the capital budgeting evaluating cash flows

1 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 CHAPTER 8 The Capital Budgeting: Evaluating Cash Flows  8.1 Overview  8.2 Payback Period  8.3 Net Present Value  8.4 Profitability Index  8.5 Internal Rate of Return  Unequal lives  Economic life 2 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 8.1 Overview  Analysis of potential projects.  Long-term decisions; involve large expenditures.  Very important to firm’s future. 3 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Steps in Capital Budgeting  Estimate cash flows (inflows & outflows).  Assess risk of cash flows.  Determine r = WACC for project.  Evaluate cash flows. 4 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 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. 5 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 8.2 Payback Period The number of years required to recover a project’s cost, or how long does it take to get the business’s money back? 6 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Payback for Franchise L (Long: Most CFs in out years) 10 80 60 0 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback L 2 + 30/80 = 2.375 years 0 100 2.4 7 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Franchise S (Short: CFs come quickly) 70 20 50 0 1 2 3 -100 CF t Cumulative -100 -30 20 40 Payback S 1 + 30/50 = 1.6 years 100 0 1.6 = 8 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the TVM. 2. Ignores CFs occurring after the payback period. 9 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 10 80 60 0 1 2 3 CF t Cumulative -100 -90.91 -41.32 18.79 Discounted payback 2 + 41.32/60.11 = 2.7 yrs Discounted Payback: Uses discounted rather than raw CFs. PVCF t -100 -100 10% 9.09 49.59 60.11 = Recover invest. + cap. costs in 2.7 yrs. 10 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 8.3 Net Present Value 11 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012   . 1 0 t t n t r CF NPV     NPV: Sum of the PVs of inflows and outflows. Cost often is CF 0 and is negative.   . 1 0 1 CF r CF NPV t t n t      12 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 What’s Franchise L’s NPV? 10 80 60 0 1 2 3 10% Project L: -100.00 9.09 49.59 60.11 18.79 = NPV L NPV S = $19.98. 13 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Calculator Solution Enter in CFLO for L: -100 10 60 80 10 CF 0 CF 1 NPV CF 2 CF 3 I = 18.78 = NPV L 14 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 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. 15 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Using NPV method, which franchise(s) should be accepted?  If Franchise S and L are mutually exclusive, accept S because NPV s > NPV L .  If S & L are independent, accept both; NPV > 0. 16 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 8.4 Profitability Index Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment. The ratio is calculated as follows: 17 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 8.5 Internal Rate of Return 0 1 2 3 CF 0 CF 1 CF 2 CF 3 Cost Inflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. 18 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012   . 1 0 NPV r CF t t n t       t n t t CF IRR     0 1 0. NPV: Enter r, solve for NPV. IRR: Enter NPV = 0, solve for IRR. 19 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 What’s Franchise L’s IRR? 10 80 60 0 1 2 3 IRR = ? -100.00 PV 3 PV 2 PV 1 0 = NPV Enter CFs in CFLO, then press IRR: IRR L = 18.13%. IRR S = 23.56%. 20 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 40 40 40 0 1 2 3 IRR = ? Find IRR if CFs are constant: -100 Or, with CFLO, enter CFs and press IRR = 9.70%. 3 -100 40 0 9.70% N I/YR PV PMT FV INPUTS OUTPUT 21 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Rationale for the IRR Method If IRR > WACC, then the project’s rate of return is greater than its cost some return is left over to boost stockholders’ returns. Example: WACC = 10%, IRR = 15%. Profitable. 22 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Decisions on Projects S and L per IRR  If S and L are independent, accept both. IRRs > r = 10%.  If S and L are mutually exclusive, accept S because IRR S > IRR L . 23 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Construct NPV Profiles Enter CFs in CFLO and find NPV L and NPV S at different discount rates: r 0 5 10 15 20 NPV L 50 33 19 7 NPV S 40 29 20 12 5 (4) 24 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 -10 0 10 20 30 40 50 60 0 5 10 15 20 23.6 NPV ($) Discount Rate (%) IRR L = 18.1% IRR S = 23.6% Crossover Point = 8.7% r 0 5 10 15 20 NPV L 50 33 19 7 (4) NPV S 40 29 20 12 5 S L 25 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 NPV and IRR always lead to the same accept/reject decision for independent projects: r > IRR and NPV < 0. Reject. NPV ($) r (%) IRR IRR > r and NPV > 0 Accept. 26 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Mutually Exclusive Projects r 8.7 r NPV % IRR S IRR L L S r < 8.7: NPV L > NPV S , IRR S > IRR L CONFLICT r > 8.7: NPV S > NPV L , IRR S > IRR L NO CONFLICT 27 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 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 don’t cross, one project dominates the other. 28 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 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 r favors small projects. 2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF especially good, NPV S > NPV L . 29 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Reinvestment Rate Assumptions  NPV assumes reinvest at r (opportunity cost of capital).  IRR assumes reinvest 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. 30 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 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 project’s 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. 