What Is Capital Budgeting? Steps: Important

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What is capital budgeting?
Steps 1. Estimate CFs (inflows & outflows).
Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firms future.
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.
Copyright 1999 by The Dryden Press All rights reserved.
Copyright 1999 by The Dryden Press
All rights reserved.
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Project Types Mutually Exclusive Projects vs Independent Projects Normal CF Projects vs Nonnormal CF Projects
Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: 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.
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What is the payback period?
Strengths of Payback: 1. Provides an indication of a projects risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback:
The number of years required to recover a projects cost, or how long does it take to get the businesss money back?
1. Ignores the TVM. 2. Ignores CFs occurring after the payback period.
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NPV: Sum of the PVs of inflows and outflows.

NPV
n t 0
Rationale for the NPV Method
1 k t
CFt
NPV = PV inflows - Cost = Net gain in wealth.

Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
All rights reserved. Copyright 1999 by The Dryden Press All rights reserved.
Cost often is CF0 and is negative.

NPV
t 1 n
1 k
CFt
CF0 .
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Using NPV method, which project(s) should be accepted?

0
Internal Rate of Return: IRR

1 CF1 2 CF2 Inflows 3 CF3
If Projects S and L are mutually exclusive, accept S because NPVs > NPVL . If S & L are independent, accept both; NPV > 0.
CF0 Cost
IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.
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NPV: Enter k, solve for NPV.
Rationale for the IRR Method
t 0
1 k t
CFt
NPV .
IRR: Enter NPV = 0, solve for IRR.

CFt t 0. t 0 1 IRR
If IRR > WACC, then the projects 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
Decisions on Projects S and L per IRR
If IRR > k, accept project.
If S and L are independent, accept both. IRRs > k = 10%. If S and L are mutually exclusive, accept S because IRRS > IRRL .
If IRR < k, reject project.
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Construct NPV Profiles Enter CFs in CFLO and find NPVL and NPVS at different discount rates:
k 0 5 10 15 20
NPV ($)
60 50 40 30 20 10 0 0 -1 0 5 10 15 20 2 3 .6
Crossover Point = 8.7%
NPVL 50 33 19 7 (4)
NPVS 40 29 20 12 5
k 0 5 10 15 20
NPVL 50 33 19 7 (4)
NPVS 40 29 20 12 5
IRRS = 23.6%
Discount Rate (%)

IRRL = 18.1%
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NPV and IRR always lead to the same accept/reject decision for independent projects:
NPV ($) IRR > k and NPV > 0 Accept. k > IRR and NPV < 0. Reject.
Mutually Exclusive Projects

NPV
L
k < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT k > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT
S k (%) IRR
IRRS
8.7
%
IRRL
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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.
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 which causes the PV of a projects terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC.
MIRR for Project L (k = 10%)

0
10%
1
10.0
10%
2
60.0
10%
3
80.0 66.0 12.1 158.1 TV inflows
-100.0
-100.0 PV outflows
$158.1 $100 = (1+MIRRL)3 MIRRL = 16.5%
MIRR = 16.5%
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Why use MIRR versus IRR?
When there are nonnormal CFs and more than one IRR, use MIRR:
0 -800,000 1 5,000,000 2 -5,000,000
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.
PV outflows @ 10% = -4,932,231.40. TV inflows @ 10% = 5,500,000.00. MIRR = 5.6%

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Accept Project P?
Incremental Cash Flow
NO. Reject because MIRR = 5.6% < k = 10%. Also, if MIRR < k, NPV will be negative: NPV = -$386,777.
= Corporate cash flow with project minus Corporate cash flow without project
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Should CFs include interest expense? Dividends?
Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis?
NO. The costs of capital are already incorporated in the analysis since we use them in discounting. If we included them as cash flows, we would be double counting capital costs.
NO. This is a sunk cost. Focus on incremental investment and operating cash flows.
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Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis? Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project. A.T. opportunity cost = $25,000 (1 - T) = $15,000 annual cost.
If the new product line would decrease sales of the firms other products by $50,000 per year, would this affect the analysis? Yes. The effects on the other projects CFs are externalities. Net CF loss per year on other lines would be a cost to this project. Externalities will be positive if new projects are complements to existing assets, negative if substitutes.
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What if you terminate a project before the asset is fully depreciated?
Example: If Sold After 3 Years (000s)
Cash flow from sale = Sale proceeds - taxes paid. Taxes are based on difference between sales price and tax basis, where: Basis = Original basis - Accum. deprec.
Original basis = $240. After 3 years = $17 remaining. Sales price Tax on sale Cash flow
= $25. = 0.4($25-$17) = $3.2. = $25-$3.2=$21.7.

