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Chapter 10:
The Basics of Capital Budgeting:
Evaluating Cash Flows
Overview and “vocabulary”
Methods
Payback, discounted payback
NPV
IRR, MIRR
Profitability Index
Unequal lives
Economic life
10 - 2
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.
10 - 5
0 1 2 2.4 3
0 1 1.6 2 3
Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
10 - 9
CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs
Project L:
0 1 2 3
10%
-100.00 10 60 80
9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
10 - 12
Calculator Solution
10 CF1
60 CF2
80 CF3
0 1 2 3
0 1 2 3
IRR = ?
-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
10 - 18
Find IRR if CFs are constant:
0 1 2 3
IRR = ?
-100 40 40 40
INPUTS 3 -100 40 0
N I/YR PV PMT FV
OUTPUT 9.70%
r (%)
IRR
10 - 24
S IRRS
r 8.7 r %
IRRL
10 - 25
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
10 - 34
0 1 2
r = 10%
IRR2 = 400%
450
0 r
100 400
IRR1 = 25%
-800
10 - 36
0 1 2
Accept Project P?
0 1 2 3 4
Project S:
(100) 60 60
Project L:
(100) 33.5 33.5 33.5 33.5
10 - 41
S L
CF0 -100,000 -100,000
CF1 60,000 33,500
Nj 2 4
I 10 10
0 1 2 3 4
Franchise S:
(100) 60 60
(100) 60 60
(100) 60 (40) 60 60
NPV = $7,547.
10 - 44
0 1 2 3 4
4,132 4,132
3,415 10%
7,547
0 1 2 3 4
Franchise S:
(100) 60 60
(105) 60 60
(45)
0 1 2 3
1. No termination (5) 2.1 2 1.75
2. Terminate 2 years (5) 2.1 4
3. Terminate 1 year (5) 5.2
10 - 48
NPV(no) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
10 - 49
Conclusions
Capital Rationing