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CHAPTER 11
The Basics of Capital Budgeting
Should we
build this
plant?
Steps
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.
Copyright © 2002 by Harcourt, Inc. All rights reserved.
11 - 5
Normal
NormalCash
CashFlow
FlowProject:
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
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plant, strip mine.
All rights reserved.
11 - 7
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
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11 - 8
0 1 2 2.4 3
0 1 1.6 2 3
Strengths of Payback
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.
Weaknesses of Payback
CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
= 2 + 41.32/ 60.11 = 2.7 years
payback
Recover invest. + cap. costs in 2.7 years.
Copyright © 2002 by Harcourt, Inc. All rights reserved.
11 - 13
CFt
n
NPV t .
t 0 1 k
Project L:
0 1 2 3
10%
-100.00 10 60 80
9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
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11 - 15
Calculator Solution
80 CF3
0 1 2 3
0 1 2 3
IRR = ?
-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
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11 - 21
Find IRR if CFs are constant:
0 1 2 3
IRR = ?
-100 40 40 40
INPUTS 3 -100 40 0
N I/YR PV PMT FV
OUTPUT 9.70%
0 1 2 10
IRR = ? ...
-1134.2 90 90 1090
40 .
Crossover 10 19 20
Point = 8.7%
. 15 7 12
30 . 20 (4) 5
20 . S
. IRRS = 23.6%
10 L . .
0
.20 . Discount Rate (%)
5 10 15 23.6
-10
IRRL = 18.1%
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11 - 28
NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > k k > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.
k (%)
IRR
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11 - 29
NPV
k < 8.7: NPVL> NPVS , IRRS > IRRL
CONFLICT
L k > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
S IRRS
%
k 8.7 k IRR
L
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0 1 2
k = 10%
IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
Copyright © 2002 by Harcourt, Inc. All rights reserved.
11 - 39
0 1 2
Accept Project P?