Ch10 PPT Brighamfm1ce

PowerPoint Presentation
prepared by
Traven Reed Canadore College
chapter 10
The Basics of Capital Budgeting: Evaluating Cash Flows
Corporate Valuation and Capital Budgeting

CH10
Copyright 2011 by Nelson Education Ltd. All rights reserved.
10-3
Topics
CH10
Overview of capital budgeting Methods

NPV IRR, MIRR Profitability Index Payback, discounted payback
Unequal lives Economic life Capital rationing

10-4
What is capital budgeting?

CH10
Plan and manage capital expenditures for long-lived assets. Analysis of potential projects. Long-term decisions. Involve large commitments. Very important to firms future.
10-5
Steps in Capital Budgeting

CH10
Estimate cash flows (inflows & outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows.
10-6
Independent versus Mutually Exclusive Projects

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Projects are:
independent, if the cash flows of one are unaffected by the acceptance of the other. Projects stand on their own. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other. All other alternatives are automatically deleted once a project is choice.
10-7
Cash Flows for Project L and Project S

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0 Ls CFs:
10%
1 10 1 70
2 60 2 50
3 80 3 20
-100.00 0 Ss CFs: 10%
-100.00
10-8
NPV: Sum of the PVs of all cash flows

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NPV =
t=0
CFt (1 + r)t
Cost often is CF0 and is negative.

n
NPV =
t=1
CFt . - CF0 (1 + r)t

10-9
Whats Project Ls NPV?

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0 Ls CFs: -100.00
10%
1 10
2 60
3 80
9.09 49.59 60.11 18.79 = NPVL
NPVS = $19.98
10-10
Calculator Solution: Project L

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-100 10 60 80 10
CF0 CF1 CF2 CF3 I NPV = 18.78 = NPVL

10-11
Rationale for the NPV Method

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NPV = PV inflows Cost This is net gain in wealth in dollar terms ($), so accept project only if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value. NPV > 0 implies EVA > 0 and MVA > 0.
10-12
Using NPV method, which project(s) should be accepted?

CH10
If Project S and Project L are mutually exclusive, accept S because NPVs > NPVL . If S & L are independent, accept both because NPV > 0.
10-13
Internal Rate of Return: IRR

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0 CF0 Cost
1 CF1
2 CF2 Inflows
3 CF3
IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0
10-14
NPV: Enter r, solve for NPV.

CH10
t=0
CFt = NPV (1 + r)t
IRR: Enter NPV = 0, solve for IRR.

n
t=0
CFt =0 (1 + IRR)t
10-15
Whats Project Ls IRR?

CH10
IRR = ?
10 80 -100.00 60 PV1 PV2 PV3 0 = NPV Enter CFs in the financial
calculator, then press IRR: IRRL = 18.13%. IRRS = 23.56%

10-16
Find IRR if CFs are constant:

CH10
0 -100
INPUTS OUTPUT 3
N
1 40
I/YR
2 40
-100
PV
3 40
40
PMT
0
FV
9.70%
Or enter CFs into the financial calculator and press IRR = 9.70%
10-17
Rationale for the IRR Method

CH10
If IRR > WACC, then the projects rate of return is greater than its cost adding extra values to stockholders. Accept the project. IRR is internal to the project and does not depend on the market interest rate. Given in %, IRR provides an easy measure of profitability.
10-18
Decisions on Project S and Project L using IRR

CH10
If S and L are independent, accept both: IRRS > rWACC and IRRL > rWACC If S and L are mutually exclusive, accept S because IRRS > IRRL given IRRS > rWACC . Otherwise, reject both. Cost must be justified.
10-19
Construct NPV Profiles

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Enter CFs in the calculator and find NPVL and NPVS at different discount rates:
r 0 5 10 15 20 NPVL 50 33 19 7 (4) NPVS 40 29 20 12 5
10-20
NPV Profile
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50 40 30 NPV ($) 20 10 0 0 -10
L
Crossover Point = 8.7%
S
IRRS = 23.6%
10
15
20
23.6
Discount rate r (%)
IRRL = 18.1%
10-21
NPV and IRR: No conflict for independent projects

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NPV ($) IRR > rWACC and NPV > 0 Accept. rWACC > IRR and NPV < 0. Reject.
IRR
r (%)
10-22
Mutually Exclusive Projects

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NPV
L
r < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT r > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT
S IRRS
8.7
%
IRRL
10-23
To Find the Crossover Rate

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Find cash flow differences between the projects. See data at beginning of the case. Enter these differences in cash flow register, then press IRR. Crossover rate = 8.68%, rounded to 8.7% Can subtract S from L or vice versa, but easier to have first CF negative. If profiles dont cross, one project dominates the other.
10-24
Two Reasons NPV Profiles Cross

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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 r favours small projects. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPVS > NPVL
10-25
Reinvestment Rate Assumptions

CH10
NPV assumes reinvest at r (opportunity cost of capital, WACC). IRR assumes reinvest at IRR. Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects if a conflict exists.
10-26
Normal vs. Nonnormal Cash Flows

CH10
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. For example, nuclear power plant or strip mine.
27 10-27
Cash flow Patterns in Years Inflow (+) or Outflow (-)

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0 + -
1 + + + +
2 + + + +
3 + + + -
4 + + + +
5 + + -
N N
NN
NN N N NN
10-28
Pavilion Project: NPV and IRR?

