Capital Budgeting Process

1. Estimate the cash flows.

2. Assess the riskiness of the cash flows.

3. Determine the appropriate discount rate.

4. Find the PV of the expected cash flows.

5. Accept the project if PV of inflows > costs.

Capital Budgeting1. Basic Data

Expected Net Cash FlowYear Project L Project S

0 ($100) ($100)1 10 702 60 503 80 20

2. Evaluation TechniquesA. Payback periodB. Discounted payback periodC. Net present value (NPV)D. Internal rate of return (IRR)E. Modified internal rate of return (MIRR)

Capital Budgeting - Illustration

I. Basic Data

Expected Net Cash Flow

Year Project L Project S

0 ($100) ($100)

1 10 70

2 60 50

3 80 20

Capital Budgeting

Weakness of Payback:

1. Ignores the time value of money. This weakness is eliminated with the discounted payback method.

2. Ignores cash flows occurring after the payback period.

Capital Budgeting

NPV = CF

t

(1+k)

Project L: 0 10% 1 2 3 -100.00 10 60 80 9.09 49.59 60.11

NPVL= 18.79 NPVS = $19.98

If the projects are independent, accept both.If the projects are mutually exclusive, accept Project S since NPVS >

NPVL

t

Capital Budgeting

IRR = CF

t = $0 = NPV (1+IRR)

Project L:

0 IRR 1 2 3 -100.00 10 60 80 8.47 43.02 48.57

0.06 = $0 IRRL=18.1% IRRS=23.6%

If the projects are independent, accept both because IRR>k.If the projects are mutually exclusive, accept Project S since IRRS > IRRL

t

Capital BudgetingProject L:

0 10% 1 2 3 -100.00 10 60 80.00

66.0012.10

100.00 MIRR = 16.5% $158.10

$0.00 = NPV TVof inflows

PV outflows = $100TV inflows =$158.10 $100=158.10

(pvif)

Capital Budgeting - Illustration

II. Evaluation Techniques

A. Payback period

B. Discounted payback period

C. Net present value (NPV)

D. Internal rate of return (IRR)

E. Modified internal rate of return

(MIRR)

Capital Budgeting - Payback Period

Payback period = Expected number of

years required to recover a project’s cost.

Project L

Expected Net Cash Flow

Year Annual Cumulative

0 ($100) ($100)

1 10 (90)

2 60 (30)

3 80 50

Capital Budgeting - Payback Period

PaybackL= 2 + $30 / $80 years

= 2.4 years

PaybackS= 1.6 years.

Weaknesses of Payback:

1. Ignores the time value of money. This weakness is eliminated with the discounted payback period.

2. Ignores cash flows occurring after the payback period.

Capital Budgeting - Net Present Value (NPV)

n

NPV = CFt

Project L: t=0 (1+k)t

0 10% 1 2 3-100.00 10 60 80 9.09 49.59

60.11

NPVL= $18.79

Capital Budgeting - Net Present Value (NPV)

n

NPV = CFt

Project S: t=0 (1+k)t

0 10% 1 2 3-100.00 70 50 20 63.64 41.32

15.03

NPVS= $19.99

Capital Budgeting - Net Present Value (NPV)

NPVS = $19.99 NPVL= $18.79

If the projects are independent, accept both.

If the projects are mutually exclusive, accept Project S since NPVS > NPVL.

Note:

NPV declines as k increases and NPV rises as k decreases.

Internal Rate of Return (IRR)

n

IRR =

CFt = $0 = NPV Project L: t=0 (1+IRR)t

0 IRR 1 2 3-100.00 10 60 80 8.47 18.13%

43.00 18.13%

48.54 18.13%

$ 0.01 $0

Internal Rate of Return (IRR)

n

IRR =

CFt = $0 = NPV Project S: t=0 (1+IRR)t

0 IRR 1 2 3-100.00 70 50 20 56.65 23.56%

32.75 23.56%

10.60 23.56%

$ 0.00

Internal Rate of Return (IRR)

IRRL = 18.13%

IRRS = 23.56%

If the projects are independent, accept both because IRR > k.

If the projects are mutually exclusive, accept Project S since IRRS > IRRL.

Note:

IRR is independent of the cost of capital.

Capital Budgeting - NPV Profilesk NPVL NPVS

0% $50 $40 5 33 2910 19 2015 7 1220 (4) 5

Modified IRR (MIRR)

Project L:

0 10% 1 2 3

-100 10 60 80.00

66.00

12.10

$158.10 =TV of

100.00 MIRR=16.5% inflows

$ 0.00 = NPV

Modified IRR (MIRR)

Project S:

0 10% 1 2 3

-100 70 50 20.00

55.00

84.70

$159.70 =TV of

100.00 MIRR=16.9% inflows

$ 0.00 = NPV

Modified IRR (MIRR)

PV outflows = $100

TV inflows = $158.10

$100 = $158.10 (PVIFMIRRL,3)

MIRRL = 16.5%

MIRRS = 16.9%

Modified IRR (MIRR)

Project L:

0 5% 1 2 3

-100 10 60 80.00

63.00

11.03

$154.03 =TV of

100.00 MIRR=15.48% inflows

$ 0.00 = NPV

Modified IRR (MIRR)

Project S:

0 5% 1 2 3

-100 70 50 20.00

52.50

77.18

$149.68 =TV of

100.00 MIRR=14.39% inflows

$ 0.00 = NPV

Modified IRR (MIRR)

MIRR is better than IRR because:

1. MIRR correctly assumes reinvestment at project’s cost of capital.

2. MIRR avoids the problem of multiple IRRs.

NPV Profile: Nonnormal Project P with Multiple IRRs

Year Cash Flow (‘000) 0 ($800) 1 5,000 2 (5,000)

NPV @10% = -$386,777. Do not accept; NPV < 0.IRR = 25% and 400%.MIRR = 5.6%. Do not accept; MIRR < k.

Debt

Bank

Equity

$100

$100

wacc=10%

$1201 year

IRR = 20%

$

%

20%wacc = 10% MCC

IOSA=20%

1000

IF IRR > WACC THEN ACCEPT PROJECT

Debt

Bank

Equity

PV(CASH IN) = 100 = CASH OUTFLOW

$100

$100

wacc=10%

$1101 year

IRR = 10%

PV(IN) = 109.09 PV(IN) = 100PV(OUT) = 100 PV(0UT) = 100NPV = 9.09 NPV = 0CF0= -100 i=10% CF0= -100 i=10%CF1= 120 CF1= 110NPV = 9.09 NPV = 0

100OUT

100OUT

IN110

IN120

1 YEAR 1 YEARWACC = 10% WACC = 10%

IRR NPVCF0 = -100 PV(IN) = 95.45CF1 = 105 PV(OUT) = 100IRR = 5% NPV = -4.55

CF0 = -100 CF1=105i = 10% NPV = -4.55

IN105

WACC = 10%

100 OUT

10%