625_l16

7/29/2019 625_l16

1/15

Lecture 16 FIN 625: Class Notes

THE BASICSOF CAPITAL BUDGETING

What is the Capital Investment Decision?

Project Evaluation Models

Focus on: Payback Period

NPV

IRR

MIRR

Comparing Payback Period, IRR, and NPV

What is Capital Budgeting and Why is it Important?

capital investments:

Why are these important decisions?

1. scarce financial resources for assets which cannot be liquidated easily

2. they define the firms line of business

3. they affect the firms cash flows for many years

4. bad decisions can cause the firms downfall

capital budgeting:

- Richard T. Bliss, Babson Universityand Terry D. Nixon, Miami University

7/29/2019 625_l16

2/15


Steps in the Capital Budgeting Process

1. Identify and estimate current and expected future cash flows.

2. Establish a decision rule (NPV, IRR, etc.)

3. Evaluate and rank the proposed projects.

4. Make a decision and monitor results.

Project Types

Mutually exclusive - a project whose selection depends on whether or not another projectis selected

Independent- a project whose selection does not depend on whether or not anotherproject is selected

Project Evaluation Models

1. Payback period or PBP

2. Net Present Value or NPV

3. Internal Rate of Return or IRR4. Modified Internal Rate of Return or MIRR

As always, only cash flow matters!

Payback Period - the expected number of years it takes to recover a projects initial

investment.


7/29/2019 625_l16

3/15


Example: You have a project with the following forecasted cash flows:

Year Cash Flow

0 -$40,000

1 $20,000

2 $15,000

3 $10,000

4 $ 5,000

What is the projects payback period?

Example: As the Chief Financial Analyst at D/A Industries, you are presented with thefollowing possible projects for investment. Compute the payback period for each project.

Year Proj. A Proj. B Proj. C Proj. D

0 -$90,000 -$90,000

-$90,000

-$90,000

1 $90,000 $65,000 $45,000 $30,000

2 $45,000 $35,000 $30,0003 $25,000 $30,000

4 $25,000 $30,000


7/29/2019 625_l16

4/15


Deficiencies of the Payback Period method

ignores the time value of money

no consideration of cash flows occurring after the payback period

no economic rationale for target payback periods

- Calculate the Payback Period for Example 3, Example 4, and the Practiceproblems from the previous Lecture

Net Present Value - the most theoretically correct model for evaluating investment

opportunities; the measure of value a project adds to the firm.

NPV = PV{cash inflows} - PV{cash outflows}

= +=

n

t t

t

r

CFNPV

0 )1(

or,

= +=

n

t t

t

WACC

CFNPV

0 )1(

CFt = forecasted after-tax operating Cash Flow (CF) at the end of year t

r = the required risk-adjusted rate of return

n = the economic life of the project

WACC = the appropriate weighted average cost of capital for the project


7/29/2019 625_l16

5/15


The decision rules associated with NPV analysis:

NPV > $0 accept project

NPV < $0 reject project

NPV = $0 indifferent to project

Example: Gamma Industries is analyzing a new project with the following information:

Initial investment = $306,000

Annual after-taxoperating cash flows: Year CF

1-3 $80,000

4-6 $90,000

In addition, the equipment being purchased will have an after-tax salvage value of

$25,000 at the end of the project. If the firms weighted average cost of capital is 15%,should Gamma undertake the project?

Timeline:

= +=

n

t t

t

WACC

CFNPV

0 )1(


7/29/2019 625_l16

6/15


Note that we used Gammas existing weighted average cost of capital (WACC) as theappropriate discount rate. What does this assume about the project and its financing?

How can we compute the NPV ofrisk-changinginvestments?

arbitrary adjustment, i.e., fudging

CAPM approach

rproject = rRF + ( rM rRF) project

Important: The CAPM approach gives us the cost of common stock for a company. If

we use rprojectas the firm's WACC, we are assuming an all equity financed firm. If thefirm has debt in its capital structure, you will need to recalculate the firm's WACC

using rproject in place of the company's usual rS.

Question: Where could we obtain a project?


7/29/2019 625_l16

7/15


Example: The CFO of Henderson-Cincinnati Corp. is evaluating the following projects:

Project beta Forecast Return

A 1.9 17.5%

B 1.2 14.0%

C 0.8 12.0%

The risk-free rate is 5% and the market return is 12%. If the firms overall WACC is 13%(assuming an all equity financed firm), which projects should be accepted?

rproject = rRF + (rM rRF) project

Question: What part does the companys overall WACC of 13% play in this problem?

