Presentation

The Basics of Capital Budgeting : Evaluating

Cash Flows
 Overview of Capital Budgeting
▪ Capital budgeting is the process of analyzing potential projects.

▪ Larger investments and risker projects require increasingly detailed analysis.

▪ Six keys methods are used to evaluate projects:

1. Net Present Value(NPV)
2. Internal Rate of Return(IRR)
3. Modified Internal Rate of Return(MIRR)
4. Profitability Index(PI)
5. Payback
6. Discounted Payback
 Net Present Value(NPV)
▪ NPV method discounts all cash flows at the project cost of capital and then sums those

cash flows.

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑁

NPV = 𝐶𝐹0 + + +....+
(1+𝑟)1 (1+𝑟)2 (1+𝑟)𝑁

𝑁 𝐶𝐹𝑡
NPV = σ𝑡=0
(1+𝑟)𝑡

where, CF = expected net cash flow at period t

r = the project’s cost of capital

n = its life
 500 400 300 100
▪ 𝑁𝑃𝑉𝑆 = -1000 + + (1.10)2 + (1.10)3 + (1.10)4 = $78.82
(1.10)1
▪ 𝑁𝑃𝑉𝐿 = $49.8

⁎Project should be accepted if NPV is positive.

▪ MEP, Project S should be accepted.

𝑁𝑃𝑉𝑆 >𝑁𝑃𝑉𝐿

▪ IP, both should be accepted.

𝑁𝑃𝑉𝑆 &𝑁𝑃𝑉𝐿 positive

▪ Mutually exclusive – If one project is taken on, the other must be rejected.
▪ Independent projects – Cash flows are independent of one another.
 Internal Rate of Return (IRR)
• IRR is the discount rate that forces the project's NPV to equal zero.

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑁

𝐶𝐹0 + + +.....+ =0
(1+𝐼𝑅𝑅)1 (1+𝐼𝑅𝑅)2 (1+𝐼𝑅𝑅)𝑁
𝐶𝐹𝑡
NPV = σ𝑛𝑡=0 =0
(1+𝐼𝑅𝑅)𝑡
 Detailed Step with Financial Calculator

• To clear historical data : CF , 2 ND , CE/C

• To get IRR : 1000 , +/- , ENTER , , 500 , ENTER , ,
400 , ENTER , , 300 , ENTER , , 100 , ENTER , ,
IRR , CPT
• 𝐼𝑅𝑅𝑆 = 14.5%
𝐼𝑅𝑅𝐿 = 11.8%

• MEP, Project S should be accepted.

𝐼𝑅𝑅𝑆 > 𝐼𝑅𝑅𝐿

• IP, Both should be accepted because they earn more than cost of capital needed
to finance.
 Comparison of the NPV and IRR Method
NPV Profiles
NVP profile is a graph that plot a project's net present value against the cost of capital
rates.

r 𝑵𝑷𝑽𝑺 𝑵𝑷𝑽𝑳
0% $300.00 $400.00
5 $180.42 $206.50
10 $ 78.82 $ 49.18
15 ($ 8.83) ($ 80.14)
NPV Rankings Depend on the Cost of Capital
• When cost of capital is high, Project S has higher NPV.
• When cost of capital is low, Project L has higher NPV.
• So, 𝑁𝑃𝑉𝐿 is 'more sensitive' to changes in cost of capital than 𝑁𝑃𝑉𝑆.

Evaluating Independent Projects

• NPV and IRR criteria lead to the same accept/reject decisions.
• Assume that project S and L are independent
̄ accept when ''cost of capital < IRR ''
̄ whenever ''cost of capital < IRR'' , NPV is positive
Evaluating Mutually Exclusive Projects
Assume that Projects S and L are mutually exclusive
• When r is larger than crossover rate - 𝑁𝑃𝑉𝑆 > 𝑁𝑃𝑉𝐿 Select Project S
(No Conflict)
- 𝐼𝑅𝑅𝑆 > 𝐼𝑅𝑅𝐿
• When r is lower than crossover rate - 𝑁𝑃𝑉𝑆 < 𝑁𝑃𝑉𝐿
Conflict
- 𝐼𝑅𝑅𝑆 > 𝐼𝑅𝑅𝐿
• Two conditions can cause NPV Profile to cross – Size(scale) differences
– Timing differences
• The rate of reinvestment – NPV assumes reinvest at cost of capital
– IRR assumes reinvest at IR
Reinvest in r is more realistic so NPV method is the best.
 Multiple IRRs
• A project has normal cash flows if it has one or more cash outflow(costs)
followed by a series of cash inflows.
• Nonnormal cash flows occur when there is more than one change in sign.
• Projects with nonnormal cash flows can actually have multiple IRRs.
𝑁 𝐶𝐹𝑡
σ𝑡=0 =0
(1+𝐼𝑅𝑅)𝑡
 Modified Internal Rate of Return (MIRR)
• MIRR is the discount rate that forces the PV of terminal value to equal the PV of
the costs.
• Terminal value(TV) is the compounded future value of cash inflow.

