CAPITAL BUDGETING ANALYSIS

Scenario

Evaluate each project assuming the following scenarios:a) Cost of capital of 12 percent.b) Cost of capital of 18 percent.

Expected Net Cash FlowsYear Project A Project B

0 (485) (650)1 (400) 205 2 (225) 225 3 (75) 225 4 800 225 5 800 250 6 975 250 7 (100) -

Note: Examples of formula calculations in Excel are shown.

Capital budgeting analysis is a process used to evaluate potential projects a company may choose as investments. Key methods used in capital budgeting include NPV, IRR, MIRR, PI, payback, and discounted payback.

In the following problem demo, you will analyze two competing and mutually exclusive projects using NPV and IRR calculations. Your goal will be investment in a project that generates maximum wealth and value for both the firm and its investors. Optimal investments are worth more than they cost.

Use the tabs at the bottom of the Excel window to navigate through the seven sheets of information. On each sheet in this document, first review the content and then examine how that information applies to the two project options. After reviewing all the information, you will review questions that will help you decide which project you will recommend.

Elliott Enterprises is considering two investment projects. It will be your responsibility to analyze each of the projects based on NPV, IRR, MIRR, PI, payback, and discounted payback assuming that the two projects are mutually exclusive.

Net Present Value (NPV) and Internal Rate of Return (IRR)

Net present value (NPV) and internal rate of return (IRR) are two of the more common methods used when analyzing capital budgeting decisions.

NPV evaluates the benefits of a project vs. the present value costs of a project. Typically, a project will require an initial cash outlay or start up cost followed by positive cash inflows. The NPV method discounts cash flows at the project’s cost of capital and then sums those cash flows. The project should be accepted if the NPV is positive (i.e., the project is worth more than its cost). A positive NPV will result in an increase in shareholder value in the firm. NPV is typically viewed as the best method for evaluation in capital budgeting, but should not be the only decision making method used by a firm. NPV does have its limitations. NPV assumes that management can make accurate predictions as to future cash flows. The longer the project, the harder it will be to make accurate estimates of future cash flows. NPV assumes that the discount rate will remain constant over the life of the project. In reality, the discount rate is affected by costs of capital, future interest rates and future use of cash flows.

Net Present ValueNet present value = sum of the present value of all cash flows.r = 12%Project ATime period: 0 1 2 3 4 5 6 7Cash flow: (485) (400) (225) (75) 800 800 975 (100)Discounted cash flow: (485.00) (357.14) (179.37) (53.38) 508.41 453.94 493.97 (45.23)

NPV = $ 336.19 = sum of discounted cash flows or use NPV function $336.19

Project BTime period: 0 1 2 3 4 5 6 7Cash flow: (650) 205 225 225 225 250 250 - Discounted cash flow: (650.00) 183.04 179.37 160.15 142.99 141.86 126.66 -

NPV = $ 284.06 = sum of discounted cash flows or use NPV function $284.06

r = 18%Project ATime period: 0 1 2 3 4 5 6 7Cash flow: (485) (400) (225) (75) 800 800 975 (100)Discounted cash flow: (485.00) (338.98) (161.59) (45.65) 412.63 349.69 361.17 (31.39)

NPV = $ 60.87 = sum of discounted cash flows or use NPV function $60.87

Project BTime period: 0 1 2 3 4 5 6 7Cash flow: (650) 205 225 225 225 250 250 - Discounted cash flow: (650.00) 173.73 161.59 136.94 116.05 109.28 92.61 -

NPV = $ 140.20 = sum of discounted cash flows or use NPV function $140.20

IRRProject A = 19.65% ←Project B = 25.83%

The IRR method calculates the discount rate at which NPV is equal to zero. Accepting a project in which the IRR is greater than the cost of capital will increase shareholder value in the firm. Unlike NPV, IRR assumes that cash inflows will be reinvested in other projects at IRR rather than cost of capital. When using the IRR method, you should determine if the IRR represents a realistic rate of reinvestment.

When evaluating independent projects, NPV and IRR will always yield the same decision (accepts or reject). When considering mutually exclusive projects, the NPV method typically proves more reliable since it assumes that cash flows can be reinvested at the cost of capital.

Modified IRR Method (MIRR) and Profitability Index (PI)

MIRRr = 12%Project A 16.28% ←Project B 17.95%

r = 18%Project A 18.94%Project B 21.34%

The Modified IRR method (MIRR) is based on the same methodology as IRR, but uses modified cash flows. MIRR considers time value of money based on WACC. MIRR is considered more realistic than IRR since cost of capital is used as reinvestment rate.

Profitability index (PI) compares the present value of cash flows to the initial investment. Projects should be rejected if PI is less than 1. PI compares the same values as the NPV method, but calculates a ratio rather than a dollar value.

