Basics of capital budgeting.ppt

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Copyright © 2002 by Harcourt, Inc. All rights reserved.

Should we build thisplant?

CHAPTER 11The Basics of Capital Budgeting

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What is capital budgeting?

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to firm’s future.

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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.

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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.

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An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.

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Normal Cash Flow Project:

Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.

Two or more changes of signs.Most common: Cost (negativeCF), then string of positive CFs,then cost to close project.Nuclear power plant, strip mine.

Normal Cash Flow Project

Nonnormal Cash Flow Project

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Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN

- + + + + + N

- + + + + - NN

- - - + + + N

+ + + - - - N

- + + - + - NN

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.

k1CF

NPV tt

n

0t

NPV: Sum of the PVs of inflows and outflows.

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What is Project L’s NPV?

10 8060

0 1 2 310%

Project L:

-100.00

9.09

49.59

60.1118.79 = NPVL

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Calculator Solution

Enter in CFLO for L:

-100

10

60

80

10

CF0

CF1

NPV

CF2

CF3

I = 18.78 = NPVL

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What is Project S’s NPV?

70 2050

0 1 2 310%

Project S:

-100.00

63.64

41.32

15.0319.99 = NPVS

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Calculator Solution

Enter in CFLO for S:

-100

70

50

20

10

CF0

CF1

NPV

CF2

CF3

I = 19.98 = NPVS

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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 ofhigher NPV. Adds most value.

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Using NPV method, which project(s) should be accepted?

If Projects S and L are mutually exclusive, accept S because NPVs > NPVL .

If S & L are independent, accept both; NPV > 0.

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Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.

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.NPV

k1CF

tt

n

0t

.0

IRR1CF

tt

n

0t

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

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What’s Project L’s IRR?

10 8060

0 1 2 3IRR = ?

-100.00

PV3

PV2

PV1

0 = NPV

Enter CFs in CFLO, then press IRR:IRRL = 18.13%.

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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%)

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What’s Project S’s IRR?

70 2050

0 1 2 3IRR = ?

-100.00

PV3

PV2

PV1

0 = NPV

Enter CFs in CFLO, then press IRR:IRRS = 23.56%.

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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%)

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90 109090

0 1 2 10IRR = ?

Q. How is a project’s IRRrelated to a bond’s YTM?

A. They are the same thing.A bond’s YTM is the IRRif you invest in the bond.

-1134.2

IRR = 7.08% (use TVM or CFLO).

...

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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.

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IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.

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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 IRRS > IRRL .

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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.

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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.

Basics of capital budgeting.ppt

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