3What is capital budgeting? Analysis of potential projects.Long-term decisions; involve large expenditures.Very important to firm’s future.
4Steps in Capital Budgeting Estimate cash flows (inflows & outflows).Assess risk of cash flows.Determine r = WACC for project.Evaluate cash flows.
5Digression: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.
6An Example of Mutually Exclusive Projects BRIDGE VS. BOAT TO GETPRODUCTS ACROSS A RIVER.
8Normal ProjectCost (negative CF) followed by a series of positive cash inflows.Nonnormal ProjectOne or more outflows occur after inflows have begun. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.
9Inflow (+) or Outflow (-) in Year 12345NNN-+++++N-++++-NN---+++N+++---NN-++-+-NN
15c(2). Strengths of Payback Provides an indication of a project’s risk and liquidity.Easy to calculate and understand.Weaknesses of PaybackIgnores the TVM.Ignores CFs occurringafter the payback period.
16c(3):Discounted Payback: Uses discounted rather than raw CFs. Apply to Project L.2.712310%CFt-100106080PVCFt-1009.0949.5960.11Cumul-100-90.91-41.3218.79Disc.payback= /60.11 = 2.7 years.Recover invest. + cap. costs in 2.7 years.
22Calculator Solution Enter in CFLO for L: = 18.78 = NPVL. -100 10 60 80
23d(2) Rationale for the NPV Method If NPV = 0, project breaks even;recovers cost of investmentinvestors earn required rate of return (i.e. opportunity cost of capital)If NPV > 0;investors get above, plus additional $.
24CONSIDER PROJECT L: SUM OF undiscounted CF’s = 150 Investors get $100 backCover their 10% cost of capital;and have $18.79 left over.Who does this $18.79 belong to?Stockholders.
25Rationale for the NPV Method NPV = PV inflows - PV of Cost= Net gain in wealth.Accept project if NPV > 0.Choose between mutuallyexclusive projects on basis ofhigher NPV. Adds most value.
26Using NPV method, which project(s) should be accepted? If Projects S and L are mutually exclusive, ?If S & L are independent, ?
27Using NPV method, which project(s) should be accepted? If Projects S and L are mutually exclusive,…..If S & L are independent, accept…..What happens to the NPV as the cost of capital changes?
28e(1) What is the Internal Rate of Return (IRR) 123CF0CF1CF2CF3CostInflows
29Internal Rate of Return (IRR) 123CF0CF1CF2CF3CostInflowsIRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.
30 NPV: Enter k, solve for NPV. CF k NPV 1 . 1.IRR: Enter NPV = 0, solve for IRR.
36Rationale 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.
45PI Acceptance Criteria If PI > 1, accept. If PI < 1, reject.The higher the PI, the better the project.For mutually exclusive projects, take the one with the highest PI. Therefore, accept L and S if independent; only accept S if mutually exclusive.Any problems with using PI?
46g(1) Construct NPV Profiles Enter CFs in CFLO and find NPVL and NPVS at different discount rates:NPVL5033197(4)NPVS402920125k5101520
50To Find the Crossover Rate 1. Find cash flow differences between the projects.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 don’t cross, one project dominates the other.
53h(1) Why do NPV profiles cross? Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opp. cost, the more valuable these funds, so high k favors small projects.Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
54Reinvestment Rate Assumptions NPV assumes reinvestment at k (opportunity cost of capital).IRR assumes reinvestment at IRR.Reinvestment at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
55i(1) Managers prefer IRR to NPV. Can we give them a better IRR?
56Managers prefer IRR to NPV. Can we give them a better IRR? Yes, modified IRR (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 forces cash inflows to be reinvested at WACC.
57MIRR for Project L (k = 10%): 12310%10.060.080.0-100.010%66.012.110%MIRR = 16.5%158.1-100.0$158.1(1+MIRRL)3$100 =TV inflowsPV outflowsMIRRL = 16.5%
58MIRR for Project L (k = 10%): 12310%10.060.080.0-100.010%66.012.110%158.1-100.0TV inflowsPV outflowsMIRRL = 16.5%
60Why use MIRR rather than IRR? MIRR correctly assumes reinvestment at opportunity cost = k.MIRR also avoids problems with multiple IRR’s with nonnormal projects.Managers like rate of return comparisons, and MIRR is better for this than IRR.
