)

Expansion of existing projects or markets (Jollibee Cebu Branch 1,2,3) Expansion into new products or markets (Jollibee expand for the first time to US, Singapore) Safety (DNV/mining companies) and/or environmental projects (Nestle Vietnams water purification system *ISO+) = (mandatory investments) Expansion of existing projects or markets (Jollibee Cebu Branch 1,2,3) Mergers Others (Office buildings, parking lots, executive aircrafts)

Projects can be:

Independent
Projects with cash flows that are not affected by the acceptance or non-acceptance of other projects. You can pick as many projects as you wish.

Mutually Exclusive
A set of projects where only one can be accepted.

Steps in Capital Budgeting:

1. 2. 3. 4. Estimate the projects cash flows Assess riskiness of the projects cash flows Determine r (WACC) for the project Find payback period, discounted payback period, NPV, IRR, and MIRR 5. Decide whether to accept or reject the project

Payback Period
A breakeven analysis Refers to the number of years or length of time required to recover a projects cost. How long does it take to get your money back? You must add the projects cash inflows to its cost until the cumulative cash flows of the project turns positive Uses Nominal Cash Flows Two possible scenarios:
When annual cash inflows are equal When annual cash inflows are unequal

Computing Payback Period, when Annual Cash Inflows are Equal

Example: A project costs P200,000. The expected returns of the project amount to P40,000 annually. What is the payback period? Answer: P200,000/P40,000 = 5 years

Computing Payback Period, when Annual Cash Inflows are Unequal

Project L CFt Cumulative PaybackL Project S CFt Cumulative PaybackS
0 -100 -100 1 10 -90 2 60 -30 3 80

50

= 2 =
0
-100 -100

+
1

30 / 80
2
50 20

= 2.375 years
3 20 40

70 -30

= 1 =

30 / 50

= 1.6 years

PBP Accept or Reject?

Depends if the project is independent or mutually exclusive (if you accept one, you have to reject the other) Independent: If you have two projects which fits your firms acceptable criteria, then you ACCEPT BOTH PROJECTS. Mutually Exclusive: If you have two projects which fits your firms acceptable criteria, ACCEPT THE PROJECT WITH THE SHORTER PAYBACK PERIOD, because in mutually exclusive projects, you cannot undertake both projects at the same time.

Advantages/Strengths of Payback Period

Indicates a projects risk and liquidity
Risk: Cash flows expected in the distant future are generally riskier than near-term cash flows Liquidity: The shorter the payback period, ceteris paribus, the greater the projects liquidity

Serves as a screening tool Identifies investments that recoup cash investments quickly. Identifies products that recoup initial investment quickly. Easy to calculate and understand

Disadvantages/Weaknesses of Payback Period

Ignores the time value of money Ignores cash flows occurring after payback period. Therefore, in mutually exclusive projects, it is possible that you might choose the project with the faster payback period but with lower total returns.

Discounted Payback Period

The length of time (number of years) required for the present value of an investments cash flows (discounted at the investments cost of capital) to recover a projects cost. Discounts the cash inflows and outflows, and compute the same way as you compute payback period. Uses Discounted Cash Flows

Discounted Payback Period

Uses discounted cash flows rather than raw CFs.
0
CFt -100
10%

1
10

2
60

3 80

PV of CFt Cumulative

-100 -100
2 +

9.09 -90.91

49.59 -41.32

60.11 18.79
= 2.7 years

Disc PaybackL = =

41.32 / 60.11

DPBP Accept or Reject?

Depends if the project is independent or mutually exclusive (if you accept one, you have to reject the other) Independent: If you have two projects which fits your firms acceptable criteria, then you ACCEPT BOTH PROJECTS. Mutually Exclusive: If you have two projects which fits your firms acceptable criteria, ACCEPT THE PROJECT WITH THE SHORTER DISCOUNTED PAYBACK PERIOD, because in mutually exclusive projects, you cannot undertake both projects at the same time.

Advantages/Strengths of Discounted Payback Period

Indicates a projects risk and liquidity Risk: Cash flows expected in the distant future are generally riskier than near-term cash flows (riskiness of cash flows through the cost of capital) Liquidity: The shorter the payback period, ceteris paribus, the greater the projects liquidity Serves as a screening tool Identifies investments that recoup cash investments quickly. Identifies products that recoup initial investment quickly. Easy to calculate and understand Considers the time value of money

Disadvantages/Weaknesses of Discounted Payback Period

Ignores cash flows occurring after payback period. Therefore, in mutually exclusive projects, it is possible that you might choose the project with the faster payback period but with lower total returns.