CH10
0 -800
r = 10%
1 5,000
2 -5,000
Enter CFs in the calculator. Enter I = 10 NPV = -386.78 IRR = ERROR. Why?
10-29
Nonnormal CFs--two sign changes, two IRRs

CH10
NPV
NPV Profile
IRR2 = 400%
450 0 -800 100 IRR1 = 25%

400
10-30
Logic of Multiple IRRs

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At very low discount rates, the PV of CF2 is large & negative, so NPV <0 At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0 In between, the discount rate hits CF2 harder than CF1, so NPV > 0 Result: 2 IRRs
10-31
Finding Multiple IRRs with Calculator

CH10
1. Enter CFs as before. 2. Enter a guess as to IRR by storing the guess. Try 10%: 10 STO IRR = 25% = lower IRR 3. Now guess large IRR, say, 200: 200 STO IRR = 400% = upper IRR
10-32
Why use MIRR versus IRR?

CH10
MIRR also avoids the problem of multiple IRRs. MIRR correctly assumes reinvestment at opportunity cost = WACC. Managers like using rates of return for comparisons, and MIRR is better for this than IRR.
10-33
Modified Internal Rate of Return (MIRR)

CH10
MIRR is the discount rate which causes the PV of a projects terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. MIRR assumes cash inflows are reinvested at WACC which is reasonable MIRR is unique. Accept the project if MIRR > rWACC.
10-34
MIRR for Franchise L: First, find PV and TV (r = 10%)

CH10
0 -100.0
10%
1 10.0
10%
2 60.0
10%
3 80.0 66.0 12.1 158.1 TV inflows
-100.0 PV outflows
10-35
Second, find discount rate that equates PV and TV

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0 -100.0 PV outflows
1
MIRR = 16.5%
3 158.1 TV inflows
$100 =
$158.1 (1+MIRRL)3
MIRRL = 16.5%
10-36
MIRR calculator solution: Step 1 - find PV of Inflows

CH10
First, enter cash inflows in the financial calculator register: CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80 Second, enter I = 10 Third, find PV of inflows: Press NPV = 118.78
10-37
Step 2 - find TV of inflows

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Enter PV = -118.78, N = 3, I = 10, PMT = 0. Press FV = 158.10 = FV of inflows.
10-38
Step 3 - find PV of outflows

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For this problem, there is only one outflow, CF0 = -100, so the PV of outflows is -100 For other problems there may be negative cash flows for several years, and you must find the present value for all negative cash flows.
10-39
Step 4 - find IRR of TV of inflows and PV of outflows

CH10
Enter FV = 158.10, PV = -100, PMT = 0, N = 3 Press I = 16.50% = MIRR
10-40
When there are nonnormal CFs and more than one IRR, use MIRR:
CH10
0 -800,000
1 5,000,000
2 -5,000,000
PV outflows @ 10% = -4,932,231.40 TV inflows @ 10% = 5,500,000.00 MIRR = 5.6%

10-41
Should this Project be accepted?

CH10
NO. Reject because MIRR = 5.6% < r = 10% Also, if MIRR < r, NPV will be negative: NPV = -$386,777
10-42
Profitability Index
CH10
The profitability index (PI) is the present value of future cash flows divided by the initial cost. PI is the scale-version of NPV. It measures the bang for the buck. To accept a project, PI > 1. PI > 1 is equivalent to NPV > 0.
10-43
Project Ls PV of Future Cash Flows

CH10
Project L:
10%
1 10
2 60
3 80
9.09 49.59 60.11 118.79

10-44
Project Ls Profitability Index

CH10
PIL =
PV future CF Initial Cost
$118.79 $100
PIL = 1.1879 PIS = 1.1998

10-45
Payback Methods
CH10
Payback period is the number of years required to recover a projects cost, or how long it takes to get the businesss money back. Firms establish a benchmark payback period; projects whose payback exceeds this benchmark are rejected.
10-46
Payback for Project L

CH10
0 CFt -100 Cumulative -100 PaybackL = 2
1 10 -90 +
2 2.4 60 -30 0 30/80
3 80 50
= 2.375 years
10-47
Payback for Project S

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0 CFt -100
1 70 -30
1.6 2
50 0 20
3 20 40
Cumulative -100 PaybackS
= 1 + 30/50 = 1.6 years

10-48
Strengths and Weaknesses of Payback

CH10
Strengths:
Provides an indication of a projects risk and liquidity. Easy to calculate and understand.
Weaknesses:
Ignores the time value of money. Ignores CFs occurring after the payback period.
10-49
Discounted Payback: Uses discounted rather than raw CFs

CH10
0 CFt PV(CFt) -100 -100
10%
1 10 9.09 -90.91
2 60 49.59 -41.32
3 80 60.11 18.79
Cumulative -100 Discounted = 2 payback
+ 41.32/60.11 = 2.7 yrs
Recover investment capital costs in 2.7 yrs.

