Você está na página 1de 46

Lecture 8 The Basics of Capital Budgeting

Learning Objectives
Understand the difference between normal and non-normal
cash flow streams.
Understand the difference between mutually exclusive and
independent projects.
Calculate and use the major capital budgeting decision
criteria, which are the 1) payback period, 2) discounted
payback period, 3) Net Present Value (NPV), 4) Internal Rate
of Return (IRR), and 5) Modified IRR (MIRR) for mutually
exclusive and independent projects.
Discuss the strengths and weaknesses of each method.
Understand and interpret the NPV profile.
Calculate and understand the importance of the crossover
point.
Discuss the conflict between NPV and IRR when evaluating
mutually exclusive projects.
Understand why NPV is superior to IRR and MIRR.
Understand the multiple IRRs problem.

1
AB1201: Financial
Management

Lecture 8 The Basics of Capital Budgeting


By: Angie Low
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

3
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Steps to Capital Budgeting


1. Estimate CFs.
Initial investments.
Subsequent cash inflows/ outflows.

2. Assess riskiness of CFs and determine the


appropriate risk-adjusted cost of capital
for discounting cash flows.

3. Find NPV and/or IRR(MIRR).

4
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Capital Budgeting Decision Criteria


Payback
Discounted payback

Net Present Value (NPV)


Internal Rate of Return (IRR)
Modified IRR (MIRR)

5
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

An Illustrative Example
Here are the projects expected after-tax cash
flows (in thousands of dollars):
0 1 2 3
| | | |
Project L -100 10 60 80
Project S -100 70 50 20
Cost of capital = 10% for both projects
Which project(s) should we take up? How
should we analyse them?

6
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Normal Cash Flow Streams versus


Non-normal Cash Flow Streams?
Normal cash flow stream Cost (negative CF)
followed by a series of positive cash inflows.
One change of signs.

Non-normal cash flow stream Two or more


changes of signs.
Most common: Cost (negative CF), then string of
positive CFs, then cost to close project (negative
CF).

7
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Independent Projects versus


Mutually Exclusive Projects
Independent projects if the cash flows of one are
unaffected by the acceptance of the other.
Both projects can be accepted

Mutually exclusive projects if one is accepted, the


other would have to be rejected.
Only one of the projects can be accepted

8
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Capital Budgeting Decision Criteria


Payback
Discounted payback

Net Present Value (NPV)


Internal Rate of Return (IRR)
Modified IRR (MIRR)

0 1 2 3
| | | |
Project L -100 10 60 80
Project S -100 70 50 20

9
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

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?
Calculated by adding projects cash inflows to its
cost until the cumulative cash flow for the project
turns positive.

10
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Calculating Payback

Project Ls Payback Calculation


0 1 2 3

CFt -100 10 60 80
Mutually exclusive
Cumulative Choose the one with shorter
payback!

Independent
Subjective benchmark has to be
PaybackL = used. E.g. Only projects with
PaybackS = payback of less than three years
are accepted.

11
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Weaknesses and Strengths of


Payback Method
Weaknesses
Arbitrary benchmark.
Ignores the time value of money.
Ignores CFs occurring after the payback period.

Strengths
Easy to calculate and understand.
Provides an indication of a projects risk and liquidity.

12
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Discounted Payback Period

Uses discounted cash flows rather than raw CFs.


Cost of capital

0 10% 1 2 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL =
Disc PaybackS =
13
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Lessons Learnt 1
Normal cash flows versus non-normal cash flows.
Independent versus mutually exclusive projects.
Payback period is the number of years it takes to
recover projects initial investment.
To calculate the payback period, we cumulate the cash
flows.
Discounted payback period builds on the payback period
method by cumulating the discounted cash flows.
Decision criteria:
Independent projects: A subjective payback benchmark needs
to be used. Projects are accepted only if payback < benchmark.
Mutually exclusive projects: Choose the one with shorter
payback.

14
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Capital Budgeting Decision Criteria


Payback
Discounted payback

Net Present Value (NPV)


Internal Rate of Return (IRR)
Modified IRR (MIRR)

15
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Net Present Value (NPV)

Sum of the PVs of all cash inflows and


outflows of a project:
N
CFt
NPV
t 0 ( 1 r ) t

CF1 CF2 CFN


CF0
(1 r ) (1 r )
1 2
( 1 r )N

Initial Investment
Cost of capital

16
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

What is Project Ls NPV?


0 1 2 3
| | | |
Project L -100 10 60 80
10 60 80
NPVL - 100 $18.79
( 1 0.1 ) ( 1 0.1 ) ( 1 0.1 )
1 2 3

Financial calculator: Enter CFs into the calculators


CFLO register.
Important to show
CF0 = -100 NPV working in exams!
CF1 = 10 Do not need to show
CF2 = 60 calculator entries
CF3 = 80
Enter I/YR = 10, press NPV button to get NPVL = $18.79.

