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1、11 - 1Copyright 2001 by Harcourt, Inc.All rights reserved.Should we build thisplant?CHAPTER 11The Basics of Capital Budgeting11 - 2Copyright 2001 by Harcourt, Inc.All rights reserved.What is capital budgeting?nAnalysis of potential additions to fixed assets.nLong-term decisions; involve large expend
2、itures.nVery important to firms future.11 - 3Copyright 2001 by Harcourt, Inc.All rights reserved.Steps1. 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.11 - 4Copyright 2001 by Harcourt, Inc.All right
3、s reserved.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.11 - 5Copyright
4、 2001 by Harcourt, Inc.All rights reserved.An Example of Mutually Exclusive ProjectsBRIDGE vs. BOAT to get products across a river.11 - 6Copyright 2001 by Harcourt, Inc.All rights reserved.Normal Cash Flow Project:Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.N
5、onnormal Cash Flow Project:Two or more changes of signs.Most common: Cost (negativeCF), then string of positive CFs,then cost to close project.Nuclear power plant, strip mine.11 - 7Copyright 2001 by Harcourt, Inc.All rights reserved.Inflow (+) or Outflow (-) in Year012345NNN-+N-+-NN-+N+-N-+-+-NN11 -
6、 8Copyright 2001 by Harcourt, Inc.All rights reserved.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?11 - 9Copyright 2001 by Harcourt, Inc.All rights reserved.Payback for Project L(Long: Large CFs in later years)10600
7、123-100=CFtCumulative -100-90-3050PaybackL2+30/80 = 2.375 years01002.48011 - 10Copyright 2001 by Harcourt, Inc.All rights reserved.Project S (Short: CFs come quickly)7020500123-100CFtCumulative -100-302040PaybackL1 + 30/50 = 1.6 years10001.6=11 - 11Copyright 2001 by Harcourt, Inc.All rights reserved
8、.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.11 - 12Copyright 2001 by Harcourt, Inc.All rights reserved.Discounted Payback: Uses discount
9、edrather than raw CFs.1080600123CFtCumulative -100-90.91-41.3218.79Discountedpayback2 + 41.32/60.11 = 2.7 yearsPVCFt-100-10010%9.0949.5960.11=Recover invest. + cap. costs in 2.7 years.11 - 13Copyright 2001 by Harcourt, Inc.All rights reserved.NPV: Sum of the PVs of inflows and outflows.11 - 14Copyri
10、ght 2001 by Harcourt, Inc.All rights reserved.Whats Project Ls NPV?108060012310%Project L:-100.009.0949.5960.1118.79 = NPVLNPVS = $19.98.11 - 15Copyright 2001 by Harcourt, Inc.All rights reserved.Calculator SolutionEnter in CFLO for L:-10010608010CF0CF1NPVCF2CF3I= 18.78 = NPVL11 - 16Copyright 2001 b
11、y Harcourt, Inc.All rights reserved.Rationale for the NPV MethodNPV= PV inflows Cost= Net gain in wealth.Accept project if NPV 0.Choose between mutually exclusive projects on basis ofhigher NPV. Adds most value.11 - 17Copyright 2001 by Harcourt, Inc.All rights reserved.Using NPV method, which projec
12、t(s) should be accepted?nIf Projects S and L are mutually exclusive, accept S because NPVs NPVL .nIf S & L are independent, accept both; NPV 0.11 - 18Copyright 2001 by Harcourt, Inc.All rights reserved.Internal Rate of Return: IRR0123CF0CF1CF2CF3CostInflowsIRR is the discount rate that forcesPV infl
13、ows = cost. This is the sameas forcing NPV = 0.11 - 19Copyright 2001 by Harcourt, Inc.All rights reserved.NPV: Enter k, solve for NPV.IRR: Enter NPV = 0, solve for IRR.11 - 20Copyright 2001 by Harcourt, Inc.All rights reserved.Whats Project Ls IRR?1080600123IRR = ?-100.00PV3PV2PV10 = NPVEnter CFs in
14、 CFLO, then press IRR:IRRL = 18.13%. IRRS = 23.56%.11 - 21Copyright 2001 by Harcourt, Inc.All rights reserved. 4040 400123IRR = ?Find IRR if CFs are constant:-100Or, with CFLO, enter CFs and press IRR = 9.70%.3-100 40 0 9.70%INPUTSOUTPUTNI/YRPVPMTFV11 - 22Copyright 2001 by Harcourt, Inc.All rights r
15、eserved.9010909001210IRR = ?Q.How is a projects IRRrelated to a bonds YTM?A.They are the same thing.A bonds YTM is the IRRif you invest in the bond.-1134.2IRR = 7.08% (use TVM or CFLO).11 - 23Copyright 2001 by Harcourt, Inc.All rights reserved.Rationale for the IRR MethodIf IRR WACC, then the projec
