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THE BASICS OF

CAPITAL
Should we
BUDGETING build this
plant?
Topic Overview

Project Types
Capital Budgeting Decision Criteria
Payback Period
Discounted Payback Period
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return
(MIRR)
Learning Objectives

Understand how to calculate and


use the 5 capital budgeting decision
techniques:, NPV, IRR, MIRR,
Payback, & Discounted Payback.
Understand the advantages and
disadvantages of each technique.
Understand which project to select
when there is a ranking conflict
between NPV and IRR.
What is capital budgeting?

Analysis of potential projects.


Long-term decisions; involve large
expenditures.
Very important to firm’s future.
Principles of Capital Budgeting
Technique

 All Cash flows should be considered


 The cash flows should be discounted at
the opportunity cost of funds
 The technique should select from a set of
mutually exclusive projects the one that
maximizes shareholder’s wealth
 Value additivity principle.
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 only one project
can be selected from a set of projects.
(if the cash flows of one can be
adversely impacted by the acceptance of
the other).
An Example of Mutually Exclusive
Projects:

BRIDGE VS. BOAT TO GET


PRODUCTS ACROSS A RIVER.
Normal vs. Non-normal Projects

 Normal Project:
Cost (negative CF) followed by a series of
positive cash inflows. One change of
signs.
 Non-normal 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.
Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
Value Additivity Principle

If we know the value of separate


projects accepted by management,
then simply adding their values will
give us the value of the firm.
 V= VJ
Capital Budgeting Techniques

The pay back method


 The accounting rate of return
The net present value
The internal rate of return
What is the payback period?

The number of years required to


recover a project’s cost,

or how long does it take to get the


business’s money back?
0

Payback for Franchise L


(Long: Most CFs in out years)

0 1 2 2.4 3

CFt -100 10 60 100 80


Cumulative -100 -90 -30 50

P!ybaciD = 2 + 30/80 = 2.375 ye`rs


Franchise S (Short: CFs come quickly)

0 1 1.6 2 3

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years


Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
Discounted Payback: Uses discounted
rather than raw CFs.
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.


The Accounting Rate of Return (ARR)

The ARR is the average after tax


profit divided by the initial cash out
lays. This is very similar to ROA or
ROI.
The Net Present Value (NPV)
NPV: Sum of the PVs of inflows and outflows.
The cash flows are discounted at the
opportunity cost of capital.
n
CFt
NPV   .
t 0 1  r 
t

Cost often is CF0 and is negative.


n
CFt
NPV    CF0 .
t 1 1  r 
t
What’s Franchise L’s NPV?

Project L:
0 1 2 3
10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
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.
Using NPV method, which franchise(s)
should be accepted?

If Franchise S and L are


mutually exclusive, accept S
because NPVs > NPVL .
If S & L are independent,
accept both; NPV > 0.
Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3


Cost Inflows

IRR is the discount rate that forces


PV inflows = cost. This is the same
as forcing NPV = 0.
NPV: Enter r, solve for NPV.
n
CFt

t  0 1  r 
t
 NPV .

IRR: Enter NPV = 0, solve for IRR.


n CFt
 t  0.
t  0 1  IRR
NPV

IRR

Discount Rate
What’s Franchise L’s IRR?

0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Use IRR function in excel
IRRL = 18.13%. IRRS = 23.56%.
Find IRR if CFs are constant:
0 1 2 3
IRR = ?

-100 40 40 40

IRR = 9.70%.
Rationale for the IRR Method

If IRR > WACC, then the project’s


rate of return is greater than its
cost-- some return is left over to
boost stockholders’ returns.

Example: WACC = 10%, IRR = 15%.