Profitability Index (PI)r = 12%

PIProject A $821.19 1.69 Project B $934.06 1.44

r = 18%

PIProject A $545.87 1.13 Project B $790.20 1.22

PV of Future Cash Flows

PV of Future Cash Flows

Payback Method

PaybackProject ATime period: 0 1 2 3 4 5 6 7Cash flow: (485) (400) (225) (75) 800 800 975 (100)Cumulative cash flow: -485 -885 -1110 -1185 -385 415 1390 1290% of year required for payback: 1.0000 1.0000 1.0000 1.0000 0.4813 0.0000 0.0000 Payback 4.4813

Project BTime period: 0 1 2 3 4 5 6 7Cash flow: (650) 205 225 225 225 250 250 - Cumulative cash flow: -650 -445 -220 5 230 480 730 730% of year required for payback: 1.0000 1.0000 0.9778 0.0000 0.0000 0.0000 0.0000 Payback 2.9778

Payback method ignores the time value of money, but is a widely used method due to its ease of calculation. Payback is similar to breakeven and focuses on the time period in which the initial investment is repaid by analyzing cumulative cash flows. Payback focuses on repayment of principal without considering interest since payback ignores time value considerations. Payback is often used due to the method’s simplicity. Despite the fact that payback ignores the time value of money, it can be a valuable measure to determine if capital will be repaid in a reasonable time period. It should not, however, be solely relied on in a capital budgeting analysis since it does not provide a measure of profitability.

Discounted Payback

Discounted Payback:Project A

12%Time period: 0 1 2 3 4 5 6 7Cash flow: (485) (400) (225) (75) 800 800 975 (100)Disc. cash flow: (485) (357) (179) (53) 508 454 494 (45)Disc. cum. cash flow: (485) (842) (1,022) (1,075) (566) (113) 381 336 % of year required for payback: 1.0000 1.0000 1.0000 1.0000 1.0000 0.2278 0.0000 Discounted Payback: 5.23

Project B12%

Time period: 0 1 2 3 4 5 6 7Cash flow: (650) 205 225 225 225 250 250 - Disc. cash flow: (650) 183 179 160 143 142 127 - Disc. cum. cash flow: (650) (467) (288) (127) 16 157 284 284 % of year required for payback: 1.0000 1.0000 1.0000 0.8913 0.0000 0.0000 0.0000 Discounted Payback: 3.89 Project A

18%Time period: 0 1 2 3 4 5 6 7Cash flow: (485) (400) (225) (75) 800 800 975 (100)Disc. cash flow: (485) (339) (162) (46) 413 350 361 (31)Disc. cum. cash flow: (485) (824) (986) (1,031) (619) (269) 92 61 % of year required for payback: 1.0000 1.0000 1.0000 1.0000 1.0000 0.7445 0.0000

Discounted payback uses similar methodology as the payback method, but focuses on cumulative present value rather than cumulative cash flows. Discounted payback focuses on the time period in which the initial investment is repaid based on cumulative present value of cash flows. Discounted payback considers repayment of both principal and interest since the time value of money is considered when using this method.

Discounted Payback: 5.74

Project B18%

Time period: 0 1 2 3 4 5 6 7Cash flow: (650) 205 225 225 225 250 250 - Disc. cash flow: (650) 174 162 137 116 109 93 - Disc. cum. cash flow: (650) (476) (315) (178) (62) 48 140 140 % of year required for payback: 1.0000 1.0000 1.0000 1.0000 0.5645 0.0000 0.0000 Discounted Payback: 4.56

Crossover Rate

Crossover Rate

Expected Net Cash FlowsYear Project A Project B Difference

0 (485) (650) 165 1 (400) 205 (605)2 (225) 225 (450)3 (75) 225 (300)4 800 225 575 5 800 250 550 6 975 250 725 7 (100) - (100)

Crossover Rate = 14.09%

NPV at crossover rate = $229.66

Crossover rate represents cost of capital at which both projects have the same net present value. It is calculated by finding the cash flow differential between two projects, then calculating IRR, and then NPV based on the calculated IRR.

Summary

Summary:WACC = 12 percent WACC = 18 percent

Project A Project B Project A Project BNPV $336.19 $284.06 $60.87 $140.20 IRR 19.65% 25.83% 19.65% 25.83%MIRR 16.28% 17.95% 18.94% 21.34%Profitability Index 1.69 1.44 1.13 1.22 Payback 4.4813 2.9778 4.4813 2.9778 Discounted Payback 5.23 3.89 5.74 4.56

Crossover Rate 14.09%NPV at crossover rate $229.66

Points for Consideration

Based on the results of our analysis, which project would you ultimately recommend? Why?

How would you incorporate the results of your analysis into recommendations for investment?

How would your recommendation(s) differ if the projects are independent (not mutually exclusive)?

Would you ever accept a project if the NPV is less than 0? Why or why not?