FinMan Unit 8 Lecture-Capital Budgeting 2021 S1

Financial Management
Unit 8: Capital Budgeting
1
Learning Objectives
1. Evaluate different capital budgeting plans
2. Calculate a project’s acceptability using
Payback, Discounted Payback, Net
Present Value (NPV)
3. Discuss Internal Rate of Return (IRR) &
Modified Internal Rate of Return (MIRR)
4. Differentiate between independent and
mutually exclusive projects
2
The Capital Budgeting Process
Should we
build this
plant?
3
The Big Picture:
The Net Present Value of a Project
Project’s Cash Flows

(CFt)
CF1 CF2 CFN

NPV = + + ··· + − Initial cost
(1 + r )1 (1 + r)2 (1 + r)N
Market Project’s
interest rates debt/equity capacity
Project’s risk-adjusted
cost of capital
(r)
Market Project’s
risk aversion business risk
4
What is capital
budgeting?
Process of
Øanalyzing investment
opportunities
Ødeciding which one to accept
5
Capital Budgeting Rule
Ø Compute the NPV
Ø Accept project if NPV

is positive
Projects with positive

NPV increase firm
value
6
Independent Projects
ØCash flows of one project are

unaffected by the acceptance of
the other.
ØAll independent projects can be

accepted if their NPV is positive
7
Mutually Exclusive Projects
Ø The cash flows of one project can be
adversely impacted by the acceptance of
the other.
Ø Not all projects can be accepted

Ø If 2 projects are mutually exclusive, then
only one can be accepted
8
Capital Budgeting Steps
1. Estimate Cash Flows (inflows & outflows).
2. Assess riskiness of Cash Flows.
3. Determine Cost of Capital [k = WACC]
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
NPV Benchmark IRR Benchmark

Project must be profitable Must exceed the hurdle rate
NPV > 0 IRR > WACC
9
Capital Budgeting Cash Flows
Normal Cash Flow Project

Ø Cost (negative CF) followed by a series of
positive cash inflows. (1 change of sign.)
Non-normal Cash Flow Project

Ø 2 or more changes of signs.
Ø Example: Initial cost (negative), then string of inflows
(positive), then further cost (negative) to start another
phase of the project, then another string of inflows
(positive).
10
Copyright 2000 Prentice Hall
The Payback Method
Ø The number of periods (years) it will take
before the cash inflows of a proposed project
equal the initial project investment.
Ø Number of years to recover initial cost
Payback method decision rule

Accept project if payback falls within the
acceptable time frame set by the firm
11
The Payback Method
Advantages
Ø Easy to calculate
Ø Provides an indication of the projects risk and
liquidity
Disadvantages
Ø It does not consider cashflows that occur after
the payback period.
Ø It does not consider the time value of money.
Ø It does not take account of the cost of capital.
12
Payback Method - Example
Calculate the Payback for

Projects P and Q. The
initial cost for both projects
is $60,000.
13
The Discounted Payback
Method
Ø Uses discounted cash flows to calculate
payback
Ø The number of periods (years) it will take
before the discounted cash inflows of a
proposed project equal the initial project
investment.
Ø Number of years to recover initial cost based
on discounted cash flows
14
Net Present Value (NPV)
NPV is the value obtained by discounting

and summing all cash outflows and
inflows of a capital investment project by
the cost of capital (or a chosen target rate
of return or )
Total PV of Inflows – Total PV of Outflows (Costs)
15
Net Present Value Steps
1. Estimate the net cash flows that the
investment/project will generate over its life
2. Discount these cash flows at an interest rate

that reflects the degree of risk inherent in the
project
3. Sum the discounted cash flows
16
Net Present Value
The resulting sum of discounted cash
flows equals the project’s net present
value (NPV).
The NPV decision rule says to invest in

projects that have a positive present value
Accept project if NPV > 0
17
Compute the NPV and
discounted payback of this
project given a cost of
capital of 18%. The project
requires an initial outlay of
$100,000.
18
Internal Rate of Return (IRR)
The IRR is the discount rate that equates the
present value of a project’s expected cash inflows
to the present value of the projects cost.
(Discount Rate at which NPV = 0)
IRR is an estimate of the project’s rate of return,

so it is comparable to the YTM on a bond.
19
Rationale for the IRR Method
ØIf IRR > WACC, then the project’s rate of
return is greater than it’s cost of capital
ØSome return is left over to boost stockholders’
returns.
ØExample: WACC = 10%, IRR = 15%.

