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Copyright © 2002 Harcourt College Publishers. All rights reserved.
Should we build thisplant?
CHAPTER 11Capital Budgeting: Decision Criteria
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Copyright © 2002 Harcourt College Publishers. All rights reserved.
What is capital budgeting?
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
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Steps
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine k = WACC for project.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
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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.
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An Example of Mutually Exclusive Projects
BRIDGE vs. BOAT to get products across a river.
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Normal Cash Flow Project:
Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.
Nonnormal 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.
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Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
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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?
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Payback for Project L(Long: Most CFs in out years)
10 8060
0 1 2 3
-100
=
CFt
Cumulative -100 -90 -30 50
PaybackL 2 + 30/80 = 2.375 years
0100
2.4
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Project S (Short: CFs come quickly)
70 2050
0 1 2 3
-100CFt
Cumulative -100 -30 20 40
PaybackS 1 + 30/50 = 1.6 years
100
0
1.6
=
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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.
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10 8060
0 1 2 3
CFt
Cumulative -100 -90.91 -41.32 18.79
Discountedpayback 2 + 41.32/60.11 = 2.7 yrs
Discounted Payback: Uses discountedrather than raw CFs.
PVCFt -100
-100
10%
9.09 49.59 60.11
=
Recover invest. + cap. costs in 2.7 yrs.
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NPV
CF
kt
nt
t 0 1
.
NPV: Sum of the PVs of inflows and outflows.
Cost often is CF0 and is negative.
.CF
k1
CFNPV 0t
tn
1t
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What’s Project L’s NPV?
10 8060
0 1 2 310%
Project L:
-100.00
9.09
49.59
60.1118.79 = NPVL NPVS = $19.98.
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Calculator Solution
Enter in CFLO for L:
-100
10
60
80
10
CF0
CF1
NPV
CF2
CF3
I = 18.78 = NPVL
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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 ofhigher NPV. Adds most value.
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Using NPV method, which project(s) should be accepted?
If Projects S and L are mutually exclusive, accept S because NPVs > NPVL .
If S & L are independent, accept both; NPV > 0.
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Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3
Cost Inflows
IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.
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t
nt
t
CF
kNPV
0 1.
t
nt
t
CF
IRR
0 10.
NPV: Enter k, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
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What’s Project 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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40 40 40
0 1 2 3IRR = ?
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
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90 1,09090
0 1 2 10IRR = ?
Q. How is a project’s IRRrelated to a bond’s YTM?
A. They are the same thing.A bond’s YTM is the IRRif you invest in the bond.
-1,134.2
IRR = 7.08% (use TVM or CFLO).
...
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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.
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IRR Acceptance Criteria
If IRR > k, accept project.
If IRR < k, reject project.
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Decisions on Projects S and L per IRR
If S and L are independent, accept both. IRRs > k = 10%.
If S and L are mutually exclusive, accept S because IRRS > IRRL .
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Construct NPV Profiles
Enter CFs in CFLO and find NPVL andNPVS at different discount rates:
k
0
5
10
15
20
NPVL
50
33
19
7
NPVS
40
29
20
12
5 (4)
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-10
0
10
20
30
40
50
60
0 5 10 15 20 23.6
NPV ($)
Discount Rate (%)
IRRL = 18.1%
IRRS = 23.6%
Crossover Point = 8.7%
k
0
5
10
15
20
NPVL
50
33
19
7
(4)
NPVS
40
29
20
12
5
S
L
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NPV and IRR always lead to the same accept/reject decision for independent projects:
k > IRRand NPV < 0.
Reject.
NPV ($)
k (%)IRR
IRR > kand NPV > 0
Accept.
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Mutually Exclusive Projects
k 8.7 k
NPV
%
IRRS
IRRL
L
S
k < 8.7: NPVL> NPVS , IRRS > IRRL
CONFLICT k > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
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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.
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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 k favors small projects.
2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
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Reinvestment Rate Assumptions
NPV assumes reinvest at k (opportunity cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
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Managers like rates--prefer IRR to NPV comparisons. Can we give them a
better IRR?
Yes, MIRR is the discount rate whichcauses the PV of a project’s terminalvalue (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.
Thus, MIRR assumes cash inflows are reinvested at WACC.
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MIRR = 16.5%
10.0 80.060.0
0 1 2 310%
66.0 12.1
158.1
MIRR for Project L (k = 10%)
-100.010%
10%
TV inflows-100.0
PV outflowsMIRRL = 16.5%
$100 = $158.1
(1+MIRRL)3
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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.
CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80
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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.
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Pavilion Project: NPV and IRR?
5,000 -5,000
0 1 2k = 10%
-800
Enter CFs in CFLO, enter I = 10.
NPV = -386.78
IRR = ERROR. Why?
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We got IRR = ERROR because there are 2 IRRs. Nonnormal CFs--two signchanges. Here’s a picture:
NPV Profile
450
-800
0400100
IRR2 = 400%
IRR1 = 25%
k
NPV
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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.
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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
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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%
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Accept Project P?
NO. Reject because MIRR = 5.6% < k = 10%.
Also, if MIRR < k, NPV will be negative: NPV = -$386,777.
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S and L are mutually exclusive and will be repeated. k = 10%. Which is
better? (000s)
0 1 2 3 4
Project S:(100)
Project L:(100)
60
33.5
60
33.5 33.5 33.5
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S LCF0 -100,000 -100,000CF1 60,000 33,500Nj 2 4I 10 10
NPV 4,132 6,190
NPVL > NPVS. But is L better?Can’t say yet. Need to perform common life analysis.
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Note that Project S could be repeated after 2 years to generate additional profits.
Can use either replacement chain or equivalent annual annuity analysis to make decision.
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Project S with Replication:
NPV = $7,547.
Replacement Chain Approach (000s)
0 1 2 3 4
Project S:(100) (100)
60 60
60(100) (40)
6060
6060
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Compare to Project L NPV = $6,190.Compare to Project L NPV = $6,190.
Or, use NPVs:
0 1 2 3 4
4,1323,4157,547
4,13210%
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If the cost to repeat S in two years rises to $105,000, which is best? (000s)
NPVS = $3,415 < NPVL = $6,190.Now choose L.NPVS = $3,415 < NPVL = $6,190.Now choose L.
0 1 2 3 4
Project S:(100)
60 60(105) (45)
60 60
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Year0123
CF ($5,000) 2,100 2,000 1,750
Salvage Value $5,000 3,100 2,000 0
Consider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage
value.
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1.751. No termination
2. Terminate 2 years
3. Terminate 1 year
(5)
(5)
(5)
2.1
2.1
5.2
2
4
0 1 2 3
CFs Under Each Alternative (000s)
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NPV(no) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
Assuming a 10% cost of capital, what is the project’s optimal, or economic life?
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The project is acceptable only if operated for 2 years.
A project’s engineering life does not always equal its economic life.
Conclusions
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Choosing the Optimal Capital Budget
Finance theory says to accept all positive NPV projects.
Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:
An increasing marginal cost of capital.
Capital rationing
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Increasing Marginal Cost 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...)
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If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
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Capital Rationing
Capital rationing occurs when a company chooses not to fund all positive NPV projects.
The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
(More...)
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Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital.
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.
(More...)
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Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects.
Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
(More...)
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Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted.
Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.