31 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 MIRR = 16.5% 10.0 80.0 60.0 0 1 2 3 10% 66.0 12.1 158.1 MIRR for Franchise L (r = 10%) -100.0 10% 10% TV inflows -100.0 PV outflows MIRR L = 16.5% $100 = $158.1 (1+MIRR L ) 3 32 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 To find TV with 10B, enter in CFLO: I = 10 NPV = 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 = -100, PMT = 0, N = 3. Press I = 16.50% = MIRR. CF 0 = 0, CF 1 = 10, CF 2 = 60, CF 3 = 80 33 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 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. 34 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 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. 35 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Inflow (+) or Outflow (-) in Year 0 1 2 3 4 5 N NN - + + + + + N - + + + + - NN - - - + + + N + + + - - - N - + + - + - NN 36 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Pavilion Project: NPV and IRR? 5,000 -5,000 0 1 2 r = 10% -800 Enter CFs in CFLO, enter I = 10. NPV = -386.78 IRR = ERROR. Why? 37 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 We got IRR = ERROR because there are 2 IRRs. Nonnormal CFs—two sign changes. Here’s a picture: NPV Profile 450 -800 0 400 100 IRR 2 = 400% IRR 1 = 25% r NPV 38 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Logic of Multiple IRRs 1. At very low discount rates, the PV of CF 2 is large & negative, so NPV < 0. 2. At very high discount rates, the PV of both CF 1 and CF 2 are low, so CF 0 dominates and again NPV < 0. 3. In between, the discount rate hits CF 2 harder than CF 1 , so NPV > 0. 4. Result: 2 IRRs. 39 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Could find IRR with calculator: 1. Enter CFs as before. 2. Enter a “guess” as to IRR by storing the guess. Try 10%: 10 STO IRR = 25% = lower IRR Now guess large IRR, say, 200: 200 STO IRR = 400% = upper IRR 40 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 When there are nonnormal CFs and more than one IRR, use MIRR: 0 1 2 -800,000 5,000,000 -5,000,000 PV outflows @ 10% = -4,932,231.40. TV inflows @ 10% = 5,500,000.00. MIRR = 5.6% [...]... of capital Externally raised capital can have large flotation costs, which increase the cost of capital Investors often perceive large capital budgets as being risky, which drives up the cost of capital (More ) 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting 53 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting 54 Capital Rationing Reason: Companies want to avoid the. .. Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects: An increasing marginal cost of capital 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting Capital rationing 51 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting 52 Increasing Marginal Cost of Capital If external funds will be raised, then the NPV of all projects should... flotation costs) and the indirect costs of issuing new capital  Capital rationing occurs when a company chooses not to fund all positive NPV projects Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital  The company typically sets an upper limit on the total amount of capital expenditures... (100) (40) 3 4,132 3,415 7,547 60 60 B02022 – Chapter 8 -The Criteria of Capital Budgeting 1 Franchise S: (100) 60 2 60 (105) (45) 3 60 45 B02022 – Chapter 8 -The Criteria of Capital Budgeting 10% 4 4,132 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 46 Consider another project with a 3-year life If terminated prior to Year 3, the machinery will have positive salvage value 4 Year 0... 23/8/2012 (5) 3 1.75 B02022 – Chapter 8 -The Criteria of Capital Budgeting NPV(no) = -$123 NPV(2) = $215 NPV(1) = -$273 49 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting 50 Choosing the Optimal Capital Budget Conclusions The project is acceptable only if operated for 2 years A project’s engineering life does not always equal its economic life Finance theory says to accept all positive... it will make in the upcoming year (More ) 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting (More ) 55 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting 56 Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates,... companies “filter” out the worst projects by limiting the total amount of projects that can be accepted Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project (More ) 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting 57 23/8/2012... repeated after 2 years to generate additional profits Can use either replacement chain or equivalent annual annuity analysis to make decision NPVL > NPVS But is L better? Can’t say yet Need to perform common life analysis 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting 43 23/8/2012 B02022 – Chapter 8 -The Criteria of Capital Budgeting 44 Replacement Chain Approach (000s) Or, use NPVs:... because MIRR = 5.6% < r = 10% 0 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 CF0 CF1 Nj I NPV S -100,000 60,000 2 10 33.5 23/8/2012 L -100,000 33,500 4 10 4,132 60 Project L: (100) 33.5 41 2 Project S: (100) 60 Also, if MIRR < r, NPV will be negative: NPV = -$386,777 1 6,190 3 4 33.5 33.5 B02022 – Chapter 8 -The Criteria of Capital Budgeting 42 Note that Project S could be repeated... choose L 23/8/2012 3 Compare to Franchise L NPV = $6,190 If the cost to repeat S in two years rises to $105,000, which is best? (000s) 0 2 60 60 NPV = $7,547 23/8/2012 1 4 47 23/8/2012 CF ($5,000) 2,100 2,000 1,750 Salvage Value $5,000 3,100 2,000 0 B02022 – Chapter 8 -The Criteria of Capital Budgeting 48 Assuming a 10% cost of capital, what is the project’s optimal, or economic life? CFs Under Each Alternative . 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 B02022. 3 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 Steps in Capital Budgeting  Estimate cash flows (inflows & outflows).  Assess risk of cash flows.  Determine r. 1 B02022 – Chapter 8 -The Criteria of Capital Budgeting 23/8/2012 CHAPTER 8 The Capital Budgeting: Evaluating Cash Flows  8.1 Overview  8.2 Payback Period 