Apital Budgeting: Decision Criteria: Should We Build This Plant?

11 - 1
CHAPTER 11
Capital Budgeting: Decision Criteria
Should we
build this
plant?
Copyright 2002 Harcourt College Publishers.
All rights reserved.
11 - 2
What is capital budgeting?
Analysis of potential additions to

fixed assets.
Long-term decisions; involve large
expenditures.
Very important to firms future.
11 - 3
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.
11 - 4
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.
11 - 5
An Example of Mutually Exclusive

Projects
BRIDGE vs. BOAT to get

products across a river.
11 - 6
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.
11 - 7
Inflow (+) or Outflow (-) in Year

0
NN
NN
NN
11 - 8
What is the payback period?
The number of years required to

recover a projects cost,
or how long does it take to get the
businesss money back?
11 - 9
Payback for Project L

(Long: Most CFs in out years)
0
CFt
-100
Cumulative -100
PaybackL
= 2
10
-90
+
30/80
2.4
60 100
-30
0
3
80
50
= 2.375 years
11 - 10
Project S (Short: CFs come quickly)

0
CFt
-100
Cumulative -100
PaybackS
1.6 2
70 100 50
20
-30
40
0 20
= 1 + 30/50 = 1.6 years
11 - 11
Strengths of Payback:
1. Provides an indication of a
projects risk and liquidity.
2. Easy to calculate and understand.
Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
11 - 12
Discounted Payback: Uses discounted

rather than raw CFs.
0
10%
10
60
80
CFt
-100
PVCFt
-100
9.09
49.59
60.11
Cumulative -100
-90.91
-41.32
18.79
Discounted
= 2
payback
+ 41.32/60.11 = 2.7 yrs
Recover invest. + cap. costs in 2.7 yrs.

11 - 13
NPV: Sum of the PVs of inflows and

outflows.
CFt
NPV
.
t
t 0 1 k
n
Cost often is CF0 and is negative.

n
NPV
t 1
CFt
1 k
CF0 .
11 - 14
Whats Project Ls NPV?

Project L:
0
-100.00
10%
10
60
80
9.09
49.59
60.11
18.79 = NPVL
NPVS = $19.98.
11 - 15
Calculator Solution
Enter in CFLO for L:
-100
CF
0
10
CF1
60
CF2
80
CF3
10
NPV
= 18.78 = NPVL
11 - 16
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 of
higher NPV. Adds most value.
11 - 17
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.
11 - 18
Internal Rate of Return: IRR

0
CF0
Cost
CF1
CF2
Inflows
3
CF3
IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.
11 - 19
NPV: Enter k, solve for NPV.

CFt
NPV.
t
t 0 1 k
n
IRR: Enter NPV = 0, solve for IRR.

CFt
0.
t
t 0 1 IRR
n
11 - 20
Whats Project Ls IRR?

0
IRR = ?
-100.00
PV1
PV2
PV3
0 = NPV
10
60
80
Enter CFs in CFLO, then press IRR:

IRRL = 18.13%. IRRS = 23.56%.
11 - 21
Find IRR if CFs are constant:

0
IRR = ?
-100
INPUTS
40
40
40
3
N
OUTPUT
I/YR
-100
40
PV
PMT
FV
9.70%
Or, with CFLO, enter CFs and press

IRR = 9.70%.
Q.
How is a projects IRR

related to a bonds YTM?
They are the same thing.
A bonds YTM is the IRR
if you invest in the bond.
A.
IRR = ?
-1,134.2
90
90
...
11 - 22
10
1,090
IRR = 7.08% (use TVM or CFLO).

11 - 23
Rationale for the IRR Method
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.
11 - 24
IRR Acceptance Criteria
If IRR > k, accept project.

If IRR < k, reject project.
11 - 25
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 .
11 - 26
Construct NPV Profiles

Enter CFs in CFLO and find NPVL and
NPVS at different discount rates:
k
0
5
10
15
20
NPVL
50
33
19
7
(4)
NPVS
40
29
20
12
5
11 - 27
NPV ($)
60
0
5
10
15
20
50
Crossover
Point = 8.7%
40
30
20
NPVS
50
33
19
7
(4)
40
29
20
12
5
10
IRRS = 23.6%
Discount Rate (%)
0
0
-10
NPVL
10
15
20
23.6
IRRL = 18.1%
11 - 28
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.
IRR
k (%)
11 - 29
Mutually Exclusive Projects

k < 8.7: NPVL> NPVS , IRRS > IRRL
CONFLICT
k > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
NPV
L
S
k
8.7
IRRS
%
IRRL
11 - 30
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 dont cross, one project
dominates the other.
11 - 31
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.
11 - 32
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.
11 - 33
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.
11 - 34
MIRR for Project L (k = 10%)

0
10%
-100.0
10.0
60.0
80.0
10%
10%
MIRR = 16.5%
-100.0
PV outflows
$158.1
$100 =
(1+MIRRL)3
66.0
12.1
158.1
TV inflows
MIRRL = 16.5%
11 - 35
To find TV with 10B, enter in CFLO:

CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80
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.
11 - 36
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.
11 - 37
Pavilion Project: NPV and IRR?

