Capital Budgeting

11-1 Overview of capital budgeting

*Stragegic business plan: long-run plan that outlines in broad terms the firms basic strategy for the
next 5 to 10 years
Types of projects
1. Replacement: needed to continue current operations (replace worn out or damaged equipment)
2. Replacement: cost reduction
3. Expansion of existing products or markets
4. Expansion into new products or markets
5. Safety and/or environmental projects: exp necessary to comply with govt orders
6. Other projects: catch all included items
7. Mergers
Company uses following criteria for deciding to accept or reject projects
1. Net Present Value (NPV) /2. Internal Rate of Return (IRR) / 3. Modified Internal Rate of Return
(MIRR)/ 4. Regular payback/ 5. Discounted payback

11-2. Net Present Value (NPV)

*Net Present Value: method of rating investment proposals using the NPV, which is equal to the
present value of the projects free cash flows discounted at the cost of capital
-Cash inflows come in relatively soon (bigger->smaller) -> short-term project
Total cash inflows but they come in later in its life (smaller->bigger): Long
-Calculating NPV
1. The present value of each cash flow is calculated and discounted at the projects risk-adusted cost
of capital
2. The sum of the discounted cash flows is defined as the projects NPV
*Independent projects: projects with cash flows that are not affected by the acceptance or nonacceptance of other projects
e.g) NPV>0 -> accept project
*Mutually exclusive projects: a set of projects where only one can be accepted
e.g) Accept the project with the highest positive NPV if no project has a positive NPV, reject them all.
11-3. Internal Rate of Return (IRR)

*Internal Rate of Return (IRR): The discount rate that forces a projects NPV to equal zero
-discount rate that forces the pv of its inflows to equal its cost.(NPV=0)
-an estimate of the projects rate of return (comparable to the UTM on a bond)
IRR calculating procedure:
1. Trial and Error: try a discounted rate; see if the equation solves to zero -> if x -> try different rate
2. Calculator Solution: put cash flows and CPT IRR
IRR is an estimate of the projects rate of return (= YTM)
If return exceeds the cost of the funds -> difference will be an additional return that goes to the
stockholders and causes the stock price
Projects should be accepted or rejected depending on whether their NPVs are positive. However, IRR
is used to rank projects and make capital budgeting decisions
-Independent projects: IRR>WACC -> accept the project / IRR<WACC -> reject
-Mutually exclusive projects: accept the project with the highest IRR provided thst IRR is greater than
WACC.
-NPV and IRR can produce conflicting conclusions when a choice is being made b/t mutually exclusive
projects -> select based on NPV

11-4 Multiple Internal Rates of Return

Nonnormal cash flows: Cash outflow occurs sometime after the inflows have commenced, meaning
that the signs of the cash flows change more than once.
*Multiple IRR: The situation where a project as two or more IRRs.
-No dilemma regarding project will arise if the NPV method was used.

11-5 Reinvestment Rate Assumptions

-NPV calculation is based on the assumption that cash inflows can be reinvested at the projects riskadjusted WACC
-IRR calculation is based on the assumption that cash flows can be reinvested at the IRR.
(Since discounting at a given rate assumes that cash flows can be reinvested at that same rate, the
IPR assumes that cash flows are reinvested at the IRR)
-Assuming reinvestment at the WACC is more reasonable for the following reasons:
Firm has access to the capital markets
If investment opportunities with positive NPVs, -> finance at the same cost of capital rate

If firm generated cash flows from past projects -> it will save cost of capital
-IRR assumption (cash flow can be reinvested at the IRR) is flawed but assumption into the NPV is
generally correct.
- true investment rate < IRR -> true rate of return on the investment must be less than the calculated
IRR.

