CHAPTER 10

The Basics of Capital

Budgeting
Should we
build this
plant?

10-1
What is capital budgeting?
 Analysis of potential additions to
fixed assets.
 Long-term decisions; involve
large expenditures.
 Very important to firm’s future.

10-2
Steps to capital budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of
capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.

10-3
 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 can be adversely
impacted by the acceptance of the
other.

10-4
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.

10-5
What is the payback
period?
 The number of years required to recover
a project’s cost, or “How long does it
take to get our money back?”
 Calculated by adding project’s cash
inflows to its cost until the cumulative
cash flow for the project turns positive.

10-6
 Calculating payback
0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

10-7
Strengths and weaknesses of
payback
 Strengths
 Provides an indication of a project’s
risk and liquidity.
 Easy to calculate and understand.
 Weaknesses
 Ignores the time value of money.
 Ignores CFs occurring after the
payback period.
10-8
 Discounted payback
period
 Uses discounted cash flows rather
than raw CFs.
0 10% 1 2 2.7 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years

10-9
Net Present Value (NPV)
 Sum of the PVs of all cash inflows and
outflows of a project:

n
CFt
NPV = ∑
t=0 ( 1 + k )
t

10-10
What is Project L’s NPV?
Year CFt PV of CFt
0 -100 -$100
1 10 9.09
2 60 49.59
3 80 60.11
NPVL = $18.79

NPVS = $19.98
10-11
Solving for NPV:
Financial calculator solution
 Enter CFs into the calculator’s CFLO
register.
 CF0 = -100
 CF1 = 10
 CF2 = 60
 CF3 = 80

 Enter I/YR = 10, press NPV button to

get NPVL = $18.78.
10-12
 Rationale for the NPV
method
NPV = PV of inflows – Cost
= Net gain in wealth
 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.
 In this example, would accept S if
mutually exclusive (NPVs > NPVL), and
would accept both if independent.
10-13
Internal Rate of Return
(IRR)
 IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:
n
CFt
0= ∑
t=0 ( 1 + IRR ) t

 Solving for IRR with a financial calculator:

 Enter CFs in CFLO register.
 Press IRR; IRRL = 18.13% and IRRS = 23.56%.

10-14
How is a project’s IRR similar to
a bond’s YTM?
 They are the same thing.
 Think of a bond as a project.
The YTM on the bond would be
the IRR of the “bond” project.
 EXAMPLE: Suppose a 10-year
bond with a 9% annual coupon
sells for $1,134.20.
 Solve for IRR = YTM = 7.08%, the
annual return for this project/bond.
10-15
Rationale for the IRR
method
 If IRR > WACC, the project’s rate
of return is greater than its
costs. There is some return left
over to boost stockholders’
returns.

10-16
IRR Acceptance Criteria
 If IRR > k, accept project.
 If IRR < k, reject project.

 If projects are independent,

accept both projects, as both IRR
> k = 10%.
 If projects are mutually exclusive,
accept S, because IRRs > IRRL.
10-17
NPV Profiles
 A graphical representation of project
NPVs at various different costs of capital.

k NPVL NPVS
0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5

10-18
 Drawing NPV profiles
NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

.. S IRRS = 23.6%
10
L . .
0 . Discount Rate (%)
5 10 15 20 23.6
-10
10-19
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 k > crossover point, the two methods lead
to the same decision and there is no
conflict.
 If k < crossover point, the two methods lead
to different accept/reject decisions.

10-20
Finding the crossover
point
1. Find cash flow differences between the
projects for each year.
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.

10-21
Reasons why NPV profiles
cross
 Size (scale) differences – the 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.
 Timing differences – the project with faster
payback provides more CF in early years for
reinvestment. If k is high, early CF especially
good, NPVS > NPVL.

10-22
Reinvestment rate
assumptions
 NPV method assumes CFs are reinvested at k,
the opportunity 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.

10-23
Since managers prefer the IRR to the
NPV method, is there a better IRR
measure?

 Yes, 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 WACC.
 MIRR assumes cash flows are
reinvested at the WACC.

10-24
 Calculating MIRR
0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% 12.1
MIRR = 16.5%
158.1
-100.0 $158.1 TV inflows
$100 =
PV outflows
(1 + MIRRL)3
MIRRL = 16.5%

10-25
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.

10-26
 Project P has cash flows (in 000s):
CF0 = -$800, CF1 = $5,000, and CF2
= -$5,000. Find Project P’s NPV and
IRR.
0 1 2
k = 10%

-800 5,000 -5,000

 Enter CFs into calculator CFLO register.

 Enter I/YR = 10.
 NPV = -$386.78.
 IRR = ERROR Why?

10-27
Multiple IRRs

NPV NPV Profile

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
10-28
Why are there multiple
IRRs?
 At very low discount rates, the PV of
CF2 is large & negative, so NPV < 0.
 At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
 In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
 Result: 2 IRRs.
10-29
Solving the multiple IRR
problem
 Using a calculator
 Enter CFs as before.
 Store a “guess” for the IRR (try 10%)
10 ■ STO
■ IRR = 25% (the lower IRR)
 Now guess a larger IRR (try 200%)
200 ■ STO
■ IRR = 400% (the higher IRR)
 When there are nonnormal CFs and
more than one IRR, use the MIRR.
10-30
When to use the MIRR instead
of the IRR? Accept Project P?
 When there are nonnormal CFs and
more than one IRR, use MIRR.
 PV of outflows @ 10% = -$4,932.2314.
 TV of inflows @ 10% = $5,500.
 MIRR = 5.6%.
 Do not accept Project P.
 NPV = -$386.78 < 0.
 MIRR = 5.6% < k = 10%.

10-31