Net Present Value Method

A method of ranking investment proposals using the NPV, which is equal to the PV of future net cash flows, discounted at the cost of capital. NPV depends on:
Risk WACC Timing of Cash Flows Amount of Cash Flows

To determine NPV
Calculate the present value of cash inflows Calculate the present value of cash outflows Subtract the present value of the outflows from the present value of the inflows
NPV emphasizes cash flows and not accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization.

Net Present Value Method

Sum of the PVs of all cash inflows and outflows of a project

CFt NPV t t 0 ( 1 r )
0 CFt PV of CFt -100 -100
10%

1 10 9.09

2 60 49.59

3 80 60.11

NPV(L) = -100 + 9.09 + 49.59 + 60.11 = 18.79 NPV (S) = 19.98

NPV Accept or Reject?

Depends if the project is independent or mutually exclusive (if you accept one, you have to reject the other) Independent: Accept Projects with Positive (+) NPV Mutually Exclusive: Accept the Project with the highest Positive (+) NPV Therefore, in the previous example, if the project is independent, we should accept both L and S. But if the project is ME, we should reject L and accept S.

Advantages/Strengths of NPV
Gives a direct measure of dollar benefit of the project to the shareholders (Tells whether the investment will increase the firms value or not) = + NPV will add value to the firm Considers all cash flows and the time value of money Considers the risk of future cash flows (through the cost of capital) Does not suffer from Multiple IRR problems

Disadvantages/Weaknesses of NPV
Expressed in terms of dollars, not as a percentage Very complex analysis, too many variables to forecast

There is a direct relationship between NPV and EVA. NPV is the PV of the projects future EVAs. Accepting +NPV projects will result to +EVA and +MVA EVA = NOPAT Capital Charges (Invested Capital x Cost of Capital) MVA = Market Value of the Firm Capital Invested in the Firm [MV Invested Capital]

Internal Rate of Return Method

A method of ranking investment proposals using the rate of return on an investment This is calculated by finding the discount rate that equates the PV of future cash inflows to the projects cost PV(Inflows) = PV(Outflows) IRR is the rate that forces the PV of cash flows =0

Internal Rate of Return

IRR is the rate that forces the PV of cash flows = 0. Therefore, this is equivalent to forcing the NPV to equal zero
CFt 0 t t 0 ( 1 IRR)
n

Two possible scenarios:

When annual cash inflows are equal When annual cash inflows are unequal

Internal Rate of Return

IRR and a bonds YTM are the same thing. Therefore, when annual cash inflows are equal, the computation of IRR is similar to the computation of YTM. You can also use the CALC function or the trial and error method. Illustration: Suppose an initial investment worth 1,134.20 good for 10 years earn a 9% interest per year. Its future value is 1,000. Solve for IRR:

Internal Rate of Return

When Future Value is not given, and/or cash flows are not equal, you have to use the TRIAL AND ERROR approach. Assume the following information, with initial investment of P45,000 and k (WACC) of 20%, compute IRR: Choices: a) 17% b) 18% c) 19% d) 21% e) 22% Start with the middle choice. If answer is +, try the higher answer. If answer is , try the lower answer.
Year (t) 1 2 3 4 5 Present Value of Cash inflows Less: Initial Investment Net Present Value (NPV) Cash inflows 28,000 12,000 10,000 10,000 10,000 PVIF (19%, t) 0.840 0.706 0.593 0.499 0.419 Present Value at 19% 23,520 8,472 5,930 4,990 4,190 47,102 45,000 2,102

Internal Rate of Return

Since using 19% reveals a positive NPV, when NPV computed has to be 0 (ZERO), we try the higher answer, 21%.
Year (t) Cash inflows PVIF (21%, t) Present Value at 21%

1 2 3
4 5 Present Value of Cash inflows Less: Initial Investment Net Present Value (NPV)

28,000 12,000 10,000

10,000 10,000

0.826 0.683 0.564

0.467 0.386

23,128 8,196 5,640

4,670 3,860 45,494 45,000 494

Using 21% still reveals a positive NPV. However, it is significantly smaller than the + NPV of k = 19%. Now, let us try to compute using the last choice, 22%.

