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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
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)
Mutually Exclusive
A set of projects where only one can be accepted.
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
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
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
Serves as a screening tool Identifies investments that recoup cash investments quickly. Identifies products that recoup initial investment quickly. Easy to calculate and understand
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
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.
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
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]
1 2 3
4 5 Present Value of Cash inflows Less: Initial Investment Net Present Value (NPV)
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%.
1 2 3
4 5 Present Value of Cash inflows Less: Initial Investment Net Present Value (NPV)
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.
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
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%.
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 $40 29.2949 19.9850 11.8271 4.6296
NPV 60 ($)
50 40 30 20 10 0
5
-10
10
15
20
23.6
Project S
23.56% NPVS $40 29.2949 19.9850 11.8271 4.6296
NPV 60 ($)
50
. 40 .
30 20 10 0
. .
k 0 5 10 15 20
.
L
10
IRRL = 18.1%
. .
15
5
-10
20
. .
.
23.6
NPV 60 ($)
50
. 40 .
30 20 10 0
. .
.
L
10
IRRL = 18.1%
. .
15
5
-10
20
. .
.
23.6
. 40 .
50
30 20 10 0
. .
.
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.
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!!!
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.
1 10.0
10% MIRR = 16.5%
2 60.0
10%
-100.0
PV outflows
$100 =
$158.1 (1 + MIRRL)3
MIRRL = 16.5%
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%
Different
Same/Different
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!
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
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?