The Basics of Capital Budgeting: Should We Build This Plant?

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CHAPTER 12
The Basics of Capital Budgeting
Should we build this plant?
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What is capital budgeting? Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.

Very important to firms future.
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Capital Budgeting Decision Rules

5 keys methods to rank project
Payback Discounted Payback Accounting Rate of Return Net Present Value (NPV)
Internal Rate of Return (IRR)

Modified Internal Rate of Return (MIRR)
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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.
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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
BRIDGE vs. BOAT to get products across a river.
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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. Nuclear power plant, strip mine.
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Inflow (+) or Outflow (-) in Year 0 1 + 2 + 3 + 4 + 5 + N N NN
+
-
+
-
+
+
+
+
+ N
NN N
NN
+
-
+
+
+
+
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What is the payback period?
- The number of years required to recover a projects cost, - or how long does it take to get our money back?
Payback = Year before full recovery + the last unrecovered cost Cash flow during year
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Example: Allied Components Company Projects net cash flows ($000), Allied Projects WACC = 10%
Year Project L Project S
0
1 2 3
(100)
10 60 80
(100)
70 50 20
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Payback for Project L (Long: Large CFs in later years)

0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 30/80 2
2.4
3 80 50
60 100 -30 0
= 2.375 years
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Project S (Short: CFs come quickly)

0
CFt -100
1.6 2
3
20 40
70 100 50 -30 0 20
Cumulative -100
Paybacks
= 1 + 30/50 = 1.6 years
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Strengths of Payback: 1. Provides an indication of a projects 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 for project L rather than raw CFs.
0 CFt PVCFt -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 years
Recover invest. + cap. costs in 2.7 years.
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Accounting Rate of Return (ARR)
ARR = Average Annual Income Average Investment

Average Annual Income = Average Cash Flow Average depreciation Average Investment = (Cost + Salvage Value)/2
12 - 16
Accounting Rate of Return (ARR)

Average Annual Income (AAI) L: Average cash flow L: 150/3 = 50 Average depreciation: 100/3 = 33.3 AAI L: 50 33.3 = 16.7 Average Investment L: (Cost + Salvage Value)/2: (100+0)/2 = 50 ARR L = 16.7/50 33.4% ARR S = 13.4/50 26.8%
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NPV: Sum of the PVs of inflows and outflows.
CFt NPV t . t 0 1 k
n
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Whats Project Ls NPV? Project L: 0 -100.00 9.09 49.59 60.11 18.79 = NPVL 10% 1 10 2 60 3 80
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Calculator Solution Enter in CF for L: -100 10 60 CF0 CF1
CF2
CF3
80
10
i%
RCL NPV
= 18.78 = NPVL
NPVS = $19.98.
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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 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.
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NPV: Enter k, solve for NPV.

CFt 1 k t NPV. t 0
n
IRR: Enter NPV = 0, solve for IRR.

CFt 1 IRR t 0. t 0
n
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Whats Project Ls IRR?

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

0
-100
INPUTS 3
N COMP i% IRR = ?
1
40
2
40
-100
PV
3
40
40
PMT
0
FV
OUTPUT
9.70%
Or, with CF, enter CFj and press IRR = 9.70%.
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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%
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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.
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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

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

NPV
L
k < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT k > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT
IRRS
8.7
%
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 CFLO 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 dont cross, one project dominates the other.
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To Find the Crossover Rate

Year 0 1 2 3 Project L (100) 10 60 80 Project S (100) 70 50 20 L-S 0 -60 10 60 8.68%
Cross
over
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Two Reasons NPV Profiles Cross 1. 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 k favors small projects. 2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
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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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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 projects 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
10%
1 10.0
10%
2 60.0
10%
3 80.0
-100.0
66.0 12.1 158.1

TV inflows
-100.0 0 = PV outflows
MIRR = 16.5%
$158.1 $-100 (1 + MIRRL)3 MIRRL = 16.5%
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To find TV with Casio, enter in CFLO: CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80 = 10 i% RCL NPV = 118.78 = PV of inflows.
Enter PV = -118.78, n = 3, i% = 10, PMT = 0. Press COMP FV = 158.10 = FV of inflows. Enter FV = 158.10, PV = -100, PMT = 0, n = 3. Press COMP i% = 16.50% = MIRR.
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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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12 - 1

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

Long-term decisions; involve large expenditures.

Capital Budgeting Decision Rules

Internal Rate of Return (IRR)

Steps 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs.

3. Determine k = WACC (adj.).

5. Accept if NPV > 0 and/or IRR > WACC.

An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.

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

What is the payback period?

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

Project S (Short: CFs come quickly)

= 1 + 30/50 = 1.6 years

+ 41.32/60.11 = 2.7 years

Recover invest. + cap. costs in 2.7 years.

Accounting Rate of Return (ARR)

ARR = Average Annual Income Average Investment

Accounting Rate of Return (ARR)

NPV: Sum of the PVs of inflows and outflows.

Calculator Solution Enter in CF for L: -100 10 60 CF0 CF1

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

Internal Rate of Return: IRR

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

Whats Project Ls IRR?

-100.00 PV1 PV2 PV3

Find IRR if CFs are constant:

Or, with CF, enter CFj and press IRR = 9.70%.

Rationale for the IRR Method

IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.

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 .

Construct NPV Profiles

Crossover Point = 8.7%

Discount Rate (%)

IRR > k and NPV > 0 Accept.

k > IRR and NPV < 0. Reject.

Mutually Exclusive Projects

To Find the Crossover Rate

Thus, MIRR assumes cash inflows are reinvested at WACC.

MIRR for Project L (k = 10%)

66.0 12.1 158.1

$158.1 $-100 (1 + MIRRL)3 MIRRL = 16.5%

Why use MIRR versus IRR?

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