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If this were a replacement rather than a new project, would the analysis change? Yes. The old equipment would be sold and the incremental CFs would be the changes from the old to the new situation.
Revenues. Costs. The relevant depreciation would be the change with the new equipment. Also, if the firm sold the old machine now, it would not receive the salvage value at the end of the machines life.
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What is cash flow estimation bias? CFs are estimated for many future periods. If company has many projects and errors are random and unbiased, errors will cancel out (aggregate NPV estimate will be OK). Studies show that forecasts often are biased (overly optimistic revenues, underestimated costs).
What is option value?
Investment in a project may lead to other valuable opportunities. Investment now may extinguish opportunity to undertake same project in the future. True project NPV = NPV + value of options.
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If 5% inflation is expected over the next 5 years, are the firms cash flow estimates accurate?
Real vs. Nominal Cash flows In DCF analysis, k includes an estimate of inflation. If cash flow estimates are not adjusted for inflation (i.e., are in todays dollars), this will bias the NPV downward. This bias may offset the optimistic bias of management.
No. Net revenues are assumed to be constant over the 4-year project life, so inflation effects have not been incorporated into the cash flows.
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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
CF0 CF1 Nj I NPV
S -100,000 60,000 2 10 4,132
L -100,000 33,500 4 10 6,190
Project S: (100) 60 Project L: (100) 33.5

60 33.5 33.5 33.5 NPVL > NPVS. But is L better? Cant say yet. Need to perform common life analysis.
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Replacement Chain Approach (000s)

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. Project S with Replication: 0 1 2 3 4
Project S: (100) 60 (100) 60
60 (100) (40)
60 60
60 60
NPV = $7,547.
Copyright 1999 by The Dryden Press All rights reserved. Copyright 1999 by The Dryden Press All rights reserved.
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Or, use NPVs: 0 4,132 3,415 7,547 1 10% 2 4,132 3 4
Equivalent Annual Annuity (EAA) Approach
Finds the constant annuity payment whose PV is equal to the projects raw NPV over its original life.
Compare to Project L NPV = $6,190.

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EAA Calculator Solution

Project S PV = Raw NPV = $4,132. n = Original project life = 2. k = 10%. Solve for PMT = EAAS = $2,381. Project L PV = $6,190; n = 4; k = 10%.
The project, in effect, provides an annuity of EAA. EAAS > EAAL so pick S. Replacement chains and EAA always lead to the same decision if cash flows are expected to stay the same.
Solve for PMT = EAAL = $1,953.
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If the cost to repeat S in two years rises to $105,000, which is best? (000s)
0 1 2 3 4
Types of Abandonment
Project S: (100) 60
60 (105) (45)
Sale to another party who can obtain greater cash flows, e.g., IBM sold typewriter division. Abandon because losing money, e.g., smokeless cigarette.
60
60
NPVS = $3,415 < NPVL = $6,190. Now choose L.

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Consider another project with a 3-year life. If abandoned prior to Year 3, the machinery will have positive abandonment value. Year 0 1 2 3 CF ($5,000) 2,100 2,000 1,750 Abandonment Value $5,000 3,100 2,000 0
CFs Under Each Alternative (000s)
0 1. No abandonment (5) 2. Abandon 2 years 3. Abandon 1 year (5) (5)
1 2.1 2.1 5.2
2 2 4
3 1.75
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Assuming a 10% cost of capital, what is the projects optimal life?
Conclusions The project is acceptable only if operated for 2 years. A projects engineering life does not always equal its economic life. The ability to abandon a project may make an otherwise unattractive project acceptable. Abandonment possibilities will be very important when we get to risk.
NPV(no) = -$123. NPV(2) = $215. NPV(1) = -$273.
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What does risk mean in capital budgeting?
Is risk analysis based on historical data or subjective judgment?
Uncertainty about a projects future profitability.