- Calculate the NPV for Example 3 (assume 12% WACC), Example 4 (assume12% WACC), and the Practice problems from the previous Lecture.


7/29/2019 625_l16

8/15


Internal Rate of Return (IRR) - the annualized rate of return a project generateson the funds invested in it.

The IRR is the interest rate that equates the PV of cash inflows with the PV of cash

outflows for any project or investment. IRR is conceptually the same as YTM.

What is the NPV if PV{inflows} = PV{outflows}?

Thus,

0)1(0=

+= =

n

t t

t

IRR

CFNPV

or,

= +=

n

t t

t

IRR

CFOutlayInvestmentInitial

1 )1(

How can we solve for IRR?

Example: You can buy a truck today for $5,200. You will use it in a delivery businessfor one year and earn an after-tax Cash Flow (CF) of $3,800. At the end of the year, theafter-tax cash flow from the sale of the truck is $2,000. What is the IRR of thisinvestment?

TIMELINE:


7/29/2019 625_l16

9/15


Example: DCH Machine Tools is considering a new stamping machine. The machinecosts $340,000 today and generates after-tax CFs of $65,000 at the end of each of thenext 6 years. What is the IRR of this investment?

= +

=n

t t

t

IRR


1 )1(

Practice: You are analyzing a project with the following cash flows. What is theprojects IRR?

Time Period Cashflow

0 -$550,000

1 $200,000

2 $400,000

3 $250,000

4 $ 50,000

5 $ 10,000

What is the projects IRR?

= +=

n

t t

t

IRR


1 )1(


7/29/2019 625_l16

10/15


Example: Sallingers Inc. is considering a new refrigerated truck that costs $25,000. Itincreases the firms after-tax cash flow by $4,000 in years 1-3, and by $10,000 in years4-6. What is the NPV of buying the truck if the appropriate discount rate (WACC) is 9%?

What is the investments IRR?

IRR Decision Rule:

if the projects IRR > WACC, the required risk-adjusted return, accept the project

if the projects IRR < WACC, reject the project

if the projects IRR = WACC, we are indifferent to the project


7/29/2019 625_l16

11/15


Potential problems with IRR:

multiple IRRs

assumes reinvestment at the IRR

- Calculate the IRR for Example 3, Example 4, and thePractice problems from the previous Lecture.

Modified Internal Rate of Return (MIRR) the discount rate at which thepresent value of a projects cost is equal to the present value of its terminal value, wherethe terminal value is found as the sum of the future values of the cash inflows,compounded at the firms cost of capital.

MIRRs main advantage over IRR is that it no longer assume reinvestment at the IRR.Funds are now assumed to be reinvested at the firms WACC (this is generally a more

reasonable assumption).

( )

( )

( ) ( ) NN

N

t

tN

tN

t t

t

MIRR

TV

MIRR

rCIF

r

COF

+=

+

+

=+

=

= 11

1

1

0

0

where,

COF = Cash outflowsCIF = Cash inflowsTV = terminal value (the compounded value of the inflows assuming

reinvestment at the WACC.


7/29/2019 625_l16

12/15


Calculate the MIRR for the previous problem (Sallingers).

- Calculate the MIRR for Example 3, Example 4, and thePractice problems from the previous Lecture.


7/29/2019 625_l16

13/15


Practice: You are the financial manager for a large and highly profitablemanufacturing company. You are currently evaluating a project proposal involving theconstruction of a new product line. The proposed project will have a 5-year life and willrequire the purchase of new capital equipment with a total purchase price of $175,000.In addition, the project will require an initial $15,000 investment in supplies and spareparts for the equipment, with 40% of this amount financed with accounts payable. Thenew product line is expected to increase annual cash sales by $80,000 and increaseannual cash operating expenses by $10,000. The new equipment will have a 3-yearMACRS class life. At the end of five years, you expect to terminate the project, liquidatethe supplies and parts, and sell the equipment for $10,000. Assume the marginal taxrate is 34 percent. Calculate the IRR and MIRR (assume a WACC of 10%) for thisproject.


7/29/2019 625_l16

14/15


Comparing NPV and IRR

Under the following assumptions, NPV and IRR will accept and reject the same projects:

1. independent projects

2. no capital rationing

Under the following assumptions, NPV and IRR may disagree regarding the ordering ofprojects:

1. mutually exclusive projects

2. capital rationing


7/29/2019 625_l16

15/15


Causes of potential disagreement between NPV and IRR:

project size (scale) differences

timing differences

(Note: A comparison of MIRR with NPV yields similar conclusions to IRRs comparisonrelative to NPV.)


625_l16

Documents

Transcript of 625_l16