11 - 1

CHAPTER 11
The Basics of Capital Budgeting
Should we build this plant?

Copyright 2002 by Harcourt, Inc.

All rights reserved.

11 - 2

What is capital budgeting? Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to firms future.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

11 - 3

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.

Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 4

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 2002 by Harcourt, Inc. All rights reserved.

11 - 5

An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.

Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 6

Normal NormalCash CashFlow FlowProject: 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 2002 by Harcourt, Inc. All rights reserved.

11 - 7

Inflow (+) or Outflow (-) in Year 0 1 + 2 + 3 + 4 + 5 + N N NN

+
-

+
-

+
+

+
+

+ N

NN N
NN
All rights reserved.

+
-

+
+

+
+

Copyright 2002 by Harcourt, Inc.

11 - 8

NPV: Sum of the PVs of inflows and outflows.

CFt NPV t . t 0 1 k
n

Copyright 2002 by Harcourt, Inc.

All rights reserved.

11 - 9

What is Project Ls NPV? Project L: 0 -100.00 9.09 49.59 60.11 18.79 = NPVL
Copyright 2002 by Harcourt, Inc. All rights reserved.

10%

1 10

2 60

3 80

11 - 10

Calculator Solution

Enter in CFLO for L:

-100

CF0
CF1

10
60

CF2
CF3 I NPV = 18.78 = NPVL
All rights reserved.

80
10

Copyright 2002 by Harcourt, Inc.

11 - 11

What is Project Ss NPV? Project S: 0 -100.00 63.64 41.32 15.03 19.99 = NPVS
Copyright 2002 by Harcourt, Inc. All rights reserved.

10%

1 70

2 50

3 20

11 - 12

Calculator Solution

Enter in CFLO for S:

-100

CF0
CF1

70
50

CF2
CF3 I NPV = 19.98 = NPVS
All rights reserved.

20
10

Copyright 2002 by Harcourt, Inc.

11 - 13

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 2002 by Harcourt, Inc. All rights reserved.

11 - 14

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.
Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 15

Internal Rate of Return: IRR

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.
Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 16

NPV: Enter k, solve for NPV.

CFt t NPV . t 0 1 k
n

IRR: Enter NPV = 0, solve for IRR.

CFt t 0. t 0 1 IRR
n
Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 17

Whats Project Ls IRR?

0
IRR = ?

1 10

2 60

3 80

-100.00 PV1 PV2 PV3

0 = NPV

Enter CFs in CFLO, then press IRR: IRRL = 18.13%.

Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 18

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%) Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 19

Whats Project Ss IRR?

0
IRR = ?

1 70

2 50

3 20

-100.00 PV1 PV2 PV3

0 = NPV

Enter CFs in CFLO, then press IRR: IRRS = 23.56%.

Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 20

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%) Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 21

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

IRR = 7.08% (use TVM or CFLO).

Copyright 2002 by Harcourt, Inc. All rights reserved.

11 - 22

Rationale for the IRR Method

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 2002 by Harcourt, Inc. All rights reserved.

11 - 23

IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

11 - 24

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 .

Copyright 2002 by Harcourt, Inc.

All rights reserved.

11 - 25

Prefer NPV to IRR

Can have multiple IRRs if you have nonnormal 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.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

11 - 26

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 2002 by Harcourt, Inc.

All rights reserved.