The Basics of Capital Budgeting: Should We Build This Plant?

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CHAPTER 11
The Basics of Capital Budgeting
Should we build this plant?
Copyright 2001 by Harcourt, Inc.
All rights reserved.
11 - 2
What is capital budgeting? Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.

Very important to firms future.
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Steps 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs.
3. Determine k = WACC (adj.).

4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.

Copyright 2001 by Harcourt, Inc. All rights reserved.
11 - 4
What is the difference between independent and 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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An Example of Mutually Exclusive Projects
BRIDGE vs. BOAT to get products across a river.

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Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.
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Inflow (+) or Outflow (-) in Year 0 1 + 2 + 3 + 4 + 5 + N N NN
+
-
+
-
+
+
+
+
+ N
NN N
NN
+
-
+
+
+
+
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What is the payback period?
The number of years required to recover a projects cost, or how long does it take to get our money back?
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Payback for Project L (Long: Large CFs in later years)

0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 30/80 2
2.4
3 80 50
60 100 -30 0
= 2.375 years
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Project S (Short: CFs come quickly)

0
CFt -100
1.6 2
3
20 40
70 100 50 -30 0 20
Cumulative -100
PaybackL
= 1 + 30/50 = 1.6 years
11 - 11
Strengths of Payback: 1. Provides an indication of a projects risk and liquidity. 2. Easy to calculate and understand.
Weaknesses of Payback:
1. Ignores the TVM. 2. Ignores CFs occurring after the payback period.
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Discounted Payback: Uses discounted rather than raw CFs.

0 CFt PVCFt -100 -100
10%
1 10 9.09 -90.91
2 60 49.59 -41.32
3 80 60.11 18.79
Cumulative -100
Discounted = 2 payback
+ 41.32/60.11 = 2.7 years
Recover invest. + cap. costs in 2.7 years.

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NPV: Sum of the PVs of inflows and outflows.
CFt NPV t . t 0 1 k
n
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Whats Project Ls NPV? Project L: 0 -100.00 9.09 49.59 60.11 18.79 = NPVL
10%
1 10
2 60
3 80
NPVS = $19.98.
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Calculator Solution
Enter in CFLO for L:

-100
CF0
CF1
10
60
CF2
CF3 I NPV = 18.78 = NPVL
80
10
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Rationale for the NPV Method NPV = PV inflows Cost = Net gain in wealth. Accept project if NPV > 0.
Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
11 - 17
Using NPV method, which project(s) should be accepted?
If Projects S and L are mutually exclusive, accept S because NPVs > NPVL . If S & L are independent, accept both; NPV > 0.
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Internal Rate of Return: IRR

0 CF0 Cost 1 CF1 2 CF2 Inflows 3 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 k, solve for NPV.

CFt t NPV . t 0 1 k
n
IRR: Enter NPV = 0, solve for IRR.

CFt t 0. t 0 1 IRR
n
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Whats Project Ls IRR?

0
IRR = ?
1 10
2 60
3 80
-100.00 PV1 PV2 PV3
0 = NPV
Enter CFs in CFLO, then press IRR: IRRL = 18.13%. IRRS = 23.56%.
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Find IRR if CFs are constant:

0
-100
INPUTS OUTPUT 3
N I/YR IRR = ?
1
40
2
40
-100
PV
3
40
40
PMT
0
FV
9.70%
Or, with CFLO, enter CFs and press IRR = 9.70%.

11 - 22
Q.
A.
How is a projects IRR related to a bonds YTM? They are the same thing. A bonds YTM is the IRR if you invest in the bond.
1
IRR = ?
10
...
90 90 1090
-1134.2
IRR = 7.08% (use TVM or CFLO).

11 - 23
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%. Profitable.
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IRR Acceptance Criteria
If IRR > k, accept project.
If IRR < k, reject project.
11 - 25
Decisions on Projects S and L per IRR
If S and L are independent, accept both. IRRs > k = 10%.
If S and L are mutually exclusive, accept S because IRRS > IRRL .
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Construct NPV Profiles

Enter CFs in CFLO and find NPVL and NPVS at different discount rates:
k 0 5 10 15 20
NPVL 50 33 19 7 (4 (4)
NPVS 40 29 20 12 5
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NPV ($)
60
. 40 .
50 30 20 10
. .
Crossover Point = 8.7%
k 0 5 10 15 20
NPVL 50 33 19 7 (4)
NPVS 40 29 20 12 5
.
L
5 10
. .
15
0
-10
. . 20
IRRS = 23.6%
.
23.6
Discount Rate (%)
IRRL = 18.1%
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NPV and IRR always lead to the same accept/reject decision for independent projects:
NPV ($)
IRR > k and NPV > 0 Accept.
k > IRR and NPV < 0. Reject.
k (%) IRR
11 - 29
Mutually Exclusive Projects