Internal Rate of Return

Now we try using r = 22%. We still try 22% because we are not sure if the answer is nearer to 21% or 22%.
Year (t) Cash inflows PVIF (22%, t) Present Value at 22%

1 2 3
4 5 Present Value of Cash inflows Less: Initial Investment Net Present Value (NPV)

28,000 12,000 10,000

10,000 10,000

0.820 0.672 0.551

0.451 0.370

22,960 8,064 5,510

4,510 3,700 44,744 45,000 256

Now your answer is a negative NPV of 256. This is nearer to zero than is the positive NPV of 494 if k = 21%. Therefore, the approximate answer is D) 22%. Take note however, that the answer has to be in between 21% and 22%, but it is nearer to 22%. If we want to be more accurate and find the exact answer, we have to interpolate.

Internal Rate of Return

How to interpolate:
K (WACC) 21% 22% X NPV + 494 256 0

(22% x) / ( 256 0) = (22% 21%) / ( 256 494) X = 21.66%

IRR Accept or Reject?

Depends if the project is independent or mutually exclusive (if you accept one, you have to reject the other) Independent: Accept Projects if IRR > WACC, because projects whose IRR > WACC means that NPV is positive. Mutually Exclusive: Accept the Project with the higher IRR, provided that the IRR must be greater than WACC. Therefore, in the previous example, if the project is independent, we should accept both L and S. But if the project is ME, we should reject L and accept S.

Advantages/Strengths of IRR
IRR measures a projects profitability in the rate of return sense (IRR = WACC implies that there are just sufficient returns on the project to provide investors with their required rate of return. IRR > WACC implies that the projects rate of return is more than sufficient to meet investors rate of return. It contains information regarding a projects safety margin It is more appealing because it provides a basis (rate of return) for decision making, rather than a dollar amount like the NPV method.

Disadvantages/Weaknesses of IRR

Reinvestment rate assumption (assume that cash flows are reinvested at the same IRR) is unrealistic. Using WACC is more realistic because it is what projects earn on average. Multiple IRR problems IRR can only rank independent projects properly, if signs do not change. They cannot properly rank mutually exclusive projects all the time. Sometimes decision rule for IRR can conflict with NPV, in which case, IRR is erroneous.

Why NPV and IRR conflict? 1. Assumption of cash flow reinvestment 2. Different lives, sizes, risk factors, timing of cash flows

NPV Profiles
A graphical representation of project NPVs at various different costs of capital.
k 0 5 10 15 20 NPVL $50 33.0526 18.7829 6.6656 (3.7037) NPVS $40 29.2949 19.9850 11.8271 4.6296

Finding the Crossover Point Mathematical Way

Crossover Rate is the cost of capital at which the NPV profiles of 2 projects cross, and thus, at which the projects NPVs are equal. Step 1: Find the difference between the cash flows of Project L and Project S (Can be disregarded if NPV Profile is already given.
Project L 0 1 -100 10 Project S -100 70 Difference 0 -60

2
3 IRR

60
80 18.126%

50
20 23.56%

+10
+60

Step 2: Find the NPVs of both Projects using various rs, and find the r closest to where the projects will equalize. (The NPV Profile is usually given, but if not, you have to solve it by yourselves.)
r 0 5 10 15 20 NPVL $50 33.0526 18.7829 6.6656 (3.7037) NPVS $40 29.2949 19.9850 11.8271 4.6296

Notice it is in between k = 5% and k = 10%. So you know for certain that the crossover point is between k = 5% and k = 10%.

Finding the Crossover Point Mathematical Way

Step 3: Find the NPV of the difference given k = 5% and k = 10% (because you have already ascertained that the crossover point is between 5% and 10%). k 5% 10% X NPV (Difference) 3.7577 - 1.2021 0

Step 4: Do interpolation to solve for r when NPV (Difference) is ZERO.

