The Basics of Capital Budgeting: Evaluating Cash Flows

1
The Basics of Capital Budgeting Evaluating
Cash Flows

• Overview and vocabulary
• Methods
• Payback, discounted payback
• NPV
• IRR, MIRR
• Profitability Index
• Unequal lives

2
What is capital budgeting?

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

3
Project Classifications

• Replacement, maintenance of business.
• Replacement, cost reduction.
• Expansion of existing products or markets.
• Expansion into new products and markets.
• Safety and/or environment projects.
• Research and development

4
What is the difference between independent and
mutually exclusive projects?

• Projects are
• mutually exclusive, (birbirini dislayan) Mutually
  exclusive projects
• If you choose one, you cant choose the other
• Example You can choose to attend graduate school
  at either Harvard or Stanford, but not both
• independent, otherwise.

5
Capital Budgeting Decision Rules

• Payback
• Discounted payback
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Modified Internal Rate of Return (MIRR)
• Profitability Index (PI)

6
Good Decision Criteria

• We need to ask ourselves the following questions
  when evaluating decision criteria
• Does the decision rule adjust for the time value
  of money?
• Does the decision rule adjust for risk?
• Does the decision rule provide information on
  whether we are creating value for the firm?

7
What is the payback period?
The number of years required to recover a
projects cost, or how long does it take to get
the businesss money back?
8
Payback for Franchise L(Long Most CFs in out
years)
2.4
0
1
2
3
10
80
60
-100
CFt
100
Cumulative
-100
-90
-30
50
0

PaybackL
2 30/80 2.375 years
9
Franchise S (Short CFs come quickly)
1.6
0
1
2
3
70
20
50
-100
CFt
100
Cumulative
-100
-30
20
40
0
PaybackS
1 30/50 1.6 years

10
Advantages and Disadvantages of Payback

• Advantages
• Easy to understand
• Adjusts for uncertainty of later cash flows
• Biased towards liquidity

• Disadvantages
• Ignores the time value of money
• Requires an arbitrary cutoff point
• Ignores cash flows beyond the cutoff date
• Biased against long-term projects, such as
  research and development, and new projects

11
Discounted Payback Uses discounted rather than
raw CFs. (Ex.Project L)
0
1
2
3
10
10
80
60
CFt
-100
PVCF0
-100
9.09
49.59
60.11
Cumulative
-100
-90.91
-41.32
18.79
Discounted payback
2 41.32/60.11 2.7 yrs

Recover invest. cap. costs in 2.7 yrs.
12
Advantages and Disadvantages of Discounted Payback

• Advantages
• Easy to understand
• Includes time value of money
• Biased towards liquidity
• Does not accept negative estimated NPV
  investments

• Disadvantages
• Requires an arbitrary cutoff point
• Ignores cash flows beyond the cutoff point
• Biased against long-term projects, such as RD
  and new products
• May reject positive NPV investments

13
Net Present Value

• It is the difference between the market value of
  a project and its cost
• Output How much value is created from
  undertaking an investment
• Steps
• 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.

14
NPV Sum of the PVs of inflows and outflows.
Cost often is CF0 and is negative.
15
Whats Franchise Ls NPV?
Project L
0
1
2
3
10
10
80
60
-100.00
9.09
49.59
60.11
18.79 NPVL
NPVS 19.98.
16
Rationale for the NPV Method
NPV PV inflows - Cost Net gain in
wealth. Accept project if NPV gt 0. Choose
between mutually exclusive projects on basis
of higher NPV. Adds most value.
17
NPV Decision Rule

• 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.

18
Using NPV method, which franchise(s) should be
accepted?

• NPVL 18.79, NPVS 19.98
• If Franchise S and L are mutually exclusive,
  accept S because NPVs gt NPVL
• If S L are independent, accept both NPV gt 0.

19
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.
20
NPV Enter r, solve for NPV.
IRR Enter NPV 0, solve for IRR.
21
Whats Franchise Ls IRR?
0
1
2
3
IRR ?
10
80
60
-100.00
PV1
PV2
PV3
0 NPV
Method Trial and error.
IRRL 18.13.
IRRS 23.56.
22
Rationale for the IRR Method

• Decision rule Accept the project if the IRR is
  greater than the required rate of return, a
  benchmark rate.
• Required rate of return cost of capital
• If IRR gt WACC, then the projects rate of return
  is greater than its cost-- some return is left
  over to boost stockholders returns.
• Example IRR 15 gt WACC 10,
• Profitable.

23
Advantages of IRR

• Knowing a return is intuitively appealing
• It is a simple way to communicate the value of a
  project to someone who doesnt know all the
  estimation details
• If the IRR is high enough, you may not need to
  estimate a required return, which is often a
  difficult task

24
Decisions on Projects S and L per IRR

• IRRL 18.13, IRRS 23.56.
• If S and L are independent, accept both. IRRs gt
  required r 10.
• If S and L are mutually exclusive, accept S
  because IRRS gt IRRL .

