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• 1. Capital Budgeting Overview Methods / decision rulesPayback, discounted paybackNPVIRR, MIRRProfitability Index Unequal lives Economic life

2. Why is capital budgeting? Long-term decisions; involve largeexpenditures. Investing too much / not investing Timing Very important to firms future. Accurate sales forecast 3. Project Classification Replacement (M/CR) Expansion (E/N) Safety / environment R&D Long term contracts 4. What is the difference betweenindependent and mutually exclusiveprojects?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. 5. What is the payback period?The number of years required torecover a projects cost,or how long does it take to get thebusinesss money back? 6. S -1000 500 400 300 100L -1000 100 300 400 600 7. 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. 8. Discounted Payback: Uses discountedrather than raw CFs. 9. Rationale for the NPV MethodNPV = PV inflows - Cost= Net gain in wealth.Accept project if NPV > 0.Choose between mutuallyexclusive projects on basis ofhigher NPV. Adds most value. 10. 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. 11. NPV +NPV? NPV and EVA 12. Internal Rate of Return: IRR01 2 3CF0CF1 CF2 CF3CostInflowsIRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0. 13. Rationale for the IRR MethodIf IRR > WACC, then the projectsrate of return is greater than itscost-- some return is left over toboost stockholders returns.Example: WACC = 10%, IRR = 15%. Profitable. 14. Decisions on Projects S and L per IRR If S and L are independent, acceptboth. IRRs > r = 10%. If S and L are mutually exclusive,accept S because IRRS > IRRL . 15. NPV Profilesfind NPVL and NPVS at different discountrates:rNPVLNPVS 0 51015 16. NPV605040CrossoverPoint3020S IRRS10 L 0Discount Rate (%)0 5 10 15 20 23.6-10 IRRL 17. To Find the Crossover Rate1. Find cash flow differences between the projects.2. Find IRR. Crossover rate = 7.2%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. 18. NPV and IRR always lead to the sameaccept/reject decision for independentprojects:NPV IRR > r r > IRR and NPV > 0 and NPV < 0. Accept. Reject. r (%) IRR 19. Mutually Exclusive ProjectsNPV r NPVS , IRRS > IRRL CONFLICTL r > 7.2: NPVS> NPVL , IRRS > IRRLNO CONFLICTS IRRSr 7.2r% IRRL 20. Two Reasons NPV Profiles Cross1. 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. 21. Reinvestment Rate Assumptions NPV assumes reinvest at r(opportunity cost of capital). IRR assumes reinvest at IRR. Realistic? 22. Normal Cash Flow Project:Cost (negative CF) followed by aseries of positive cash inflows.One change of signs.Nonnormal Cash Flow Project:Two or more changes of signs.Most common: Cost (negativeCF), then string of positive CFs,then cost to close project.Nuclear power plant, strip mine. 23. Nonnormal CFs--two sign changes.NPVNPV Profile IRR2 = 400%0r100400IRR1 = 25% 24. Logic of Multiple IRRs1. 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 CF 2 harder than CF1, so NPV > 0.4. Result: 2 IRRs. 25. Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?MIRR is the discount rate whichcauses the PV of a projects terminalvalue (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.Thus, MIRR assumes cash inflows arereinvested at WACC. 26. Why use MIRR versus IRR?MIRR correctly assumes reinvestmentat opportunity cost = WACC. MIRRalso avoids the problem of multipleIRRs.Managers like rate of returncomparisons, and MIRR is better forthis than IRR. 27. Accept Project?MIRR = 5.6% < r = 10%.Also, if MIRR < r, NPV will benegative 28. Mutually exclusive projects Project C0 C1IRR NPV @12% P -10000 20000 Q -50000 75000Incremental cash flow associated with the switch? 29. Lending Vs BorrowingProject C0 C1IRR NPV @ 10%X-4000 6000Y+4000 -7000 30. PI PI = PV of future CFs / Initial cost 31. Unequal Lives S and L are mutually exclusive and will be repeated. r = 10%. Which isbetter? (000s)0123 4Project S:(100)60 60Project L:(100)33.5 33.533.5 33.5 32. S LCF0-100,000 -100,000CF160,000 33,500Nj24I10 10NPV 4,1326,190NPVL > NPVS. But is L better? 33. Note that Project S could berepeated after 2 years to generateadditional profits. Can use either replacement chainor equivalent annual annuityanalysis to make decision. 34. Replacement Chain Approach (000s) Project S with Replication:01234Project S:(100)60 60(100)60 60(100) 60 (40)60 60NPV = 7,547. 35. Or, use NPVs:0 12344,1324,1323,415 10%7,547 Compare to Project L NPV = 6,190. 36. If the cost to repeat S in two years rises to $105,000, which is best? (000s)01 23 4Project S:(100)6060 (105)60 60(45)NPVS = $3,415 < NPVL = $6,190.Now choose L. 37. Economic LifeConsider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvagevalue. Year CFSalvage Value0(5,000)5,00012,100 3,10022,000 2,00031,750 0 38. CFs Under Each Alternative (000s) 01 2 31. No termination (5) 2.1 2 1.752. Terminate 2 years (5)2.1 43. Terminate 1 year (5) 5.2 39. Assuming a 10% cost of capital, what isthe projects optimal, or economic life?NPV(no) = -123.NPV(2) = 215.NPV(1) = -273. 40. Conclusions The project is acceptable only ifoperated for 2 years. A projects engineering life does notalways equal its economic life. 41. Choosing the Optimal Capital Budget Finance theory says to accept allpositive NPV projects. Two problems can occur when thereis not enough internally generatedcash to fund all positive NPV projects:An increasing marginal cost of capital.Capital rationing 42. Increasing Marginal Cost of Capital Externally raised capital can havelarge flotation costs, which increasethe cost of capital. Investors often perceive large capitalbudgets as being risky, which drivesup the cost of capital.(More...) 43. If external funds will be raised, thenthe NPV of all projects should beestimated using this higher marginalcost of capital. 44. Capital Rationing Capital rationing occurs when acompany chooses not to fund allpositive NPV projects. The company typically sets anupper limit on the total amountof capital expenditures that it willmake in the upcoming year.(More...) 45. Reason: Companies want to avoid thedirect costs (i.e., flotation costs) andthe indirect costs of issuing newcapital.(More...) 46. Reason: Companies dont haveenough managerial, marketing, orengineering staff to implement allpositive NPV projects. (More...) 47. Reason: Companies believe that theprojects managers forecastunreasonably high cash flow estimates,so companies filter out the worstprojects by limiting the total amount ofprojects that can be accepted.