Chapter 10 Capital Budgeting Decisions

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Chapter 10 Outline• What is capital budgeting?• Where does value come from?• Discounted cash flow and maximizing

owners’ wealth

The Capital

Budgeting Process

• The net present value method (NPV)• The internal rate of return (IRR)• Payback methods• The profitability index• What methods do companies really use?

Evaluating

Investment

Projects

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A capital expenditure is a company’s investment in long-lived assets, which may be tangible assets, such as property, plants, and equipment, or intangible assets, such as research and development, copyrights, brand names, and franchise agreements.

Tangible assets are hard, physical assets, whereas intangible ones are more abstract; it is easier for a company to borrow against tangible assets than against intangible ones.

The capital budgeting process

What is capital budgeting?Analysis of potential additions to fixed

assets.Long-term decisions; involve large

expenditures.Necessary for a company’s future.

Steps to capital budgeting

Make a decision.

Apply a capital budgeting technique (e.g., NPV).

Determine the appropriate cost of capital.

Assess riskiness of the cash flows

Estimate cash flows (inflows & outflows).

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Where does value come from?A company that does not invest effectively will find itself at a competitive disadvantage, which in the extreme will affect its long-term survival. In the short run, poor investment decisions will make a company

less attractive than those that have better prepared themselves for the future.

Recall from economics that to earn more than a “normal” profit, a company must have some type of comparative or competitive advantage.

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Normal profit - the return on an investment that compensates the investor for explicit and implicit costs, where implicit costs include the opportunity cost of the investor’s capital.

Economic profit - the return on an investment in excess of the normal profit. This is the essence of creating value: generating economic profits through capital investment.

What profit?

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ValueA comparative advantage is the ability of a company to produce a product at a lower cost than its competitors.

This includes the innate advantage that a company has over other companies due to access to resources, inputs, or markets.

Examples of such access include ownership of oil fields, mines, chemicals, land, or production of inputs.

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Competitive advantage - any strategy or company action that reduces the competition that the company experiences.

These advantages include patents, copyrights, and trademarks, which may keep competitors at bay, or at least slow down imitations of products.

An example of competitive advantage is economies of scale;

Another example of a competitive advantage is when a government grants a monopoly to a company.

Value

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Michael Porter reframed these basic economic principles by identifying five critical factors that determine the attractiveness of an industry in terms of the ability to generate economic profit, often referred to as the five forces:

1. Entry barriers2. The threat of substitutes3. The bargaining power of buyers4. The bargaining power of suppliers5. Rivalry among existing competitors

Porter’s Five Forces

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DCF valuation involves estimating future cash flows and comparing their discounted values with investment outlays required today. In this way, they are technically identical to the approaches used

to evaluate bonds and stock. The only practical difference is that whereas the cash

flows are fixed in valuing bonds and shares in the sense that the analyst cannot change them, in making capital investment decisions the analyst can change the underlying cash flows by changing the structure of the project.

Discounted cash flow (DCF) and maximizing owners’ wealth

What is the difference between independent and mutually exclusive projects?

Independent projects – if the cash flows of one are unaffected by the acceptance of the other.

Mutually exclusive projects – if the cash flows of one affects the acceptance of the other.

What is the difference between normal and nonnormal cash flow streams?

Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs.

Nonnormal cash flow stream – 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, etc.

Techniques for evaluating cash flows

Net present value

Internal rate of return

Modified internal rate of return

Payback periods

Profitability index

Net present value

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The net present value (NPV) of an investment is the estimated value added of a project, which we calculate as the sum of the present value of all future after-tax incremental cash flows generated by an initial cash outlay, less the present value of the investment outlays.

The NPV is the present value of the expected cash flows net of the costs needed to generate them.

where CFn = the estimated cash flow at time n, and CF0 = the initial cash outlay, which is a negative cash flow.

The net present value

Sample projectsEnd of year cash

flows

Year Project A Project B

0 -$100.00 -$100.00

1 $25.00 $0.00

2 $50.00 $0.00

3 $75.00 $155.00

Assume that the required rate of return for each project is 10%

Net Present Value (NPV)The net present value is the sum of the

PVs of all cash inflows and outflows of a project.

The discount rate is the project’s cost of capital, r.

