Professional Documents
Culture Documents
decision criteria:
Evaluating Cash Flows
Financial Management-II
CCBMDO Batch-15
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Topics
Overview and “vocabulary”
Methods
NPV
IRR, MIRR
Benefit Cost ratio
Payback, discounted payback
Accounting rate of return
Unequal lives
Economic life
Optimal capital budget
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The Big Picture:
The Net Present Value of a Project
Market Project’s
interest rates debt/equity capacity
Project’s risk-adjusted
cost of capital
(r)
Market Project’s
risk aversion business risk
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What is capital budgeting?
Analysis of potential projects.
Long-term decisions; involve large
expenditures.
Very important to firm’s future.
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11.1 Capital budgeting process
Identification of potential invt opportunities
Assembling proposed investments
Decision making
Preparation of capital budget
Preparation of budget and appropriations
Implementation
Performance review
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11.1 Capital budgeting process
Identification of potential invt opportunities
Planning body develops sales estimates serves
as basis for setting pdn targets
Identify required investments in plant & eqpt.,
R&D, distribution, …
How to identify the investment ideas?
Monitoring external environment to scout opportunities
Formulate a well defined corp stgy based on SWOT analysis
Sharing the corp stgy and perspectives with persons involved in
the process of capital budgeting
Motivate the employees to make suggestions
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11.1 Capital budgeting process
Assembling proposed investments
Operating departments submits the capital investment
proposals in a standardized proposal form.
Each dept route the proposals through several persons to
ensure that it is viewed from different angles
Helps in creating a climate for bringing about coordination of
interrelated activities.
Investment proposals are usually classified into
various categories for facilitation decision-making,
budgeting and control. (list to follow)
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Capital Budgeting Project
Categories
1. Replacement to continue profitable
operations
2. Replacement to reduce costs
3. Expansion of existing products or markets
4. Expansion into new products/markets
5. Contraction decisions
6. Safety and/or environmental projects
7. Mergers
8. New product investments and Others
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Steps in Capital Budgeting
Estimate cash flows (inflows &
outflows).
Assess risk of cash flows.
Determine r = WACC for project.
Evaluate cash flows.
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Independent versus 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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Cash Flows for A, B and C
0 12% 1 2 3
A’s CFs:
-15000 11,000 7,000 4,800
0 1 2 3
B’s CFs: 12%
-15,000 3,500 8,000 13,000
0 1 2 3
12%
C’s CFs:
-15,000 42,000 -4,000 0
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NPV: Sum of the PVs of All
Cash Flows
N CFt
NPV = Σ
(1 + r)t
t=0
0 1 2 3
L’s CFs: 12%
9,821
5,580
3,417
3,818 = NPVA NPVB = 3,756
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13
Rationale for the NPV Method
NPV = PV inflows – Cost
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Internal Rate of Return: IRR
0 1 2 3
N CFt N CFt
Σ (1 + IRR)t
=0
Σ (1 + IRR)t
-P=0
t=0 t=1
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What’s A’s IRR?
0 1 2 3
IRR = ?
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Decisions on A and B per IRR
If A and B are independent, accept
both: IRRA > r and IRRB > r.
If A and B are mutually exclusive,
accept A because IRRA > IRRB.
IRR is not dependent on the cost of
capital used.
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SUMMARY
Capital budgeting is the process of analyzing potential projects.
These are probably most important decisions that managers must make.
NPV) method discounts all cash flows at the project’s cost of
capital and then sums those cash flows.
Accept positive-NPV project as it increases shareholders’ value.
IRR is that discount rate that forces a project’s NPV to zero.
The project should be accepted if the IRR > WACC
The NPV and IRR methods make the same accept–reject
decisions for independent projects, but
If projects are mutually exclusive then ranking conflicts can
arise the NPV method should generally be relied upon.
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Construct NPV Profiles
Chart Title
r A B C ₹8,000
Crossover
5% ₹ 5,972 ₹ 6,819 ₹ 21,372 ₹6,000
Point = 11.44%
10% ₹ 4,391 ₹ 4,560 ₹ 19,876 ₹4,000
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NPV and IRR: No conflict for
independent projects.
NPV ($)
r (%)
IRR
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Mutually Exclusive Projects
NPV ($) r < 11.44%: NPVB> NPVA , IRRA > IRRB
CONFLICT
B
r > 11.44%: NPVA> NPVB , IRRB > IRRA
NO CONFLICT
A IRRA
11.44
IRRB r (%)
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To Find the Crossover Rate
Find cash flow differences between the projects. See data
at beginning of the case.
Enter these differences in CFLO register, then press IRR.
Crossover rate = 11.44%, rounded to 11.4%.
Can subtract A from B or vice versa and consistently, but
easier to have first CF negative.
If profiles don’t cross, one project dominates the other.
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Two Reasons NPV Profiles Cross
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 r favors small projects.
Timing differences. Project with faster
payback provides more CF in early years for
reinvestment. If r is high, early CF especially
good, NPVA > NPVB.
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Modified Internal Rate of Return
(MIRR)
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.