(10% x) / ( 1.2021 0) = (10% 5%) / ( 1.2021 3.7577) X = 8.788%

Finding the Crossover Point Graphical Way

Step 1: Find the IRRs of the individual projects. (You have already computed this before)
Project L Project S

0
1 2 3

-100
10 60 80

-100
70 50 20

IRR

18.126%

23.56%

Step 2: Find the NPVs of both Projects using various rs, and find the r closest to where the projects will equalize. (The NPV Profile is usually given, but if not, you have to solve it by yourselves.)
k 0 5 10 15 20 NPVL $50 33.0526 18.7829 6.6656 (3.7037) NPVS $40 29.2949 19.9850 11.8271 4.6296

Finding the Crossover Point Graphical Way

Step 3: Draw a graph, with r or WACC in the X-axis and NPV in the Y-axis

NPV 60 ($)
50 40 30 20 10 0

5
-10

10

15

20

23.6

Discount Rate (%)

Finding the Crossover Point Graphical Way

Step 4: Plot the graph. At r = 0, NPV of Project L is 50 and at r = 0, NPV of Project S is 40. At NPV = 0, r of Project L is 18.126% and at NPV = 0, r of Project S is 23.56%
Project L
IRR 18.126% NPVL $50 33.0526 18.7829 6.6656 (3.7037)

Project S
23.56% NPVS $40 29.2949 19.9850 11.8271 4.6296

NPV 60 ($)
50

. 40 .
30 20 10 0

. .

Crossover Point = 8.7%

k 0 5 10 15 20

.
L
10

IRRL = 18.1%

. .
15

5
-10

20

. .

.
23.6

IRRS = 23.6% Discount Rate (%)

Interpreting the NPV Profile

If r is less than 8.7%, NPV of Project L is greater than NPV of Project S. So, if it is a mutually exclusive project, we should choose Project L. If r is greater than 8.7%, NPV of Project S is greater than NPV of Project L. So, if it is a mutually exclusive project, we should choose Project S.

NPV 60 ($)
50

. 40 .
30 20 10 0

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

. .
15

5
-10

20

. .

.
23.6

IRRS = 23.6% Discount Rate (%)

Comparing the NPV and IRR methods

NPV 60 ($)

. 40 .
50
30 20 10 0

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

. .
15

5 -10

20

. .

.
23.6

IRRS = 23.6%

If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive If r > crossover point, the two methods lead to the same decision and there is no conflict. If r < crossover point, the two methods lead to different accept/reject decisions.

Reinvestment rate assumptions

NPV method assumes CFs are reinvested at k, the opportunity cost of capital. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, because:
If a firm has a reasonably good access to capital markets, it can raise all the capital it needs at the going rate (WACC). Since the firm can obtain capital at the going rate (WACC), if it has investment opportunities with positive NPVs, it should take them on and finance them at the going rate (WACC). If the firm uses internally generated cash flows from past projects rather than external capital, it will save the going rate (WACC).

Thus, NPV method is the best. NPV method should be used to choose between mutually exclusive projects. Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.
In case of conflict between NPV and IRR, ALWAYS choose NPV!!!

Another Problem for using IRR

Multiple IRR the situation where a project has 2 or more IRRs
A non-normal cash flow occurs when a project calls for a large cash outflow sometime during or at the end of its life. Project P has cash flows (in 000s): CF0 = -$800, CF1 = $5,000, and CF2 = -$5,000. Find Project Ps NPV and IRR.
0 -800
r = 10%

1 5,000

2 -5,000

Project P has cash flows (in 000s): CF0 = -$800, CF1 = $5,000, and CF2 = -$5,000. Find Project Ps NPV and IRR.
0 -800
k = 10%

1 5,000

2 -5,000

NPV = -$386.78 IRR = ? n CFt 0 t t 0 (1 IRR) Try using 25% and try using 400%

Multiple IRRs
NPV Profile A situation where a project has two or more IRRs NPV
IRR2 = 400% 450
0 100 IRR1 = 25% 400

-800

You typically encounter Multiple IRR problems when any of your cash flows change signs more than once. (Non-normal Cash Flows)

I dont care about what you said! I still prefer to use IRR than NPV!!!! I dont care if theres a conflict, and I dont care about Multiple IRR Problems!!!

Some managers prefer the IRR to the NPV method, even though NPV method is more reliable. Is there a better IRR measure?

YES!!!
MIRR (Modified Internal Rate of Return) is the discount rate that causes the PV of a projects terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. MIRR assumes cash flows are reinvested at the WACC. 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.