Profitable.
Internal Rate of Return (IRR)

 Internal Rate of Return is a project’s


expected rate of return on its investment.
 IRR is the interest rate where the PV of the
inflows equals the PV of the outflows.
 In other words, the IRR is the rate where a
project’s NPV = 0.
 Decision Rule: Accept if IRR > k (cost of
capital).
 Non-normal projects have multiple IRRs. Don’t
use IRR to decide on non-normal projects.
Decisions on Projects S and L per IRR

If S and L are independent, accept


both. IRRs > r = 10%.
If S and L are mutually exclusive,
accept S because IRRS > IRRL .
Comparison of NPV & IRR

For normal independent projects, both


methods give same accept/reject
decision.
NPV > 0 yields IRR > k in order to
lower NPV to 0.
However, the methods can rank
mutually exclusive projects differently.
What to do, then?
NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > r r > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.

r (%)
IRR
Construct NPV Profiles

NPVL and NPVS at different discount rates:

r NPVL NPVS
0 50 40
5 33 29
10 19 20
15 7 12
20 (4) 5
NPV ($) r NPVL NPVS
60
0 50 40
50 5 33 29
Crossover 10 19 20
40
Point = 8.7% 15 7 12
30 (4) 5
20
20 S
IRRS = 23.6%
10 L
0 Discount Rate (%)
0 5 10 15 20 23.6
-10
IRRL = 18.1%
Mutually Exclusive Projects

NPV r < 8.7: NPVL> NPVS , IRRS > IRRL


CONFLICT
L r > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT

S IRRS

r 8.7 r %
IRRL
Determining NPV/IRR Conflict Range

 For each year, subtract one project’s cash


flows from the other.
 If there is a change of signs of these cash
flow differences, a ranking conflict exists.
 Find IRR of these cash flow differences to
find rate where the two projects have the
same NPV = crossover rate.
 At a cost of capital less than this
crossover rate, a ranking conflict between
NPV and IRR exists.
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 r favors small projects.
2. Timing differences. Project with faster
payback provides more CF in early
years for reinvestment. If r is high,
early CF especially good, NPVS > NPVL.
Value Additivity
 IRR can violate the value additivity principle.
 Consider, project 1 and 2 are mutually
exclusive and project 3 is an independent
project.
 If the value additivity hold then we should be
able to choose the better of the two mutually
exclusive project without having to consider
the independent project.
Year Project 1 Project 2 Project 3 1+3 2+3 Discount
0 -100 -100 -100 -200 -200 1
1 0 225 450 450 675 0.909091
2 550 0 0 550 0 0.826446
NPV 354.55 104.55 309.09 663.64 413.64
IRR 135% 125% 350% 213% 238%

NPV : Project 1 and 1+3 ; IRR : Project 1 and 2+3


Reconciling Ranking Conflicts absent capital
rationing.
 Shareholder Wealth Maximization:
 Want to add more value to the firm than less.
 Reinvestment Rate Assumption:
 NPV assumes cash flows are reinvested at
company’s cost of capital (i.e.: the investors’
required rate of return).
 IRR assumes cash flows are reinvested at
IRR.
 The NPV reinvestment rate assumption is more
realistic.
 Result: Choose project with highest NPV when
NPV/IRR ranking conflict exists for mutually
exclusive projects.
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.
Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
Pavilion Project: NPV and IRR?

0 1 2
r = 10%

-800 5,000 -5,000

NPV = -386.78
IRR = ERROR. Why?
The IRR is incorrect because there
are 2 IRRs. Nonnormal CFs--two sign
changes. Here’s a picture:

NPV NPV Profile

IRR2 = 400%
450
0 r
100 400
IRR1 = 25%
-800
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.
Managers like rates--prefer IRR to NPV
comparisons. Can we give them a
better IRR?
Yes, MIRR( Modified Internal Rate of Return
(MIRR)). is the discount rate which
causes the PV of a project’s 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.
MIRR for Franchise L (r = 10%)
0 1 2 3
10%

-100.0 10.0 60.0 80.0


10%
66.0
10%
12.1
MIRR =
158.1
16.5%
-100.0 $158.1 TV inflows
$100 =
(1+MIRRL)3
PV outflows
MIRRL = 16.5%
Modified Internal Rate of Return, MIRR

 The interest rate where the FV of a


project’s inflows (TV) are discounted to
equal the PV of a project’s outflows.
 Assumes cash inflows are reinvested at
the project’s cost of capital (k).
 PV(outflows) = TV/(1+MIRR)n, where
 TV = CIFt(1+k)n-t, and
 PV(outflows) = COFt/(1+k)t
Where CIF = annual cash inflow, and
COF = annual cash outflow.
Steps to finding MIRR.