NPV
L
k < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT k > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT
IRRS
8.7
%
IRRL
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To Find the Crossover Rate 1. Find cash flow differences between the projects. See data at beginning of the case. 2. Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%. 3. Can subtract S from L or vice versa, but better to have first CF negative. 4. If profiles dont cross, one project dominates the other.
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Two Reasons NPV Profiles Cross 1. 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 k favors small projects. 2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
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Reinvestment Rate Assumptions NPV assumes reinvest at k (opportunity cost of capital). IRR assumes reinvest at IRR. Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
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Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?
Yes, MIRR 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.
Thus, MIRR assumes cash inflows are reinvested at WACC.

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MIRR for Project L (k = 10%)

0
10%
1 10.0
10%
2 60.0
10%
3 80.0
-100.0
66.0 12.1 158.1

TV inflows
MIRR = 16.5%
-100.0 PV outflows
$158.1 $100 = (1 + MIRRL)3 MIRRL = 16.5%
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To find TV with HP 10B, enter in CFLO: CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80 I = 10 NPV = 118.78 = PV of inflows.
Enter PV = -118.78, N = 3, I = 10, PMT = 0. Press FV = 158.10 = FV of inflows. Enter FV = 158.10, PV = -100, PMT = 0, N = 3. Press 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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Pavilion Project: NPV and IRR?
0 -800
k = 10%
1 5,000
2 -5,000
Enter CFs in CFLO, enter I = 10. NPV = -386.78 IRR = ERROR. Why?
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We got IRR = ERROR because there are 2 IRRs. Nonnormal CFs--two sign changes. Heres a picture:
NPV
NPV Profile
IRR2 = 400%
450 0 100 IRR1 = 25%

400
-800
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Logic of Multiple IRRs

1. At very low discount rates, the PV of CF2 is large & negative, so NPV < 0.
2. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0.
3. In between, the discount rate hits CF2 harder than CF1, so NPV > 0.
4. Result: 2 IRRs.
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Could find IRR with calculator:

1. Enter CFs as before. 2. Enter a guess as to IRR by storing the guess. Try 10%: 10 STO
IRR = 25% = lower IRR

Now guess large IRR, say, 200: 200 STO IRR = 400% = upper IRR
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When there are nonnormal CFs and more than one IRR, use MIRR:
0 -800,000 1 5,000,000 2 -5,000,000
PV outflows @ 10% = -4,932,231.40. TV inflows @ 10% = 5,500,000.00. MIRR = 5.6%

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Accept Project P?
NO. Reject because MIRR = 5.6% < k = 10%. Also, if MIRR < k, NPV will be negative: NPV = -$386,777.

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11 - 1

Copyright 2001 by Harcourt, Inc.

All rights reserved.

What is capital budgeting? Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Steps 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs.

3. Determine k = WACC (adj.).

5. Accept if NPV > 0 and/or IRR > WACC.

An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.

Inflow (+) or Outflow (-) in Year 0 1 + 2 + 3 + 4 + 5 + N N NN

Copyright 2001 by Harcourt, Inc.

What is the payback period?

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Payback for Project L (Long: Large CFs in later years)

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Project S (Short: CFs come quickly)

= 1 + 30/50 = 1.6 years

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Discounted Payback: Uses discounted rather than raw CFs.

+ 41.32/60.11 = 2.7 years

Recover invest. + cap. costs in 2.7 years.

NPV: Sum of the PVs of inflows and outflows.

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Enter in CFLO for L:

Copyright 2001 by Harcourt, Inc.

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

Internal Rate of Return: IRR

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

Whats Project Ls IRR?

-100.00 PV1 PV2 PV3

Find IRR if CFs are constant:

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

IRR = 7.08% (use TVM or CFLO).

Rationale for the IRR Method

IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Decisions on Projects S and L per IRR

If S and L are independent, accept both. IRRs > k = 10%.

If S and L are mutually exclusive, accept S because IRRS > IRRL .

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Construct NPV Profiles

Crossover Point = 8.7%

Discount Rate (%)

Copyright 2001 by Harcourt, Inc.

IRR > k and NPV > 0 Accept.

k > IRR and NPV < 0. Reject.

Mutually Exclusive Projects

Copyright 2001 by Harcourt, Inc.

Thus, MIRR assumes cash inflows are reinvested at WACC.

MIRR for Project L (k = 10%)