Calculating MIRR (Normal CFs)

0 -100.0
10%

1 10.0
10% MIRR = 16.5%

2 60.0
10%

3 80.0 66.0 12.1 158.1

TV inflows

-100.0
PV outflows

$100 =

$158.1 (1 + MIRRL)3

MIRRL = 16.5%

Calculating MIRR (Non-Normal CFs)

0 -1,000
r = 10%

1 5,000

2 -1,000

-826.446
PV outflows TV inflows

5,500 -1,826.446

1,826.446

5,500 = (1 + MIRRA)2

MIRRA = 73.53%

MIRR Accept or Reject?

Depends if the project is independent or mutually exclusive (if you accept one, you have to reject the other) Independent: Accept Projects if MIRR > WACC Mutually Exclusive: Accept the Project with the higher MIRR, provided that the MIRR must be greater than WACC.

Can NPV and MIRR conflict? (Page 410)

Size Equal Equal Life Same Different Verdict NPV and MIRR same conclusion NPV and MIRR same conclusion

Different

Same/Different

NPV and MIRR may conflict

Which should be followed if NPV and MIRR conflict?

OO LALA!!!! NPV JUD!!!!

Conclusions:
NPV is important in the capital budgeting process as it gives a DIRECT MEASURE of the dollar/peso benefit of the project to the shareholders. NPV is absolutely the best single measure of profitability. Hence, in case of conflicts between PBP, DPBP, NPV, IRR and MIRR, we must choose NPV!

IRR is also important as it also measures profitability as a percentage rate of return and gives information concerning a projects safety margin. These information are not revealed by the NPV. Thats why managers prefer to use IRR. However, problems such as assuming cash flows to be reinvested at the IRR are unrealistic, and we also encounter Multiple IRR Problems if cash flows are non-normal.

Conclusions:
To counter with problems with IRR, we can use MIRR as it has all the virtues of the IRR but incorporates a better reinvestment rate assumption (reinvest at WACC), and it avoids multiple rate of return problems as well!

Still, even when MIRR looks infallible, we must still use NPV in case of conflicts!

Decision Criteria Used in Practice

1960 (Primary Criterion) Payback Discounted Payback NPV IRR Others TOTAL 35% NA 0% 20% 45% 100% 1970 (Primary Criterion) 15% NA 0% 60% 25% 100% 1980 (Primary Criterion) 5% NA 15% 65% 15% 100% 1999 (USES) 57% 29% 75% 76% NA

Post-Audit
A comparison of actual versus expected results for a given capital project. Purposes:
To Improve Cash Flow Forecasts To Improve Operations and bring results in line with forecasts

Problems 12-1 to 12-5

Project K costs $52,125, its expected net cash inflows are $12,000 per year for 8 years, and its WACC is 12% Requirements:
Problem 12-1: What is the projects NPV? Problem 12-2: What is the projects IRR? Problem 12-3: What is the projects MIRR? Problem 12-4: What is the projects payback? Problem 12-5: What is the projects discounted payback?

Problem 12-11
Project S costs $15,000, and its expected cash flows would be $4,500 per year for 5 years. Mutually exclusive Project L costs $37,500, and its expected cash flows would be $11,100 per year for 5 years. If both projects have a WACC of 14%, which project would you recommend? Explain.

Problem 12-13
A firm is considering two mutually exclusive projects, X and Y, with the following cash flows: Project X = -1000, 100, 300, 400, 700 Project Y = -1000, 1000, 100, 50, 50 The projects are equally risky and their WACC is 12%. What is the MIRR of the project that maximizes shareholder value?

Problem 12-14
K. Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC and LCC (for high and low capital costs, respectively). HCC has a high capital cost but relatively low operating costs, while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the units are shown here. Kims WACC is 7%. HCC = -600k, -50k, -50k, -50k, -50k, -50k LCC = -100k, -175k, -175k, -175k, -175k, -175k Requirements:
Which unit would you recommend? Explain. If Kims controller wanted to know the IRRs of the two projects, what would you tell him? If the WACC rose to 15%, would this affect your recommendation? Explain your answer and the reason this result occurred.

Problem 12-20
A project has annual cash flows of $7,500 for the next 10 years and then $10,000 each year for the following 10 years. The IRR of this 20year project is 10.98%. If the firms WACC is 9%, what is the projects NPV?