N

0tt

t

)r 1 (CF

NPV

What is Project A’s NPV?

Year Cash flow

Present value of cash

flow

0 -$100.00 -$100.000

1 $25.00 $22.727

2 $50.00 $41.322

3 $75.00 $56.349

NPV = $20.398

Solving for NPV:Financial calculator solution

HP10B Enter CFs into the calculator’s CF register.

CF0 = -100

CF1 = 25

CF2 = 50

CF3 = 75

Enter I/YR = 10, then NPV

TI83/84 Enter CFs for

period 1 through 3 in a list:

{25,50,75}, say L1 Use NPV(.1,-

100,L1)

Using Excel: Project A’s NPV

A B

1 Year Cash flow2 0 -$100.003 1 $25.004 2 $50.005 3 $75.006 NPV $20.398 =NPV(0.1,B3:B5)+B2

Rationale for the NPV Method

NPV = PV of inflows – PV of outflows

= Added value If projects are independent, accept if the

project NPV > $0. If projects are mutually exclusive, accept

projects with the highest positive NPV, those that add the most value.

NPV profiles

0% 2% 4% 6% 8% 10%

12%

14%

16%

18%

20%

22%

24%

-$30

-$20

-$10

$0

$10

$20

$30

$40

$50

$60Project A Project B

Discount rate

NP

V

The internal rate of return

Internal rate of return (IRR)

Nt

tt 0

CF$0

(1 IRR)

The internal rate of return (IRR) is the discount rate that forces the present value of the inflows equal to the present value of the outflows, and the NPV = $0:

Solving for NPV:financial calculator solution

HP10B

Enter CFs into the calculator’s CF register.

CF0 = -100

CF1 = 25

CF2 = 50

CF3 = 75

Then IRR

TI83/84

Enter CFs for period 1 through 3 in a list:{25,50,75} STO L1The IRR(-100,L1)

Using excel: project AA B

1 Year Cash flow2 0 -$100.003 1 $25.004 2 $50.005 3 $75.006 IRR 19.44% =IRR(B2:B5)

What is the IRR of Project B?

Rationale for the IRR method

If IRR > project's cost of capital, the project’s return exceeds its costs and there is some return left over to boost stockholders’ returns.

If IRR > project's cost of capital, accept project. If IRR < project's cost of capital, reject project.

Multiple IRRsConsider a project with the following cash flows:

YearCash flows

0 -$1001 $1952 -$1003 $1004 -$100

• What is the IRR of this project?• What happens when you try to solve this

using a calculator?

Profile

0% 3% 6% 9% 12%

15%

18%

21%

24%

27%

30%

33%

36%

39%

42%

45%

-$6.00-$5.00-$4.00-$3.00-$2.00-$1.00$0.00$1.00$2.00$3.00$4.00

Discount rate

NP

V

Two of the IRRs: 6.528% & 35.415%

Why are there multiple IRRs?A series of numbers that is being

compounded or discounted can have as many roots as there are sign changes. [Rene Descartes, 16th century philosopher]

Are they useful? No. The IRRs in these cases are not useful in decision-making.

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 project's cost of capital > crossover rate, the

methods lead to the same decision and there is no conflict.

If project's cost of capital < crossover rate, the methods lead to different accept/reject decisions.

BOTTOM LINE: Do not use IRR when deciding between or among mutually exclusive projects

Determining the cross-over rateThe cross-over rate is the rate at which the two projects have the same NPV:

Step 1: calculate the differences in cash flows Step 2: calculate the IRR of these differences

Cash flows

Year Project A Project B Differences0 -$100.00 -$100.00 $0.001 $25.00 $0.00 $25.002 $50.00 $0.00 $50.003 $75.00 $155.00 -$80.00

IRR 19.44% 15.73% 4.94%

NPV profiles

0% 2% 4% 6% 8% 10%

12%

14%

16%

18%

20%

22%

24%

-$30-$20-$10

$0$10$20$30$40$50$60

Project A Project B

Discount rate

NP

V

Cross-over 4.94%

IRRA = 19.44%

IRRB = 15.73%

Reasons why NPV profiles crossSize (scale) differences

The smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high project's cost of capital favors small projects.

Timing differences The project with faster payback provides more

CF in early years for reinvestment.

