Professional Documents
Culture Documents
10-1
Case presents a situation where we have to decide the best possible option to invest $1 million. The two possible options are below1.Franchise L ( Lisas soup, salads) 2.Franchise S ( Fried Chicken) Few Facts Ls cash flow will start of slowly but will increase quickly because of the health awareness among the people Ss cash flow will start quickly but will trail off once other chicken competitors enter the market and people start avoiding fried chicken
10-2
The investment is for 3 years Both franchises have risk that require a return of 10%
10-3
Problem Evaluation
10-4
10-5
Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC.
10-6
10-7
10-8
CALCULATING PAYBACK
Project L CFt Cumulative PaybackL Project S CFt Cumulative PaybackS 0 -100 -100 = 2 = 0 -100 -100 == 1 + + 1 70 -30 1 10 -90 2 2.4 3
60 100 80 -30 0 50
100 5 0 0 20
What is the rationale for the payback method? According to the payback criterion, which franchise or franchises should be accepted if the firms maximum acceptable payback is two years and if franchises L and S are independent? If they are mutually exclusive?
10-10
Sol: In mutually exclusive projects the one with shorter payback period is chosen. If L and S are independent projects then Franchise S is accepted because its payback period is less than 2 years(max). If L and S are mutually exclusive projects then Franchise S would be chosen because S has the shorter payback period.
10-11
What is the difference between the regular and discounted payback periods?
Sol. Simple payback method do not care about the time-value of money principle while discounted payback period do take care of this principle in calculation.
10-12
What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decision?
Sol. The main disadvantages are: Ignores the time value of money. Ignores CFs occurring after the payback period.
10-13
CFt NPV ! t t !0 ( 1 k )
Where, CFt is the expected net cash flow at period t. r is the projects cost of capital. N is its life.
10-14
NPVS = $19.98
10-15
10-16
10-17
10-18
CFt 0! ( 1 IRR ) t t !0
Solving for IRR with a financial calculator: Enter CFs in CFLO register. Press IRR; IRRL = 18.13% and IRRS = 23.56%.
10-19
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 $1,134.20. Solve for IRR = YTM = 7.08%, the annual return for this project/bond.
10-20
What is the logic behind the IRR method? According to IRR which franchises should be accepted if they are independent? Mutually exclusive?
Sol:
If IRR > WACC, the projects rate of return is greater than its costs. There is some return left over to boost stockholders returns.
10-21
10-22
10-23
NPV PROFILES
A graphical representation of project NPVs at various different costs of capital. k 0 5 10 15 20 NPVL ($) 50 33 19 7 (4) NPVS ($) 40 29 20 12 5
10-24
NPV 60 ($)
50
. 40 .
30 20 10 0
. .
.
L
10
IRRL = 18.1%
. .
15
5 -10
20
. .
.
23.6
Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6% ?
10-26
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. At 23.6% cost of capital, project S is accepted as IRR> COC and project L will be rejected.
10-27
What is the underlying cause of ranking conflicts between NPV and IRR?
Sol: Two basic conditions of conflict When project size or scale differences exist, meaning that the cost of one project is greater than that of other. When timing differences exist. Cash flows in previous or later years.
10-28
10-29
10-30
Define the term modified IRR (MIRR). Find the MIRRs for Franchises L and S.
MIRR value is always unique given that we have at least one negative and one positive net cash flow. The modified internal rate of return is a geometric average of the compounded future value of positive cash flows over the discounted present value of negative cash flows. MIRR Formula
10-31
CALCULATING MIRR
0 -100.0
10%
1 10.0
10% MIRR = 16.5%
2 60.0
10%
-100.0
PV outflows
$100 =
$158.1 (1 + MIRRL)3
MIRRL = 16.5%
10-32
What are the MIRRs advantages and disadvantages vis--vis the regular IRR? What are the MIRRs advantages and disadvantages vis--vis the NPV?
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. NPV method is still the best way to choose among competing projects because it provides the best indication of how much each project will add to the value of the firm.
10-33
As a separate project (Project P), you are considering sponsoring a pavilion at the upcoming Worlds Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project Ps expected net cash flows look like this (in millions of dollars): Year Net Cash Flows 0 ($0.8) 1 5.0 2 (5.0) The project is estimated to be of average risk, so its cost of capital is 10%. (1) What are normal and non normal cash flows?
10-34
10-35
N N
NN
NN
0 -800
r = 10%
1 5,000
2 -5,000
Enter CFs in CFLO, enter I = 10. NPV = -386.78 IRR = ERROR. Why?
10-37
We got IRR = ERROR because there are 2 IRRs. Non-normal CFs--two sign changes. Heres a picture:
NPV
NPV Profile
IRR2 = 400%
400
10-39
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
10-40
When there are non-normal CFs and more than one IRR, use MIRR:
0 -800,000 1 5,000,000 2 -5,000,000
ACCEPT PROJECT P?
NO. Reject because MIRR = 5.6% < r = 10%. Also, if MIRR < r, NPV will be negative: NPV = -$386,777.
10-42
S and L are mutually exclusive and will be repeated. r = 10%. Which is better? (Thousands)
0 Project S: (100) Project L: (100) 1 2 3 4
60 33.5
10-43
NPVL > NPVS. But is L better? Cant say yet. Need to perform common life analysis.
10-44
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.
10-45
10-46
60 (100) (40)
60 60
60 60
NPV = $7,547.
10-47
2 4,132
10%
Project S should be chosen as its extended NPV is more than that of project L.
10-48
If the cost to repeat S in two years rises to $105,000, which is best? (Thousands)
0 1 2 3 4
Franchise S: (100) 60
60 (105) (45)
60
60
k. You are also considering another project that has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the projects estimated cash flows:
Year 0 1 2 3 CF ($5,000) 2,100 2,000 1,750 Salvage Value $5,000 3,100 2,000 0
10-50
Using the 10% cost of capital, what is the projects NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the projects optimal (economic) life?
10-51
2 2 4
3 1.75
10-52
Assuming a 10% cost of capital, what is the projects optimal, or economic life?
NPV(no) NPV(2) NPV(1) = -$123. = $215. = -$273.
The project is acceptable only if operated for 2 years. A projects engineering life does not always equal its economic life.
10-53
After examining all the potential projects, you discover that there are many more projects this year with positive NPVs than in a normal year. What two problems might this extra large capital budget cause?
(1) Increasing marginal cost of capital and (2) Capital rationing.
10-54
CLOSURE
10-55
Capital Budgeting - Analysing which of the two franchises is to be selected Various methods used for analysis are1.NPV 2.IRR 3.MIRR 4.Pay Back 5.Profitability Index
10-56
NPV helps in deciding the project which adds most wealth to the share holders and in this case NPV of S>L IRR is an indicator of safety margin and in this case IRR of S>L PI measures the profitability relative to any project and here also S>L Payback tells about the liquidity and risk of the project and we find S>L
10-57
In our view project S seems to be more profitable than L Also, because the NPVS of the two projects are positive so both can be selected
10-58