The Basics of Capital Budgeting

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CHAPTER 10

• The Basics of Capital Budgeting
• Omar Al Nasser, Ph.D.
• FIN 6352

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Chapter Outline

• Net Present Value
• The Payback Rule
• The Internal Rate of Return
• The Profitability Index

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The Big Picture The Net Present Value of a
Project
Projects Cash Flows (CFt)
Projects debt/equity capacity
Market interest rates
Projects risk-adjusted cost of capital (r)
Projects business risk
Market risk aversion
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What is capital budgeting?

• Analysis of potential projects.
• Long-term decisions involve large expenditures.
• Very important to firms future.

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Net Present Value

• The difference between the market value of a
  project and its cost
• How much value is created from undertaking an
  investment?
• The first step is to estimate the expected future
  cash flows.
• The second step is to estimate the required
  return for projects of this risk level.
• The third step is to find the present value of
  the cash flows and subtract the initial
  investment.

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NPV Decision Rule

• If the NPV is positive, accept the project
• A positive NPV means that the project is expected
  to add value to the firm and will therefore
  increase the wealth of the owners.
• Since our goal is to increase owner wealth, NPV
  is a direct measure of how well this project will
  meet our goal.

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Net Present Value

• NPV equal to the PV of future net cash flows,
  discounted at the cost of capital.

Cost often is CF0 and is negative.
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Project Example Information

• You are looking at a new project and you have
  estimated the following cash flows
• Year 0 CF -165,000
• Year 1 CF 63,120
• Year 2 CF 70,800
• Year 3 CF 91,080
• Your required return for assets of this risk is
  12.

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Computing NPV for the Project

• Using the formulas
• NPV 63,120/(1.12) 70,800/(1.12)2
  91,080/(1.12)3 165,000 12,627.41
• Using the calculator
• CF0 -165,000 C01 63,120 F01 1 C02
  70,800 F02 1 C03 91,080 F03 1 NPV I
  12 CPT NPV 12,627.41
• Do we accept or reject the project?

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Cash Flows for Franchise L and Franchise S
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Whats Franchise Ls NPV?
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Calculator Solution Enter values in CFLO
register for L.
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Independent versus 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.

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Using NPV method, which franchise(s) should be
accepted?

• If Franchises S and L are mutually exclusive,
  accept S because NPVs gt NPVL.
• If S L are independent, accept both NPV gt 0.
• NPV is dependent on cost of capital.

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What is the payback period?

• The number of years required for an investment to
  recover its cost, or how long does it take to get
  the businesss money back?
• Computation
• Estimate the cash flows
• Subtract the future cash flows from the initial
  cost until the initial investment has been
  recovered
• Decision Rule Accept if the payback period is
  less than some preset limit

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Payback for Franchise L
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Payback for Franchise S
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Strengths and Weaknesses of Payback

• Strengths
• Provides an indication of a projects risk and
  liquidity.
• Easy to calculate and understand.
• Weaknesses
• Ignores CFs occurring after the payback period.
• Unlike the NPV, which tells us by how much the
  project should increase shareholder wealth, the
  payback tells us when we get our investment back.
• No specification of acceptable payback.

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Internal Rate of Return

• This is the most important alternative to NPV
• It is based entirely on the estimated cash flows
  and is independent of interest rates found
  elsewhere.
• IRR is the discount rate that forces a projects
  NPV to equal zero.
• Decision Rule Accept the project if the IRR is
  greater than the required return

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Internal Rate of Return
IRR Enter NPV 0, solve for IRR.
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Whats Franchise Ls IRR?
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Calculator Solution Whats Franchise Ls IRR?
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Rationale for the IRR Method

• If IRR gt the required return , then the projects
  rate of return is greater than its cost the
  project expected to earn more than the cost of
  capital need to finance the project.
• Example
• the required return 10, IRR 15.
• So this project adds extra return to shareholders.

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Decisions on Franchises S and L per IRR

• If S and L are independent, accept both IRRS gt
  r and IRRL gt r.
• If S and L are mutually exclusive, accept S
  because IRRS gt IRRL.

