1. 11 - 1 Copyright © 2002 by Harcourt, Inc.All rights reserved. Should we build this plant? CHAPTER 11 The Basics of Capital Budgeting

2. 11 - 2 Copyright © 2002 by Harcourt, Inc.All rights reserved. What is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future.

3. 11 - 3 Copyright © 2002 by Harcourt, Inc.All rights reserved. Steps 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.

4. 11 - 4 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

5. 11 - 5 Copyright © 2002 by Harcourt, Inc.All rights reserved. An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river.

6. 11 - 6 Copyright © 2002 by Harcourt, Inc.All rights reserved. Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs. 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. Normal Cash Flow Project Nonnormal Cash Flow Project

7. 11 - 7 Copyright © 2002 by Harcourt, Inc.All rights reserved. Inflow (+) or Outflow (-) in Year 012345NNN -+++++N -++++- ---+++N +++---N -++-+-

8. 11 - 8 Copyright © 2002 by Harcourt, Inc.All rights reserved. NPV:Sum of the PVs of inflows and outflows.

9. 11 - 9 Copyright © 2002 by Harcourt, Inc.All rights reserved. What is Project L’s NPV? 108060 0123 10% Project L: -100.00 9.09 49.59 60.11 18.79 = NPV L

10. 11 - 10 Copyright © 2002 by Harcourt, Inc.All rights reserved. Calculator Solution Enter in CFLO for L: -100 10 60 80 10 CF 0 CF 1 NPV CF 2 CF 3 I = 18.78 = NPV L

11. 11 - 11 Copyright © 2002 by Harcourt, Inc.All rights reserved. What is Project S’s NPV? 702050 0123 10% Project S: -100.00 63.64 41.32 15.03 19.99 = NPV S

12. 11 - 12 Copyright © 2002 by Harcourt, Inc.All rights reserved. Calculator Solution Enter in CFLO for S: -100 70 50 20 10 CF 0 CF 1 NPV CF 2 CF 3 I = 19.98 = NPV S

13. 11 - 13 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

14. 11 - 14 Copyright © 2002 by Harcourt, Inc.All rights reserved. Using NPV method, which project(s) should be accepted? If Projects S and L are mutually exclusive, accept S because NPV s > NPV L. If S & L are independent, accept both; NPV > 0.

15. 11 - 15 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

16. 11 - 16 Copyright © 2002 by Harcourt, Inc.All rights reserved. NPV: Enter k, solve for NPV. IRR: Enter NPV = 0, solve for IRR.

17. 11 - 17 Copyright © 2002 by Harcourt, Inc.All rights reserved. What’s Project L’s IRR? 108060 0123 IRR = ? -100.00 PV 3 PV 2 PV 1 0 = NPV Enter CFs in CFLO, then press IRR: IRR L = 18.13%.

18. 11 - 18 Copyright © 2002 by Harcourt, Inc.All rights reserved. Finding IRR Without a Financial Calculator Find the NPV first. If the NPV is positive, then try an IRR > WACC. Project L, Try 20%: 100 =(10*1/1.2)+(60*1/(1.2) 2 ) +(80*1/(1.2) 3 ) 100=96.30 Need higher PV, so lower IRR Answer 10%<IRR<20%, accept (WACC = 10%)

19. 11 - 19 Copyright © 2002 by Harcourt, Inc.All rights reserved. What’s Project S’s IRR? 702050 0123 IRR = ? -100.00 PV 3 PV 2 PV 1 0 = NPV Enter CFs in CFLO, then press IRR: IRR S = 23.56%.

20. 11 - 20 Copyright © 2002 by Harcourt, Inc.All rights reserved. Finding IRR Without a Financial Calculator Find the NPV first. If the NPV is positive, then try an IRR > WACC. Project S, Try 12%: 100 =(70*1/1.12)+(50*1/(1.12) 2 ) +(20*1/(1.12) 3 ) 100=116.60 Need lower PV, so higher IRR Answer IRR>12%, accept (WACC = 10%)

21. 11 - 21 Copyright © 2002 by Harcourt, Inc.All rights reserved. 90109090 01210 IRR = ? Q.How is a project’s IRR related to a bond’s YTM? A.They are the same thing. A bond’s YTM is the IRR if you invest in the bond. -1134.2 IRR = 7.08% (use TVM or CFLO)....

22. 11 - 22 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

23. 11 - 23 Copyright © 2002 by Harcourt, Inc.All rights reserved. IRR Acceptance Criteria If IRR > k, accept project. If IRR < k, reject project.

24. 11 - 24 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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 IRR S > IRR L.

25. 11 - 25 Copyright © 2002 by Harcourt, Inc.All rights reserved. Prefer NPV to IRR Can have multiple IRR’s if you have non- normal cash flows. Can get different results depending on the WACC used when ranking projects using NPV and IRR. Reinvestment rate assumption makes more sense with NPV than with IRR.

26. 11 - 26 Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.