The Basics of Capital Budgeting: Evaluating Cash Flows

Should we build this plant?

What is capital budgeting?

Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firms future.

Major projects classification category

Replacement maintenance of business Replacement cost reduction Expansion of existing products or markets Expansion into new products or markets Safety and/or environmental projects Research and development Long-term contracts

Steps
1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.

Six key methods

1. 2. 3. 4. 5. 6. Payback period Discounted payback NPV IRR Modified IRR Profitability Index

Payback period
The number of years required to recover a projects cost, or how long does it take to get the businesss money back?

Payback for Project L (Long: Most CFs in out 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

Project S (Short: CFs come quickly)

0 CFt -100 1

1.6 2

3 20 40

70 100 50 -30 0 20

Cumulative -100 PaybackS

= 1 + 30/50 = 1.6 years

Strengths of Payback: 1. Provides an indication of a projects liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the TVM. 2. Ignores CFs occurring after the payback period.

Discounted Payback: Uses discounted 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 yrs

Recover invest. + cap. costs in 2.7 yrs.

NPV

CFt NPV = . t t = 0 (1 + k )
n

Cost often is CF0 and is negative.

NPV =
t =1 n

(1+ k)

CFt

CF0 .

Whats Project Ls NPV?

Project L: 0 -100.00 10% 1 10 2 60 3 80

9.09 49.59 60.11 18.79 = NPVL

NPVS = $19.98.

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.

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.

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.

NPV: Enter k, solve for NPV.

CFt = NPV. t t = 0 (1 + k )
n

IRR: Enter NPV = 0, solve for IRR.

CFt t = 0. t = 0 (1 + IRR)
n

Whats Project Ls IRR?

0
IRR = ?

1 10

2 60

3 80

-100.00 PV1 PV2 PV3 0 = NPV

IRRL = 18.13%. IRRS = 23.56%.

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.

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

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) NPVS 40 29 20 12 5

NPV ($)
60 50 40 30 20 10 0 0 -10 5 10 15 20 23.6

k 0 5 10 15 20

NPVL 50 33 19 7 (4)

NPVS 40 29 20 12 5

Crossover Point = 8.7%

S L IRRS = 23.6%

Discount Rate (%)

IRRL = 18.1%

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.

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.

Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?
Yes, 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 inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC.

MIRR for Project L (k = 10%)

0 -100.0
10%

1 10.0
10% MIRR = 16.5%

2 60.0
10%

3 80.0 66.0 12.1 158.1 TV inflows

-100.0 PV outflows

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

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.