The Basics of Capital Budgeting

Topics

Overview Methods

NPV IRR, MIRR Payback, discounted payback

What is capital budgeting?

A process for determining the profitability of a capital investment. Long-term decisions; involve large expenditures. Very important to firms future.

Steps in Capital Budgeting

Estimate cash flows (inflows & outflows). Assess risk of cash flows. Determine r = WACC for project. WACC = Weighted Avg. Cost of Capital Evaluate cash flows.

Independent vs. 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.

What does this represent?

=

t=0

CFt (1 + r)t

NPV: Sum of the PVs of all cash flows.

NPV =
t=0

CFt (1 + r)t

Cost often is CF0 and is negative. NPV =

t=1

CFt (1 + r)t

- CF0
7

Cash Flows for project L and project S

0
Ls CFs: -100 0 Ss CFs: -100 10% 10%

1
10 1 70

2
60 2 50

3
80 3 20
8

Whats project Ls NPV?

0
Ls CFs: -100 10%

1
10

2
60

3
80

= NPVL
9

Whats project Ls NPV?

0
Ls CFs: -100 9.09 49.59 10%

1
10

2
60

3
80

60.11 18.79 = NPVL

NPVS = $19.98.
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Which project should be chosen?

What if mutually exclusive? L or S? What if independent projects? L or S?

11

Calculator Solution: Enter values in CF register for L.

-100 10 60 80 10

CF0
CF1

CF2
CF3 I NPV = 18.78 = NPVL
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Rationale for the NPV Method

NPV = PV inflows Cost This is net gain in wealth, so accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
13

Using NPV method, which project(s) should be accepted?

If project S and L are mutually exclusive, accept S because NPVs > NPVL . If S & L are independent, accept both; NPV > 0.

14

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 r, solve for NPV.

t=0

CFt = NPV . (1 + r)t

IRR: Enter NPV = 0, solve for IRR.

t=0

CFt = 0. (1 + IRR)t
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Whats project Ls IRR?

0 -100 PV1 PV2
IRR = ?

1 10

2 60

3 80

PV3
0 = NPV Enter Cash Flows in CF, then

press IRR:
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Whats project Ls IRR?

0 -100 PV1 PV2
IRR = ?

1 10

2 60

3 80

PV3
0 = NPV Enter Cash Flows in CF, then

press IRR: IRRL = 18.13%. IRRS = 23.56%.

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Find IRR if CFs are constant:

0
-100

1
40

2
40

3
40

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Find IRR if CFs are constant:

0
-100
INPUTS 3
N I/YR

1
40

2
40
-100
PV

3
40
40
PMT

OUTPUT

9.70%

Or, with CF, enter CFs and press IRR = 9.70%.

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Decisions on Projects S and L per IRR

IRRS = 18% IRRL = 23% WACC = 10% If S and L are independent, what to do? If S and L are mutually exclusive, what to do?

21

Rationale for the IRR Method

If IRR > WACC, then the projects rate of return is greater than its cost-- some return is left over to boost stockholders returns. Example: WACC = 10%, IRR = 15%. So this project adds extra return to shareholders.
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Reinvestment Rate Assumptions

NPV assumes reinvest at r (opportunity cost of capital). IRR assumes reinvest CFs at IRR. Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
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Modified Internal Rate of Return (MIRR)

MIRR is the discount rate which causes the PV of a projects terminal value (TV) to equal the PV of costs. TV is found by compounding (FV) inflows at the WACC. Thus, MIRR assumes cash inflows are reinvested at the WACC.
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MIRR for project L: First, find PV and TV (r = 10%)

0
10%

1 10.0
10%

2 60.0
10%

3 80.0

-100

66.0 12.1 158.1

TV inflows
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-100
PV outflows

Second, find discount rate that equates PV and TV

0 -100 PV outflows 1
MIRR = 16.5%

3 158.1 TV inflows

$100 =

$158.1 (1+MIRRL)3
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MIRRL = 16.5%

To find TV with calculator: Step 1, find PV of Inflows

First, enter cash inflows in CF register: CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80 Second, enter I = 10. Third, find PV of inflows: Press NPV = 118.78
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Step 2, find TV of inflows.

Enter PV = -118.78, N = 3, I = 10 CPT FV = 158.10 = FV of inflows.

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Step 3, find PV of outflows.

For this problem, there is only one outflow, CF0 = -100, so the PV of outflows is -100.

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Step 4, find IRR of TV of inflows and PV of outflows.

Enter FV = 158.10, PV = -100, N = 3. CPT 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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What is the payback period?

The number of years required to recover a projects cost,

or how long it takes to get the businesss money back.

32

What is the payback period?

0 1 2 3

-100

50

50

50

33

What is the payback period?

0 -100 1 40 2 40 3 40

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What are the payback periods for projects L and S?

0
Ls CFs: -100 0 Ss CFs: -100 10% 10%

1
10 1 70

2
60 2 50

3
80 3 20
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Payback for project L

0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 2 60 -30 30/80

2.4

3 80 50

= 2.375 years

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Payback for project S

0 CFt -100 1 70 -30 0

1.6 2
50 20

3 20 40

Cumulative -100 PaybackS

= 1 + 30/50 = 1.6 years

37

Strengths and Weaknesses of Payback

Strengths:

Provides an indication of a projects risk and liquidity. Easy to calculate and understand. Ignores the TVM. Ignores CFs occurring after the payback period.
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Weaknesses:

Discounted Payback: Uses discounted rather than raw CFs.

0 CFt PVCFt -100 -100 10% 1 10 9.09 2 60 49.59 3 80 60.11

Cumulative -100
Discounted = 2 payback

-90.91

-41.32

18.79

+ 41.32/60.11 = 2.7 yrs

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Recovers invest. + costs in 2.7 yrs.