Chapter 11: Capital Budgeting: Decision Criteria

1
Chapter 11 Capital Budgeting Decision
Criteria

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

2
Overview of Capital Budgeting

• Capital Budget
• Outline of planned investments in operating
  assets
• Capital Budgeting
• Whole process of analyzing projects and deciding
  which ones to include in the capital budget

3
Overview of Capital Budgeting

• Analysis of potential projects
• Identifying those projects that add value
• Long-term decisions involve large expenditures
• Very important to firms future
• Too much investment
• Firm incurs unnecessary high depreciation and
  other expenses
• Too little investment
• Old equipment
• Uncompetitive
• Loss of market share

4
Project Classification

• Replacement
• Maintenance of business
• Cost reduction
• Expansion
• Existing products or markets
• New products or markets
• Safety and/or environmental projects
• Research and Development
• Long-term contracts

5
Steps in Capital Budgeting

• Estimate cash flows
• (inflows outflows)
• Assess risk of cash flows
• Determine r WACC for project
• Evaluate cash flows

6
What is the difference between independent and
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.

7
Mini Case Chapter 11Page 406

• Required rate of return 10

8
Franchise L (Long Most CFs in later years)
Mini Case Cash Flows
Franchise S (Short CFs come quickly)
9
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?
10
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
11
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

12
Strengths of Payback
1. Provides an indication of a projects risk and
liquidity. 2. Easy to calculate and understand.
Weaknesses of Payback
1. Ignores the TVM (regular payback). 2. Ignores
CFs occurring after the payback period.
13
Discounted Payback Uses discounted rather than
raw CFs.
0
1
2
3
10
10
80
60
CFt
-100
PVCFt
-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.
14
Net Present Value (NPV)
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
Calculator Solution
Enter in CFLO for L
-100 10 60 80 10
CF0
CF1
CF2
CF3
NPV
I
18.78 NPVL
17
Whats Franchise Ss NPV?
Project S
0
1
2
3
10
70
20
50
-100.00
63.64
41.32
15.03
NPVS 19.98.
18
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.
19
Using NPV method, which franchise(s) should be
accepted?

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

20
Internal Rate of Return IRR
IRR is the discount rate that equates the present
value of a projects expected cash inflows to the
present value of the projects costs PV
(Investment costs) PV (Inflows) Or the rate
that forces NPV to equal zero
21
NPV Enter r, solve for NPV.
IRR Enter NPV 0, solve for IRR.
22
Whats Franchise Ls IRR?
23
Whats Franchise Ls IRR?
Find the discount rate that equates PV
(Investment costs) PV (Inflows)
Enter CFs in CFLO, then press IRR
IRRL 18.13.
IRRS 23.56.
24
Find IRR if CFs are constant
0
1
2
3
IRR ?
40
40
40
-100
INPUTS
3 -100 40 0 9.70
OUTPUT
Or, with CFLO, enter CFs and press IRR 9.70.
25
Rationale for the IRR Method
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 WAC
C 10, IRR 15. Profitable.
26
Decisions on Projects S and L per IRR

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

27
Construct NPV Profiles
Enter CFs in CFLO and find NPVL and NPVS at
different discount rates
r 0 5 10 15 20
NPVS 40 29 20 12 5
28
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
29
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
30
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
31
To Find the Crossover Rate
1. Find cash flow differences between the
projects. See data at beginning of the
case. 2. Enter these differences in CFLO
register, then press IRR. Crossover rate
8.68, rounded to 8.7. 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.
32
To Find the Crossover Rate
33
Two Reasons NPV Profiles Cross
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.
34
Reinvestment Rate Assumptions

• NPV assumes reinvest at r (opportunity cost of
  capital).
• IRR assumes reinvest at IRR.
• Reinvest at opportunity cost, r, is more
  realistic, so NPV method is best. NPV should be
  used to choose between mutually exclusive
  projects.

