What is capital budgeting?

 Analysis of potential additions to

fixed assets.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.

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 Steps

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine k = WACC (adj.).
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >
WACC.
2
 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.
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An Example of Mutually Exclusive
Projects

Firm owns one corner lot,

then it can build a gas
station or an apartment
building, but not both.

4
Normal(Conventional) 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.
e.g. Nuclear power plant
5
Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
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 What is the payback period?

The number of years required to

recover a project’s cost,

or how long does it take to get our

money back?

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 Payback for Project L
(Long: Large CFs in later years)

0 1 2 2.4 3

CFt -100 10 60 80
Cumulative -100 -90 -30 50

PaybackL = 2 + 30/80 = 2.375 years

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 Project S (Short: CFs come quickly)

0 1 1.6 2 3

CFt -100 70 50 20

Cumulative -100 -30 20 40

PaybackS = 1 + 30/50 = 1.6 years

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Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
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Discounted Payback: Uses discounted
rather than raw CFs.
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 years

Recover investment in 2.7 years.

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NPV: Sum of the PVs of inflows and
outflows.

n
CFt
NPV   t .
t 0  1  k 

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 What’s Project L’s NPV?

Project L:
0 1 2 3
10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
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 Calculator Solution

Enter CFs for L:

-100 CF0

10 CF1

60 CF2

80 CF3

10 I NPV = 18.78 = NPVL

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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.
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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.

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 Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.
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NPV: Enter k, solve for NPV.
n
CFt

t 0  1  k 
t  NPV .

IRR: Enter NPV = 0, solve for IRR.

n
CFt

t 0  1  IRR 
t  0.

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 What’s Project L’s IRR?

0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFs , then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
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Find IRR if CFs are constant:
0 1 2 3
IRR = ?

-100 40 40 40

INPUTS 3 -100 40 0
N I/YR PV PMT FV
OUTPUT 9.70%

Or enter CFs and press IRR = 9.70%.

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 Q. How is a project’s IRR
related to a bond’s YTM?
A. They are the same thing.
A bond’s YTM is the IRR
if you invest in the bond.

0 1 2 10
IRR = ? ...
-1134.2 90 90 1090

IRR = 7.08% (using Fin. Calc.)

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 Rationale for the IRR Method

If IRR > WACC, then the project’s

rate of return is greater than its
cost--some return is left over to
boost stockholders’ returns.

Example: WACC = 10%, IRR = 15%.

Profitable.
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IRR Acceptance Criteria

 If IRR > k, accept project.

 If IRR < k, reject project.

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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 .

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 Construct NPV Profiles

Fin. Calc.: Enter CFs and find NPVL and

NPVS at different discount rates:
k NPVL NPVS
0 50 40
5 29
10 33 20
15 19 12
20 7
(4) 5
(4 25
NPV ($) k NPVL NPVS
60
0 50 40
50 . 5 33 29
40 .
Crossover 10 19 20
. Point = 8.7%
15 7 12
30 . 20 (4) 5
20 . S
. IRRS = 23.6%
10 L . .
0
.20 . Discount Rate (%)
5 10 15 23.6
-10
IRRL = 18.1%
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NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > k k > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.

k (%)
IRR
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 Mutually Exclusive Projects

NPV k < 8.7: NPVL> NPVS , IRRS > IRRL

CONFLICT
L k > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT

S IRRS

k 8.7 k %
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 CF
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 don’t cross, one project
dominates the other.
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 Reasons for conflict
Difference in project characteristics

1. Timing differences. Project with

faster payback provides more CF
in early years for reinvestment. If
k is high, early CF especially
good, NPVS > NPVL.
k NPVL NPVS
0 50 40
5 33 29
10 19 20
15 7 12
20 (4) 5
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 Difference in assumption of NPV and IRR

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.

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 To see the reinvestment rate assumptions

Calculate average holding period return per year for projects

S and L using WACC and IRR as reinvestment rates.

WACC 5% L S
-100 -100
10 70
60 50
80 20

IRR 18.13% 23.56%

FV @wacc 154.03 149.68

FV @IRR 164.83 188.66

avg. hpr @wacc 15.49% 14.39%

@IRR 18.13% 23.56%

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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 project’s terminal
value (TV) to equal the PV of costs.
TV is found by compounding inflows
at WACC.

Thus, MIRR assumes cash inflows are

reinvested at WACC.
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 MIRR for Project L (k = 10%)
0 1 2 3
10%

-100.0 10.0 60.0 80.0

10%
66.0
10%
12.1
MIRR =
158.1
16.5%
-100.0 $158.1
$100 = TV inflows
(1 + MIRRL)3
PV outflows
MIRRL = 16.5%
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 Why use MIRR versus IRR?

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.
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 Consider projects S and L

Calculate MIRR and NPV of Projects S and L

at different rates of cost of capital
k MIRR L MIRR S NPV L NPV S
1% 14.7% 12.4% 46.37 37.73
2% 14.9% 12.9% 42.86 35.53
3% 15.1% 13.4% 39.48 33.39
4% 15.3% 13.9% 36.21 31.32
5% 15.5% 14.4% 33.05 29.29
6% 15.7% 14.9% 30.00 27.33
7% 15.9% 15.4% 27.06 25.42
8% 16.1% 15.9% 24.21 23.56
9% 16.3% 16.4% 21.45 21.75
10% 16.5% 16.9% 18.78 19.98
11% 16.7% 17.4% 16.20 18.27
12% 16.9% 17.9% 13.70 16.60
13% 17.1% 18.4% 11.28 14.97
14% 17.3% 18.9% 8.94 13.38
15% 17.5% 19.4% 6.67 11.83

Thus, the use of MIRR accounts for timing differences.

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 Project P: NPV and IRR?

0 1 2
k = 10%

-800 5,000 -5,000

Enter CFs in CF register, enter I = 10.

NPV = -386.78
IRR = ERROR. Why?
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We got IRR = ERROR because there
are 2 IRRs. Nonnormal CFs--two sign
changes. Here’s a picture:

NPV NPV Profile

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
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 Logic of Multiple IRRs

1. At very low discount rates, the PV of CF2 is

large & negative, so NPV < 0.
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. 39
 When there are nonnormal CFs and
more than one IRR, use MIRR:

0 1 2

-800,000 5,000,000 -5,000,000

PV outflows @ 10% = -4,932,231.40.

TV inflows @ 10% = 5,500,000.00.
MIRR = 5.6%
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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.

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 Reasons for conflict:
Difference in project characteristics
2. Size (scale) differences.

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 Reasons for conflict
Difference in project characteristics

 If Big and Little are mutually exclusive projects,

which project should a firm prefer?
 If the firm goes strictly by the PI, IRR, or MIRR
criteria, it would choose Project Little.
 But is this the better project? Project Big provides
more value -- $89,299 versus $0.18.

The techniques that ignore the scale of the

investment such as IRR may lead to an incorrect
decision.
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