The Basics of Capital Budgeting

12-1

Should we build this

plant?

Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future.

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What is capital budgeting?

1. Estimate CFs (inflows & outflows).2. Assess riskiness of CFs.3. Determine the appropriate cost of capital.4. Find NPV and/or IRR.5. Accept if NPV > 0 and/or IRR > WACC.

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Steps to Capital Budgeting

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.

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What is the difference between independent and mutually exclusive projects?

1. Net Present Value (NPV) 2. Internal Rate of Return (IRR) 3. Modified Internal Rate of Return (MIRR) 4. Regular Payback 5. Discounted Payback

11-5

Criteria for deciding:

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

Nonnormal 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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What is the difference between normal and nonnormal cash flow streams?

Sum of the PVs of all cash inflows and outflows of a project:

12-7

Net Present Value (NPV)

N

0tt

t

)r 1 (CF

NPV

12-8

What is Project S’s NPV?

11-9

What is Project S’s NPV?

NPV= PV of inflows – Cost

= Net gain in wealth Independent projects: If NPV exceeds zero, accept the

project. Mutually exclusive projects: Accept the project with

the highest positive NPV. If no project has a positive NPV, reject them all.

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Rationale for the NPV Method

N

0tt

t

IRR) (1CF

0

12-11

Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

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.

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

Independent projects: If IRR exceeds the project’s WACC, accept the project.

If IRR is less than the project’s WACC, reject it.

Mutually exclusive projects. Accept the project with the highest IRR, provided that IRR is greater than WACC. Reject all projects if the best IRR does not exceed WACC.

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Rationale for the IRR Method

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Multiple IRRs

The discount rate at which the present value of a project’s cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm’s cost of capital.

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Modified Internal Rate of Return (MIRR)

11-16

Modified Internal Rate of Return (MIRR)

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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What is the payback period?

12-18

Calculating 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.

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Strengths and Weaknesses of Payback

Uses discounted cash flows rather than raw CFs.

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Discounted Payback Period

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Conclusions

Five capital budgeting decision criteria: NPV, IRR, MIRR, Payback and Discounted PaybackNPV is the single best criterion.NPV – direct measure of value the project adds to

shareholder wealthIRR & MIRR – measures profitabilityPayback and Discounted Payback – measures

liquidity

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END