N Amin - Summer 2020 BFII 7/4/2020: The Basics of Capital Budgeting

N
Amin – Summer 2020 BFII 7/4/2020
Overview
The Basics of Capital
Budgeting
Net Present Value (NPV)
Chapter 11
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Payback Methods: Regular vs. Discounted
Multiple IRRs
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Internal Rate of Return (IRR) How is a project’s IRR similar to a bond’s YTM?
 Solving for IRR with a financial calculator:  They are the same thing.
 Think of a bond as a project. The YTM on the
bond would be the IRR of the “bond” project.
 EXAMPLE: Suppose a 10-year bond with a 9%
 Enter CFs in CFLO register. annual coupon and $1,000 par value sells for
• Press IRR; IRRL = 18.13% and $1,134.20.
IRRS = 23.56%. • Solve for IRR = YTM = 7.08%, the annual return
for this project/bond.
• Solving for IRR with Excel:
=IRR(CF0:CFn,guess for rate)
1
N Amin – Summer 2020 BFII 7/4/2020
Rationale for the IRR Method NPV Profiles
 If IRR > WACC, the project’s return exceeds its  A graphical representation of project NPVs at
costs and there is some return left over to boost various different costs of capital.
stockholders’ returns.
If IRR > WACC, accept project. WACC NPVL NPVS
0 $50 $40
If IRR < WACC, reject project.
5 33 29
 If projects are independent, accept both 10 19 20
projects, as both IRR > WACC = 10%. 15 7 12
 If projects are mutually exclusive, accept S, 20 (4) 5
because IRRs > IRRL.
Independent Projects Mutually Exclusive Projects
NPV and IRR always lead to the same accept/reject NPV

If r < 8.7%: NPVL > NPVS
decision for any given independent project. IRRS > IRRL
L
CONFLICT
NPV ($) If r > 8.7%: NPVS > NPVL ,
IRR > r IRRS > IRRL
r > IRR NO CONFLICT
and NPV > 0 and NPV < 0.
Accept. Reject. S
r = 18.1%
%
r 8.7 r
IRRL = 18.1% r (%) IRRL IRRs
2
Finding the Crossover Rate Reasons Why NPV Profiles Cross
 Find cash flow differences between the projects.  Size (scale) differences: The smaller project
See Slide 11-8. frees up funds at t = 0 for investment. The
higher the opportunity cost, the more valuable
 Enter the CFs in CFj register, then press these funds, so a high WACC favors small
 IRR. Crossover rate = 8.68%, rounded to projects.
8.7%.
 Timing differences: The project with faster
 If profiles don’t cross, one project dominates payback provides more CF in early years for
the other. reinvestment. If WACC is high, early CF
especially good, NPVS > NPVL.
Managers prefer the IRR to the NPV method; is there

Reinvestment Rate Assumptions a better IRR measure?
 NPV method assumes CFs are reinvested at the  Yes, MIRR is the discount rate that causes the
WACC. PV of a project’s terminal value (TV) to equal
the PV of costs. TV is found by compounding
 IRR method assumes CFs are reinvested at IRR. inflows at WACC.
 Assuming CFs are reinvested at the opportunity  MIRR assumes cash flows are reinvested at the
cost of capital is more realistic, so NPV method WACC.
is the best. NPV method should be used to
choose between mutually exclusive projects.
 Perhaps a hybrid of the IRR that assumes cost

of capital reinvestment is needed.
3
Calculating MIRR Why use MIRR versus IRR?
0
10%
1 2 3  MIRR assumes reinvestment at the opportunity
cost = WACC. MIRR also avoids the multiple IRR
-100.0 10.0 60.0 80.0 problem.
10%
66.0
10%
12.1
 Managers like rate of return comparisons, and
MIRR = 16.5% MIRR is better for this than IRR.
-100.0 158.1
PV outflows $158.1 TV inflows
$100 =
(1 + MIRRL)3
MIRRL = 16.5%
Excel: MIRR(CF0:CFn,Finance_rate,Reinvest_rate)
We assume that both rates = WACC.
What is the payback period? Calculating Payback
 The number of years required to recover a Project L’s Payback Calculation

project’s cost, or “How long does it take to get
our money back?” 0 1 2 3
 Calculated by adding project’s cash inflows to CFt -100 10 60 80

its cost until the cumulative cash flow for the
project turns positive. Cumulative -100 -90 -30 50
PaybackL = 2 + 30 / 80
= 2.375 years
PaybackS = 1.600 years
4
Discounted Payback Period Strengths and Weaknesses of Payback
Uses discounted cash flows rather than raw CFs.  Strengths

• Provides an indication of a project’s risk and
0 1 2 3 liquidity.
10%
• Easy to calculate and understand.
CFt -100 10 60 80  Weaknesses
PV of CFt -100 9.09 49.59 60.11 • Ignores the time value of money (TVM).
• Ignores CFs occurring after the payback period.
Cumulative -100 -90.91 -41.32 18.79 • No relationship between a given payback and
investor wealth maximization.
Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years Discounted payback considers TVM, but other 2
flaws remain.
Find Project P’s NPV and IRR Multiple IRRs
Project P has cash flows (in 000s): CF0 = NPV

-$800, CF1 = $5,000, and CF2 = -$5,000.
0 1 2
IRR2 = 400%
WACC = 10% 450
-800 5,000 -5,000
0 WACC
100 400
 Enter CFs into calculator CFLO register.
 Enter I/YR = 10. IRR1 = 25%
-800
 NPV = -$386.78.
 IRR = ERROR Why?
5
When to use the MIRR instead of the IRR? Accept

Why are there multiple IRRs? Project P?
 At very low discount rates, the PV of CF2 is large  When there are nonnormal CFs and more than
and negative, so NPV < 0. one IRR, use MIRR.
 At very high discount rates, the PV of both CF1 • PV of outflows @ 10% = -$4,932.2314.
and CF2 are low, so CF0 dominates and again • TV of inflows @ 10% = $5,500.
NPV < 0. • MIRR = 5.6%.
 In between, the discount rate hits CF2 harder  Do not accept Project P.
than CF1, so NPV > 0.
• NPV = -$386.78 < 0.
 Result: 2 IRRs. • MIRR = 5.6% < WACC = 10%.
End of Chapter 11
© 2019 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5

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Amin – Summer 2020 BFII 7/4/2020

Modified Internal Rate of Return (MIRR)

Payback Methods: Regular vs. Discounted

Rationale for the IRR Method NPV Profiles

Independent Projects Mutually Exclusive Projects

NPV and IRR always lead to the same accept/reject NPV

Finding the Crossover Rate Reasons Why NPV Profiles Cross

Managers prefer the IRR to the NPV method; is there

 Perhaps a hybrid of the IRR that assumes cost

Calculating MIRR Why use MIRR versus IRR?

What is the payback period? Calculating Payback

 The number of years required to recover a Project L’s Payback Calculation

 Calculated by adding project’s cash inflows to CFt -100 10 60 80

Discounted Payback Period Strengths and Weaknesses of Payback

Uses discounted cash flows rather than raw CFs.  Strengths

Find Project P’s NPV and IRR Multiple IRRs

Project P has cash flows (in 000s): CF0 = NPV

When to use the MIRR instead of the IRR? Accept

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