Chapter11.The Basics of Capital Budgeting*Do you recall why we are in business? To make money-What do we need? Idea(s), then capital (money)*4 major decisions to be made? 1. Examine the idea(s) under consideration to take or reject, if chosen-capital budgeting2. Then need to come up with money, equity (internal vs. external?) or debt, how much each? -capital structure3. Short-term management (working capital mgt) and long-term management4. How much paid out to shareholders in the form of dividends and how much to be kept within the firm in the form of additional retained earnings–dividend policy First, we have to estimate 1. The size of initial investment (initial outlay) 2. (NET) future cash flows on a timeline (note cash flows are different from (net) earnings as we are interested in cash flows.) 3. Determine appropriate weighted cost of capital (WACC, which can be used as a discount rate)Note: Different types of projects: independent (take all “good” projects), mutually exclusive (onlythe “best” one among the “good” ones).* 5 Alternative Methods (Payback, Discounted Payback, NPV, IRR, MIRR)Example:A: IO=10k B: IO=10kFuture Cash Flows C1=5k C1=2kC2=5k C2=3kC3=5k C3=4kC4=5kC5=6k 1. Payback Period: How many periods to recover IO (your investment) - no discount rate used (it,no PVs),(Cumulative future cash flows) (p.353 – p.355)PBa = 2 periodsPBb = 3.2 periodsDecision Rule: Accept the project if PB < Max period allowed or choose the one with a shorter payback period for mutually exclusive projects. If Max allowed = 3 periods? (A only) 4 periods (take both)?, If these are mutually exclusive with Max allowed=4 periods (A)?Advantage: Intuitive and simple, popular choiceDisadvantage: Ignores cash flows beyond payback period, No TVM2. Discounted PaybackUse discounted PVs.3. Net Present Value (p. 338 – p. 341)Recall from Chapter 7 and 9 to buy a security from an individual investor’s perspective, PV>Price => Buy/Invest. Here, IO is like a price of a project and we need to consider buying a project from a corporate perspective.Define NPV=PV-IOThen, PV>IO (or price) NPV>0 (or +NPV)Decision Rule: Accept all +NPV projects or choose the project with the largest +NPV if mutually exclusive.Given K=10%, NPVa = 2.43k, NPVb = 4.44k => take both or only BGiven K=23.3%, NPVa = 0.011k, NPVb=-0.002k => take A (pretty weak, though) and reject B.(Note: as r (discount rate) increases, PV and NPV declines. NPV profile is a trace of the NPV for different discount rates)(Note: NPV function on Excel is actually a PV function. Therefore you need to useNPV(discount rate, C1 cell address: Cn cell address)-IO to determine NPV.)4. Internal Rate of Return: Special discount rate which makes PV=IO (price) (p. 341 – p. 345) or NPV=0. Note: YTM = Bond’s IRRDecision Rule: Accept if IRR>hurdle rate (=discount rate, required rate, WACC) or choose the one with the highest IRR in case of mutually exclusive projects.PVa = 5*PVIFA(r%, 3) set equal to IO=10, what is the special r (discount rate) which satisfies this equation? That special r is the IRR (return on the investment) for the project=> PVIFA(r%, 3) = 2. Using the PVIF table, we can find out IRR should be approximately 23%~24%=> Using the financial calculator -10 PV, 5 PMT, 3 N => i/Y= 23.38% (this is simple, since the cash flow stream is an ordinary annuity)PVb = 2*PVIF(r%, 1)+3*PVIF(r%, 2)+4*PVIF(r%, 3)+5*PVIF(r%, 4)+6*PVIF(r%,5) set equal to IO=10, How to solve? Trial & ErrorOr a Financial Calculator if you know how to deal of uneven cash flowsOr Excel Spreadsheet IRR(-IO cell address: Cn cell address) => 23.29%Sometimes, IRR may not work well (how and when?). The best capital budgeting method is NPVapproach, although IRR is widely used in the real world (p. 349 – p.353).* Crossover rate and its significance* Modified Internal Rate of Return (MIRR) (p. 347 – p. 349) ~ use WACC to determine FV of theall future cash flows. Then try to determine IRR based on Co ( - IO) and the FV of all future cash
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