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CHAPTER 11The Basics of Capital Budgeting

Should we build this

plant?

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What is capital budgeting? Analysis of potential additions to

fixed assets. Long-term decisions; involve

large expenditures. Very important to firm’s future.

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Steps to capital budgeting

1. Estimate CFs (inflows & outflows).2. Assess riskiness of CFs.3. Determine the appropriate cost of

capital. (If the new project is as risky as existing assets in the firm, we can use WACC as the cost of capital, also called discount rate. Otherwise we should get the discount rate based on the riskness of the project.)

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Steps to capital budgeting

4. Find NPV=present value of future cash inflow-initial cost.

5. Accept if NPV > 0. (For a normal project, we can

also accept if IRR > WACC.)

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What is the difference between independent and mutually exclusive projects?

Independent projects – if the cash flows of one are unaffected by the acceptance of the other.

Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other. If one project is taken, the other has to be rejected.

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What is the difference between normal and non-normal cash flow streams?

Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs.

Non-normal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

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We will discuss 3 investment criteria.

Payback NPV IRR

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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?”

Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.

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Calculating payback

PaybackL = 2 + / = 2.375 years

CFt -100 10 60 100Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

PaybackS = 1 + / = 1.6 years

CFt -100 70 100 20Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50-30

Project S

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Strengths and weaknesses of payback

Strengths Provides an indication of a project’s risk and

liquidity. Easy to calculate and understand.

Weaknesses Ignores the time value of money. Ignores CFs occurring after the payback

period. Tend to bias in favor of short term projects.

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Discounted payback period

Uses discounted cash flows rather than raw CFs.

Disc PaybackL = 2 + / = 2.7 years

CFt -100 10 60 80

Cumulative -100 -90.91 18.79

0 1 2 3

=

2.7

60.11

-41.32

PV of CFt -100 9.09 49.59

41.32 60.11

10%

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Net Present Value (NPV) Sum of the PVs of all cash inflows and

outflows of a project:

N

0tt

t

)r 1 (CF

NPV

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What is Project L’s NPV?Project L Year CFt PV of CFt

0 -100 -$100 1 10 9.09 2 60 49.59 3 80 60.11

NPVL = $18.79 Project S Year CFt PV of CFt

0 -100 -$100 1 70 ? 2 50 ? 3 20 ?

NPVS = $19.98

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Solving for NPV:Financial calculator solution

Enter CFs into the calculator’s CFLO register. CF0 = -100 CF1 = 10 CF2 = 60 CF3 = 80

Enter I/YR = 10, press NPV button to get NPVL = $18.78.

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Detailed steps To clear historical data: CF, 2nd ,CE/C To get PV: CF , 100 , +/-, Enter ,”Co1”, 10, Enter, ↓,↓ ,

“C02”,60 , Enter, ↓, ↓, “C03”,80 , Enter, ↓, ↓,

NPV, “I=”, 10,Enter, ↓, “NPV=”, CPT “NPV=18.7828” IRR, CPT “18.1257”

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NPV method

NPV= PV of inflows – PV of all Cost

= Net gain in wealth If projects are independent,

accept if the project NPV > 0.

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NPV

If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value.

In our example, would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent.

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Internal Rate of Return (IRR) IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:

Solving for IRR with a financial calculator: Enter CFs in CFLO register. Press IRR; IRRL = 18.13% and IRRS = 23.56%.

n

0tt

t

) IRR 1 (CF

0

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How is a project’s IRR similar to a bond’s YTM?

They are the same thing. Think of a bond as a project.

The YTM on the bond would be the IRR of the “bond” project.

EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20. Solve for IRR = YTM = 7.08%, the

annual return for this project/bond.

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Rationale for the IRR method

For normal projects: If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ wealth.

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Comparing the NPV and IRR methods

NPV always leads to correct decision.

IRR rules some times not. Payback often biases in favor of

quick projects.

You do not need to know MIRR.

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Exercises1. The net present value (NPV) rule can be best

stated as: A)An investment should be accepted if, and only

if, the NPV is exactly equal to zero. B)An investment should be rejected if the NPV is

positive and accepted if it is negative. C) An investment should be accepted if

the NPV is positive and rejected if it is negative.

D) An investment with greater cash inflows than cash outflows, regardless of when the cash flows occur, will always have a positive NPV and therefore should always be accepted.

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3. Net present value __________.

A)is equal to the initial investment in a project B)is equal to the present value of the project

benefits C)is equal to zero when the discount rate

used is equal to the IRR D) is simplified by the fact that future cash

flows are easy to estimate E)requires the firm set an arbitrary cutoff point

for determining whether an investment is acceptable

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4. What is the NPV of the following set of cash flows if the required return is 15%?

Cf0= -$667.6 Cf1=$500 Cf2=$500 Cf3=$400

A) The NPV is negative B) $ 408.27 C) $ 950.44 D) $1,247.90 E) $4,656.12

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5. A project costs $300 and has cash flows of $75 for the first three years and $50 in each of the project's last three years.

What is the payback period of the project?

A) The project never pays back B) 3.75 years C) 4.50 years D) 5.25 years E) 5.50 years

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6. Bill plans to open a do-it-yourself dog bathing center in a storefront. The bathing equipment will cost $50,000.

Bill expects the after-tax cash inflows to be $15,000 annually for 8 years, after which he plans to scrap the equipment and retire to the beaches of Jamaica.

Assume the required return is 20%. What is the project's IRR? Should it be accepted?

A)15%; yes B)15%; no C)25%; yes D) 25%; no E)20%; indifferent