Capital Budgeting Process 1. Estimate the cash flows. 2. Assess the riskiness of the cash flows. 3....
-
date post
20-Dec-2015 -
Category
Documents
-
view
215 -
download
0
Transcript of Capital Budgeting Process 1. Estimate the cash flows. 2. Assess the riskiness of the cash flows. 3....
Capital Budgeting Process
1. Estimate the cash flows.
2. Assess the riskiness of the cash flows.
3. Determine the appropriate discount rate.
4. Find the PV of the expected cash flows.
5. Accept the project if PV of inflows > costs.
Capital Budgeting1. Basic Data
Expected Net Cash FlowYear Project L Project S
0 ($100) ($100)1 10 702 60 503 80 20
2. Evaluation TechniquesA. Payback periodB. Discounted payback periodC. Net present value (NPV)D. Internal rate of return (IRR)E. Modified internal rate of return (MIRR)
Capital Budgeting - Illustration
I. Basic Data
Expected Net Cash Flow
Year Project L Project S
0 ($100) ($100)
1 10 70
2 60 50
3 80 20
Capital Budgeting
Weakness of Payback:
1. Ignores the time value of money. This weakness is eliminated with the discounted payback method.
2. Ignores cash flows occurring after the payback period.
Capital Budgeting
NPV = CF
t
(1+k)
Project L: 0 10% 1 2 3 -100.00 10 60 80 9.09 49.59 60.11
NPVL= 18.79 NPVS = $19.98
If the projects are independent, accept both.If the projects are mutually exclusive, accept Project S since NPVS >
NPVL
t
Capital Budgeting
IRR = CF
t = $0 = NPV (1+IRR)
Project L:
0 IRR 1 2 3 -100.00 10 60 80 8.47 43.02 48.57
0.06 = $0 IRRL=18.1% IRRS=23.6%
If the projects are independent, accept both because IRR>k.If the projects are mutually exclusive, accept Project S since IRRS > IRRL
t
Capital BudgetingProject L:
0 10% 1 2 3 -100.00 10 60 80.00
66.0012.10
100.00 MIRR = 16.5% $158.10
$0.00 = NPV TVof inflows
PV outflows = $100TV inflows =$158.10 $100=158.10
(pvif)
Capital Budgeting - Illustration
II. Evaluation Techniques
A. Payback period
B. Discounted payback period
C. Net present value (NPV)
D. Internal rate of return (IRR)
E. Modified internal rate of return
(MIRR)
Capital Budgeting - Payback Period
Payback period = Expected number of
years required to recover a project’s cost.
Project L
Expected Net Cash Flow
Year Annual Cumulative
0 ($100) ($100)
1 10 (90)
2 60 (30)
3 80 50
Capital Budgeting - Payback Period
PaybackL= 2 + $30 / $80 years
= 2.4 years
PaybackS= 1.6 years.
Weaknesses of Payback:
1. Ignores the time value of money. This weakness is eliminated with the discounted payback period.
2. Ignores cash flows occurring after the payback period.
Capital Budgeting - Net Present Value (NPV)
n
NPV = CFt
Project L: t=0 (1+k)t
0 10% 1 2 3-100.00 10 60 80 9.09 49.59
60.11
NPVL= $18.79
Capital Budgeting - Net Present Value (NPV)
n
NPV = CFt
Project S: t=0 (1+k)t
0 10% 1 2 3-100.00 70 50 20 63.64 41.32
15.03
NPVS= $19.99
Capital Budgeting - Net Present Value (NPV)
NPVS = $19.99 NPVL= $18.79
If the projects are independent, accept both.
If the projects are mutually exclusive, accept Project S since NPVS > NPVL.
Note:
NPV declines as k increases and NPV rises as k decreases.
Internal Rate of Return (IRR)
n
IRR =
CFt = $0 = NPV Project L: t=0 (1+IRR)t
0 IRR 1 2 3-100.00 10 60 80 8.47 18.13%
43.00 18.13%
48.54 18.13%
$ 0.01 $0
Internal Rate of Return (IRR)
n
IRR =
CFt = $0 = NPV Project S: t=0 (1+IRR)t
0 IRR 1 2 3-100.00 70 50 20 56.65 23.56%
32.75 23.56%
10.60 23.56%
$ 0.00
Internal Rate of Return (IRR)
IRRL = 18.13%
IRRS = 23.56%
If the projects are independent, accept both because IRR > k.
If the projects are mutually exclusive, accept Project S since IRRS > IRRL.
Note:
IRR is independent of the cost of capital.
Capital Budgeting - NPV Profilesk NPVL NPVS
0% $50 $40 5 33 2910 19 2015 7 1220 (4) 5
Modified IRR (MIRR)
Project L:
0 10% 1 2 3
-100 10 60 80.00
66.00
12.10
$158.10 =TV of
100.00 MIRR=16.5% inflows
$ 0.00 = NPV
Modified IRR (MIRR)
Project S:
0 10% 1 2 3
-100 70 50 20.00
55.00
84.70
$159.70 =TV of
100.00 MIRR=16.9% inflows
$ 0.00 = NPV
Modified IRR (MIRR)
PV outflows = $100
TV inflows = $158.10
$100 = $158.10 (PVIFMIRRL,3)
MIRRL = 16.5%
MIRRS = 16.9%
Modified IRR (MIRR)
Project L:
0 5% 1 2 3
-100 10 60 80.00
63.00
11.03
$154.03 =TV of
100.00 MIRR=15.48% inflows
$ 0.00 = NPV
Modified IRR (MIRR)
Project S:
0 5% 1 2 3
-100 70 50 20.00
52.50
77.18
$149.68 =TV of
100.00 MIRR=14.39% inflows
$ 0.00 = NPV
Modified IRR (MIRR)
MIRR is better than IRR because:
1. MIRR correctly assumes reinvestment at project’s cost of capital.
2. MIRR avoids the problem of multiple IRRs.
NPV Profile: Nonnormal Project P with Multiple IRRs
Year Cash Flow (‘000) 0 ($800) 1 5,000 2 (5,000)
NPV @10% = -$386,777. Do not accept; NPV < 0.IRR = 25% and 400%.MIRR = 5.6%. Do not accept; MIRR < k.
Debt
Bank
Equity
$100
$100
wacc=10%
$1201 year
IRR = 20%
$
%
20%wacc = 10% MCC
IOSA=20%
1000
IF IRR > WACC THEN ACCEPT PROJECT
Debt
Bank
Equity
PV(CASH IN) = 100 = CASH OUTFLOW
$100
$100
wacc=10%
$1101 year
IRR = 10%
PV(IN) = 109.09 PV(IN) = 100PV(OUT) = 100 PV(0UT) = 100NPV = 9.09 NPV = 0CF0= -100 i=10% CF0= -100 i=10%CF1= 120 CF1= 110NPV = 9.09 NPV = 0
100OUT
100OUT
IN110
IN120
1 YEAR 1 YEARWACC = 10% WACC = 10%
IRR NPVCF0 = -100 PV(IN) = 95.45CF1 = 105 PV(OUT) = 100IRR = 5% NPV = -4.55
CF0 = -100 CF1=105i = 10% NPV = -4.55
IN105
WACC = 10%
100 OUT
10%