35
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.
36
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 16.5
158.1
-100.0
TV inflows
PV outflows
MIRRL 16.5
37
To find TV with 10B, enter in CFLO
CF0 0, CF1 10, CF2 60, CF3 80
I 10
NPV 118.78 PV of inflows.
Enter PV -118.78, N 3, I 10, PMT 0. Press
FV 158.10 FV of inflows.
Enter FV 158.10, PV -100, PMT 0, N
3. Press I 16.50 MIRR.
38
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 for this
than IRR.
39
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.
40
Inflow () or Outflow (-) in Year
0
1
2
3
4
5
N
NN
-





N
-




-
NN
-
-
-



N



-
-
-
N
-


-

-
NN
41
Pavilion Project NPV and IRR?
0
1
2
r 10
5,000
-5,000
-800
Enter CFs in CFLO, enter I 10.
NPV -386.78
IRR ERROR. Why?
42
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
43
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.
44
When there are nonnormal CFs and more than one
IRR, use MIRR
PV outflows _at_ 10 -4,932,231.40.
FV inflows _at_ 10 5,500,000.00.
MIRR 5.6
45
Accept Project P?
NO. Reject because MIRR 5.6 lt r
10. Also, if MIRR lt r, NPV will be negative
NPV -386,777.
46
Profitability Index?
Project L PV of future cash flows
118.79 Initial cost 100 ? PI
1.19 Project L is expected to produce 1.19
present value for each invested.
47
Comparing Projects with Unequal Lives
When one has to chose between two Mutually
Exclusive alternatives with significant different
lives, an adjustment is necessary.
48
S and L are mutually exclusive and will be
repeated. r 10. Which is better? (000s)
0
1
2
3
4
Project S (100) Project L (100)
60 33.5
60 33.5
33.5
33.5
49
S L CF0 -100,000
-100,000 CF1 60,000 33,500 Nj
2 4 I 10 10 NPV 4,132
6,190
NPVL gt NPVS. But is L better? Cant say yet.
Need to perform common life analysis.
50

• Note that Project S could be repeated after 2
  years to generate additional profits.
• Can use either replacement chain or equivalent
  annual annuity analysis to make decision.

51
Franchise S with Replication
Replacement Chain Approach (000s)
0
1
2
3
4
Franchise S (100) (100)
60 60
60 (100) (40)
60 60
60 60
NPV 7,547.
52
Or, use NPVs
0
1
2
3
4
4,132 3,415 7,547
4,132
10
Compare to Franchise L NPV 6,190.
53
Serious Weaknesses

• If inflation is expected, equipment will have
  higher price.
• Replacement might employ new technology.
• Difficult to estimate the lives of a series of
  projects.

54
If the cost to repeat S in two years rises to
105,000, which is best? (000s)
0
1
2
3
4
Franchise S (100)
60
60 (105) (45)
60
60
NPVS 3,415 lt NPVL 6,190. Now choose L.
55
Economic Life versus Physical Life.
Consider another project with a 3-year life. If
terminated prior to Year 3, the machinery will
have positive salvage value.
56
CFs Under Each Alternative (000s)
0
1
2
3
1.75
1. No termination 2. Terminate 2 years 3.
Terminate 1 year
(5) (5) (5)
2.1 2.1 5.2
2 4
57
Assuming a 10 cost of capital, what is the
projects optimal, or economic life?
NPV(no termination) -123. NPV(terminate after
2 yrs) 215. NPV(terminate after 1 yr)
-273.
58
Conclusions

• The project is acceptable only if operated for 2
  years.
• A projects engineering life does not always
  equal its economic life.

59
Choosing the Optimal Capital Budget

• 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

60
Increasing Marginal Cost of Capital

• Externally raised capital can have large
  flotation costs, which increase the cost of
  capital.
• Investors often perceive large capital budgets as
  being risky, which drives up the cost of capital.
• If external funds will be raised, then the NPV of
  all projects should be estimated using this
  higher marginal cost of capital.

61
Capital Rationing

• Capital rationing occurs when a company chooses
  not to fund all positive NPV projects.
• The company typically sets an upper limit on the
  total amount of capital expenditures that it
  will make in the upcoming year.

(More...)
62

• Reason Companies want to avoid the direct costs
  (i.e., flotation costs) and the indirect costs of
  issuing new capital.
• Solution Increase the cost of capital by enough
  to reflect all of these costs, and then accept
  all projects that still have a positive NPV with
  the higher cost of capital.

(More...)
63

• Reason Companies dont have enough managerial,
  marketing, or engineering staff to implement all
  positive NPV projects.
• Solution Use linear programming to maximize NPV
  subject to not exceeding the constraints on
  staffing.

(More...)
64

• Reason Companies believe that the projects
  managers forecast unreasonably high cash flow
  estimates, so companies filter out the worst
  projects by limiting the total amount of projects
  that can be accepted.
• Solution Implement a post-audit process and tie
  the managers compensation to the subsequent
  performance of the project.