26
11 - 1 Copyright © 2002 by Harcourt, Inc. All rights reserved. Should we build this plant? CHAPTER 11 The Basics of Capital Budgeting
11 - 1
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Should we build thisplant?
CHAPTER 11The Basics of Capital Budgeting
11 - 2
Copyright © 2002 by Harcourt, Inc. All rights reserved.
What is capital budgeting?
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
11 - 3
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Steps
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine k = WACC.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
11 - 4
Copyright © 2002 by Harcourt, Inc. All rights reserved.
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.
11 - 5
Copyright © 2002 by Harcourt, Inc. All rights reserved.
An Example of Mutually Exclusive Projects
BRIDGE vs. BOAT to get products across a river.
11 - 6
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Normal Cash Flow Project:
Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.
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.
Normal Cash Flow Project
Nonnormal Cash Flow Project
11 - 7
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
11 - 8
Copyright © 2002 by Harcourt, Inc. All rights reserved.
.
k1CF
NPV tt
n
0t
NPV: Sum of the PVs of inflows and outflows.
11 - 9
Copyright © 2002 by Harcourt, Inc. All rights reserved.
What is Project L’s NPV?
10 8060
0 1 2 310%
Project L:
-100.00
9.09
49.59
60.1118.79 = NPVL
11 - 10
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Calculator Solution
Enter in CFLO for L:
-100
10
60
80
10
CF0
CF1
NPV
CF2
CF3
I = 18.78 = NPVL
11 - 11
Copyright © 2002 by Harcourt, Inc. All rights reserved.
What is Project S’s NPV?
70 2050
0 1 2 310%
Project S:
-100.00
63.64
41.32
15.0319.99 = NPVS
11 - 12
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Calculator Solution
Enter in CFLO for S:
-100
70
50
20
10
CF0
CF1
NPV
CF2
CF3
I = 19.98 = NPVS
11 - 13
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Rationale for the NPV Method
NPV = PV inflows – Cost= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually exclusive projects on basis ofhigher NPV. Adds most value.
11 - 14
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Using NPV method, which project(s) should be accepted?
If Projects S and L are mutually exclusive, accept S because NPVs > NPVL .
If S & L are independent, accept both; NPV > 0.
11 - 15
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3
Cost Inflows
IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.
11 - 16
Copyright © 2002 by Harcourt, Inc. All rights reserved.
.NPV
k1CF
tt
n
0t
.0
IRR1CF
tt
n
0t
NPV: Enter k, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
11 - 17
Copyright © 2002 by Harcourt, Inc. All rights reserved.
What’s Project L’s IRR?
10 8060
0 1 2 3IRR = ?
-100.00
PV3
PV2
PV1
0 = NPV
Enter CFs in CFLO, then press IRR:IRRL = 18.13%.
11 - 18
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Finding IRR Without a Financial Calculator
Find the NPV first. If the NPV is positive, then try an IRR > WACC.
Project L, Try 20%:
100 =(10*1/1.2)+(60*1/(1.2)2) +(80*1/(1.2)3)
100=96.30 Need higher PV, so lower IRR
Answer 10%<IRR<20%, accept (WACC = 10%)
11 - 19
Copyright © 2002 by Harcourt, Inc. All rights reserved.
What’s Project S’s IRR?
70 2050
0 1 2 3IRR = ?
-100.00
PV3
PV2
PV1
0 = NPV
Enter CFs in CFLO, then press IRR:IRRS = 23.56%.
11 - 20
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Finding IRR Without a Financial Calculator
Find the NPV first. If the NPV is positive, then try an IRR > WACC.
Project S, Try 12%:
100 =(70*1/1.12)+(50*1/(1.12)2) +(20*1/(1.12)3)
100=116.60 Need lower PV, so higher IRR
Answer IRR>12%, accept (WACC = 10%)
11 - 21
Copyright © 2002 by Harcourt, Inc. All rights reserved.
90 109090
0 1 2 10IRR = ?
Q. How is a project’s IRRrelated to a bond’s YTM?
A. They are the same thing.A bond’s YTM is the IRRif you invest in the bond.
-1134.2
IRR = 7.08% (use TVM or CFLO).
...
11 - 22
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Rationale for the IRR Method
If IRR > WACC, then the project’s rate of return is greater than its cost--some return is left over to boost stockholders’ returns.
Example: WACC = 10%, IRR = 15%. Profitable.
11 - 23
Copyright © 2002 by Harcourt, Inc. All rights reserved.
IRR Acceptance Criteria
If IRR > k, accept project.
If IRR < k, reject project.
11 - 24
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Decisions on Projects S and L per IRR
If S and L are independent, accept both. IRRs > k = 10%.
If S and L are mutually exclusive, accept S because IRRS > IRRL .
11 - 25
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Prefer NPV to IRR
Can have multiple IRR’s if you have non-normal cash flows.
Can get different results depending on the WACC used when ranking projects using NPV and IRR.
Reinvestment rate assumption makes more sense with NPV than with IRR.
11 - 26
Copyright © 2002 by Harcourt, Inc. All rights reserved.
Reinvestment Rate Assumptions
NPV assumes reinvest at k (opportunity cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
