13 - 1Copyright © 2002 Harcourt, Inc. All rights reserved.Should we build thisplant?CHAPTER 13The Basics of Capital Budgeting: Evaluating Cash Flows13 - 2Copyright © 2002 Harcourt, Inc. All rights reserved.What is capital budgeting?nAnalysis of potential additions to fixed assets.nLong-term decisions; involve large expenditures.nVery important to firm’s future.13 - 3Copyright © 2002 Harcourt, Inc. All rights reserved.Steps1. Estimate CFs (inflows & outflows).2. Assess riskiness of CFs.3. Determine k = WACC for project.4. Find NPV and/or IRR.5. Accept if NPV > 0 and/or IRR > WACC.13 - 4Copyright © 2002 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.13 - 5Copyright © 2002 Harcourt, Inc. All rights reserved.An Example of Mutually Exclusive ProjectsBRIDGE vs. BOAT to get products across a river.13 - 6Copyright © 2002 Harcourt, Inc. All rights reserved.Normal Cash Flow Project:Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.Nonnormal Cash Flow Project: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.13 - 7Copyright © 2002 Harcourt, Inc. All rights reserved.Inflow (+) or Outflow (-) in Year0 1 2 3 4 5 N NN- + + + + + N- + + + + - NN- - - + + + N+ + + - - - N- + + - + - NN13 - 8Copyright © 2002 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 the business’s money back?13 - 9Copyright © 2002 Harcourt, Inc. All rights reserved.Payback for Project L(Long: Most CFs in out years)10 80600 1 2 3-100=CFtCumulative -100 -90 -30 50PaybackL2 + 30/80 = 2.375 years01002.413 - 10Copyright © 2002 Harcourt, Inc. All rights reserved.Project S (Short: CFs come quickly)70 20500 1 2 3-100CFtCumulative -100 -30 20 40PaybackS1 + 30/50 = 1.6 years10001.6=13 - 11Copyright © 2002 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.13 - 12Copyright © 2002 Harcourt, Inc. All rights reserved.10 80600 1 2 3CFtCumulative -100 -90.91 -41.32 18.79Discountedpayback2 + 41.32/60.11 = 2.7yrsDiscounted Payback: Uses discountedrather than raw CFs.PVCFt-100-10010%9.09 49.59 60.11=Recover invest. + cap. costs in 2.7 yrs.13 - 13Copyright © 2002 Harcourt, Inc. All rights reserved.(( ))NPVCFktntt== ∑∑++== 0 1.NPV: Sum of the PVs of inflows and outflows.Cost often is CF0and is negative.(( )).CFk1CFNPV0ttn1t−−++==∑∑==13 - 14Copyright © 2002 Harcourt, Inc. All rights reserved.What’s Project L’s NPV?10 80600 1 2 310%Project L:-100.009.0949.5960.1118.79 = NPVLNPVS= $19.98.13 - 15Copyright © 2002 Harcourt, Inc. All rights reserved.Calculator SolutionEnter in CFLO for L:-10010608010CF0CF1NPVCF2CF3I = 18.78 = NPVL13 - 16Copyright © 2002 Harcourt, Inc. All rights reserved.Rationale for the NPV MethodNPV= PV inflows - Cost= Net gain in wealth.Accept project if NPV > 0.Choose between mutually exclusive projects on basis ofhigher NPV. Adds most value.13 - 17Copyright © 2002 Harcourt, Inc. All rights reserved.Using NPV method, which project(s) should be accepted?nIf Projects S and L are mutually exclusive, accept S because NPVs> NPVL .nIf S & L are independent, accept both; NPV > 0.13 - 18Copyright © 2002 Harcourt, Inc. All rights reserved.Internal Rate of Return: IRR0 1 2 3CF0CF1CF2CF3Cost InflowsIRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.13 - 19Copyright © 2002 Harcourt, Inc. All rights reserved.(( ))tnttCFkNPV==∑∑++==0 1.(( ))tnttCFIRR==∑∑++==0 10.NPV: Enter k, solve for NPV.IRR: Enter NPV = 0, solve for IRR.13 - 20Copyright © 2002 Harcourt, Inc. All rights reserved.What’s Project L’s IRR?10 80600 1 2 3IRR = ?-100.00PV3PV2PV10 = NPVEnter CFs in CFLO, then press IRR:IRRL= 18.13%. IRRS= 23.56%.13 - 21Copyright © 2002 Harcourt, Inc. All rights reserved.40 40400 1 2 3IRR = ?Find IRR if CFs are constant:-100Or, with CFLO, enter CFs and press IRR = 9.70%.3 -100 40 0 9.70%N I/YR PV PMT FVINPUTSOUTPUT13 - 22Copyright © 2002 Harcourt, Inc. All rights reserved.90 1,090900 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.-1,134.2IRR = 7.08% (use TVM or CFLO)....13 - 23Copyright © 2002 Harcourt, Inc. All rights reserved.Rationale for the IRR MethodIf 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.13 - 24Copyright © 2002 Harcourt, Inc. All rights reserved.IRR Acceptance CriterianIf IRR > k, accept project.nIf IRR < k, reject project.13 - 25Copyright © 2002 Harcourt, Inc. All rights reserved.Decisions on Projects S and L per IRRnIf S and L are independent, accept both. IRRs > k = 10%.nIf S and L are mutually exclusive, accept S because IRRS> IRRL.13 - 26Copyright © 2002 Harcourt, Inc. All rights reserved.Construct NPV ProfilesEnter CFs in CFLO and find NPVLandNPVSat different discount rates: k05101520NPVL50 33197NPVS402920125 (4)13 - 27Copyright © 2002 Harcourt, Inc. All rights reserved.-1001020304050600 5 10 15 20 23.6NPV ($)Discount Rate (%)IRRL= 18.1%IRRS= 23.6%Crossover Point = 8.7%k05101520NPVL5033197(4) NPVS402920125 SL13 - 28Copyright © 2002 Harcourt, Inc. All rights reserved.NPV and IRR always lead to the same accept/reject decision for independent projects:k > IRRand NPV < 0.Reject.NPV ($)k (%)IRRIRR > kand NPV > 0Accept.13 - 29Copyright © 2002 Harcourt, Inc. All rights reserved.Mutually Exclusive Projectsk 8.7 kNPV%IRRSIRRLLSk < 8.7: NPVL> NPVS , IRRS > IRRLCONFLICT k > 8.7: NPVS> NPVL , IRRS > IRRLNO CONFLICT 13 - 30Copyright © 2002 Harcourt, Inc. All rights reserved.To Find the Crossover Rate1. Find cash flow differences between the projects. See data at beginning of the case.2. Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%,