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MIRR for Project A: First, find
PV and TV (r = 12%).
0 1 2 3
10%
MIRR = 20.79%
-15,000 26,438
PV outflows TV inflows
15,000 = 26,438
(1+MIRRA)3
MIRRA = 20.79%
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To find TV with financial calculator:
Step 1, Find PV of inflows.
First, enter cash inflows in CFLO register:
CF0 = 0, CF1 = 11000, CF2 = 7000, CF3 = 4,800
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Step 2, Find TV of inflows.
Enter PV = -18,818, N = 3, I/YR = 12,
PMT = 0.
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Step 3, Find PV of outflows.
For this problem, there is only one
outflow, CF0 = -15,000, so the PV of
outflows is -15,000.
For other problems there may be
negative cash flows for several years,
and you must find the present value for
all negative cash flows.
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Step 4, Find “IRR” of TV of
inflows and PV of outflows.
Enter FV = 26438, PV = -15,000,
PMT = 0, N = 3.
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Benefit Cost Ratio (BCR)
The profitability index (PI) is the present
value of future cash flows divided by the
initial cost.
It measures the “bang for the buck.”
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Pjt A’s PV of Future Cash Flows
Project L:
0 1 2 3
12%
9,821
5,580
3,417
18,818
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Project A’s Profitability Index
PV future CF 18,818
PIL = =
Initial cost 15,000
PIA = 1.2546
PIB = 1.2504
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What is the payback period?
The number of years required to
recover a project’s cost,
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Payback period for Project A
0 1 1.57 2 3
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38
Payback period for Project B
0 1 2 2.3 3
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43
Pavilion Project: NPV and IRR?
0 1 2
r = 12%
IRR2 = 170%
450
0
0 60 120 170 r (%)
IRR1 = -90%
-800
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Logic of Multiple IRRs
At very low discount rates, the PV of
CF2 is large & negative, so NPV < 0.
At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
Result: 2 IRRs.
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46
Finding Multiple IRRs with
Calculator
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When there are nonnormal CFs and
more than one IRR, use MIRR.
0 1 2
12%
-15,000 42,000 -4,000
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50
Review
A project to have more than one IRR if cash
flows change signs more than once.
A project never has more than one MIRR.
Find the terminal value (TV) of the cash inflows,
compounding them at the firm’s cost of capital,
Determine the discount rate that forces the PV of
the TV to equal the present value of the outflows.
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51
Review
BCR (PI) measures relative profitability—that is, the
amount of PV per dollar of investment.
The regular payback period method has three flaws:
It ignores cash flows beyond the payback period,
it does not consider the time value of money, and
it doesn’t give a precise acceptance rule.
PBP provide an indication of a project’s risk and
liquidity how long the invested capital will be tied up.
Discounted PBP payback considers the time value of money,
but it still ignores cash flows beyond the payback period.
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52
Projects T (for two years) and F (for four
years) are mutually exclusive and will be
repeated; r = 10%.
0 1 2 3 4
T: -100 60 60
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Equivalent Annual Annuity
Approach (EAA)
Convert the PV into a stream of annuity
payments with the same PV.
T: N=2, I/YR=10, PV=-4.132, FV = 0.
Solve for PMT = EAAT = $2.38.
F: N=4, I/YR=10, PV=-6.190, FV = 0.
Solve for PMT = EAAF = $1.95.
T has higher EAA, so it is a better
project.
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55
Replacement Chain
Note that Project T could be repeated after 2
years to generate additional profits.
Use replacement chain to put on common life.
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56
Replacement Chain Approach: f with
Replication ($ thousands)
0 1 2 3 4
T: -100 60 60
-100 60 60
-100 60 -40 60 60
NPV = $7.547.
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Or, Use NPVs
0 1 2 3 4
4.132 4.132
10%
3.415
7.547
0 1 2 3 4
10%
T: -100 60 60
-105 60 60
-45
NPVT = $3.415 < NPVT = $6.190.
Now choose T.
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59
Economic Life vs. Physical Life
Consider another project with a 3-year
life.
If terminated prior to Year 3, the
machinery will have positive salvage
value.
Should you always operate for the full
physical life?
See next slide for cash flows.
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Economic Life vs. Physical Life
(Continued)
Year CF Salvage Value
0 -$5,000 $5,000
1 2,100 3,100
2 2,000 2,000
3 1,750 0
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CFs Under Each Alternative
(000s)
Years: 0 1 2 3
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NPVs under Alternative Lives (Cost of
Capital = 10%)
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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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64
Review
If ME projects have unequal lives, it may be
necessary to adjust the analysis to put the projects
on an equal-life basis. This can be done using the
replacement chain (common life) approach or
the equivalent annual annuity (EAA) approach.
A project’s true value may be greater than the NPV
based on its physical life if it can be terminated at the
end of its economic life.
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65
Review
Flotation costs and increased risk associated with
unusually large expansion programs can cause the
marginal cost of capital to increase as the size of the
capital budget increases.
Capital rationing occurs when management places a
constraint on the size of the firm’s capital budget
during a particular period.
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