CHAPTER 10 The Basics of Capital Budgeting

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CHAPTER 10The Basics of Capital Budgeting
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Capital Budgeting

• The process of planning for purchases of assets
  whose returns are expected to continue beyond a
  year
• Capital Expenditure
• A cash outlay expected to generate a flow of
  future cash benefits for more than a year
• Decisions can be the most complex facing
  management

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What is capital budgeting?

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

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Capital Expenditure Decisions

• Expand an existing product line
• Working capital
• Refunding
• Leasing
• Merger and acquisition

• Enter a new line of business
• Replacement
• Advertising campaign
• R and D
• Education and training

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Steps to capital budgeting

• Estimate CFs (inflows outflows).
• Assess riskiness of CFs.
• Determine the appropriate cost of capital.
• Find NPV and/or IRR.
• Accept if NPV gt 0 and/or IRR gt 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.

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Types of Cash Flows (CF)

• Cost of the Investment
• Typically incurred at the start.
• Negative cash flow.
• Annual After-tax Net Cash Flows
• Cash inflows minus cash outflows during each year
  of the projects life on an after-tax basis.
• Typically positive.

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

• 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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Inflow () or Outflow (-) in Year
0
1
2
3
4
5
N
NN
-





N
-




-
NN
-
-
-



N



-
-
-
N
-


-

-
NN
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Capital Budgeting Decision Rules

• 1. Payback Period (PB)
• 2. Net Present Value (NPV)
• 3. Internal Rate of Return (IRR)

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What is the payback period?

• The number of years required to recover a
  projects cost, or How long does it take to get
  our money back?
• Calculated by adding projects cash inflows to
  its cost until the cumulative cash flow for the
  project turns positive.

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Payback Period

• Number of years for the cumulative net cash flows
  from a project to equal the initial cash outlay

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Payback Example

• Project A Equal annual CFs
• PB30,000/10,000 3 years
• Project B Unequal annual CFs
• Cumulative CFs at year 4
• 5,00010,00015,00015,00045,000
• Need 5,000 more from year 5 CF of 25,000
• 5,000/25,000 0.20
• PB 4.20 years.

 
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Calculating payback
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Payback Period Decision Rules

• Independent projects
• Choose the ones that are acceptable given the
  managements cut-off payback period for each type
  of project.
• Mutually exclusive projects
• Choose the one with the quickest payback.

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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 the time value of money.
• Ignores CFs occurring after the payback period.

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Net Present Value (NPV)

• NPV is the PV of the future CFs from a project
  minus the projects initial investment.
• NPV PVCF - Investment
• PV is calculated using the projects cost of
  capital (k).

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Net Present Value (NPV)

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

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What is Project Ls NPV?

• Year CFt PV of CFt
• 0 -100 -100
• 1 10 9.09
• 2 60 49.59
• 3 80 60.11
• NPVL 18.79
• NPVS

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Solving for NPVFinancial calculator solution

• Enter CFs into the calculators 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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Whats Project Ls NPV?
Project L
0
1
2
3
10
10
80
60
-100.00
9.09
49.59
60.11
18.79 NPVL
NPVS
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Rationale for the NPV method

• NPV PV of inflows Cost
• Net gain in wealth
• If projects are independent, accept if the
  project NPV gt 0.
• If projects are mutually exclusive, accept
  projects with the highest positive NPV, those
  that add the most value.
• In this example, would accept S if mutually
  exclusive (NPVs gt 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 .

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Internal Rate of Return (IRR)

• IRR is the discount rate that equates the PV of
  future cash flows of a project with the PV of
  projects investment costs.

• IRR is the discount rate at which the NPV equals
  zero.
• If PVCFInvestment
• Then NPV PVCF - Investment0

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Internal Rate of Return IRR
0
1
2
3
CF0
CF1
CF2
CF3
Cost
Inflows
IRR is the discount rate that forces PV inflows
cost. This is the same as forcing NPV 0.
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NPV Enter k, solve for NPV.
IRR Enter NPV 0, solve for IRR.
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Rationale for the IRR method

• If IRR gt WACC, the projects rate of return is
  greater than its costs. There is some return
  left over to boost stockholders returns.
• ExampleWACC 10, IRR 15. Profitable.

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IRR Acceptance Criteria

• If IRR gt k, accept project.
• If IRR lt k, reject project.
• If projects are independent, accept both
  projects, as both IRR gt k 10.
• If projects are mutually exclusive, accept S,
  because IRRs gt IRRL.

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Evaluation using IRR

• IRR Decision Rule
• Independent projects Accept if its IRR is
  greater than the cost of capital (k).
• Mutually exclusive projects Accept the project
  with the highest IRR, if IRRgtk.
• Relationship between NPV and IRR
• When a projects IRR is greater than cost of
  capital, the net present value of the project is
  greater than 0.
• IRR gt k, the NPV gt 0
• When a projects IRR is less than cost of
  capital, the net present value of the project is
  less than 0.
• IRRlt k, the NPV lt 0

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Problems with IRR

• For independent projects
• NPV and IRR lead to the same decision.
• For mutually exclusive projects
• NPV and IRR may not lead to the same decision due
  to two problems.
• Project size (scale) differences
• Timing differences in cash flow patterns
• Multiple IRR problem Nonnormal CF patterns (CFs
  having more than one sign change) can result in
  more than one IRR.
• NPV leads to the correct decision in all
  situations.
• If NPV IRR criteria disagree, then use the NPV.

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NPV and IRR always lead to the same accept/reject
decision for independent projects
NPV ()
k gt IRR and NPV lt 0. Reject.
IRR gt k and NPV gt 0 Accept.
k ()
IRR
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Project P has cash flows (in 000s) CF0 -800,
CF1 5,000, and CF2 -5,000. Find Project
Ps NPV and IRR.

• Enter CFs into calculator CFLO register.
• Enter I/YR 10.
• NPV -386.78.
• IRR ERROR Why?

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Multiple IRRs
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Why are there multiple IRRs?

• At very low discount rates, the PV of CF2 is
  large negative, so NPV lt 0.
• At very high discount rates, the PV of both CF1
  and CF2 are low, so CF0 dominates and again NPV lt
  0.
• In between, the discount rate hits CF2 harder
  than CF1, so NPV gt 0.
• Result 2 IRRs.