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1 Chapter 12 The Basics of Capital Budgeting: Evaluating Cash Flows

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2 Topics Overview and “vocabulary” Methods NPV IRR, MIRR Payback

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3 What is capital budgeting? Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to firm’s future.

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4 Steps in Capital Budgeting Estimate cash flows (inflows & outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows.

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5 Independent versus 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.

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6 Cash Flows for Franchise L and Franchise S % L’s CFs: % S’s CFs:

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7 NPV: Sum of the PVs of all cash flows. Cost often is CF 0 and is negative. NPV = ∑ n t = 0 CF t (1 + r) t. NPV = ∑ n t = 1 CF t (1 + r) t. - CF 0.

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8 What’s Franchise L’s NPV? % L’s CFs: = NPV L NPV S = $19.98.

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9 Calculator Solution: Enter values in CFLO register for L CF 0 CF 1 NPV CF 2 CF 3 I = = NPV L

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10 Rationale for the NPV Method NPV = PV inflows – Cost This is net gain in wealth, so accept project if NPV > 0. Choose between mutuallyexclusive projects on basis of higher NPV. Adds most value.

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11 Using NPV method, which franchise(s) should be accepted? If Franchise S and L are mutually exclusive, accept S because NPV s > NPV L. If S & L are independent, accept both; NPV > 0.

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12 Internal Rate of Return: IRR 0123 CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

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13 NPV: Enter r, solve for NPV. IRR: Enter NPV = 0, solve for IRR. = NPV ∑ n t = 0 CF t (1 + r) t.= 0 ∑ n t = 0 CF t (1 + IRR) t.

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14 What’s Franchise L’s IRR? IRR = ? PV 3 PV 2 PV 1 0 = NPV Enter CFs in CFLO, then press IRR: IRR L = 18.13%. IRR S = 23.56%.

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Or, with CFLO, enter CFs and press IRR = 9.70% % NI/YRPVPMTFV INPUTS OUTPUT Find IRR if CFs are constant:

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16 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%. So this project adds extra return to shareholders.

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17 Decisions on Projects S and L per IRR If S and L are independent, accept both: IRR S > r and IRR L > r. If S and L are mutually exclusive, accept S because IRR S > IRR L.

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18 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.

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19 Modified Internal Rate of Return (MIRR) 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.

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% % TV inflows PV outflows MIRR for Franchise L: First, find PV and TV (r = 10%)

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21 Second, find discount rate that equates PV and TV MIRR = 16.5% TV inflows PV outflows MIRR L = 16.5% $100 = $158.1 (1+MIRR L ) 3

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22 To find TV with 10B: Step 1, find PV of Inflows First, enter cash inflows in CFLO register: CF 0 = 0, CF 1 = 10, CF 2 = 60, CF 3 = 80 Second, enter I = 10. Third, find PV of inflows: Press NPV =

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23 Step 2, find TV of inflows. Enter PV = , N = 3, I = 10, PMT = 0. Press FV = = FV of inflows.

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24 Step 3, find PV of outflows. For this problem, there is only one outflow, CF 0 = -100, so the PV of outflows is For other problems there may be negative cash flows for several years, and you must find the present value for all negative cash flows.

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25 Step 4, find “IRR” of TV of inflows and PV of outflows. Enter FV = , PV = -100, PMT = 0, N = 3. Press I = 16.50% = MIRR.

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26 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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27 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?

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28 Payback for Franchise L = CF t Cumulative Payback L 2+30/80 = years 0 2.4

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29 Payback for Franchise S CF t Cumulative Payback S /50 = 1.6 years =

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30 Strengths and Weaknesses of Payback Strengths: Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses: Ignores the TVM. Ignores CFs occurring after the payback period.

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