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CHAPTER 11
The Basics of Capital Budgeting
Should we build this plant?
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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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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+ N
NN N
NN
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The number of years required to recover a projects cost, or how long does it take to get our money back?
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2.4
3 80 50
60 100 -30 0
= 2.375 years
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1.6 2
3
20 40
70 100 50 -30 0 20
Cumulative -100
PaybackL
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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. 2. Ignores CFs occurring after the payback period.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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10%
1 10 9.09 -90.91
2 60 49.59 -41.32
3 80 60.11 18.79
Cumulative -100
Discounted = 2 payback
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CFt NPV t . t 0 1 k
n
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Whats Project Ls NPV? Project L: 0 -100.00 9.09 49.59 60.11 18.79 = NPVL
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10%
1 10
2 60
3 80
NPVS = $19.98.
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Calculator Solution
CF0
CF1
10
60
CF2
CF3 I NPV = 18.78 = NPVL
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80
10
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Rationale for the NPV Method NPV = PV inflows Cost = Net gain in wealth. Accept project if NPV > 0.
Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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If Projects S and L are mutually exclusive, accept S because NPVs > NPVL . If S & L are independent, accept both; NPV > 0.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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1 10
2 60
3 80
0 = NPV
Enter CFs in CFLO, then press IRR: IRRL = 18.13%. IRRS = 23.56%.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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1
40
2
40
-100
PV
3
40
40
PMT
0
FV
9.70%
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Q.
A.
How is a projects IRR related to a bonds YTM? They are the same thing. A bonds YTM is the IRR if you invest in the bond.
1
IRR = ?
10
...
90 90 1090
-1134.2
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If IRR > WACC, then the projects rate of return is greater than its cost--some return is left over to boost stockholders returns. Example: WACC = 10%, IRR = 15%. Profitable.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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NPVL 50 33 19 7 (4 (4)
NPVS 40 29 20 12 5
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NPV ($)
60
. 40 .
50 30 20 10
. .
k 0 5 10 15 20
NPVL 50 33 19 7 (4)
NPVS 40 29 20 12 5
.
L
5 10
. .
15
0
-10
. . 20
IRRS = 23.6%
.
23.6
IRRL = 18.1%
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NPV and IRR always lead to the same accept/reject decision for independent projects:
NPV ($)
k (%) IRR
Copyright 2001 by Harcourt, Inc. All rights reserved.
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k < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT k > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT
IRRS
8.7
%
IRRL
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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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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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 k favors small projects. 2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?
Yes, MIRR is the discount rate that causes the PV of a projects terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC.
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1 10.0
10%
2 60.0
10%
3 80.0
-100.0
MIRR = 16.5%
-100.0 PV outflows
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To find TV with HP 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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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0 -800
k = 10%
1 5,000
2 -5,000
Enter CFs in CFLO, enter I = 10. NPV = -386.78 IRR = ERROR. Why?
Copyright 2001 by Harcourt, Inc. All rights reserved.
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We got IRR = ERROR because there are 2 IRRs. Nonnormal CFs--two sign changes. Heres a picture:
NPV
NPV Profile
IRR2 = 400%
400
-800
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2. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0.
3. In between, the discount rate hits CF2 harder than CF1, so NPV > 0.
4. Result: 2 IRRs.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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When there are nonnormal CFs and more than one IRR, use MIRR:
0 -800,000 1 5,000,000 2 -5,000,000
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Accept Project P?
NO. Reject because MIRR = 5.6% < k = 10%. Also, if MIRR < k, NPV will be negative: NPV = -$386,777.