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CORPORATE FINANCE INSTRUCTOR: TOM BARKLEY

INSTRUCTIONAL NOTE A Comparison of Capital Budgeting Tools


1) General Definitions (i) Independent projects are projects whose cash flows are not affected by the acceptance or rejection of
other projects. (ii) Mutually exclusive projects are a set of projects from which only one can be accepted. (iii) A normal cash flow stream has one or more cash outflows (costs) followed by a series of cash inflows: there is only one change of signs. + + + + + (iv) A nonnormal cash flow stream has a subsequent cash outflow after the inflows have begun: there is more than one change of signs. + + + + +

2) Definitions of Investment Decision Rules (i)


The Net Present Value (NPV) of a project is the present value of all cash inflows from the project minus the present value of the cash outflows to the project, where present values are computed using the appropriate discount rate for the project. [Note: The appropriate discount rate or hurdle rate for an average project for a company is the companys weighted average cost of capital (WACC). However, if a project is more risky than average then the hurdle rate should be higher. Similarly, if a project is less risky than average then the hurdle rate should be lower. For the rest of this instructional note, it will be assumed that the WACC is the appropriate cost of capital.]

NPV = CF0 +
(ii)

N CF1 CF2 CFN CFt + ++ = 1 2 N (1 + r ) ( 1 + r ) (1 + r ) t = 0 (1 + r ) t

Decision Rule: Accept projects that have positive net present values.

The Internal Rate of Return (IRR) of a project is the discount rate that forces the projects NPV to equal zero.

NPV = CF0 +

N CF1 CF2 CFN CFt + ++ = =0 1 2 N (1 + IRR) (1 + IRR ) (1 + IRR) t =0 (1 + IRR) t

Decision Rule: Accept projects that have internal rates of return in excess of their opportunity costs of capital (WACCs).

(iii) The Modified Internal Rate of Return (MIRR) of a project is the discount rate at which the
present value of a projects cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firms cost of capital.

PV ( costs ) = PV ( terminal value )

(1 + r )
t =0

COFt
t

CIF (1 + r )
t =0 t

N t

(1 + MIRR ) N

Decision Rule: Accept projects that have modified internal rates of return in excess of their opportunity costs of capital (WACCs).

(iv) The Payback Period of a project is the length of time required for its net revenues to cover its cost.
Payback = No. of years prior to full recovery + Unrecovere d cost at start of year Cash flow during full recovery year

(v)

Decision Rule: Accept projects that pay back in less time than some previously established benchmark cut-off period. The Discounted Payback Period of a project is the length of time required for its net revenues, discounted at the projects cost of capital, to cover its cost. Decision Rule: Accept projects that pay back in less time than some previously established benchmark cut-off period. requires outlays in two or more periods, the denominator in the ratio should be the present value of these cash outflows. Present va lue Profitabil ity index = Initial investment Decision Rule: Accept projects that have profitability indexes greater than one.

(vi) The Profitability Index of a project is its present value per dollar of initial outlay. If a project

(vii) The Book Rate of Return of a project is its average book income divided by the average book
value of assets over the life of the project. This is also referred to as Accounting Rate of Return. The components reflect accounting and tax figures, not market values or cash flows. Book income Book rate of return = Book assets Decision Rule: Accept projects that have book rates of return that are greater than the shareholders opportunity cost of capital (ROE).

Investment Decision Rule


NPV

Pros
1. Uses market-determined, risk-adjusted discount rates to account for the time value of money 2. Is consistent with shareholder value maximization 3. Uses objective criteria for determining cash flows and discount rates 4. Correctly analyzes mutually exclusive projects 5. Makes analysis of multiple projects easier, since NPVs are value-additive 6. Is not that difficult to use! 1. Summarizes information about the project in a single number 2. Allows firms to set hurdle rates and thus, perhaps, allows for easier management control 3. Can be computed without knowing the required rate of return 4. Will provide the same answers as the NPV rule, under certain circumstances

Cons

Further Comments
1. Capital markets appear to respond to corporate decisions in terms of the NPV they add to (or subtract from) stock prices 2. It forces careful, systematic, explicit thought about the assumptions being made in the investment decisions 3. Many of the larger corporations in the world use it these days 4. NPV profiles cross due to size (scale) differences, and timing differences in the cash flows 5. It assumes cash flows are reinvested at the WACC 1. If a bond is thought of as a project to be invested in, then the YTM on the bond would be the IRR of the bond project 2. If projects are independent, the NPV and IRR rules lead to the same accept/reject decisions 3. If projects are mutually exclusive, the NPV and IRR rules lead to the same decisions if the WACC is greater than the crossover rate, and to conflicting decisions if the WACC is less than the crossover rate 4. It assumes cash flows are reinvested at the IRR 1. Avoids the problem of multiple internal rates of return (when there are nonnormal cash flows) 2. It assumes cash flows are reinvested at the WACC 3. Managers like rate of return

IRR

1. Allows the possibility of multiple rates of return 2. Cannot correctly analyze mutually exclusive projects 3. Can give incorrect answers when combinations of projects are involved, as the IRR rule is not value-additive 4. Can imply different opportunity costs of capital for risk-equivalent cash flows 5. Can sometimes give answers that have no economic meaning

MIRR

Payback

1. Is simple to use may allow for a greater sense of management control 2. Provides an indication of a projects liquidity 3. Avoids dealing with uncertainty (but doesnt make it disappear) 4. May not be too bad for small ticket items (e.g., a copy machine)

1. Does not consider the time value of money 2. Does not account for the risk of cash flows 3. Implies that the cost of capital is either zero or infinity 4. Ignores cash flows after the cut-off date 5. Is biased against long-term projects 6. No objective criterion for choosing the cut-off date 1. Assumes that there may be capital constraints 2. May not always choose valuemaximizing projects, and as a result the firm may forego opportunities for additional value creation

comparisons, and MIRR is better than IRR in this 1. This is essentially a breakeven calculation in the sense that if cash flows come in at the expected rate until the payback year, then the project will break even

Discounted Payback Profitability Index

1. It takes into account the time value of money 1. Uses the same concepts as the NPV rule 2. Is useful if there truly are capital constraints 3. Gives the same result as the NPV rule for projects of the same scale 4. Summarizes the information about a project in a single number which is perhaps easier to communicate

Book Rate of Return

1. Depends on which items the accountant chooses to treat as capital investments and how rapidly they are depreciated 2. May not be a good measure of true profitability, as it is an average across all of the firms activities

1. Book income is reported to shareholders, and gets most of their immediate attention 2. Cash flows and book income are often very different, since accountants label some cash outflows as capital investments and others as operating expenses