11-6 Modified Internal Rate of Return (MIRR)

-The assumption of IRR (reinvested) is generally incorrect, and this causes the IRR to overstate the
projects true return.
*Modified IRR (MIRR): discount rate at which the pv of a projects cost is equal to the pv of its
terminal value, where the terminal value is found as the sum of the fv of the cash inflows,
compounded at the firms cost of capital
1. pv of cash outflows (cost)
2. find future value of each inflow compounded at the WACC out to the terminal year (Terminal Value)
3. find the discount rate that will cause the PV of the terminal value to equal the cost
(N=4, PV=-1000, PMT=0, FV=1579.50) -> CPT I/YR -> MIRR is 12.11%
Advantages:
1) MIRR assumes that cash flows are reinvested at the cost of capital. (<-> at IRR)
2) eliminates multiple IRR problem
Conclusions:
-independent projects: NPV, IRR and MIRR always reach the same accept/ reject
-mutually exclusive: NPV is the best
- good way order: NPV>MIRR>IRR

11-7 NPV Profiles

*Net Present Value Profile: graph showing the relationship b/t a projects NPV and the firms cost of
capital (figure 11.5 p.385)
-IRR is fixed and S has the higher IRR regardless of the cost of capital
-NPV vary depending on the actual cost of capital
-

Project S-1000

500

400

300

100

-Project L

-1000

100

300

400

675

CF.S-CF.L

400

100

-100

-575

IRR =

11.975%

Crossover rate

-Project L has the higher NPV if the cost of the capital is less than the crossover rate, but S has the
higher NPV if the cost of capital is greater than that rate (Figure 11.6 pg. 386)
- Project L has the steeper the steeper slope, indicating that a given increase in the cost of capital
causes a larger decline in NPV.L than in NPV.S. (Remember Ls cash flows come in later than those
of S)
-L is LT project (cash inflow bigger) <-> S is ST project (smaller)
-If a project has most of its cash flows coming in the later years, its NPV will decline sharply of the cost
of capital increases. (but project whose cash flows come earlier will not be severely penalized by high
capital costs)
-Independent Projects: NPV and IRR criteria always lead to the same accept/reject decision
(Figure 11.5 -> accept when cost of capital is less than the IRR and NPV is positive) if the IRR says
accept, so will the NPV
-Mutually Exclusive Projects: As long as the cost of capital is greater than the crossover rate, both
method agree that project S is better: NPV.S > NPV.L & IRR.S > IRR.L (NO CONFLICT)
-if the cost of capital is less than the crossover rate, a conflict arises: NPV ranks L higher but IRR
ranks S higher (CONFLICT)
-Basic conditions that cause NPV profiles to cross and thus lead to conflicts
1) Timing differences: come in early vs come in later -> profiles may cross and result in a conflict
2) Project size difference
-> the rate of return at which differential cash flows can be reinvested is a critical issue ->USE NPV
Quick Question
0
Project A -1000
Project B-1000

1
1150
100

2
100
1300

Project A NPV, IRR, MIRR

1) NPV: CF0=-1000, CF1=1150, CF2=100 I/YR=10 CPT NPV = $128.10

2) IRR: CF0= -1000 CF1=1150, CF2=100 CPT IRR = 23.12%
3) MIRR: N=2, PV= -1000, PMT =0, FV 1365 (fv of 1150+100 = 1150*1.10+100) CPT
I/YR=16.83%
Mutually exclusive -> the highest NPV is the best

11-8. Payback Period

*Payback Period: length of time required foir an investments cash flows to cover its cost
-the first selection criterion was the payback period (See Figure 11.7 pg. 388)
-payback year: the year prior to full recovery + fraction equal to the shortfall at the end of that year
divided by the cash flow during the full recovery year.
Payback = Number of years prior to full recovery+ (Unrecovered cost at start of year/ Cash flow during
full recovery year)
-long payback means that cash flows must be forecasted far out into the future, and that probably
makes the project riskier than one with a shorter payback.
-3 flaws:
1) All dollars received in different years are given the same weight
2) Cash flows beyond the payback year are given no consideration
3)merely tells when we recover our investment (x relate with wealth maximization)
*Discounted payback: The length of time required for an investments cash flows, discounted at the
investments cost of capital, to cover its cost (consider cost of capital but still x consider cash flows
beyond the payback year)
-HOWEVER, payback methods provide info about liquidity and risk.