Measured by sNPV, sIRR, beta. Will taking on the project increase the firms and stockholders risk?
Can sometimes use historical data, but generally cannot.

So risk analysis in capital budgeting is usually based on subjective judgments.
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What three types of risk are relevant in capital budgeting?
How is each type of risk measured, and how do they relate to one another? 1. Stand-Alone Risk: The projects risk if it were the firms only asset and there were no shareholders. Ignores both firm and shareholder diversification. Measured by the s or CV of NPV, IRR, or MIRR.
Stand-alone risk Corporate risk
Market (or beta) risk
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Probability Density
Flatter distribution, larger s, larger stand-alone risk.
2. Corporate Risk:
Reflects the projects effect on corporate earnings stability. Considers firms other assets (diversification within firm). Depends on:
projects s, and
E(NPV)
NPV
its correlation with returns on firms other assets.
Such graphics are increasingly used by corporations.

Measured by the projects corporate beta.

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Profitability Project X Total Firm Rest of Firm
3. Market Risk:
Reflects the projects effect on a welldiversified stock portfolio. Takes account of stockholders other assets. Depends on projects s and correlation with the stock market. Measured by the projects market beta.
Years
1. Project X is negatively correlated to firms other assets. 2. If r < 1.0, some diversification benefits. 3. If r = 1.0, no diversification effects.
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How is each type of risk used? Market risk is theoretically best in most situations. However, creditors, customers, suppliers, and employees are more affected by corporate risk. Therefore, corporate risk is also relevant.
Stand-alone risk is easiest to measure, more intuitive. Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk. If the project is highly correlated with the economy, stand-alone risk also reflects market risk.
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What is sensitivity analysis? Shows how changes in a variable such as unit sales affect NPV or IRR. Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. Answers what if questions, e.g. What if sales decline by 30%?
Illustration
Change from Base Level Resulting NPV (000s) Unit Sales Salvage k
-30% -20 -10 0 +10 +20 +30
$ 10 35 58 82 105 129 153
$78 80 81 82 83 84 85
$105 97 89 82 74 67 61
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NPV (000s) Unit Sales
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Results of Sensitivity Analysis
82 k
Salvage
Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV.
Unit sales line is steeper than salvage value or k, so for this project, should worry most about accuracy of sales forecast.
-30
-20
-10 Base 10 Value
20
30
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What are the weaknesses of sensitivity analysis? Does not reflect diversification. Says nothing about the likelihood of change in a variable, i.e. a steep sales line is not a problem if sales wont fall. Ignores relationships among variables.
Why is sensitivity analysis useful?
Gives some idea of stand-alone risk. Identifies dangerous variables. Gives some breakeven information.
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What is scenario analysis?
Assume we know with certainty all variables except unit sales, which could range from 900 to 1,600. Scenario Worst Base Best Probability 0.25 0.50 0.25 NPV(000) $ 15 82 148
Examines several possible situations, usually worst case, most likely case, and best case. Provides a range of possible outcomes.
E(NPV) = $ 82 47 CV(NPV) = s(NPV)/E(NPV) = 0.57
s(NPV) =
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If the firms average project has a CV of 0.2 to 0.4, is this a high-risk project? What type of risk is being measured?
Would a project in a firms core business likely be highly correlated with the firms other assets? Yes. Economy and customer demand would affect all core products. But each product would be more or less successful, so correlation < +1.0. Core projects probably have correlations within a range of +0.5 to +0.9.
Since CV = 0.57 > 0.4, this project has high risk. CV measures a projects standalone risk. It does not reflect firm or stockholder diversification.
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How do correlation and s affect a projects contribution to corporate risk? If sP is relatively high, then projects corporate risk will be high unless diversification benefits are significant. If project cash flows are highly correlated with the firms aggregate cash flows, then the projects corporate risk will be high if sP is high.
Would correlation with the economy affect market risk?
Yes.
High correlation increases market risk (beta). Low correlation lowers it.
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Should subjective risk factors be considered?
Are there any problems with scenario analysis?