17
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

What is Project Ss NPV?

0 1 2 3
| | | |

Project S -100 70 50 20

18
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Rationale for the NPV Method

NPV = PV of Inflows PV of Costs


= Net gain in wealth

NPV indicates how much shareholders wealth will


increase if project is taken up.
Higher NPV Higher increase in shareholders wealth.
NPVL = $18.79 Shareholders wealth increases by
$18.79 if Project L is accepted.
NPVS = $19.98 Shareholders wealth increases by
$19.98 if Project S is accepted.

19
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Rationale for the NPV Method

NPV = PV of Inflows PV of Costs


= Net gain in wealth

If projects are independent, accept if the project


NPV > 0.
Accept both projects
If projects are mutually exclusive, accept projects
with the highest positive NPV, those that add the
most value.
Accept S since NPVS > NPVL

20
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

NPV Profiles
A graphical representation of project
NPVs at various different costs of capital.

Cost of Capital NPVL NPVS

0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5

21
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Drawing NPV profiles


NPV
($)

.
60

. .
50

40

30 . .
.. . ..
20 Crossover Point = 8.7%
10 S

0
5 10 15
. L 20 23.6
Discount Rate (%)

-10
22
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Lessons Learnt 2
N
CFt
NPV
t 0 ( 1 r ) t

NPV = PV of inflows PV of costs


NPV represents the net gain in shareholders wealth if a
project is accepted.
Decision criteria:
Independent projects: Projects are accepted only if NPV > 0.
Mutually exclusive projects: Choose the one with higher NPV.
NPV profile is a graphical representation of project
NPVs at various different cost of capital.
The choice of project differs depending on whether the
discount rate is higher or lower than the crossover point.

23
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Capital Budgeting Decision Criteria

Payback
Discounted payback

Net Present Value (NPV)


Internal Rate of Return (IRR)
Modified IRR (MIRR)

24
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Internal Rate of Return (IRR)

IRR is the discount rate that forces NPV = 0:


N
CFt
0 t
t 0 (1 IRR)

IRR is the expected annual rate of return that


the firm will earn if it invests in the project and
receives the given cash flows.

25
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

IRR for Project L


0 1 2 3
| | | |
Project L -100 10 60 80
10 60 80
0 - 100
( 1 IRR L ) ( 1 IRR L
1
) ( 1 IRR L ) 3
2

Solving for IRR with a financial calculator:


Enter CFs in CFLO register
Press IRR; IRRL = 18.13%
Expected annual return for Project L is 18.13%.

26
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

What is the IRR for Project S?

0 1 2 3
| | | |

Project S -100 70 50 20

27
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Decision Criteria for IRR Method


If IRR > cost of capital, the projects return exceeds
its costs and there is some return left over to boost
stockholders returns.
Mutually exclusive projects:
Independent projects:
Accept project with highest IRR
If IRR > cost of capital, accept project.
provided project IRR > cost of
If IRR < cost of capital, reject project.
capital.

If Projects S and L are independent, accept both


projects as both IRR > cost of capital = 10%.
If Projects S and L are mutually exclusive, accept S,
because IRRs > IRRL.

28
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Comparing NPV and IRR


NPV
($)

.
60

. .
50

40

30 . . Crossover Point
= 8.7%

.. . ..
20

10 S

0
5 10 15
. L 20 23.6
Discount Rate (%)

-10
29
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Comparing the NPV and IRR methods


If projects are independent, the two methods
always lead to the same accept/reject decisions.
If projects are mutually exclusive
If discount rate > crossover rate, the methods lead to the
same decision and there is no conflict.
If discount rate < crossover rate, the methods lead to
different accept/reject decisions.

30
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Comparing the NPV and IRR methods


The conflict between NPV and IRR arises due to timing
differences in cash flows and differences in project size
(scale).
When there are differences in cash flow timing or project
scale, this implies that the firm will have different amounts to
reinvest at various years depending on which of the mutually
exclusive projects it accepts.
The rate at which the intermediate cash flows are reinvested
at is a critical issue.

31
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

NPV is Superior 1) Reinvestment rate


assumptions
NPV method assumes intermediate CFs are reinvested
at the cost of capital.
IRR method assumes intermediate CFs are reinvested
at IRR.
Assuming CFs are reinvested at the cost of capital is
more realistic.
NPV method is better.
NPV method should be used to choose
between mutually exclusive projects.

