Capital Budgeting: Decision Criteria

1
Capital Budgeting Decision Criteria

• Chapter 12

2
What is Capital Budgeting?

• Analysis of potential additions to fixed assets
• Long-term decisions
• Large expenditures
• Very important to firms future
• strategic direction

3
Overview 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

4
Some 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)

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





N
-




-
NN
-
-
-



N



-
-
-
N
-


-

-
NN
6
Example 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.

7
Payback 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)

8
Discounted Payback Period

• Discount CFs at projects cost of capital
• ExampleFor LYear CF PV of CF Cum.Discou
  nted payback

9
Payback 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

10
Net 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.

11
Net Present Value
Project L
0
1
2
3
10
15
120
90
-150.00
NPV L
12
Net 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?

13
Internal 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

14
IRR Example
0
1
2
3
IRR ?
-150.00
15
120
90
15
IRR

• 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?

16
Comparing 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

17
NPV 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
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NPV 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

19
Finding 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???

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Reinvestment 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

21
Nonnormal 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

22
Nonnormal 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.
23
Logic 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

24
Nonnormal 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

25
Modified 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

26
MIRR for L when r10
0
1
2
3
r 10
15.00
120.00
90.00
-150.00
27
IRR, MIRR, NPV

• MIRR is superior to IRR as an indicator of
  projects true return
• NPV is still better for mutually exclusive
  projects

28
Profitability Index

• Benefit/cost ratiowhere CIF are cash
  inflows (benefits) and COF are outflows (costs)

29
PI Example

PI
L
Accept project if PI gt 1.0.
30
Conclusions

• 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

31
Comparing 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

32
Comparing Projects with Unequal Lives
33
Comparing 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.
34
Comparing 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

35
Abandonment 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

36
Abandonment Value

• Consider the following 3-year projectYear CF Sa
  lvage Value0 -5000 50001 2100 31002 2000
  20003 1750 0

37
Abandonment 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

38
Choosing 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

39
Problem

• 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.