Title: Capital Budgeting: Decision Criteria
1Capital Budgeting Decision Criteria
2What is Capital Budgeting?
- Analysis of potential additions to fixed assets
- Long-term decisions
- Large expenditures
- Very important to firms future
- strategic direction
3Overview of the Process
- Estimate expected cash flows (inflows and
outflows) - Assess the riskiness of CFs
- Determine the cost of capital (r WACC)
- Evaluate
- Techniques for evaluation
- Payback, Discounted Payback, NPV, IRR,
Profitability Index, MIRR
4Some definitions to get started
- Mutually exclusive
- If one project is taken other is rejected
- ______ Cash Flow Project
- Cost (negative CF) followed by positive CFs
- ONE sign change
- _______ Cash Flow Project
- Two or more sign changes
- Usually cost to close project (example Nuclear
Power Plant)
5Normal versus Nonnormal
Inflow () or Outflow (-) in Year
or
0
1
2
3
4
5
N
NN
-
N
-
-
NN
-
-
-
N
-
-
-
N
-
-
-
NN
6Example Set Up
- Evaluating two mutually exclusive projects (S and
L) with expected CFsYear L S0 -150 -1501
15 1052 90 753 120 30(Note Depr, net
working capital requirements, and tax effects are
included in CFs)Both have required rates of
return of 10.
7Payback Period
- The number of years required to cover a projects
cost - ExampleFor LYear CF Cum.CF
- Payback Year before full recovery
(unrecovered cost at start of yr/CF during yr)
8Discounted Payback Period
- Discount CFs at projects cost of capital
- ExampleFor LYear CF PV of CF Cum.Discou
nted payback
9Payback Analysis
- Breakeven calculation
- Regular ignores cost of capital (TVM)
- Both ignore CFs after payback period
- Serious deficiencies
- Purposes
- Provides information on project _______
- One indicator of projects riskiness
10Net Present Value
- Sum of the PVs of inflows and outflows
- Formula where CFt is expected net CF at time
t, r is projects cost of capital, and n is
life of project.
11Net Present Value
Project L
0
1
2
3
10
15
120
90
-150.00
NPV L
12Net Present Value
- Rationale for NPV
- 0 means CFs are just sufficient to repay
invested capital and to provide the required rate
of return on capital - indifferent
- means excess CFs that accrue solely to the
firms stockholders - improves S/H wealth
- If mutually exclusive, choose higher NPV
- Choose S or L? What if they were independent?
13Internal Rate of Return (IRR)
- Discount rate which equates the PV of expected
cash inflows to the PV of projects costs - Rate which forces NPV 0
- Formula
14IRR Example
0
1
2
3
IRR ?
-150.00
15
120
90
15IRR
- Rationale
- If IRR gt WACC, then the projects rate of return
is ______ than its costs (some return is left
over to boost S/H return) - Decisions
- Accept if IRR gt WACC
- Reject if IRR lt WACC
- Choose S or L? What if they were independent?
16Comparing NPV and IRR
- If projects are independent, IRR and NPV give
same rankings - If projects are mutually exclusive, can give
conflicting rankings - NPV Profile
- Graph that plots a projects NPV against the
discount rate - Find NPV at different discount rates and plot
17NPV Profile
r 0 5 10 15 20
NPVL 75 50 28 10 (6)
NPVS 60 44 30 18 7
NPV ()
Crossover Point 8.7
S
IRRS 23.6
L
Discount Rate ()
IRRL 18.1
18NPV Profile
- From graph
- If r gt 8.7
- NPVS gt NPVL AND IRRS gt IRRL
- No conflict
- If r lt 8.7
- NPVL gt NPVS AND IRRS gt IRRL
- Conflict
- When does this occur?
- Project size (scale) differences exist or timing
differences exist
19Finding the Crossover Rate
- Find CF differences
- Use differences as CFs and solve for IRR
- Example CF0 -150 - -150 0 CF1 15 - 105
-90 CF2 90 - 75 15 CF3 120 - 30 90,
IRR? - Can use S - L or L - S
- Note If profiles do not cross, then one project
dominates. Conflict???
20Reinvestment Rates
- Why are there conflicts?
