FM11 Ch 10 The Basics of Capital Budgeting_Evaluating Cash Flows

10 - 1 Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows  Overview and “vocabulary”  Methods  Payback, discounted payback  NPV  IRR, MIRR  Profitability Index  Unequal lives  Economic life 10 - 2 What is capital budgeting?  Analysis of potential projects.  Long-term decisions; involve large expenditures.  Very important to firm’s future. 10 - 3 Steps in Capital Budgeting  Estimate cash flows (inflows & outflows).  Assess risk of cash flows.  Determine r = WACC for project.  Evaluate cash flows. 10 - 4 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. 10 - 5 What is the 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? 10 - 6 Payback for Franchise L (Long: Most CFs in out years) 10 8060 0 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback L 2 + 30/80 = 2.375 years 0 100 2.4 10 - 7 Franchise S (Short: CFs come quickly) 70 2050 0 1 2 3 -100CF t Cumulative -100 -30 20 40 Payback S 1 + 30/50 = 1.6 years 100 0 1.6 = 10 - 8 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. 10 - 9 10 8060 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 - 10 ( ) . 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 − + = ∑ = [...]... -100 .0 1 2 3 10. 0 60.0 80.0 10% 10% MIRR = 16.5% -100 .0 PV outflows $158.1 $100 = (1+MIRRL)3 MIRRL = 16.5% 66.0 12.1 158.1 TV inflows 10 - 30 To find TV with 10B, enter in CFLO: CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80 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 10 - 31... used to choose between mutually exclusive projects 10 - 28 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 10 - 29 MIRR for Franchise L (r = 10% ) 0 10% -100 .0... cost = WACC MIRR also avoids the problem of multiple IRRs Managers like rate of return comparisons, and MIRR is better for this than IRR 10 - 32 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.. .10 - 11 What’s Franchise L’s NPV? Project L: 0 -100 .00 10% 1 2 3 10 60 80 9.09 49.59 60.11 18.79 = NPVL NPVS = $19.98 10 - 12 Calculator Solution Enter in CFLO for L: -100 CF0 10 CF1 60 CF2 80 CF3 10 I NPV = 18.78 = NPVL 10 - 13 Rationale for the NPV Method NPV = PV inflows - Cost = Net gain in wealth Accept project if NPV > 0 Choose between mutually exclusive projects on basis of higher... IRR) n 10 - 17 What’s Franchise L’s IRR? 0 IRR = ? -100 .00 PV1 PV2 PV3 0 = NPV 1 2 3 10 60 80 Enter CFs in CFLO, then press IRR: IRRL = 18.13% IRRS = 23.56% 10 - 18 Find IRR if CFs are constant: 0 1 -100 INPUTS 40 40 3 N OUTPUT 3 40 IRR = ? 2 -100 I/YR 40 0 PV PMT FV 9.70% Or, with CFLO, enter CFs and press IRR = 9.70% 10 - 19 Rationale for the IRR Method If IRR > WACC, then the project’s rate of return... IRRL 10 - 25 To Find the Crossover Rate 1 Find cash flow differences between the projects See data at beginning of the case 2 Enter these differences in CFLO register, then press IRR Crossover rate = 8.68%, rounded to 8.7% 3 Can subtract S from L or vice versa, but better to have first CF negative 4 If profiles don’t cross, one project dominates the other 10 - 26 Two Reasons NPV Profiles Cross 1 Size... NPV Adds most value 10 - 14 Using NPV method, which franchise(s) should be accepted?  If Franchise S and L are mutually exclusive, accept S because NPVs > NPVL  If S & L are independent, accept both; NPV > 0 10 - 15 Internal Rate of Return: IRR 0 1 2 CF0 Cost CF1 CF2 Inflows 3 CF3 IRR is the discount rate that forces PV inflows = cost This is the same as forcing NPV = 0 10 - 16 NPV: Enter r,... Example: WACC = 10% , IRR = 15% Profitable 10 - 20 Decisions on Projects S and L per IRR  If S and L are independent, accept both IRRs > r = 10%  If S and L are mutually exclusive, accept S because IRRS > IRRL 10 - 21 Construct NPV Profiles Enter CFs in CFLO and find NPVL and NPVS at different discount rates: r NPVL 0 5 10 15 20 50 33 19 7 (4) NPVS 40 29 20 12 5 10 - 22 NPV ($) r 60 0 5 10 15 20 50... plant, strip mine 10 - 33 Inflow (+) or Outflow (-) in Year 0 1 2 3 4 5 N - + + + + + N - + + + + - - - - + + + N + + + - - - N - + + - + - NN NN NN 10 - 34 Pavilion Project: NPV and IRR? 0 -800 r = 10% 1 2 5,000 -5,000 Enter CFs in CFLO, enter I = 10 NPV = -386.78 IRR = ERROR Why? 10 - 35 We got IRR = ERROR because there are 2 IRRs Nonnormal CFs two sign changes Here’s a picture: NPV Profile NPV IRR2... CFs two sign changes Here’s a picture: NPV Profile NPV IRR2 = 400% 450 0 -800 100 IRR1 = 25% 400 r 10 - 36 Logic of Multiple IRRs 1 At very low discount rates, the PV of CF2 is large & negative, so NPV < 0 2 At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0 3 In between, the discount rate hits CF2 harder than CF1, so NPV > 0 4 Result: 2 IRRs  . 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. 10 - 5 What. 10 - 1 Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows  Overview and “vocabulary”  Methods  Payback, discounted payback  NPV  IRR, MIRR  Profitability Index  Unequal. Capital Budgeting  Estimate cash flows (inflows & outflows).  Assess risk of cash flows.  Determine r = WACC for project.  Evaluate cash flows. 10 - 4 What is the difference between independent