16、ts rate of return is greater than its cost-some return is left over to boost stockholders returns.Example: WACC = 10%, IRR = 15%. Profitable.11 - 24Copyright 2001 by Harcourt, Inc.All rights reserved.IRR Acceptance CriterianIf IRR k, accept project.nIf IRR k = 10%.nIf S and L are mutually exclusive,
17、 accept S because IRRS IRRL .11 - 26Copyright 2001 by Harcourt, Inc.All rights reserved.Construct NPV ProfilesEnter CFs in CFLO and find NPVL andNPVS at different discount rates: k 05101520NPVL50 33197(4 NPVS402920125 (4)11 - 27Copyright 2001 by Harcourt, Inc.All rights reserved.-1001020304050605101
18、52023.6NPV ($)Discount Rate (%)IRRL = 18.1%IRRS = 23.6%Crossover Point = 8.7%k 05101520NPVL5033197(4) NPVS402920125 SL.11 - 28Copyright 2001 by Harcourt, Inc.All rights reserved.NPV and IRR always lead to the same accept/reject decision for independent projects:k IRRand NPV kand NPV 0Accept.11 - 29C
19、opyright 2001 by Harcourt, Inc.All rights reserved.Mutually Exclusive Projectsk 8.7 kNPV%IRRSIRRLLSk NPVS , IRRS IRRLCONFLICT k 8.7: NPVS NPVL , IRRS IRRLNO CONFLICT 11 - 30Copyright 2001 by Harcourt, Inc.All rights reserved.To Find the Crossover Rate1. Find cash flow differences between the project
20、s. 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.11 - 31Copyright 2001 by H
21、arcourt, Inc.All rights reserved.Two Reasons NPV Profiles Cross1. 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 provi
22、des more CF in early years for reinvestment. If k is high, early CF especially good, NPVS NPVL.11 - 32Copyright 2001 by Harcourt, Inc.All rights reserved.Reinvestment Rate AssumptionsnNPV assumes reinvest at k (opportunity cost of capital).nIRR assumes reinvest at IRR.nReinvest at opportunity cost,
23、k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.11 - 33Copyright 2001 by Harcourt, Inc.All rights reserved.Managers like rates-prefer IRR to NPV comparisons. Can we give them a better IRR?Yes, MIRR is the discount rate thatcauses the PV o
24、f a projects terminalvalue (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.Thus, MIRR assumes cash inflows are reinvested at WACC.11 - 34Copyright 2001 by Harcourt, Inc.All rights reserved.MIRR = 16.5%10.080.060.0012310% 66.0 12.1158.1MIRR for Project L (k = 10%)-100.010%10%T
25、V inflows-100.0PV outflowsMIRRL = 16.5% $100 = $158.1(1 + MIRRL)311 - 35Copyright 2001 by Harcourt, Inc.All rights reserved.To find TV with HP 10B, enter in CFLO:I = 10NPV = 118.78 = PV of inflows.Enter PV = -118.78, N = 3, I = 10, PMT = 0.Press FV = 158.10 = FV of inflows.Enter FV = 158.10, PV = -1
26、00, PMT = 0, N = 3.Press I = 16.50% = MIRR.CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 8011 - 36Copyright 2001 by Harcourt, Inc.All rights reserved.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 retur
27、n comparisons, and MIRR is better for this than IRR.11 - 37Copyright 2001 by Harcourt, Inc.All rights reserved.Pavilion Project: NPV and IRR?5,000-5,000012k = 10%-800Enter CFs in CFLO, enter I = 10.NPV = -386.78IRR = ERROR. Why?11 - 38Copyright 2001 by Harcourt, Inc.All rights reserved.We got IRR =
28、ERROR because there are 2 IRRs. Nonnormal CFs-two signchanges. Heres a picture:NPV Profile450-8000400100IRR2 = 400%IRR1 = 25%kNPV11 - 39Copyright 2001 by Harcourt, Inc.All rights reserved.Logic of Multiple IRRs1. At very low discount rates, the PV of CF2 is large & negative, so NPV 0.2. At very high
29、 discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV 0.4. Result: 2 IRRs. 11 - 40Copyright 2001 by Harcourt, Inc.All rights reserved.Could find IRR with calculator:1. Enter CFs as before.2. Enter a “guess” as to IRR by storing the guess. Try 10%:10STO IRR = 25% = lower
30、 IRRNow guess large IRR, say, 200:200STO IRR = 400% = upper IRR 11 - 41Copyright 2001 by Harcourt, Inc.All rights reserved.When there are nonnormal CFs and more than one IRR, use MIRR:012-800,0005,000,000-5,000,000PV outflows 10% = -4,932,231.40.TV inflows 10% = 5,500,000.00.MIRR = 5.6%11 - 42Copyright 2001 by Harcourt, Inc.All rights reserved.Accept Project P?NO. Reject because MIRR = 5.6% k = 10%.Also, if MIRR k, NPV will be negative: NPV = -$386,777.