- NPV assumes firm reinvests at the cost of capital
while IRR assumes firm reinvests at the IRR - Reinvestment at WACC is more realistic
- Use NPV for mutually exclusive projects
21Nonnormal Projects and IRR
- Nonnormal projects can cause
- Wrong IRR decision, no IRR, or multiple IRRs
- Example CF0 -800, CF1 5000, CF2 -5000, IRR?
- IRR ERROR
- But, if i10, NPV -386.78
- Why no IRR?
- Nonnormal two IRRs
22Nonnormal Projects and IRR
NPV Profile
NPV
IRR2 400
250
0
r
400
100
IRR1 25
-375
Also possible for line never to touch x axis.
Then, no IRR.
23Logic of 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 - MIRR will work (explained later)!
- Try for practice MIRR5.6
24Nonnormal Projects and IRR
- Example of Wrong DecisionYear L B0 -100,000
83,3331 120,000 -100,000IRR 20 for
bothNPVL 9,091NPVB -7,576B Borrowing, so
B is acceptable only if IRR is LESS than r
25Modified IRR
- Modified IRR (MIRR)
- Discount rate which causes PV of projects
terminal value (TV) to equal the PV of costs.
The TV is found by compounding inflows at WACC.
MIRR assumes cash inflows are reinvested at WACC. - MIRR solves the multiple IRR problem
- If projects differ in size, still can have
conflicts
26MIRR for L when r10
0
1
2
3
r 10
15.00
120.00
90.00
-150.00
27IRR, MIRR, NPV
- MIRR is superior to IRR as an indicator of
projects true return - NPV is still better for mutually exclusive
projects
28Profitability Index
- Benefit/cost ratiowhere CIF are cash
inflows (benefits) and COF are outflows (costs)
29PI Example
PI
L
Accept project if PI gt 1.0.
30Conclusions
- Many firms calculate all
- Payback
- risk and liquidity
- NPV
- direct measure of dollar benefit
- single best measure of profitability
- IRR
- gives return
- MIRR
- better reinvestment rate assumption
- PI
- bang per buck
31Comparing Projects with Unequal Lives
- Adjustment is needed (common life analysis)
- Easiest (most used) approach is replacement chain
method - ExampleYear S L0 -100 -100 1 60
33.52 60 33.53 33.54 33.5 - If i10, NPVS4,132 and NPVL6,190
- Which do we choose?
- Note that S could be repeated after 2 years
32Comparing Projects with Unequal Lives
33Comparing Projects with Unequal Lives
Or, use NPVs
0
1
2
3
4
4,132 3,415 7,547
4,132
10
Compare to Project L NPV 6,190.
34Comparing Projects with Unequal Lives
- When do we worry about this?
- Mutually exclusive projects with significantly
different ______ - Only if high probability project will be repeated
- Weaknesses
- ignores inflation, new technologies, etc.
- Can make some adjustments
- estimating series may just be speculation
35Abandonment Value
- Normally assume full life
- May be best to abandon before
- Example New Coke
- Project should be abandoned if value w/
abandoning gt PV of future CFs w/o abandoning - Sell to someone else (i.e., salvage value)
- Abandon if losing money
36Abandonment Value
- Consider the following 3-year projectYear CF Sa
lvage Value0 -5000 50001 2100 31002 2000
20003 1750 0
37Abandonment Value
- What is optimal life if i10?
- Engineering (physical) life does not always equal
economic life - Ability to abandon may make otherwise
unattractive project acceptable
38Choosing the Optimal Capital Budget
- Optimal maximizes value of firm
- Finance theory says to accept all positive NPV
projects. - Two problems can occur when there is not enough
internally generated cash to fund all positive
NPV projects - An increasing marginal cost of capital
- Capital rationing
39Problem
- Edelman Engineering is considering a truck and an
overhead pulley system. Projects are
independent. The truck costs 17,100 and the
pulley costs 22,430. Firms cost of capital is
14. The following are the after-tax
cfs Truck PulleyYear 1 5100 7500Year
2 5100 7500 Year 3 5100 7500Year
4 5100 7500Year 5 5100 7500 - Calculate NPV, IRR, MIRR.
- Indicate accept/reject decision for each.