Chapter 10

The Basics of
Capital Budgeting

1
Topics
Overview
Methods
NPV
IRR, MIRR
Payback, discounted payback

2
What is capital budgeting?
A process for determining the
profitability of a capital investment.
Long-term decisions; involve large
expenditures.
Very important to firms future.

3
Steps in Capital Budgeting
Estimate cash flows (inflows &
outflows).
Assess risk of cash flows.
Determine r = WACC for project.
WACC = Weighted Avg. Cost of Capital
Evaluate cash flows.

4
Independent vs.
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.

5
What does this represent?
n CFt
= (1 + r)t
t=0

6
NPV: Sum of the PVs of all
cash flows.
n CFt
NPV =
(1 + r)t
t=0

Cost often is CF0 and is negative.

n CFt
NPV = - CF0
(1 + r)t
t=1
7
 Cash Flows for project L and
project S

0 1 2 3
Ls CFs: 10%

-100 10 60 80

0 1 2 3
Ss CFs: 10%

-100 70 50 20

8
 Whats project Ls NPV?

0 1 2 3
Ls CFs: 10%

-100 10 60 80

= NPVL
9
 Whats project Ls NPV?

0 1 2 3
Ls CFs: 10%

-100 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
10
Which project should be chosen?

What if mutually exclusive? L or S?

What if independent projects? L or S?

11
Calculator Solution: Enter
values in CF register for L.

-100 CF0
10 CF1
60 CF2

80 CF3

10 I NPV = 18.78 = NPVL

12
Rationale for the NPV Method
NPV = PV inflows Cost

This is net gain in wealth, so accept

project if NPV > 0.

Choose between mutually exclusive

projects on basis of higher NPV. Adds
most value.
13
Using NPV method, which project(s)
should be accepted?

If project S and L are mutually

exclusive, accept S because
NPVs > NPVL .
If S & L are independent, accept both;
NPV > 0.

14
 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 r, solve for NPV.
n CFt
(1 + r)t
= NPV .
t=0

IRR: Enter NPV = 0, solve for IRR.

n CFt
(1 + IRR)t
= 0.
t=0
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 Whats project Ls IRR?
0 1 2 3
IRR = ?

-100 10 60 80
PV1
PV2
PV3
0 = NPV Enter Cash Flows in CF, then
press IRR:
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 Whats project Ls IRR?
0 1 2 3
IRR = ?

-100 10 60 80
PV1
PV2
PV3
0 = NPV Enter Cash Flows in CF, then
press IRR: IRRL = 18.13%.
IRRS = 23.56%.
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Find IRR if CFs are constant:
0 1 2 3

-100 40 40 40

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Find IRR if CFs are constant:
0 1 2 3

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

Or, with CF, enter CFs and press

IRR = 9.70%.
20
Decisions on Projects S and L
per IRR
IRRS = 18% IRRL = 23%
WACC = 10%
If S and L are independent, what to do?
If S and L are mutually exclusive, what
to do?

21
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%.
So this project adds extra return to
shareholders.
22
Reinvestment Rate
Assumptions
NPV assumes reinvest at r (opportunity
cost of capital).
IRR assumes reinvest CFs at IRR.
Reinvest at opportunity cost, r, is more
realistic, so NPV method is best. NPV
should be used to choose between
mutually exclusive projects.

23
Modified Internal Rate of
Return (MIRR)
MIRR is the discount rate which causes
the PV of a projects terminal value (TV)
to equal the PV of costs.
TV is found by compounding (FV)
inflows at the WACC.
Thus, MIRR assumes cash inflows are
reinvested at the WACC.

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 MIRR for project L: First, find
PV and TV (r = 10%)

0 1 2 3
10%

-100 10.0 60.0 80.0

10%
66.0
10%
12.1
-100 158.1
PV outflows TV inflows
25
 Second, find discount rate that
equates PV and TV

0 1 2 3

MIRR = 16.5%
-100 158.1

PV outflows TV inflows

$100 = $158.1
(1+MIRRL)3

MIRRL = 16.5% 26
To find TV with calculator:
Step 1, find PV of Inflows
First, enter cash inflows in CF register:
CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

Second, enter I = 10.

Third, find PV of inflows:

Press NPV = 118.78

27
Step 2, find TV of inflows.
Enter PV = -118.78, N = 3, I = 10

CPT FV = 158.10 = FV of inflows.

28
Step 3, find PV of outflows.
For this problem, there is only one
outflow, CF0 = -100, so the PV of
outflows is -100.

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Step 4, find IRR of TV of
inflows and PV of outflows.
Enter FV = 158.10, PV = -100, N = 3.
CPT 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.

31
What is the payback period?
The number of years required to
recover a projects cost,

or how long it takes to get the

businesss money back.

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What is the payback period?
0 1 2 3

-100 50 50 50

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What is the payback period?
0 1 2 3

-100 40 40 40

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 What are the payback periods
for projects L and S?

0 1 2 3
Ls CFs: 10%

-100 10 60 80

0 1 2 3
Ss CFs: 10%

-100 70 50 20

35
 Payback for project L

0 1 2 2.4 3

CFt -100 10 60 80
Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

36
 Payback for project S

0 1 1.6 2 3

CFt -100 70 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

37
Strengths and Weaknesses of
Payback
Strengths:
Provides an indication of a projects risk
and liquidity.
Easy to calculate and understand.
Weaknesses:
Ignores the TVM.
Ignores CFs occurring after the payback
period.
38
 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 yrs

Recovers invest. + costs in 2.7 yrs. 39