Reinvestment rate assumptionsNPV method assumes CFs are reinvested at the

project's cost of capital. IRR method assumes CFs are reinvested at IRR.

Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects.

Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.

The modified internal rate of return

The MIRR

The modified internal rate of return, (MIRR) is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at project's cost of capital.

We often assume that cash flows are reinvested at the project's cost of capital, but that is not always appropriate. What are the investment opportunities?

The MIRR calculation

Solve for the rate that causes the PVoutflows = FVinflows

Calculate the present value of all outflows, discounting at the required rate of return

Calculate the future value of all inflows, using the reinvestment rate as the

compound rate

Why use MIRR versus IRR?MIRR assumes reinvestment at a more

realistic reinvestment rate. MIRR avoids the multiple IRR problem.Managers like rate of return comparisons,

and MIRR is better for this than IRR.

MIRR & financial calculators There is no built-in program for MIRR in financial

calculators. Using most financial calculators requires the

calculation of the FV for each inflow and then the summing of these FVs. Then use the PV, FV and n to solve for i.

Trick to find TV: Calculate the NPV of the cash inflows (not outflows) at

the reinvestment rate (be sure to use 0 for CF0). Calculate the FV of this NPV using the reinvestment rate.

Example: Project AAssume that the reinvestment rate is 0%.

YearProject A

cash flows

Future value of cash inflows

Present value of cash

outflows0 -$100.00 -$100.001 $25.00 $25.002 $50.00 50.003 $75.00 75.00

Sum $150.00 -$100.00

MIRR 14.471%

Example: Project A, continued

Assume that the reinvestment rate is 5%.

YearProject A

cash flows

Future value of cash inflows

Present value of cash

outflows0 -$100.00 -$100.001 $25.00 $27.562 $50.00 52.503 $75.00 75.00

Sum $155.06 -$100.00

MIRR 15.745%

Example: Project A, continued

Assume that the reinvestment rate is 10%.

YearProject A

cash flows

Future value of cash inflows

Present value of cash

outflows0 -$100.00 -$100.001 $25.00 $30.252 $50.00 55.003 $75.00 75.00

Sum $160.25 -$100.00

MIRR 17.022%

Using Excel: Project A

A B

1 Year Cash flow2 0 -$100.003 1 $25.004 2 $50.005 3 $75.006 MIRR 16.00% =MIRR(C40:C43,0.1,0.06)

6% reinvestment rate and 10% cost of capital

Payback methods

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Payback period - number of years required to fully recover the initial cash outlay associated with a capital expenditure

Shorter payback periods are better, and usually this decision criterion is implemented by choosing a cutoff date and rejecting projects whose payback period is longer than the cutoff period.

Payback period

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The discounted payback period alleviates the first shortcoming of the payback period by accounting for the time value of money.

It is defined as the number of years required to fully recover the initial cash outlay in terms of discounted cash flows.

Shorter periods are better, and projects with discounted payback periods before the cutoff date will be accepted.

Discounted payback period

Other issues

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Capital rationing is the presence of a limit on the capital budget.

When there is capital rationing, our goal is to select projects that maximize the total net present value, subject to constraints.

Capital rationing

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Comparing evaluation techniques

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Comparing evaluation techniques (continued)

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What methods do companies really use?

Evaluation Criteria Used by Companies

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There are alternative approaches to evaluating capital investment projects.

The net present value method requires the calculation of the value added from the project.

The internal rate of return is the yield on the project, which we derive by solving for the discount rate resulting in a zero net present value.

Summary

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The modified internal rate of return is return on a project assuming the reinvestment of project cash flows at a specific rate.

The profitability index is the ratio of the present value of inflows to the present value of outflows.

Paybacks methods (payback period and discounted payback) are used to gauge the liquidity of a project.

Summary

Practice problems

Problem 1What is the modified internal rate of return for Project B if the reinvestment rate is 0%? 10%?

Problem 2Calculate the NPV, the IRR, cross-over rate, and the MIRR for projects C & D, assuming a project cost of capital and reinvestment rate of 8%:   Cash flows

YearProject C Project D

0-

$100.00 -$100.001 $80.00 $0.002 $40.00 $0.003 $20.00 $160.00Which project would you choose and why?

The end