0
-800
k = 10%
5,000
-5,000
Enter CFs in CFLO, enter I = 10.

NPV = -386.78
IRR = ERROR. Why?
11 - 38
We got IRR = ERROR because there

are 2 IRRs. Nonnormal CFs--two sign
changes. Heres a picture:
NPV Profile
NPV
IRR2 = 400%
450
0
-800
100
400
IRR1 = 25%
11 - 39
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 CF 2
harder than CF1, so NPV > 0.
4. Result: 2 IRRs.
11 - 40
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
11 - 41
When there are nonnormal CFs and

more than one IRR, use MIRR:
0
-800,000
1
5,000,000
2
-5,000,000
PV outflows @ 10% = -4,932,231.40.

TV inflows @ 10% = 5,500,000.00.
MIRR = 5.6%
11 - 42
Accept Project P?
NO. Reject because MIRR =

5.6% < k = 10%.
Also, if MIRR < k, NPV will be
negative: NPV = -$386,777.
11 - 43
S and L are mutually exclusive and

will be repeated. k = 10%. Which is
better? (000s)
0
Project S:
(100)
60
60
Project L:
(100)
33.5
33.5
33.5
33.5
11 - 44
CF0
CF1
Nj
I
NPV
S
-100,000
60,000
2
10
L
-100,000
33,500
4
10
4,132
6,190
NPVL > NPVS. But is L better?

Cant say yet. Need to perform
common life analysis.
11 - 45
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.
11 - 46
Replacement Chain Approach (000s)

Project S with Replication:
0
Project S:
(100)
60
(100)
60
60
(100)
(40)
60
60
60
60
NPV = $7,547.
11 - 47
Or, use NPVs:

0
4,132
3,415
7,547
1
10%
4,132
Compare to Project L NPV = $6,190.

11 - 48
If the cost to repeat S in two years

rises to $105,000, which is best? (000s)
0
Project S:
(100)
60
60
(105)
(45)
60
60
NPVS = $3,415 < NPVL = $6,190.

Now choose L.
11 - 49
Consider another project with a 3-year

life. If terminated prior to Year 3, the
machinery will have positive salvage
value.
Year
0
1
2
3
CF
($5,000)
2,100
2,000
1,750
Salvage Value
$5,000
3,100
2,000
0
11 - 50
CFs Under Each Alternative (000s)
0
(5)
1
2.1
2
2
2. Terminate 2 years (5)
2.1
3. Terminate 1 year
5.2
1. No termination
(5)
3
1.75
11 - 51
Assuming a 10% cost of capital, what is

the projects optimal, or economic life?
NPV(no) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
11 - 52
Conclusions
The project is acceptable only if
operated for 2 years.
A projects engineering life does not
always equal its economic life.
11 - 53
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
11 - 54
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...)
11 - 55
If external funds will be raised, then

the NPV of all projects should be
estimated using this higher marginal
cost of capital.
11 - 56
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...)
11 - 57
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...)
11 - 58
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...)
11 - 59
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.

Apital Budgeting: Decision Criteria: Should We Build This Plant?

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11 - 1

Copyright 2002 Harcourt College Publishers.

All rights reserved.

What is capital budgeting?

Analysis of potential additions to

Copyright 2002 Harcourt College Publishers.

All rights reserved.

All rights reserved.

What is the difference between

All rights reserved.

An Example of Mutually Exclusive

BRIDGE vs. BOAT to get

All rights reserved.

Normal Cash Flow Project:

All rights reserved.

Inflow (+) or Outflow (-) in Year

Copyright 2002 Harcourt College Publishers.

What is the payback period?

The number of years required to

Copyright 2002 Harcourt College Publishers.

All rights reserved.

Payback for Project L

Copyright 2002 Harcourt College Publishers.

All rights reserved.

Project S (Short: CFs come quickly)

= 1 + 30/50 = 1.6 years

Copyright 2002 Harcourt College Publishers.

All rights reserved.

All rights reserved.

Discounted Payback: Uses discounted

+ 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.

All rights reserved.

NPV: Sum of the PVs of inflows and

Cost often is CF0 and is negative.

Copyright 2002 Harcourt College Publishers.

All rights reserved.

Whats Project Ls NPV?

Copyright 2002 Harcourt College Publishers.

Rationale for the NPV Method

All rights reserved.

Using NPV method, which project(s)

If Projects S and L are mutually

All rights reserved.

Internal Rate of Return: IRR

IRR is the discount rate that forces

All rights reserved.

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

Copyright 2002 Harcourt College Publishers.

All rights reserved.

Whats Project Ls IRR?

Enter CFs in CFLO, then press IRR:

All rights reserved.

Find IRR if CFs are constant:

Or, with CFLO, enter CFs and press

All rights reserved.

How is a projects IRR

IRR = 7.08% (use TVM or CFLO).

All rights reserved.

Rationale for the IRR Method

If IRR > WACC, then the projects

All rights reserved.