 Find TV of inflows by finding FV of each


annual inflow to the end of the project’s
life at the cost of capital.
 Find PV of outflows at the cost of capital
today.
 Then find interest rate over the n years of
the project that equates the TV (=FV) to
the PV of the outflows(=PV).
 Decision rule same as IRR: Compare MIRR
to cost of capital.
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.
When there are nonnormal CFs and
more than one IRR, use MIRR:

0 1 2

-5 30 -30

FV (INFLOWS) PV (OUTFLOWS)
-5 0 5
30 33
-30 0 24.79338843
TV 33 NPV (INFLOWS) 29.79338843
MIRR 5.24%
Accept Project P?

NO. Reject because MIRR =


5.6% < r = 10%.

Also, if MIRR < r, NPV will be


negative: NPV = -$2.52
Summary of Capital Budgeting
Methods
Want a method that uses the time
value of money with all project cash
flows: NPV, IRR & MIRR.
IRR can give erroneous decision for
non-normal projects.
Overall, NPV is the best and
preferred method.
Appendix
S and L are mutually exclusive and
will be repeated. r = 10%. Which is
better? (000s)

0 1 2 3 4

Project S:
(100) 60 60
Project L:
(100) 33.5 33.5 33.5 33.5
S L
CF0 -100,000 -100,000
CF1 60,000 33,500
Nj 2 4
I 10 10

NPV 4,132 6,190

NPVL > NPVS. But is L better?


Can’t say yet. Need to perform
common life analysis.
Note that Project S could be
repeated after 2 years to generate
additional profits.
Can use either replacement chain
or equivalent annual annuity
analysis to make decision.
Replacement Chain Approach (000s)

Franchise S with Replication:

0 1 2 3 4

Franchise S:
(100) 60 60
(100) 60 60
(100) 60 (40) 60 60

NPV = $7,547.
Or, use NPVs:

0 1 2 3 4

4,132 4,132
3,415 10%
7,547

Compare to Franchise L NPV =


$6,190.
If the cost to repeat S in two years rises
to $105,000, which is best? (000s)

0 1 2 3 4

Franchise S:
(100) 60 60
(105) 60 60
(45)
NPVS = $3,415 < NPVL = $6,190.
Now choose L.
Consider another project with a 3-year
life. If terminated prior to Year 3, the
machinery will have positive salvage
value.

Year CF Salvage Value


0 ($5,000) $5,000
1 2,100 3,100
2 2,000 2,000
3 1,750 0
CFs Under Each Alternative (000s)

0 1 2 3
1. No termination (5) 2.1 2 1.75
2. Terminate 2 years (5) 2.1 4
3. Terminate 1 year (5) 5.2
Assuming a 10% cost of capital, what is
the project’s optimal, or economic life?

NPV(no) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
Conclusions

The project is acceptable only if


operated for 2 years.
A project’s engineering life does not
always equal its economic life.
Equivalent Annual Cost (EAC)

In finance the equivalent annual cost


(EAC) is the cost per year of owning
and operating an asset over its entire
lifespan
EAC is calculated by dividing the
NPV of a project by the present value
of an annuity factor
AF

 Annuity Factor

 1 
1 -
 (1 + r)t 
AF   
 r 
 
Choosing the Optimal Capital Budget

Finance theory says to accept all


positive NPV projects.
Two problems can occur when there
is not enough internally generated
cash to fund all positive NPV projects:
An increasing marginal cost of
capital.
Capital rationing
Increasing Marginal Cost of Capital

Externally raised capital can have


large flotation costs, which increase
the cost of capital.
Investors often perceive large capital
budgets as being risky, which drives
up the cost of capital.
(More...)
If external funds will be raised, then
the NPV of all projects should be
estimated using this higher marginal
cost of capital.
Capital Rationing

 Capital rationing occurs when a


company chooses not to fund all
positive NPV projects.
 The company typically sets an
upper limit on the total amount
of capital expenditures that it will
make in the upcoming year.
(More...)
Reason: Companies want to avoid the
direct costs (i.e., flotation costs) and
the indirect costs of issuing new
capital.
Solution: Increase the cost of capital
by enough to reflect all of these costs,
and then accept all projects that still
have a positive NPV with the higher
cost of capital.
(More...)
Reason: Companies don’t have
enough managerial, marketing, or
engineering staff to implement all
positive NPV projects.

Solution: Use linear programming to


maximize NPV subject to not
exceeding the constraints on staffing.
(More...)