1、7-1Chapter 7:The Basics of Capital Budgeting:Evaluating Cash FlowsnOverview and“vocabulary”nMethodslPayback,discounted paybacklNPVlIRR,MIRRlProfitability IndexnUnequal livesnEconomic life7-2What is capital budgeting?nAnalysis of potential projects.nLong-term decisions;involve large expenditures.nVer
2、y important to firms future.7-3Steps in Capital BudgetingnEstimate cash flows(inflows&outflows).nAssess risk of cash flows.nDetermine r=WACC for project.nEvaluate cash flows.7-4What is the difference between independent and mutually exclusive projects?Projects are:independent,if the cash flows of on
3、e 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.7-5What 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?7-6Payba
4、ck for Project L(Long:Most CFs in out years)1080600123-100=CFtCumulative-100-90-3050PaybackL2+30/80 =2.375 years01002.47-7Project S(Short:CFs come quickly)7020500123-100CFtCumulative-100-302040PaybackS1 +30/50 =1.6 years10001.6=7-8Strengths of Payback:1.Provides an indication of a projects risk and
5、liquidity.2.Easy to calculate and understand.Weaknesses of Payback:1.Ignores the TVM.2.Ignores CFs occurring after the payback period.7-91080600123CFtCumulative-100-90.91-41.3218.79Discountedpayback2 +41.32/60.11 =2.7 yrsDiscounted Payback:Uses discountedrather than raw CFs.PVCFt-100-10010%9.0949.59
6、60.11=Recover invest.+cap.costs in 2.7 yrs.7-10.10ttntrCFNPVNPV:Sum of the PVs of inflows and outflows.Cost often is CF0 and is negative.101CFrCFNPVttnt7-11Whats Project Ls NPV?108060012310%Project L:-100.009.0949.5960.1118.79 =NPVLNPVS=$19.98.7-12Calculator SolutionEnter in CFLO for L:-10010608010C
7、F0CF1NPVCF2CF3I=18.78=NPVL7-13Rationale for the NPV MethodNPV=PV inflows-Cost=Net gain in wealth.Accept project if NPV 0.Choose between mutually exclusive projects on basis ofhigher NPV.Adds most value.7-14Using NPV method,which project(s)should be accepted?nIf Projects S and L are mutually exclusiv
8、e,accept S because NPVs NPVL.nIf S&L are independent,accept both;NPV 0.7-15Internal Rate of Return:IRR0123CF0CF1CF2CF3CostInflowsIRR is the discount rate that forcesPV inflows=cost.This is the sameas forcing NPV=0.7-16.10NPVrCFttnt tnttCFIRR 010.NPV:Enter r,solve for NPV.IRR:Enter NPV=0,solve for IR
9、R.7-17Whats Project Ls IRR?1080600123IRR=?-100.00PV3PV2PV10=NPVEnter CFs in CFLO,then press IRR:IRRL=18.13%.IRRS=23.56%.7-18 4040 400123IRR=?Find IRR if CFs are constant:-100Or,with CFLO,enter CFs and press IRR=9.70%.3-100 40 0 9.70%NI/YRPVPMTFVINPUTSOUTPUT7-19Rationale for the IRR MethodIf IRR WACC
10、,then the projects rate of return is greater than its cost-some return is left over to boost stockholders returns.Example:WACC=10%,IRR=15%.Profitable.7-20Decisions on Projects S and L per IRRnIf S and L are independent,accept both.IRRs r=10%.nIf S and L are mutually exclusive,accept S because IRRS I
11、RRL.7-21Construct NPV ProfilesEnter CFs in CFLO and find NPVL andNPVS at different discount rates:r 05101520NPVL50 33197 NPVS402920125(4)7-22-1001020304050600510152023.6NPV($)Discount Rate(%)IRRL=18.1%IRRS=23.6%Crossover Point =8.7%r 05101520NPVL5033197(4)NPVS402920125 SL7-23NPV and IRR always lead
12、to the same accept/reject decision for independent projects:r IRRand NPV rand NPV 0Accept.7-24Mutually Exclusive Projectsr 8.7 rNPV%IRRSIRRLLSr NPVS,IRRS IRRLCONFLICT r 8.7:NPVS NPVL,IRRS IRRLNO CONFLICT 7-25To Find the Crossover Rate1.Find cash flow differences between the projects.See data at begi
13、nning 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.7-26Two Reasons NPV Profiles Cross1.Size(scale)differen
14、ces.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 NPVL.7-2
15、7Reinvestment Rate AssumptionsnNPV assumes reinvest at r(opportunity cost of capital).nIRR assumes reinvest at IRR.nReinvest at opportunity cost,r,is more realistic,so NPV method is best.NPV should be used to choose between mutually exclusive projects.7-28Managers like rates-prefer IRR to NPV compar
16、isons.Can we give them a better IRR?Yes,MIRR is the discount rate whichcauses the PV of a projects terminalvalue(TV)to equal the PV of costs.TV is found by compounding inflowsat WACC.Thus,MIRR assumes cash inflows are reinvested at WACC.7-29MIRR=16.5%10.080.060.0012310%66.0 12.1158.1MIRR for Project