25
Comparison Compare NPV and IRR
NPV profile Find NPVL and NPVS at different
discount rates
NPVL 50 33 19 7
NPVS 40 29 20 12 5
r 0 5 10 15 20
(4)
26
NPV ()
r 0 5 10 15 20
NPVL 50 33 19 7 (4)
NPVS 40 29 20 12 5
Crossover Point 8.7
S
IRRS 23.6
L
Discount Rate ()
IRRL 18.1
27
NPV and IRR always lead to the same accept/reject
decision for independent projects
NPV ()
r gt IRR and NPV lt 0. Reject.
IRR gt r and NPV gt 0 Accept.
r ()
IRR IRR hurdle rate r
28
Mutually Exclusive Projects
NPV
r lt 8.7 NPVLgt NPVS , IRRS gt IRRL CONFLICT
L
r gt 8.7 NPVSgt NPVL , IRRS gt IRRL NO CONFLICT
IRRS
S

r 8.7 r
IRRL
29
Example With Mutually Exclusive Projects
The required return for both projects is
10. Which project should you accept and why?
30
To Find the Crossover Rate
1. Find cash flow differences between the
projects. See data at beginning of the
case. 2. Find the IRR for this new stream of
differential cash flows. That is the crossover
rate. 3. Can subtract S from L or vice versa, but
better to have first CF negative. 4. If profiles
dont cross, one project dominates the other.
31
Two Reasons NPV Profiles Cross and thus conflicts
to arise between NPV and IRR
1. Size (scale) differences. Smaller project
frees up funds at t 0 for investment. The
higher the opportunity cost, the more valuable
these funds, so high r favors small
projects. 2. Timing differences. Project with
faster payback provides more CF in early years
for reinvestment. If r is high, early CF
especially good, (NPVS gt NPVL).
32
Reinvestment Rate Assumptions

• NPV assumes that cash flows can be reinvested at
  r (opportunity cost of capital).
• IRR assumes that cash flows are reinvested at
  IRR.
• Which assumption is better?
• Reinvest at opportunity cost, r, is more
  realistic, so NPV method is best. NPV should be
  used to choose between mutually exclusive
  projects.

33
Managers like rates--prefer IRR to NPV
comparisons. Can we give them a better IRR?
Yes, MIRR is the discount rate which causes the
PV of a projects terminal value (TV) to equal
the PV of costs. TV is found by compounding
inflows at WACC.
Thus, MIRR assumes cash inflows are reinvested at
WACC.
34
MIRR

• Calculate the PV of the cash outflows Using the
  required rate of return.
• Calculate the FV of the cash inflows at the last
  year of the projects time line Using the
  required rate of return. This is called the
  terminal value (TV).
• MIRR is the discount rate that equates the PV of
  the cash outflows with the PV of the terminal
  value, ie, that makes
• PVoutflows PVinflows

35
MIRR for Franchise L (r 10)
0
1
2
3
10
10.0
80.0
60.0
-100.0
10
66.0 12.1
10
MIRR
158.1
-100.0
TV inflows
PV outflows
MIRRL 16.5
36
MIRR for Franchise S (r 10)
0
1
2
3
10
70.0
20.0
50.0
-100.0
10
55.0 84.7
10
MIRR 11.8
159.7
-100.0
TV inflows
PV outflows
MIRRS 16.9
37
Why use MIRR versus IRR?
MIRR correctly assumes reinvestment at
opportunity cost WACC. MIRR also avoids the
problem of multiple IRRs. Managers like rate of
return comparisons, and MIRR is better than IRR.
38
Normal Cash Flow Project
Cost (negative CF) followed by a series of
positive cash inflows. One change of signs.
Nonnormal Cash Flow Project
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.
39
Inflow () or Outflow (-) in Year
0
1
2
3
4
5
N
NN
-





N
-




-
NN
-
-
-



N



-
-
-
N
-


-

-
NN
40
Pavilion Project NPV and IRR?
0
1
2
r 10
5,000
-5,000
-800
NPV -800 5000/1.1 5000/1.21
-8004545.45-4132.23 NPV - 386.78 IRR NPV
-800 5000/(1IRR) 5000/(1IRR)2 The machine
would give error message. Why?
41
We got IRR ERROR because there are 2 IRRs.
Nonnormal CFs--two sign changes. Heres a
picture
NPV Profile
NPV
IRR2 400
450
0
r
400
100
IRR1 25
-800
42
Logic of Multiple IRRs
1. At very low discount rates, the PV of CF2 is
large negative, so NPV lt 0. 2. At very high
discount rates, the PV of both CF1 and CF2 are
low, so CF0 dominates and again NPV lt 0. 3. In
between, the discount rate hits CF2 harder than
CF1, so NPV gt 0. 4. Result 2 IRRs.
43
When there are nonnormal CFs and more than one
IRR, use MIRR
0
1
2
-800
5,000
-5,000
PV outflows _at_ 10 -800 - 4,132.23-4932.23.
TV inflows _at_ 10 5,500,00.
MIRR 0.056 gt 5500 / (1MIRR)2 4932.23
44
Accept Project P?
NO. Reject because MIRR 5.6 lt r 10. Also,
if MIRR lt r, NPV will be negative NPV -386.7.
45
Profitability Index

• The PI shows the relative profitability of any
  project, or
• The present value per dollar of initial cost.
• PI PV of future cash flows / Initial cost
• A project is acceptable if its PI is greater than
  1.
• PIL 118.79 / 100 1.1879
• PIS 119.98 / 100 1.1998

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Summary of Decisions For The Projects Assuming
They are Independent
47
Summary of Decisions For The Projects Assuming
They are Mutually Independent
48
Summary

• Mathematically, the NPV, IRR, MIRR, and PI
  methods will always lead to the same
  accept/reject decisions for independent projects.
• However, these methods can give conflicting
  rankings for mutually exclusive projects.