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NPV vs. IRR

• NPV and IRR will generally give us the same
  decision
• Despite a strong academic preference for NPV,
  surveys indicate that executives prefer IRR over
  NPV because managers find it more appealing to
  evaluate investments in terms of percentage rates
  of return than dollars of NPV.
• However, you should always use NPV as your
  decision criteria because it selects the project
  that adds the most to shareholders wealth.
• Whenever there is a conflict between NPV and
  another decision rule, you should always use NPV

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Modified Internal Rate of Return (MIRR)

• MIRR is the discount rate which causes the PV of
  a projects terminal value (TV) to equal the PV
  of costs.
• TV is found as the sum of the future values of
  the cash inflows compounded at the firms cost of
  capital.
• MIRR assumes that all cash flows are reinvested
  at the firm's cost of capital. Therefore, MIRR
  more accurately reflects the profitability of a
  project.

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MIRR for Franchise L
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Franchise Ls Step 1, Find PV of inflows
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Step 1, Find PV of Inflows

• First, enter cash inflows in CFLO register
• CF0 0, CF1 10, CF2 60, CF3 80
• Second, enter I/YR 10.
• Third, find PV of inflows
• Press NPV 118.78

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Step 2, Find FV of Inflows

• Enter PV -118.78, N 3, I/YR 10, PMT 0.
• Press FV 158.10 FV of inflows.

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Step 3, Find IRR of FV of Inflows and PV of
Outflows

• For this problem, there is only one outflow, CF0
  -100, so the PV of outflows is -100.
• Enter FV 158.10, PV -100, PMT 0, N 3.
• Press I/YR 16.50 MIRR.

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Financial Calculator

• First, enter cash inflows in CFLO register
• CF0 0, CF1 10, CF2 60, CF3 80
• Second, enter I 10.
• Third, find PV of inflows
• Press NPV 118.78
• Then
• Enter PV -118.78, N 3, I 10, PMT 0.
• Press FV 158.10 FV of inflows.
• Then
• Enter FV 158.10, PV -100, PMT 0, N 3.
• Press I 16.50 MIRR.

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Profitability Index

• The profitability index (PI) is the present value
  of future cash flows divided by the initial cost.
• Profitability index is a good tool for ranking
  projects because it allows you to clearly
  identify the amount of value created per unit of
  investment.
• If PI gt 1 then accept the project if PI lt 1 then
  reject the project.
• The higher the PI, the higher the projects
  ranking.

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Franchise Ls PV of Future Cash Flows
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Franchise Ls Profitability Index
118.79
PV future CF
PIL

Initial Cost
100
PIL 1.1879
PIS 1.1998

• So project L is expected to produce 1.1879 for
  each 1 of investment. A profitability index of
  1.1879 implies that for every 1 of investment,
  we receive 1.1879 worth of benefits, so we
  create an additional 0.1879 in value
• Both projects should be accepted by PI, but
  project S will be ranked ahead of L because it
  has a higher PI .

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Comprehensive Problem

• An investment project has the following cash
  flows CF0 -1,000,000 C01 C08 200,000 each
• If the required rate of return is 12, what
  decision should be made using NPV?
• What decision should be made using IRR?

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Excel Example Information

• You are looking at a new project and you have
  estimated the following cash flows
• Year 0 CF -165,000
• Year 1 CF 63,120
• Year 2 CF 70,800
• Year 3 CF 91,080
• Your required return for assets of this risk is
  12.

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Calculating NPVs with a Spreadsheet

• Spreadsheets are an excellent way to compute
  NPVs, especially when you have to compute the
  cash flows as well.
• Using the NPV function
• The first component is the required return
  entered as a decimal
• The second component is the range of cash flows
  beginning with year 1
• Subtract the initial investment after computing
  the NPV
• Check your calculations with a hand held
  calculator to ensure that the formulae have been
  correctly set up.

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Calculating IRRs With a Spreadsheet

• You start with the cash flows the same as you did
  for the NPV
• You use the IRR function
• You first enter your range of cash flows,
  beginning with the initial cash flow
• You can enter a guess, but it is not necessary
• The default format is a whole percent you will
  normally want to increase the decimal places to
  at least two

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Calculating PI With a Spreadsheet
PV future CF
PI
Initial Cost

• The profitability index (PI) is the present value
  of future cash flows divided by the initial cost.
• You start with the calculating the PV of future
  cash flows, then divided by the initial cost.

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Calculating MIRR With a Spreadsheet

• Modified Internal Rate of Return the cash flow
  cell range is the same as in the IRR, but both
  the required rate of return, and the
  re-investment rate, are entered into the formula.