17、 L(r=10%)-100.010%10%TV inflows-100.0PV outflowsMIRRL=16.5%$100=$158.1(1+MIRRL)37-30To find TV with 10B,enter in CFLO:I=10NPV=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.CF0=0,CF1=10,CF2=60,CF3=807-31Why use
18、 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.7-32Normal Cash Flow Project:Cost(negative CF)followed by aseries of positive cash inflows.One cha
19、nge of signs.Nonnormal Cash Flow Project:Two or more changes of signs.Most common:Cost(negativeCF),then string of positive CFs,then cost to close project.Nuclear power plant,strip mine.7-33Inflow(+)or Outflow(-)in Year012345NNN-+N-+-NN-+N+-N-+-+-NN7-34Pavilion Project:NPV and IRR?5,000-5,000012r=10%
20、-800Enter CFs in CFLO,enter I=10.NPV=-386.78IRR=ERROR.Why?7-35We got IRR=ERROR because there are 2 IRRs.Nonnormal CFs-two signchanges.Heres a picture:NPV Profile450-8000400100IRR2=400%IRR1=25%rNPV7-36Logic of Multiple IRRs1.At very low discount rates,the PV of CF2 is large&negative,so NPV 0.2.At ver
21、y high discount rates,the PV of both CF1 and CF2 are low,so CF0 dominates and again NPV 0.4.Result:2 IRRs.7-37Could find IRR with calculator:1.Enter CFs as before.2.Enter a“guess”as to IRR by storing the guess.Try 10%:10STO IRR=25%=lower IRRNow guess large IRR,say,200:200STO IRR=400%=upper IRR 7-38W
22、hen there are nonnormal CFs and more than one IRR,use MIRR:012-800,0005,000,000-5,000,000PV outflows 10%=-4,932,231.40.TV inflows 10%=5,500,000.00.MIRR=5.6%7-39Accept Project P?NO.Reject because MIRR=5.6%r=10%.Also,if MIRR NPVS.But is L better?Cant say yet.Need to perform common life analysis.7-42nN
23、ote that Project S could be repeated after 2 years to generate additional profits.nCan use either replacement chain or equivalent annual annuity analysis to make decision.7-43Project S with Replication:NPV=$7,547.Replacement Chain Approach (000s)01234Project S:(100)(100)60 60 60(100)(40)606060607-44
24、Compare to Project L NPV=$6,190.Or,use NPVs:012344,1323,4157,547 4,13210%7-45If the cost to repeat S in two years rises to$105,000,which is best?(000s)NPVS=$3,415 NPVL=$6,190.Now choose L.01234Project S:(100)60 60(105)(45)60607-46Year0123 CF ($5,000)2,100 2,000 1,750 Salvage Value$5,000 3,100 2,000
25、0Consider another project with a 3-year life.If terminated prior to Year 3,the machinery will have positive salvage value.7-471.751.No termination2.Terminate 2 years3.Terminate 1 year(5)(5)(5)2.12.15.2240123CFs Under Each Alternative(000s)7-48NPV(no)=-$123.NPV(2)=$215.NPV(1)=-$273.Assuming a 10%cost
26、 of capital,what is the projects optimal,or economic life?7-49nThe project is acceptable only if operated for 2 years.nA projects engineering life does not always equal its economic life.Conclusions7-50Choosing the Optimal Capital BudgetnFinance theory says to accept all positive NPV projects.nTwo p
27、roblems can occur when there is not enough internally generated cash to fund all positive NPV projects:lAn increasing marginal cost of capital.lCapital rationing7-51Increasing Marginal Cost of CapitalnExternally raised capital can have large flotation costs,which increase the cost of capital.nInvest
28、ors often perceive large capital budgets as being risky,which drives up the cost of capital.(More.)7-52nIf external funds will be raised,then the NPV of all projects should be estimated using this higher marginal cost of capital.7-53Capital RationingnCapital rationing occurs when a company chooses n
29、ot to fund all positive NPV projects.nThe company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.(More.)7-54Reason:Companies want to avoid the direct costs(i.e.,flotation costs)and the indirect costs of issuing new capital.Solution:In
30、crease 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.)7-55Reason:Companies dont have enough managerial,marketing,or engineering staff to implement all positive NPV projects.Solution:Use li
31、near programming to maximize NPV subject to not exceeding the constraints on staffing.(More.)7-56Reason: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.