Only considers a few possible outcomes. Assumes that inputs are perfectly correlated--all bad values occur together and all good values occur together. Focuses on stand-alone risk, although subjective adjustments can be made.
Yes. A numerical analysis may not capture all of the risk factors inherent in the project. For example, if the project has the potential for bringing on harmful lawsuits, then it might be riskier than a standard analysis would indicate.
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What is a simulation analysis? NPV and IRR are calculated. A computerized version of scenario analysis which uses continuous probability distributions. Computer selects values for each variable based on given probability distributions.
(More...)
Process is repeated many times (1,000 or more). End result: Probability distribution of NPV and IRR based on sample of simulated values. Generally shown graphically.
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Probability Density
What are the advantages of simulation analysis?
xxxx x xxxxxx xx xxxxxx x xxx xxxxxx xx xxxxxxxxxxx xxxx xxxxxxxxxxxxxxxxxxxxxxxxx
Reflects the probability distributions of each input.

Shows range of NPVs, the expected NPV, sNPV, and CVNPV. Gives an intuitive graph of the risk situation.
E(NPV)
NPV
Also gives sNPV, CVNPV, probability of NPV > 0.

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What are the disadvantages of simulation? Difficult to specify probability distributions and correlations. If inputs are bad, output will be bad: Garbage in, garbage out. May look more accurate than it really is.
(More...)
Sensitivity, scenario, and simulation analyses do not provide a decision rule. They do not indicate whether a projects expected return is sufficient to compensate for its risk. Sensitivity, scenario, and simulation analyses all ignore diversification. Thus they measure only stand-alone risk, which may not be the most relevant risk in capital budgeting.
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How does the projects market risk compare with the firms overall market risk?
Is the projects relative market risk consistent with its stand-alone risk?
Project k = 12.2% versus companys k = 10%. Indicates that projects market risk is greater than firms average project.
Yes. Project CV = 0.57 versus 0.3 for an average project, which is consistent with projects higher market risk.
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Methods for estimating a projects beta Accounting beta. Run regression between projects ROA and S&P index ROA. Accounting betas are correlated (0.5-0.6) with market betas. But normally cant get data on new projects ROAs before the capital budgeting decision has been made.
Pure play. Find several publicly traded companies exclusively in projects business. Use average of their betas as proxy for projects beta.
Hard to find such companies.
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Advantages and disadvantages of applying the CAPM in capital budgeting Disadvantages: Advantages: A projects market risk is the most relevant risk to stockholders, hence to determine the effect of the project on stock price.
It is virtually impossible to estimate betas for many projects.

People sometimes focus on market risk to the exclusion of corporate risk, and this may be a mistake.
It results in a definite hurdle rate for use in evaluating the project.

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Divisional Costs of Capital Debt Cost of Capacity Capital Low Avg. High 14% 10% 8%
Project Risk Adjustments
Division Heirloom Maple School
Beta High Avg. Low
Crockett Furniture classifies each project within a division as high risk, average risk, and low risk. Crockett adjusts divisional costs of capital by:
Adding 2% for high risk project No adjustment for average risk project Subtracting 1% for low risk project
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Evaluating Our Project
Evaluating Risky Outflows Company is evaluating two alternative production processes. Plan W requires more workers but less capital. Plan C requires more capital but fewer workers. Both systems have 3-year lives. The choice will have no impact on revenues, so the decision will be based on relative costs.
Our project is a high risk project in the Heirloom division.
Project cost of capital = 16%

NPV = $42 thousand
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Year 0 1 2 3
Plan W ($500) (500) (500) (500)
Plan C ($1,000) (300) (300) (300)
Now suppose Plan W is riskier than Plan C because future wage rates are difficult to forecast. Would this affect the choice? If we add a 3% risk adjustment to the 10% to get kW = 13%, new PV would be: PVCOSTS-W = -$1,681 which is < old PVCOSTS-W = -$1,743. W now looks even better.
The two systems are of average risk, so k = 10%. Which to accept? PVCOSTS-W = -$1,743. PVCOSTS-C = -$1,746.
Ws costs are slightly lower so pick W.

