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CHAPTER 10

The Basics of Capital Budgeting

Omar Al Nasser, Ph.D.

FIN 6352

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Chapter Outline

• Net Present Value

• The Payback Rule

• The Internal Rate of Return

• The Profitability Index

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Project’s Cash Flows (CFt)

Marketinterest rates

Project’s business risk

Marketrisk aversion

Project’sdebt/equity capacityProject’s risk-adjusted

cost of capital (r)

The Big Picture:The Net Present Value of a

Project

NPV = + + ··· + − Initial cost

CF1

CF2

CFN

(1 + r )1 (1 + r)N(1 + r)2

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What is capital budgeting?

• Analysis of potential projects.• Long-term decisions; involve large

expenditures.• Very important to firm’s future.

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Net Present Value

• The difference between the market value of a project and its cost

• How much value is created from undertaking an investment?– The first step is to estimate the expected

future cash flows.– The second step is to estimate the required

return for projects of this risk level.– The third step is to find the present value of

the cash flows and subtract the initial investment.

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NPV Decision Rule

• If the NPV is positive, accept the project

• A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

• Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

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Net Present Value

Cost often is CF0 and is negative.

NPV = ∑n

t = 0

CFt

(1 + r)t

.

NPV = ∑n

t = 1

CFt

(1 + r)t

. - CF0 .

NPV equal to the PV of future net cash flows, discounted at the cost of capital.

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Project Example Information• You are looking at a new project and

you have estimated the following cash flows:– Year 0: CF = -165,000– Year 1: CF = 63,120; – Year 2: CF = 70,800; – Year 3: CF = 91,080;

• Your required return for assets of this risk is 12%.

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Computing NPV for the Project

• Using the formulas:– NPV = 63,120/(1.12) + 70,800/(1.12)2 +

91,080/(1.12)3 – 165,000 = $12,627.41

• Using the calculator:– CF0 = -165,000; C01 = 63,120; F01 = 1; C02

= 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41

• Do we accept or reject the project?

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Cash Flows for Franchise L and Franchise S

10 8060

0 1 2 310%L’s CFs:

-100.00

70 2050

0 1 2 310%S’s CFs:

-100.00

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What’s Franchise L’s NPV?

10 8060

0 1 2 310%L’s CFs:

-100.00

9.09

49.59

60.1118.79 = NPVL NPVS = $19.98.

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Calculator Solution: Enter values in CFLO register for L.

-100

10

60

80

10

CF0

CF1

NPV

CF2

CF3

I = 18.78 = NPVL

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Independent versus 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.

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Using NPV method, which franchise(s) should be accepted?

• If Franchises S and L are mutually exclusive, accept S because NPVs > NPVL.

• If S & L are independent, accept both; NPV > 0.

• NPV is dependent on cost of capital.

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What is the payback period?• The number of years required for an investment to

recover its cost, or how long does it take to get the business’s money back?

• Computation

– Estimate the cash flows

– Subtract the future cash flows from the initial cost until the initial investment has been recovered

• Decision Rule – Accept if the payback period is less than some preset limit

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Payback for Franchise L

10 8060

0 1 2 3

-100

=

CFt

Cumulative -100 -90 -30 50

PaybackL 2 + 30/80 = 2.375 years

0

2.4

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Payback for Franchise S

70 2050

0 1 2 3

-100CFt

Cumulative -100 -30 20 40

PaybackS 1 + 30/50 = 1.6 years

0

1.6

=

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Strengths and Weaknesses of Payback• Strengths:

– Provides an indication of a project’s risk and liquidity.

– Easy to calculate and understand.

• Weaknesses: – Ignores CFs occurring after the payback period.– Unlike the NPV, which tells us by how much the

project should increase shareholder wealth, the payback tells us when we get our investment back.

– No specification of acceptable payback.

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Internal Rate of Return

• This is the most important alternative to NPV

• It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.

• IRR is the discount rate that forces a project’s NPV to equal zero.

• Decision Rule: Accept the project if the IRR is greater than the required return

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Internal Rate of Return

IRR: Enter NPV = 0, solve for IRR.

= NPV ∑n

t = 0

CFt

(1 + r)t.

= 0 ∑n

t = 0

CFt

(1 + IRR)t.

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What’s Franchise L’s IRR?

10 8060

0 1 2 3IRR = ?

-100.00

PV3

PV2

PV1

0 = NPV Enter CFs in CFLO, then press IRR: IRRL = 18.13%. IRRS = 23.56%.

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Calculator Solution: What’s Franchise L’s IRR?

-100

10

60

80

CF0

CF1

IRR

CF2

CF3

= 18.13% = IRRL

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Rationale for the IRR Method

• If IRR > the required return , then the project’s rate of return is greater than its cost– the project expected to earn more than the cost of capital need to finance the project.