10-50
CH10
Capital Budgeting Process: Conclusion

Quantitative methods provide valuable information, but they should not be used as the sole criteria for accept/reject decisions in capital budgeting process NPV is the single most important method showing the absolute profitability IRR is ranked second of importance Payback is still used significantly among small businesses
10-51
Mutually Exclusive Projects with unequal lives. r = 10%.

CH10
Project S: 60 (100) Project L: 33.5 (100)
60 33.5 33.5 33.5

10-52
NPVL > NPVS. But is Project L really better?

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Inputs CF0 CF1 N I NPV
S -100 60 2 10 4.132
L -100 33.5 4 10 6.190

10-53
Equivalent Annual Annuity Approach (EAA)

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Convert the PV into a stream of annuity payments with the same PV. S: N=2, I/YR=10, PV=-4.132, FV = 0. Solve for PMT = EAAS = $2.38 L: N=4, I/YR=10, PV=-6.190, FV = 0. Solve for PMT = EAAL = $1.95 S has higher EAA, so it is a better project.
10-54
Economic Life versus Physical Life

CH10
Projects are normally analyzed under the assumption that the firm will operate the asset till its end. Consider a project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage value. Should you always operate for the full physical life?
10-55
Economic Life versus Physical Life (contd)

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Year 0 1 2 3
CF ($4,800) 2,000 2,000 1,750
Salvage Value $4,800 3,000 1,650 0

10-56
CFs Under Each Alternative (000s)

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0 1. No termination (4.8)
1 2 2 5
2 2 4
3 1.75
2. Terminate 2 years (4.8) 3. Terminate 1 year (4.8)
10-57
Economic Life versus Physical Life (contd)

CH10
NPVs under alternative lives:

NPV(3) @10% NPV(2) @10% NPV(1) @10% = -$14.12 = $34.71 = -$254.55
The project is acceptable only if operated for 2 years. A projects engineering life does not always equal its economic life.
10-58
Optimal Capital Budget

CH10
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.
10-59
Increasing Marginal Cost of Capital

CH10
Externally raised capital can have large flotation costs, which increase the cost of capital. Investors often perceive large capital budgets as being risky, which drives up the cost of capital. If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
10-60
Capital Rationing
CH10
Capital rationing occurs when a company chooses not to fund all positive NPV projects. The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
10-61
Capital Rationing (contd)

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Reason: Reluctance to issue new stock. Firms want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase 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.
10-62

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Reason: Constraints on nonmonetary resources. Firms do not have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
10-63

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Reason: Controlling estimate bias. Firms 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.
10-64

Ch10 PPT Brighamfm1ce

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PowerPoint Presentation

Traven Reed Canadore College

Corporate Valuation and Capital Budgeting

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Overview of capital budgeting Methods

Unequal lives Economic life Capital rationing

What is capital budgeting?

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Steps in Capital Budgeting

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Independent versus Mutually Exclusive Projects

Cash Flows for Project L and Project S

-100.00 0 Ss CFs: 10%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

NPV: Sum of the PVs of all cash flows

Cost often is CF0 and is negative.

CFt . - CF0 (1 + r)t

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Whats Project Ls NPV?

9.09 49.59 60.11 18.79 = NPVL

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Calculator Solution: Project L

CF0 CF1 CF2 CF3 I NPV = 18.78 = NPVL

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Rationale for the NPV Method

Using NPV method, which project(s) should be accepted?

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Internal Rate of Return: IRR

NPV: Enter r, solve for NPV.

CFt = NPV (1 + r)t

IRR: Enter NPV = 0, solve for IRR.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Whats Project Ls IRR?

10 80 -100.00 60 PV1 PV2 PV3 0 = NPV Enter CFs in the financial

calculator, then press IRR: IRRL = 18.13%. IRRS = 23.56%

Find IRR if CFs are constant:

Rationale for the IRR Method

Decisions on Project S and Project L using IRR

Construct NPV Profiles

Copyright 2011 by Nelson Education Ltd. All rights reserved.

50 40 30 NPV ($) 20 10 0 0 -10

Discount rate r (%)

Copyright 2011 by Nelson Education Ltd. All rights reserved.

NPV and IRR: No conflict for independent projects

Mutually Exclusive Projects

To Find the Crossover Rate

Two Reasons NPV Profiles Cross

Reinvestment Rate Assumptions

Normal vs. Nonnormal Cash Flows

Normal Cash Flow Project:

Nonnormal Cash Flow Project:

Cash flow Patterns in Years Inflow (+) or Outflow (-)

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Pavilion Project: NPV and IRR?

Nonnormal CFs--two sign changes, two IRRs

450 0 -800 100 IRR1 = 25%

Logic of Multiple IRRs

Finding Multiple IRRs with Calculator

Why use MIRR versus IRR?

Modified Internal Rate of Return (MIRR)

MIRR for Franchise L: First, find PV and TV (r = 10%)

3 80.0 66.0 12.1 158.1 TV inflows