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Plan W now looks better, but since it is riskier, it should look worse! When costs are being discounted, we must use a lower discount rate to reflect higher risk. Thus, the appropriate discount rate would be 10% - 3% = 7%, making PVCOSTS-W = -$1,812 > old -$1,743.
Note that neither plan has an IRR. IRR is the discount rate that equates the PV (inflows) to the PV (outflows). Since there are only outflows, there can be no IRR (or MIRR). Similarly, a meaningful NPV can only be calculated if a project has both inflows and outflows.
With risk adjustment, PVCOSTS-W > PVCOSTS-C, so now choose Plan C.

If CFs all have the same sign, the result is a PV, not an NPV.
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Real Options Real options occur when managers have the opportunity to influence the cash flows of a project after the project has been implemented. Real options also are called:
How do real options increase the value of a project? Real options allow managers to avoid negative project cash flows or magnify positive project cash flows.
Managerial options. Strategic options.

Increases size of expected cash flows. Decreases risk of expected cash flows.
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How is the DCF method affected? (1) Its easy to quantify the increase in the size of the expected cash flows. (2) Its very hard to quantify the decrease in the risk of the expected cash flows.
Types of Real Options Flexibility options Abandonment options Options to contract or temporarily suspend operations Options to expand volume of product Options to expand into new geographic areas
(3) The correct cost of capital cannot be identified, so the DCF method doesnt work very well.
(More...)
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What attributes increase the value of real options? Options to add complementary products Options to add successive generations of the same product Options to delay
All real options have a positive value.

Even if its not possible to determine a quantitative estimate of a real options value, its better to have a qualitative estimate than to ignore the real option.
(More...)
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Choosing the Optimal Capital Budget Real options are more valuable if:
They have a long time until you must exercise them. The underlying source of risk is very volatile. Interest rates are high.
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 If external funds will be raised, then the NPV of all projects should be estimated using this higher 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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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...)
Copyright 1999 by The Dryden Press All rights reserved. Copyright 1999 by The Dryden Press
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 dont 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...)
Reason: Companies believe that the projects 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.
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Blum Industries has 5 potential projects:
Weve seen how to evaluate projects. We need cost of capital for evaluation. But corporate cost of capital depends on size of capital budget. Must combine WACC and capital budget analysis.
Project Cost CF Life (N) IRR A $400,000 $119,326 5 15% B 200,000 56,863 5 13 B* 200,000 35,397 10 12 C 100,000 27,057 5 11 D 300,000 79,139 5 10 Projects B & B* are mutually exclusive, the others are independent. Neither B nor B* will be repeated.
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Additional Information
Interest rate on new debt Tax rate Debt ratio Current stock price, P0 Last dividend, D0 Expected growth rate, g Flotation cost on CS, F Expected addition to RE (NI = $500,000, Payout = 60%.) 8.0% 40.0% 60.0% $20.00 $2.00 6.0% 19.0% $200,000
Calculate WACC, then plot IOS and MCC schedules. Step 1: Estimate the cost of equity
D0(1 + g) + g = $2(1.06) + 6% = 16.6%. P0 $20 D1 $2(1.06) + 6% ke = +g= P0(1 - F) $20(1 - 0.19) ks = = $2.12 + 6% = 19.1%. $16.2
For differential project risk, add or subtract 2% to WACC.

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Step 2: Estimate the WACCs

WACC1 = w dkd(1 - T) + w ceks = (0.6)(8%)(0.6) + 0.4(16.6%) = 9.5%.
Step 3: Estimate the RE break point BPRE = Retained earnings Equity fraction $200,000 = $500,000. 0.4
=
WACC2 = w dkd(1 - T) + w ceke = (0.6)(8%)(0.6) + 0.4(19.1%) = 10.5%.
Each dollar up to $500,000 has $0.40 of RE at cost of 16.6%, then WACC rises. Only 1 compensating cost increase, so only 1 break point.
11 - 117 % 16 15 14 13 12 11 10 9 8 7 500 700 New Capital (000s)

All rights reserved. Copyright 1999 by The Dryden Press
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FIGURE 1
A
B
The IOS schedule plots projects in descending order of IRR.