ØProject return covers project cost and leaves 5% to
boost shareholders’ returns.
ØProject adds extra return to shareholders.
20
Benefits of IRR method:
Ø It focuses on all cashflows associated
with the project.
Ø It adjusts for the time value of money.
Limitations:
Ø assumes that the cashflows from each
project are reinvested at the project´s
own IRR
21
Advantages
Ø Closely related to NPV rule, often leading to the
same decisions
Ø Easy to understand and communicate
Disadvantages
Ø May result in multiple IRRs with non-conventional
cash flows.
Ø May lead to incorrect decisions with mutually
exclusive investment projects.
Ø Not always easy to calculate.
Ø Possible to have no IRR
22
Independent vs Mutually Exclusive
Projects (Decision Making)
Independent Projects
Ø Accept all independent projects with NPVs > 0.
Ø Accept all independent projects having IRRs greater
than the hurdle rate (WACC).
Mutually Exclusive Projects

Ø Rank projects from highest NPV (1st) to lowest NPV
Ø Accept the highest NPV project if only one can be
accepted (NPV is King)
23
Reinvestment Rate
Assumptions
Ø NPV assumes that cashflows are reinvested at
the cost of capital (k).
Ø IRR assumes that cashflows are reinvested at
the IRR.
Ø Reinvesting at opportunity cost, k, is more
realistic, so NPV method is best.
Ø NPV should be used to choose between
mutually exclusive projects
24
Computing the IRR
Estimation Formula (Interpolation)
𝑁𝑃𝑉!
𝐼𝑅𝑅 = 𝑎 + 𝑏−𝑎
𝑁𝑃𝑉! − 𝑁𝑃𝑉"
Where:
a = lower of the 2 rates used
b = higher of the 2 rates used
NPVa = NPV obtained using the lower rate
NPVb = NPV obtained using the higher rate
25
Computing the IRR
Need to compute 2 NPV values. Ideally one
should be positive and the other negative
Ø Calculate the net present value using the
company’s cost of capital
Ø Compute the NPV using a 2nd discount rate.
If the NPV from step 1 is
Ø positive, then the 2nd discount rate should
be higher than the 1st.
Ø negative, then the 2nd discount rate
should be lower that the 1st.
26
A company is trying to decide whether to buy a machine
for $80,000 which will save costs of $20,000 per year for
five years and which will have a resale value of $10,000 at
the end of year 5. It is the company’s policy to undertake
projects only if they expect a yield of 10% or more.
NPV at 10% = $2,030 NPV at 12% = -$2,230
27
Modified Internal Rate of
Return (MIRR)
Ø MIRR is the discount rate that causes
the PV of a project’s terminal value
(TV) to equal the PV of costs.
Ø TV is found by compounding inflows at
WACC.
Ø Thus, MIRR assumes cash inflows are
reinvested at WACC.
28
Why use MIRR versus IRR?
! MIRR realistically 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.
29

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Financial Management

Unit 8: Capital Budgeting

Project’s Cash Flows

CF1 CF2 CFN

Ø Compute the NPV

Ø Accept project if NPV

Projects with positive

ØCash flows of one project are

ØAll independent projects can be

Ø Not all projects can be accepted

NPV Benchmark IRR Benchmark

Normal Cash Flow Project

Non-normal Cash Flow Project

Payback method decision rule

Calculate the Payback for

NPV is the value obtained by discounting

Total PV of Inflows – Total PV of Outflows (Costs)

2. Discount these cash flows at an interest rate

3. Sum the discounted cash flows

The NPV decision rule says to invest in

Accept project if NPV > 0

IRR is an estimate of the project’s rate of return,

ØExample: WACC = 10%, IRR = 15%.

Mutually Exclusive Projects

! MIRR realistically assumes reinvestment

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