The Basics of Capital Budgeting:

Evaluating Cash Flows

Overview and “vocabulary”
Methods
Payback, discounted payback
NPV
IRR, MIRR
Unequal lives
Economic life
 What is capital budgeting?

Analysis of potential projects.

Long-term decisions; involve large
expenditures.
Very important to firm’s future.
 Steps in Capital Budgeting

Estimate cash flows (inflows &

outflows).
Assess risk of cash flows.
Determine r = WACC for project.
Evaluate cash flows.
 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.
 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?
 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 0 50

PaybackL = 2 + 30/80 = 2.375 years

 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

 Payback
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
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.

 Net Present Value
NPV: Sum of the PVs of inflows and
outflows.
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.
 Internal Rate of Return: IRR
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
 What’s Franchise L’s IRR?

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%.
 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.
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 .
 r NPVL NPVS
NPV ($) 0 50 40
60
5 33 29
50 10 19 20
Crossover 15 7 12
40
Point = 8.7% 20 (4) 5
30

20 S
IRRS = 23.6%
10 L
0 Discount Rate (%)
0 5 10 15 20 23.6
-10
IRRL = 18.1%
 Independent projects
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
 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
 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.
 Reinvestment Rate Assumptions

NPV assumes reinvest at r

(opportunity cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, r, is
more realistic, so NPV method is
best. NPV should be used to choose
between mutually exclusive projects.
Managers like rates--prefer IRR to NPV
comparisons. Can we give them a
better IRR?

Yes, 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%
 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.
 Project cash Flows
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.
 Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
 With some cash flows (as noted below) the NPV of
the project increases s the discount rate increases.
 This is contrary to the normal relationship between
NPV and discount rates.

Project C0 C1 IRR NPV @10%

A  1,000  1,500  50%  364
B  1,000  1,500  50%  364
 Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
 Certain cash flows can generate NPV=0 at two different
discount rates.

 The following cash flow generates NPV=$A 253 million at

both IRR% of +3.50% and +19.54%.

Cash Flows (millions of Australian dollars)

C0 C1...... ......C9 C10

3 1 1  6.5
 Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
 Certain cash flows can generate NPV=0 at two different discount
rates.

 The following cash flow generates NPV=$A 253 million at both

IRR% of +3.50% and +19.54%.
NPV
40
IRR=19.54
20
%
0 Discou
nt Rate
-40 IRR=
3.50%
-60
 Internal Rate of Return

Pitfall 2 - Multiple Rates of Return

 It is possible to have a zero IRR and a positive
NPV

Project C0 C1 C2 IRR NPV @ 10%

C  1,000  3,000  2,500 None  339
 Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects

 IRR sometimes ignores the magnitude of the
project.
 The following two projects illustrate that problem.
Project C0 C1 IRR NPV @10%
D  10,000  20,000 100%  8,182
E  20,000  35,000  75%  11,818
 Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects

 Internal Rate of Return

Pitfall 4 – What Happens When There is

More than
One Opportunity Cost of Capital
 Term Structure Assumption
 We assume that discount rates are stable
during the term of the project
 This assumption implies that all funds are
reinvested at the IRR
 This is a false assumption
 Profitability Index

 When resources are limited, the

profitability index (PI) provides a tool for
selecting among various project
combinations and alternatives

 A set of limited resources and projects

can yield various combinations.

 The highest weighted average PI can

indicate which projects to select.
 Profitability Index
Cash Flows (Rs. millions)

Project C0 C1 C2 NPV @ 10%

A  10  30  5 21
B  5  5  20 16
C  5  5  15 12
D 0  40 60 13
 Profitability Index
Cash Flows (Rs. millions)

Project Investment ($) NPV ($) Profitabil ity Index

A 10 21 2.1
B 5 16 3.2
C 5 12 2.4
D 0 13 0.4

NPV
Profitabil ity Index 
Investment