C WACC2 = 10.5%
MCC IOS
B*
Two potential IOS schedules--one with A, B, C, and D and another with A, B*, C, and D.
WACC1 = 9.5%
The WACC has a break point at $500,000 of new capital.
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What MCC do we use for capital budgeting, i.e., for calculating NPV?
If all 5 projects are average risk, whats the optimal capital budget? MCC = 10.5%.
MCC: WACC that exists where IOS and MCC schedules intersect. In this case, MCC = 10.5%.
IRR and NPV lead to same decisions for independent projects. Thus, all independent projects with IRRs above 10.5% should be accepted. Therefore, accept A and C, reject D, and accept B or B*.
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NPV and IRR can conflict for mutually exclusive projects.
Suppose you arent sure of WACC. At what WACC would B and B* have the same NPV? Get differences: CF0 = 200,000 - 200,000 CF1- 5 = 56,863 - 35,397 CF6-10 = 0 - 35,397
NPV method is better, so choose between B and B* based on NPV at WACC = 10.5%.
NPVB* = $12,905 > NPVB = $12,830, so choose B* over B.
= 0 = 21,466 = -35,397
Indifference WACC = IRR = 10.52%.

Copyright 1999 by The Dryden Press All rights reserved. All rights reserved.
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The risk-adjusted rates are as follows: WACC = 10.5% 2% Risk-Adjusted Hurdle Rate 8.5% 10.5 12.5
A B B* C D
IRR 15% 13 12 11 10
Hurdle Rate 12.5% 10.5 10.5 8.5 8.5 Accept Accept Accept Accept Accept
one
Project Risk Low: C, D Average: B, B* High: A
Now the optimal capital budget consists of A, B (or B*), C, and D, for a total of $1,000,000. Corporate k is still = 10.5%, so NPVB* still larger than NPVB.
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11 - 1

What is capital budgeting?

Steps 1. Estimate CFs (inflows & outflows).

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What is the payback period?

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NPV: Sum of the PVs of inflows and outflows.

Rationale for the NPV Method

NPV = PV inflows - Cost = Net gain in wealth.

Cost often is CF0 and is negative.

Copyright 1999 by The Dryden Press

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

Internal Rate of Return: IRR

NPV: Enter k, solve for NPV.

Rationale for the IRR Method

IRR: Enter NPV = 0, solve for IRR.

IRR Acceptance Criteria

Decisions on Projects S and L per IRR

If IRR > k, accept project.

If IRR < k, reject project.

Copyright 1999 by The Dryden Press

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Copyright 1999 by The Dryden Press

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Crossover Point = 8.7%

Discount Rate (%)

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Mutually Exclusive Projects

Copyright 1999 by The Dryden Press

Reinvestment Rate Assumptions

NPV assumes reinvest at k (opportunity cost of capital).

IRR assumes reinvest at IRR.

MIRR for Project L (k = 10%)

$158.1 $100 = (1+MIRRL)3 MIRRL = 16.5%

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Why use MIRR versus IRR?

PV outflows @ 10% = -4,932,231.40. TV inflows @ 10% = 5,500,000.00. MIRR = 5.6%

Incremental Cash Flow

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Should CFs include interest expense? Dividends?

Copyright 1999 by The Dryden Press

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Copyright 1999 by The Dryden Press

What if you terminate a project before the asset is fully depreciated?

Example: If Sold After 3 Years (000s)

= $25. = 0.4($25-$17) = $3.2. = $25-$3.2=$21.7.

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What is option value?

CF0 CF1 Nj I NPV

S -100,000 60,000 2 10 4,132

L -100,000 33,500 4 10 6,190

Project S: (100) 60 Project L: (100) 33.5

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Replacement Chain Approach (000s)

Project S: (100) 60 (100) 60

Or, use NPVs: 0 4,132 3,415 7,547 1 10% 2 4,132 3 4