Capital Budgeting: Decision Criteria Chapter 12 Capital Budgeting: Decision Criteria

Ch 12: Capital Budgeting Decision Criteria Topics Overview Methods Payback, discounted payback NPV IRR, MIRR Profitability Index Evaluating projects with unequal lives Economic life

What is capital budgeting? Analysis of potential additions to the capital budget. Long-term decisions; often involve large outlays.

Steps in Capital Budgeting 1. Estimate cash flows. 2. Assess risk of cash flows. 3. Determine required return (r). 4. Evaluate cash flows. Chapter 12 focuses on step 4: evaluation of cash flows.

Capital Budgeting Techniques The best capital budgeting techniques: Use cash flows (not unadjusted accounting numbers) Consider the time value of money. We refer to them as DCF (discounted cash flow) methods. Examples of DCF methods: NPV, IRR, MIRR.

Corporate Practice Capital budgeting practices of US corporations: 99% use IRR or MIRR 85% use NPV 84% use payback 23% adjust WACC by divisions 73% adjust WACC for project risk

Payback Payback: # of years to recover a project’s cost. Decision rule: based on firm’s policy.

∑ Net Present Value: NPV CFt NPV = (1 + r)t Cost often is CF0 and is negative. r is cost of capital (discount rate).

Rationale for the NPV Method NPV = PV inflows – Initial investment NPV measures change in firm value, so the decision rule is: Accept if NPV > 0. Rank mutually exclusive projects on basis of higher NPV.

Internal Rate of Return: IRR The IRR: the discount rate that causes NPV to equal zero. IRR is one measure of the percentage return on a project. Accept if IRR > cost of capital (r) If IRR > WACC, the project’s rate of return is greater than cost of financing.

Comparing NPV & IRR NPV assumes reinvestment at r (cost of capital). IRR assumes reinvestment at IRR. Reinvestment at cost of capital, r, is more realistic. This is one reason NPV is better method than IRR.

An Alternative Measure of Returns: MIRR Even though NPV is a better technique than IRR, managers prefer percentage returns. Is there a better measure of return than IRR? Yes. MIRR is the % return on a project if cash flows are reinvested at the cost of capital. MIRR also avoids the problem of multiple IRRs.

Normal vs. Nonnormal Cash Flows 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. Examples: nuclear power plant or strip mine.

Nonnormal CFs Projects with nonnormal CFs: Can have one IRR, no IRR or more than one IRR. Even if IRRs exist, they have no economic interpretation. Use MIRR &/or NPV for such projects.

Ranking Mutually Exclusive Projects Consider two mutually exclusive projects, A & B: Project NPV IRR A $12,000 28% B $98,000 22% This is an example of a ranking conflict. Which one should be chosen?

Mutually Exclusive Projects with Unequal Lives Typically, we can rank mutually exclusive projects on the basis of NPV. An exception to this is the case of mutually exclusive projects with unequal lives that will be repeated.

Mutually Exclusive Projects with Unequal Lives To evaluate mutually exclusive projects with unequal lives, we: Use replacement chain NPV or Use equivalent annual annuity

Choosing 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