1. 9 - 1 Copyright © 2001 by Harcourt, Inc.All rights reserved. Should we build this plant? CHAPTER 11 The Basics of Capital Budgeting

2. 9 - 2 Copyright © 2001 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. 9 - 3 Copyright © 2001 by Harcourt, Inc.All rights reserved. Steps 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC (adj.). 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.

4. 9 - 4 Copyright © 2001 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. 9 - 5 Copyright © 2001 by Harcourt, Inc.All rights reserved. An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river.

6. 9 - 6 Copyright © 2001 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. 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. Nuclear power plant, strip mine.

7. 9 - 7 Copyright © 2001 by Harcourt, Inc.All rights reserved. What is the payback period? The number of years required to recover a project’s cost, or how long does it take to get our money back?

8. 9 - 8 Copyright © 2001 by Harcourt, Inc.All rights reserved. Payback for Project L (Long: Large CFs in later years) 1060 0123 -100 = CF t Cumulative-100-90-3050 Payback L 2+30/80 = 2.375 years 0 100 2.4 80

9. 9 - 9 Copyright © 2001 by Harcourt, Inc.All rights reserved. Project S (Short: CFs come quickly) 702050 0123 -100CF t Cumulative-100-302040 Payback L 1 + 30/50 = 1.6 years 100 0 1.6 =

10. 9 - 10 Copyright © 2001 by Harcourt, Inc.All rights reserved. Strengths of Payback: 1.Provides an indication of a project’s risk and liquidity. 2.Easy to calculate and understand. Weaknesses of Payback: 1.Ignores the TVM. 2.Ignores CFs occurring after the payback period.

11. 9 - 11 Copyright © 2001 by Harcourt, Inc.All rights reserved. NPV:Sum of the PVs of inflows and outflows.

12. 9 - 12 Copyright © 2001 by Harcourt, Inc.All rights reserved. What’s Project L’s NPV? 108060 0123 10% Project L: -100.00 9.09 49.59 60.11 18.79 = NPV L NPV S = $19.98.

13. 9 - 13 Copyright © 2001 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. 9 - 14 Copyright © 2001 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. 9 - 15 Copyright © 2001 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. 9 - 16 Copyright © 2001 by Harcourt, Inc.All rights reserved. NPV: Enter k, solve for NPV. IRR: Enter NPV = 0, solve for IRR.

17. 9 - 17 Copyright © 2001 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%.IRR S = 23.56%.

18. 9 - 18 Copyright © 2001 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)....

19. 9 - 19 Copyright © 2001 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.

20. 9 - 20 Copyright © 2001 by Harcourt, Inc.All rights reserved. IRR Acceptance Criteria If IRR > k, accept project. If IRR < k, reject project.

21. 9 - 21 Copyright © 2001 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.

22. 9 - 22 Copyright © 2001 by Harcourt, Inc.All rights reserved. Reasons NPV different from IRR 1.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 k favors small projects. 2.Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPV S > NPV L.

23. 9 - 23 Copyright © 2001 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.

24. 9 - 24 Copyright © 2001 by Harcourt, Inc.All rights reserved. Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR? Yes, MIRR is the discount rate that 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.

25. 9 - 25 Copyright © 2001 by Harcourt, Inc.All rights reserved. MIRR = 16.5% 10.080.060.0 0123 10% 66.0 12.1 158.1 MIRR for Project L (k = 10%) -100.0 10% TV inflows -100.0 PV outflows MIRR L = 16.5% $100 = $158.1 (1 + MIRR L ) 3

26. 9 - 26 Copyright © 2001 by Harcourt, Inc.All rights reserved. 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.