Capital Budgeting

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CHAPTER 11
The Basics of Capital Budgeting
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Copyright 2001 by Harcourt, Inc.
All rights reserved.
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What is capital budgeting? Menganalsis tamban potensi fixed asset. Keputusan jangka panjang; menyangkut dana dalam jumlah besar. Sangat penting dan berpengaruh pada perusahaan di masa depan.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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Steps 1. Estimasi Cash Flows (inflows & outflows). 2.Menilai risiko arus kas. 3. Menentukan k = WACC (adj.). 4. Menghitungd NPV and IRR. 5. Menerima jika NPV > 0 dan IRR > WACC.
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independent dan mutually exclusive projects Projects are: independent, jika cash flows yang satu tidak dipengaruhi oleh penerimaan yang lain. mutually exclusive, jika cashflow yang satu dipengaruhi secara negatif dengan penerimaan yang lain by Harcourt, Inc. Copyright 2001 All rights reserved.
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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 N
NN 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 2
2.4
3 80 50
60 100 -30 0 30/80
= 2.375 years
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Project S (Short: CFs come quickly)

0 CFt -100 1
1.6 2
3 20 40
70 100 50 -30 0 20
Cumulative -100 PaybackL
= 1 + 30/50 = 1.6 years
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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 = payback 2
+ 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 10 60 80 10 CF0 CF1 CF2 CF3 I NPV = 18.78 = NPVL
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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.
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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 ( 1 + k ) t = NPV. t =0

n
IRR: Enter NPV = 0, solve for IRR. CFt ( 1 + IRR ) t = 0. t =0

n
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IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5) $40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) + $ 7,000(.621) $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 = $41,444 [Discount Rate terlalu rendah!]
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IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5) $40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) + $10,000(.572) + $ 7,000(.497) $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 = $36,841 [Discount Rate is too high!!]
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IRR Solution (Interpolate)

.10 .15 X .05 $41,444 $36,841
.05
IRR $40,000
$1,444
$4,603
$1,444 $4,603
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.10 .15 X .05 $41,444 $36,841
.05
IRR $40,000
$1,444
$4,603
$1,444 $4,603
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.10 .15 $41,444 $36,841
.05
IRR $40,000
$1,444
$4,603
X = ($1,444)(0.05) $4,603
X = .0157
IRR = .10 + .0157 = .1157 or 11.57%

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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%.

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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 90 2 90 10 1090
0 -1134.2
IRR = ?
...
IRR = 7.08% (use TVM or CFLO).

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

NPV
L
k < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT k > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT
S k 8.7 k
IRRS
%
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 -100.0
10%
1 10.0
10% MIRR = 16.5%
2 60.0
10%
3 80.0 66.0 12.1 158.1 TV inflows
-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 = 118.78 = PV of inflows. NPV 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 1 5,000 2 -5,000
k = 10%
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 -800 100 IRR1 = 25%

400
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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.

Capital Budgeting

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11 - 1

Copyright 2001 by Harcourt, Inc.

All rights reserved.

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)

60 100 -30 0 30/80

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Project S (Short: CFs come quickly)

Cumulative -100 PaybackL

= 1 + 30/50 = 1.6 years

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Discounted Payback: Uses discounted rather than raw CFs.

Cumulative -100 Discounted = payback 2

+ 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.

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. CFt ( 1 + k ) t = NPV. t =0

IRR: Enter NPV = 0, solve for IRR. CFt ( 1 + IRR ) t = 0. t =0

IRR Solution (Try 10%)

IRR Solution (Try 15%)

IRR Solution (Interpolate)

Copyright 2001 by Harcourt, Inc.

All rights reserved.

IRR Solution (Interpolate)

Copyright 2001 by Harcourt, Inc.

All rights reserved.

IRR Solution (Interpolate)

IRR = .10 + .0157 = .1157 or 11.57%

Whats Project Ls IRR?

-100.00 PV1 PV2 PV3 0 = NPV

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

Copyright 2001 by Harcourt, Inc.

All rights reserved.

Crossover Point = 8.7%

Discount Rate (%)

Copyright 2001 by Harcourt, Inc.

Mutually Exclusive Projects

Copyright 2001 by Harcourt, Inc.

MIRR for Project L (k = 10%)

3 80.0 66.0 12.1 158.1 TV inflows

$158.1 $100 = (1 + MIRRL)3 MIRRL = 16.5%

Copyright 2001 by Harcourt, Inc.