Tài chính doanh nghiệp - Chapter 10: The basics of capital budgeting

CHAPTER 10The Basics of Capital BudgetingShould we build thisplant?What is capital budgeting?Analysis of potential additions to fixed assets.Long-term decisions; involve large expenditures.Very important to firm’s future.Steps to capital budgetingEstimate 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.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.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.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.Calculating paybackPaybackL = 2 + / = 2.375 yearsCFt -100 10 60 100Cumulative -100 -90 0 500123=2.4308080-30Project LPaybackS = 1 + / = 1.6 yearsCFt -100 70 100 20Cumulative -100 0 20 400123=1.6305050-30Project SStrengths and weaknesses of paybackStrengthsProvides an indication of a project’s risk and liquidity.Easy to calculate and understand.WeaknessesIgnores the time value of money.Ignores CFs occurring after the payback period.Discounted payback periodUses discounted cash flows rather than raw CFs.Disc PaybackL = 2 + / = 2.7 yearsCFt -100 10 60 80Cumulative -100 -90.91 18.790123=2.760.11-41.32PV of CFt -100 9.09 49.5941.3260.1110%Net Present Value (NPV)Sum of the PVs of all cash inflows and outflows of a project: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 = $19.98Solving for NPV:Financial calculator solutionEnter CFs into the calculator’s CFLO register.CF0 = -100CF1 = 10CF2 = 60CF3 = 80Enter I/YR = 10, press NPV button to get NPVL = $18.78.Rationale for the NPV method NPV = PV of inflows – Cost = Net gain in wealthIf 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.Internal Rate of Return (IRR)IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:Solving for IRR with a financial calculator:Enter CFs in CFLO register.Press IRR; IRRL = 18.13% and IRRS = 23.56%.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.Rationale for the IRR methodIf IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns.IRR Acceptance CriteriaIf IRR > k, accept project.If IRR k = 10%.If projects are mutually exclusive, accept S, because IRRs > IRRL.NPV ProfilesA graphical representation of project NPVs at various different costs of capital. k NPVL NPVS 0 $50 $40 5 33 29 10 19 20 15 7 12 20 (4) 5Drawing NPV profiles-100102030405060510152023.6NPV ($)Discount Rate (%)IRRL = 18.1%IRRS = 23.6%Crossover Point = 8.7%SL...........Comparing the NPV and IRR methodsIf 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 NPVL.Reinvestment rate assumptionsNPV 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.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.Calculating MIRR 66.0 12.110%10%-100.0 10.0 60.0 80.00 1 2 310%PV outflows-100.0$100MIRR = 16.5%158.1TV inflowsMIRRL = 16.5%$158.1(1 + MIRRL)3= 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.Project P has cash flows (in 000s): CF0 = -$800, CF1 = $5,000, and CF2 = -$5,000. Find Project P’s NPV and IRR.Enter CFs into calculator CFLO register.Enter I/YR = 10.NPV = -$386.78.IRR = ERROR Why?-800 5,000 -5,0000 1 2k = 10%Multiple IRRsNPV Profile450-8000400100IRR2 = 400%IRR1 = 25%kNPVWhy are there multiple IRRs?At very low discount rates, the PV of CF2 is large & negative, so NPV 0.Result: 2 IRRs. Solving the multiple IRR problemUsing a calculatorEnter 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.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%.