32
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

NPV is Superior 2) Projects with


different scales
Suppose a firm with adequate access to capital and a 10% cost
of capital is choosing between two equally risky, mutually
exclusive projects. Both projects will last for 10 years.
Project Large (L) Project Small (S)
CF0 -$100,000 -$1.00
CF1-10 $50,000 $0.60
WACC 10% 10%
NPV
IRR

Box titled Why NPV is better than IRR. Adapted from Essentials of Financial
Management (p. 414), by Brigham, Houston, Hsu, Kong, and Bany-Ariffin, 2013,
Singapore: Cengage Learning.
33
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Lessons Learnt 3 N
CFt
0
IRR is the discount rate that forces NPV = 0 t 0 ( 1 IRR ) t

IRR is the expected annual rate of return on a project.


Decision criteria:
Independent projects: Projects are accepted only if IRR > cost of capital.
Mutually exclusive projects: Choose the one with higher IRR.
For independent projects, IRR and NPV always gives the same
accept/reject decision.
For mutually exclusive projects, IRR and NPV may give
conflicting decision:
Base decision on NPV criteria as NPV is superior.
NPV assumes reinvestment of intermediate CFs at the cost of capital
which is more realistic. IRR assumes reinvestment at IRR rate.
NPV also gives a better indication of how much shareholders wealth is
affected when evaluating projects with different scale.

34
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Capital Budgeting Decision Criteria


Payback
Discounted payback

Net Present Value (NPV)


Internal Rate of Return (IRR)
Modified IRR (MIRR)

35
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Since managers prefer the IRR to the


NPV method, is there a better IRR
measure?
Modify the IRR method such that intermediate cash
flows are reinvested at the cost of capital.

MIRR (modified IRR) 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 cost of capital.

36
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Calculating MIRR

0 10% 1 2 3

-100.0 10.0 60.0 80.0


66.0
12.1
Discount @ MIRR to t = 0
158.1
$158.1 TV inflows
PV outflows $100 =
(1+MIRR)3
MIRRL = 16.5%

37
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Recap: MIRR method


To calculate MIRR:
PV (cash outflows)= PV (terminal values of cash inflows)

PV cash outflows PV (TV cash inflows)


N

N
COFt CIF (1 r ) N t


t 0 (1 r ) t
t 0
( 1 MIRR ) N

38
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

What is the MIRR for Project S?

0 1 2 3
| | | |

Project S -100 70 50 20

39
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Why use MIRR versus IRR?


Managers like rate of return comparisons, and MIRR is better
for this than IRR.
MIRR assumes reinvestment at cost of capital which is more
realistic.
MIRR also avoids the multiple IRRs problem.
Is MIRR superior or equivalent to NPV?
When evaluating mutually exclusive projects, NPV is superior to
MIRR but MIRR is superior to IRR
MIRR has the same problem with IRR when evaluating projects
with different scale (Refer to the box titled Why NPV is better
than IRR in section 12.3 of the textbook)
When evaluating independent projects, the three criteria
give the same accept/ reject decisions.
40
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Multiple IRRs Example:


Find Project Ps NPV and IRR.
Project P has cash flows (in 000s): CF0 = -$0.8 million,
CF1 = $5 million, and CF2 = -$5 million.

0 1 2
10%

-800 5,000 -5,000

Enter CFs into calculator CFLO register. Non-normal


Cash flows!
Enter I/YR = 10.
NPV = -$386.78.
IRR = 25% or ERROR Why?

41
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

NPV Profiles: Multiple IRRs


Suspect multiple IRRs
problem if the CFs are non-
normal and if cash inflows
NPV and outflows are roughly
similar in magnitude

IRR2 = 400%
450
0 Discount rate
100 400
IRR1 = 25%
-800

42
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

When to use the MIRR instead of the


IRR? Accept Project P?
When there are non-normal CFs and more than one IRR, use
MIRR.
MIRR of Project P:

0 1 2
10%

-800 5,000 -5,000

Do not accept Project P.


NPV = -$386.78 < 0.
MIRR = 5.6% < Cost of capital =10%.

43
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Lessons Learnt 4
MIRR is a modified version of the IRR where
intermediate cash flows are assumed to be
reinvested at the cost of capital.
More realistic reinvestment assumption than IRR.
MIRR avoids the multiple IRRs problem.
Decision criteria is similar to IRR
NPV, IRR, and MIRR leads to same accept/reject
decision when choosing independent projects.
When choosing mutually exclusive projects, conflicts
can still arise between NPV and MIRR.
NPV is superior to MIRR.

44
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion

Capital Budgeting Decision Criteria

Payback
Discounted payback

Net Present Value (NPV)

Internal Rate of Return (IRR)


Modified IRR (MIRR) Assumes interim CFs
reinvested at cost of capital

45
List of Images (1 of 2)
Slide no. Title of image/Source Author/Website License/Terms of use
3 IPhone at Macworld (rear view) blakeburris CC BY 2.0
http://www.flickr.com/photos/blake https://www.flickr.com/phot http://creativecommons.org/licenses/
4tx/352328190 os/blake4tx/ by/2.0/deed.en

46

Você também pode gostar