Capital Budget2

7/30/2019 Capital Budget2

1/39

1

The Basics of

Capital Budgeting


2/39

2

Topics Overview

Methods NPV IRR, MIRR

Payback, discounted payback


3/39

3

What is capital budgeting?A process for determining the

profitability of a capital investment.

Long-term decisions; involve largeexpenditures.

Very important to firms future.


4/39

4

Steps in Capital Budgeting Estimate cash flows (inflows &

outflows).

Assess risk of cash flows.

Determine r = WACC for project.

WACC = Weighted Avg. Cost of Capital

Evaluate cash flows.


5/39


6/39

6

What does this represent?

= n

t = 0

CFt

(1 + r)t


7/39

7

NPV: Sum of the PVs of all

cash flows.

Cost often is CF0 and is negative.

NPV =n

t = 0

CFt

(1 + r)t

NPV =n

t = 1

CFt

(1 + r)t- CF0


8/39

8

Cash Flows for project L and

project S

10 8060

0 1 2 310%

Ls CFs:

-100

70 2050

0 1 2 3

10%Ss CFs:

-100


9/39

9

Whats project Ls NPV?

10 8060

0 1 2 310%

Ls CFs:

-100

= NPVL


10/39

10

Whats project Ls NPV?

10 8060

0 1 2 310%

Ls CFs:

-100

9.09

49.59

60.11

18.79 = NPVL NPVS = $19.98.


11/39

Which project should be chosen?

11

What if mutually exclusive? L or S?What if independent projects? L or S?


12/39

12

Calculator Solution: Enter

values in CF register for L.

-100

10

60

80

10

CF0

CF1

NPV

CF2

CF3

I = 18.78 = NPVL


13/39

13

Rationale for the NPV Method NPV = PV inflows Cost

This is net gain in wealth, so acceptproject if NPV > 0.

Choose between mutually exclusiveprojects on basis of higher NPV. Addsmost value.


14/39

14

Using NPV method, which project(s)

should be accepted? If project S and L are mutually

exclusive, accept S because

NPVs > NPVL .

If S & L are independent, accept both;NPV > 0.


15/39

15

Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3Cost Inflows

IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.


16/39

16

NPV: Enter r, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

= NPVn

t = 0

CFt

(1 + r)t

.

= 0n

t = 0

CFt

(1 + IRR)t.


17/39

17

Whats project Ls IRR?

10 8060

0 1 2 3IRR = ?

-100

PV3

PV2

PV1

0 = NPV Enter Cash Flows in CF, thenpress IRR:


18/39

18

Whats project Ls IRR?

10 8060

0 1 2 3IRR = ?

-100

PV3

PV2

PV1

0 = NPV Enter Cash Flows in CF, thenpress IRR: IRRL = 18.13%.

IRRS = 23.56%.


19/39

19

40 4040

0 1 2 3

-100

Find IRR if CFs are constant:


20/39

20

40 4040

0 1 2 3

-100

Or, with CF, enter CFs and pressIRR = 9.70%.

3 -100 40

9.70%

N I/YR PV PMT

INPUTS

OUTPUT

Find IRR if CFs are constant:


21/39

21

Decisions on Projects S and Lper IRR

IRRS = 18% IRRL = 23% WACC = 10%

If S and L are independent, what to do?

If S and L are mutually exclusive, whatto do?


22/39

22

Rationale for the IRR Method

If IRR > WACC, then the projects rateof return is greater than its cost-- some

return is left over to boost stockholdersreturns.

Example:WACC = 10%, IRR = 15%.

So this project adds extra return toshareholders.


23/39

23

Reinvestment RateAssumptions

NPV assumes reinvest at r (opportunitycost of capital).

IRR assumes reinvest CFs at IRR.

Reinvest at opportunity cost, r, is morerealistic, so NPV method is best. NPV

should be used to choose betweenmutually exclusive projects.


24/39

24

Modified Internal Rate ofReturn (MIRR)

MIRR is the discount rate which causesthe PV of a projects terminal value (TV)

to equal the PV of costs. TV is found by compounding (FV)

inflows at the WACC.

Thus, MIRR assumes cash inflows arereinvested at the WACC.


25/39

25

10.0 80.060.0

0 1 2 3

10%

66.0

12.1158.1

-10010%

10%

TV inflows

-100

PV outflows

MIRR for project L: First, findPV and TV (r = 10%)


26/39

26

Second, find discount rate thatequates PV and TV

MIRR = 16.5% 158.1

0 1 2 3

-100

TV inflowsPV outflows

MIRRL = 16.5%

$100 = $158.1(1+MIRRL)

3


27/39

27

To find TV with calculator:Step 1, find PV of Inflows

First, enter cash inflows in CF register:

CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

Second, enter I = 10.

Third, find PV of inflows: Press NPV = 118.78


28/39

28

Step 2, find TV of inflows.

Enter PV = -118.78, N = 3, I = 10

CPT FV = 158.10 = FV of inflows.


29/39

29

Step 3, find PV of outflows.

For this problem, there is only oneoutflow, CF0 = -100, so the PV of

outflows is -100.


30/39

30

Step 4, find IRR of TV ofinflows and PV of outflows.

Enter FV = 158.10, PV = -100, N = 3.

CPT I = 16.50% = MIRR.


31/39

31

Why use MIRR versus IRR?

MIRR correctly assumes reinvestment atopportunity cost = WACC. MIRR also

avoids the problem of multiple IRRs. Managers like rate of return

comparisons, and MIRR is better for this

than IRR.


32/39

32

What is the payback period?

The number of years required torecover a projects cost,

or how long it takes to get thebusinesss money back.


33/39


33

50 5050

0 1 2 3

-100


34/39


34

40 4040

0 1 2 3

-100


35/39

35

What are the payback periodsfor projects L and S?

10 8060

0 1 2 310%

Ls CFs:

-100

70 2050

0 1 2 3

10%Ss CFs:

-100


36/39

36

Payback for project L

10 8060

0 1 2 3

-100

=

CFtCumulative -100 -90 -30 50

PaybackL 2 + 30/80 = 2.375 years

0

2.4


37/39

37

Payback for project S

70 2050

0 1 2 3

-100CFt

Cumulative -100 -30 20 40

PaybackS 1 + 30/50 = 1.6 years

0

1.6

=


38/39

38

Strengths and Weaknesses ofPayback

Strengths:

Provides an indication of a projects risk

and liquidity. Easy to calculate and understand.

Weaknesses:

Ignores the TVM. Ignores CFs occurring after the payback

period.


39/39

39

10 8060

0 1 2 3

CFt

Cumulative -100 -90.91 -41.32 18.79Discountedpayback 2 + 41.32/60.11 = 2.7 yrs

PVCFt -100

-100

10%

9.09 49.59 60.11

=

R i i 2 7

Discounted Payback: Usesdiscounted rather than raw CFs.

Date post:	04-Apr-2018
Category:	Documents
Upload:	hilario-ponce-saplada
View:	221 times
Download:	0 times

Capital Budget2

Documents