𝑁 𝐶𝑂𝐹𝑡 σ𝑁
𝑡=0 𝐶𝐼𝐹𝑡 (1+𝑟)
𝑁−1
σ𝑖=0 =
(1+𝑟)𝑡 (1+𝑀𝐼𝑅𝑅)𝑁

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
PV of costs =
(1+𝑀𝐼𝑅𝑅)𝑁

where, COF = Cash outflows (negative number)

CIF = Cash inflows (positive number)
 𝑴𝑰𝑹𝑹𝑺 = 12.1%
𝑴𝑰𝑹𝑹𝑳 = 11.3%

• ME, Project S should be accepted. ( 𝑀𝐼𝑅𝑅𝑆 > 𝑀𝐼𝑅𝑅𝐿 )

• IP, Both should be Selected. ( 𝑀𝐼𝑅𝑅𝑆 and 𝑀𝐼𝑅𝑅𝐿 > r )
• MIRR is better than IRR – MIRR correctly assumes reinvestment of cost of capital
– MIRR avoids the problem of multiple IRRs.
 Profitability Index
• PI shows the dollars of PV divided by initial cost, so it measures relative
profitability.

PV =

$1078.82
𝑃𝐼𝑆 = = 1.08
$1000

𝑃𝐼𝐿 = 1.05
A project is accepted if its PI > 1.0
• ME, 𝑃𝐼𝑆 > 𝑃𝐼𝐿 ( Project S)
• IP , 𝑃𝐼𝑆 and 𝑃𝐼𝐿 > 1(Both)
 Payback Methods
Payback Period
• Payback period is defined as the expected number of years required to recover the
original investment.
Number of
𝑈𝑛𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑦𝑒𝑎𝑟
Payback = years prior to +
fully recovery 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑓𝑢𝑙𝑙𝑦 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟
$100
𝑃𝑎𝑦𝑏𝑎𝑐𝑘𝑆 = 2 + = 2.33yrs
$300

𝑃𝑎𝑦𝑏𝑎𝑐𝑘𝑙 = 3.33yrs
• The shorter the payback period, the better.
• Project S should be selected.(𝑃𝑎𝑦𝑏𝑎𝑐𝑘𝑆< 𝑃𝑎𝑦𝑏𝑎𝑐𝑘𝑙 )
Payback has three main flaws :
• dollars received in different years – same weight
• cash flow beyond payback year – no consideration
• NPV – how much project increases shareholder wealth
IRR – how much project yields over cost of capital
Payback – when we get our invest back
 Discounted Payback Period
• The discounted payback period is defined as the number of years required to
recover the investment from discounted cash flows.
$215
𝑃𝑎𝑦𝑏𝑎𝑐𝑘𝑆 = 2 + = 2.95yrs
$225

$361
𝑃𝑎𝑦𝑏𝑎𝑐𝑘𝐿 = 3 + = 3.88yrs
$410

• 𝑃𝑎𝑦𝑏𝑎𝑐𝑘𝑆 < 𝑃𝑎𝑦𝑏𝑎𝑐𝑘𝐿 (Project S should be selected).

 Conclusions on Capital Budgeting Methods
• NPV gives a direct measure of the dollar benefit to the shareholders.
• IRR provides information about a project's "safety margin".
• MIRR has all the virtues of IRR but
‾ it incorporates a better reinvestment rate assumption
‾ it avoids multiple IRRs problem
• PI shows the 'bang per buck'
• Payback and discounted payback indicate risk and liquidity of the project.

* Quantitative methods should be considered as an aid to informed decisions but not

as a substitute for sound managerial judgement .
 Business Practices
Capital Budgeting Methods Used in Practice
Comparing Projects with Unequal Lives
 To correctly compare projects, two different approaches can be used :

▪ Replacement Chains

• The key to replacement chain is to analyze both projects using a common life.

• Over a 6yr period, Project C's NPV = $7165 , IRR = 17.5%

Project F's NPV = $9281 , IRR = 25.2%

• Project F should be selected.

▪ Equivalent Annual Annuities(EAA)

• EAA calculates the constant annual cash flow generated by a project.
• Project C's EAA = $1718
• Project F's EAA = $ 2225
• 𝐸𝐴𝐴𝐹 > 𝐸𝐴𝐴𝐶 (Project F is a better project)
▪ Conclusion on Unequal Lives
• The unequal life issues – does not arise for independent projects
• arise for mutually exclusive projects with different lives

Weakness of unequal lives

• inflation – replacement equipment will have higher price
• employing new technology might changes the cash flows
• difficult to estimate the lives of most projects
Economic Life Versus Physical Life
• Based on 3yrs operating cash flows,
2000 2000 1750
NPV = -4800 + 1 + 2 + = -$14.12
(1.1) (1.1) (1.1)3

• Based on 2yrs operating cash flows,

2000 3650
NPV = -4800 + + = $34.71
(1.1)1 (1.1)2

• Economic life is the life that maximizes the NPV and thus maximized
shareholder wealth.
• Physical life is the total period an asset last.
• For Project A, the economic life is 2yrs and physical life is 3yrs.
 The Optimal Capital Budget
• The optimal capital budget is the set of projects that maximizes the value of firm.
• Finance theory says to accept all with positive NPV projects.
• Two complications arise in practice:
1) An Increasing Marginal Cost of Capital
2) Capital Rationing

An Increasing Marginal Cost of Capital

• Flotation costs can increase cost of capital.
• Large capital budget is risky, which drives up the cost of capital.
Capital Rationing
• Capital rationing occurs when the firm limits its capital expenditure to less than
the amount required to find the optimal capital budget.
• Why would any company forgo value-adding projects?
1) Reluctance to issue new stock
2) Constraints on nonmonetary resources
3) Controlling estimation bias