61J: Pavillion Project: NPV and IRR? 12k = 10%-8005,000-5,000What is NPV?, IRR?What is MIRR?
62Pavillion Project: NPV and IRR? 12k = 10%-8005,000-5,000Enter CFs in CFj, enter I/YR = 10.NPV = -$386.78IRR = ERROR. Why?
63How do we find the IRR on a 12c? Make a guess for i and key it in i.RCL g R/S.
64We got IRR = ERROR because there are 2 IRRs. Nonnormal CFs with two sign changes. Here’s a picture:NPVNPV ProfileIRR2 = 400%450k100400IRR1 = 25%-800
65Logic of Multiple IRRsAt very low disc. rates, the PV of CF2 is large & negative, so NPV < 0.At very high disc. rates, the PV of CF1 and CF2 are both low, so CF0 dominates and again NPV < 0.In between, the disc. rate hits CF2 harder than CF1 , so NPV > 0.Result: 2 IRRs.
66When there are nonnormal CFs, use MIRR: 12-800,0005,000,000-5,000,000PV 10% = -4,932,TV 10% = 5,500,MIRR = 5.6%
68Accept Project P?NO. Reject because MIRR = 5.6% < k = 10%.Also, if MIRR < k, NPV will be negative: NPV = -$386,777.
69NEW QUESTION: Which of the following mutually exclusive project’s is better? (000s) 1234Project S:(100)Project L:6033.56033.533.533.523
70S LCF , ,000CF , ,500NjINPV , ,190NPVL > NPVS. But is L better?Can’t say yet. Need to perform common life analysis.
71Note 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.
72Franchise S with Replication: Replacement Chain Approach (000s)Franchise S with Replication:1234Franchise S:(100)6060(100)(40)6060NPV = $7,547.
73Or, use NPVs:12344,1323,4157,5474,13210%Compare to Franchise L NPV = $6,190.
74Equivalent Annual Annuity (EAA) Approach Finds the constant annuity payment whose PV is equal to the project’s raw NPV over its original life.28
75EAA Calculator Solution Project SPV = Raw NPV = $4,132.n = Original project life = 2.k = 10%.Solve for PMT = EAAS = $2,381.Project LPV = $6,190; n = 4; k = 10%.Solve for PMT = EAAL = $1,953.29
76The project, in effect, provides an annuity of EAA. EAAS > EAAL so pick S.Replacement chains and EAA always lead to the same decision if cash flows are expected to stay the same.30
77If the cost to repeat S in two years rises to $105,000, which is best If the cost to repeat S in two years rises to $105,000, which is best? (000s)1234Franchise S:(100)6060(105)(45)6060NPVS = $3,415 < NPVL = $6,190.Now choose L.
78Abandon because losing money, e.g., smokeless cigarette. Types of AbandonmentSale to another party who can obtain greater cash flows, e.g., IBM sold typewriter division.Abandon because losing money, e.g., smokeless cigarette.31
79Consider another project with a 3-year life Consider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage value.Year123CF($5,000)2,1002,0001,750Salvage Value$5,0003,1002,000
80CFs Under Each Alternative (000s) 1231. No termination2. Terminate 2 years3. Terminate 1 year(5)2.15.2241.75
81Assuming a 10% cost of capital, what is the project’s optimal, or economic life? NPV(no) = -$123.NPV(2) = $215.NPV(1) = -$273.
82ConclusionsThe project is acceptable only if operated for 2 years.A project’s engineering life does not always equal its economic life.
83The project is acceptable only if operated for 2 years. ConclusionsThe project is acceptable only if operated for 2 years.A project’s engineering life does not always equal its economic life.The ability to abandon a project may make an otherwise unattractive project acceptable.Abandonment possibilities will be very important when we get to risk.35
84Choosing 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
85Increasing 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...)
86If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
87Capital RationingCapital 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...)
88Reason: Companies want to avoid the direct costs (i. e 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...)
89Reason: 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...)
90Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted.Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.