• Example:

the required return = 10%, IRR = 15%.• So this project adds extra return to

shareholders.

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Decisions on Franchises S and L per IRR

• If S and L are independent, accept both: IRRS > r and IRRL > r.

• If S and L are mutually exclusive, accept S because IRRS > IRRL.

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NPV vs. IRR• NPV and IRR will generally give us the same

decision• Despite a strong academic preference for NPV,

surveys indicate that executives prefer IRR over NPV because managers find it more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

• However, you should always use NPV as your decision criteria because it selects the project that adds the most to shareholder’s wealth.

• Whenever there is a conflict between NPV and another decision rule, you should always use NPV

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Modified Internal Rate of Return (MIRR)

• 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 as the sum of the future values of the cash inflows compounded at the firm’s cost of capital.

• MIRR assumes that all cash flows are reinvested at the firm's cost of capital. Therefore, MIRR more accurately reflects the profitability of a project.

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MIRR for Franchise L

10 8060

0 1 2 310%L’s CFs:

-100.00

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Franchise L’s Step 1, Find PV of inflows

10 8060

0 1 2 310%

Project L:

9.09

49.59

60.11118.79

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Step 1, Find PV of Inflows

• First, enter cash inflows in CFLO register:

CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

• Second, enter I/YR = 10.

• Third, find PV of inflows:

Press NPV = 118.78

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Step 2, Find FV of Inflows

• Enter PV = -118.78, N = 3, I/YR = 10, PMT = 0.

• Press FV = 158.10 = FV of inflows.

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Step 3, Find “IRR” of FV of Inflows and PV of Outflows• For this problem, there is only one

outflow, CF0 = -100, so the PV of outflows is -100.

• Enter FV = 158.10, PV = -100, PMT = 0, N = 3.

• Press I/YR = 16.50% = MIRR.

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Financial Calculator• First, enter cash inflows in CFLO register:• CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80• Second, enter I = 10.• Third, find PV of inflows:• Press NPV = 118.78Then:• Enter PV = -118.78, N = 3, I = 10, PMT = 0.• Press FV = 158.10 = FV of inflows.Then: • Enter FV = 158.10, PV = -100, PMT = 0, N = 3.• Press I = 16.50% = MIRR.

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Profitability Index

• The profitability index (PI) is the present value of future cash flows divided by the initial cost.

• Profitability index is a good tool for ranking projects because it allows you to clearly identify the amount of value created per unit of investment.

• If PI > 1 then accept the project if PI < 1 then reject the project.

• The higher the PI, the higher the project’s ranking.

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Franchise L’s PV of Future Cash Flows

10 8060

0 1 2 310%

Project L:

9.09

49.59

60.11118.79

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Franchise L’s Profitability Index

PIL =PV future CF

Initial Cost

$118.79=

PIL = 1.1879

$100

PIS = 1.1998• So project L is expected to produce $1.1879 for each $1

of investment. A profitability index of 1.1879 implies that for every $1 of investment, we receive $ 1.1879 worth of benefits, so we create an additional $0.1879 in value

• Both projects should be accepted by PI, but project S will be ranked ahead of L because it has a higher PI .

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Comprehensive Problem

• An investment project has the following cash flows: CF0 = -1,000,000; C01 – C08 = 200,000 each

• If the required rate of return is 12%, what decision should be made using NPV?

• What decision should be made using IRR?

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Excel Example Information• You are looking at a new project and

you have estimated the following cash flows:– Year 0: CF = -165,000– Year 1: CF = 63,120; – Year 2: CF = 70,800; – Year 3: CF = 91,080;

• Your required return for assets of this risk is 12%.

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Calculating NPVs with a Spreadsheet

• Spreadsheets are an excellent way to compute NPVs, especially when you have to compute the cash flows as well.

• Using the NPV function– The first component is the required return entered

as a decimal– The second component is the range of cash flows

beginning with year 1– Subtract the initial investment after computing the

NPV– Check your calculations with a hand held calculator

to ensure that the formulae have been correctly set up.

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Calculating IRRs With a Spreadsheet

• You start with the cash flows the same as you did for the NPV

• You use the IRR function– You first enter your range of cash flows,

beginning with the initial cash flow

– You can enter a guess, but it is not necessary

– The default format is a whole percent – you will normally want to increase the decimal places to at least two

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Calculating PI With a Spreadsheet

• The profitability index (PI) is the present value of future cash flows divided by the initial cost.

• You start with the calculating the PV of future cash flows, then divided by the initial cost.

PI =PV future CF

Initial Cost

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Calculating MIRR With a Spreadsheet

Modified Internal Rate of Return – the cash flow cell range is the same as in the IRR, but both the required rate of return, and the re-investment rate, are entered into the formula.