Slide 1What is capital budgeting?StepsWhat is the difference between independent and mutually exclusive projects?An Example of Mutually Exclusive ProjectsNormal Cash Flow Project:Slide 7What is the payback period?Payback for Project L (Long: Large CFs in later years)Project S (Short: CFs come quickly)Slide 11Slide 12Slide 13What’s Project L’s NPV?Calculator SolutionRationale for the NPV MethodUsing NPV method, which project(s) should be accepted?Internal Rate of Return: IRRSlide 19What’s Project L’s IRR?Slide 21Slide 22Rationale for the IRR MethodIRR Acceptance CriteriaDecisions on Projects S and L per IRRConstruct NPV ProfilesSlide 27Slide 28Slide 29To Find the Crossover RateTwo Reasons NPV Profiles CrossReinvestment Rate AssumptionsManagers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?Slide 34Slide 35Why use MIRR versus IRR?Pavilion Project: NPV and IRR?Slide 38Logic of Multiple IRRsSlide 40Slide 41Accept Project P?11 - 1Copyright © 2001 by Harcourt, Inc. All rights reserved.Should we build thisplant?CHAPTER 11The Basics of Capital Budgeting11 - 2Copyright © 2001 by Harcourt, Inc. All rights reserved.What is capital budgeting?Analysis of potential additions to fixed assets.Long-term decisions; involve large expenditures.Very important to firm’s future.11 - 3Copyright © 2001 by Harcourt, Inc. All rights reserved.Steps1. Estimate CFs (inflows & outflows).2. Assess riskiness of CFs.3. Determine k = WACC (adj.).4. Find NPV and/or IRR.5. Accept if NPV > 0 and/or IRR > WACC.11 - 4Copyright © 2001 by 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.11 - 5Copyright © 2001 by Harcourt, Inc. All rights reserved.An Example of Mutually Exclusive ProjectsBRIDGE vs. BOAT to get products across a river.11 - 6Copyright © 2001 by 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.11 - 7Copyright © 2001 by Harcourt, Inc. All rights reserved.Inflow (+) or Outflow (-) in Year0 1 2 3 4 5 N NN- + + + + + N- + + + + - NN- - - + + + N+ + + - - - N- + + - + - NN11 - 8Copyright © 2001 by 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 our money back?11 - 9Copyright © 2001 by Harcourt, Inc. All rights reserved.Payback for Project L(Long: Large CFs in later years)10 600 1 2 3-100=CFtCumulative -100 -90 -30 50PaybackL2 + 30/80 = 2.375 years01002.48011 - 10Copyright © 2001 by Harcourt, Inc. All rights reserved.Project S (Short: CFs come quickly)70 20500 1 2 3-100CFtCumulative -100 -30 20 40PaybackL1 + 30/50 = 1.6 years10001.6=11 - 11Copyright © 2001 by 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.11 - 12Copyright © 2001 by Harcourt, Inc. All rights reserved.Discounted Payback: Uses discountedrather than raw CFs.10 80600 1 2 3CFtCumulative -100 -90.91 -41.32 18.79Discountedpayback2 + 41.32/60.11 = 2.7 yearsPVCFt-100-10010%9.09 49.59 60.11=Recover invest. + cap. costs in 2.7 years.11 - 13Copyright © 2001 by Harcourt, Inc. All rights reserved. .k1CFNPVttn0tNPV: Sum of the PVs of inflows and outflows.11 - 14Copyright © 2001 by 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 = $19.98.11 - 15Copyright © 2001 by Harcourt, Inc. All rights reserved.Calculator SolutionEnter in CFLO for L:-10010608010CF0CF1NPVCF2CF3I= 18.78 = NPVL11 - 16Copyright © 2001 by 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.11 - 17Copyright © 2001 by Harcourt, Inc. All rights reserved.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 > 0.11 - 18Copyright © 2001 by 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 = 0.11 - 19Copyright © 2001 by Harcourt, Inc. All rights reserved. .NPVk1CFttn0t .0IRR1CFttn0tNPV: Enter k, solve for NPV.IRR: Enter NPV = 0, solve for IRR.11 - 20Copyright © 2001 by 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%.11 - 21Copyright © 2001 by Harcourt, Inc. All rights reserved. 40 40 400 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%INPUTSOUTPUTN I/YR PV PMT FV11 - 22Copyright © 2001 by Harcourt, Inc. All rights reserved.90 1090900 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.-1134.2IRR = 7.08% (use TVM or CFLO)....11 - 23Copyright © 2001 by 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.11 - 24Copyright © 2001 by Harcourt, Inc. All rights reserved.IRR Acceptance CriteriaIf IRR > k, accept project.If IRR < k, reject project.11 - 25Copyright © 2001 by Harcourt, Inc. All rights reserved.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 .11 - 26Copyright © 2001 by Harcourt, Inc. All rights reserved.Construct NPV