The Basics of Capital BudgetingEvaluating Cash Flows.ppt

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1、Chapter 7: The Basics of Capital Budgeting: Evaluating Cash Flows,Overview and “vocabulary”MethodsPayback, discounted paybackNPVIRR, MIRRProfitability IndexUnequal livesEconomic life,What is capital budgeting?,Analysis of potential projects.Long-term decisions; involve large expenditures.Very import

2、ant to firms future.,Steps in Capital Budgeting,Estimate cash flows (inflows & outflows).Assess risk of cash flows.Determine r = WACC for project.Evaluate cash flows.,What is the difference between independent and mutually exclusive projects?,Projects are:independent, if the cash flows of one are un

3、affected by the acceptance of the other.mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.,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?,Payback for Pro

4、ject L(Long: Most CFs in out years),10,80,60,0,1,2,3,-100,=,CFt,Cumulative,-100,-90,-30,50,PaybackL,2+30/80 = 2.375 years,0,100,2.4,Project S (Short: CFs come quickly),70,20,50,0,1,2,3,-100,CFt,Cumulative,-100,-30,20,40,PaybackS,1 + 30/50 = 1.6 years,100,0,1.6,=,Strengths of Payback:,1.Provides an i

5、ndication 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.,10,80,60,0,1,2,3,CFt,Cumulative,-100,-90.91,-41.32,18.79,Discountedpayback,2 + 41.32/60.11 = 2.7 yrs,Discounted Payback: Uses disc

6、ountedrather than raw CFs.,PVCFt,-100,-100,10%,9.09,49.59,60.11,=,Recover invest. + cap. costs in 2.7 yrs.,NPV:Sum of the PVs of inflows and outflows.,Cost often is CF0 and is negative.,Whats Project Ls NPV?,10,80,60,0,1,2,3,10%,Project L:,-100.00,9.09,49.59,60.11,18.79 = NPVL,NPVS = $19.98.,Calcula

7、tor Solution,Enter in CFLO for L:,-10010608010,CF0,CF1,NPV,CF2,CF3,I,= 18.78 = NPVL,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 ofhigher NPV. Adds most value.,Using NPV method, which project(s) sh

8、ould be accepted?,If Projects S and L are mutually exclusive, accept S because NPVs NPVL .If S NPV 0.,Internal Rate of Return: IRR,0,1,2,3,CF0,CF1,CF2,CF3,Cost,Inflows,IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.,NPV: Enter r, solve for NPV.,IRR: Enter N

9、PV = 0, solve for IRR.,Whats Project Ls IRR?,10,80,60,0,1,2,3,IRR = ?,-100.00,PV3,PV2,PV1,0 = NPV,Enter CFs in CFLO, then press IRR:,IRRL = 18.13%.,IRRS = 23.56%.,40,40,40,0,1,2,3,IRR = ?,Find IRR if CFs are constant:,-100,Or, with CFLO, enter CFs and press IRR = 9.70%.,3 -100 40 0 9.70%,INPUTS,OUTP

10、UT,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.,Decisions on Projects S and L per IRR,If S and L are independent, accept both. IRRs r = 10%.If S an

11、d L are mutually exclusive, accept S because IRRS IRRL .,Construct NPV Profiles,Enter CFs in CFLO and find NPVL andNPVS at different discount rates:,r 05101520,NPVL50 33197,NPVS402920125,(4),NPV ($),Discount Rate (%),IRRL = 18.1%,IRRS = 23.6%,Crossover Point = 8.7%,r 05101520,NPVL5033197(4),NPVS4029

12、20125,S,L,NPV and IRR always lead to the same accept/reject decision for independent projects:,r IRRand NPV rand NPV 0Accept.,Mutually Exclusive Projects,r 8.7 r,NPV,%,IRRS,IRRL,L,S,r NPVS , IRRS IRRLCONFLICT,r 8.7: NPVS NPVL , IRRS IRRLNO CONFLICT,To Find the Crossover Rate,1.Find cash flow differe

13、nces 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.,Two

14、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 r favors small projects.2.Timing differences. Project with faster payback provides more CF in early years for reinves

15、tment. If r is high, early CF especially good, NPVS NPVL.,Reinvestment Rate Assumptions,NPV assumes reinvest at r (opportunity cost of capital).IRR assumes reinvest at IRR.Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusi

16、ve projects.,Managers like rates-prefer IRR to NPV comparisons. Can we give them a better IRR?,Yes, MIRR is the discount rate whichcauses the PV of a projects terminalvalue (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.,Thus, MIRR assumes cash inflows are reinvested at WACC

17、.,MIRR = 16.5%,10.0,80.0,60.0,0,1,2,3,10%,66.0 12.1,158.1,MIRR for Project L (r = 10%),-100.0,10%,10%,TV inflows,-100.0,PV outflows,MIRRL = 16.5%,To find TV with 10B, enter in CFLO:,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.,Ent

18、er FV = 158.10, PV = -100, PMT = 0, N = 3.Press I = 16.50% = MIRR.,CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80,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

19、 for this than IRR.,Normal Cash Flow Project:,Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.,Nonnormal Cash Flow Project:,Two or more changes of signs.Most common: Cost (negativeCF), then string of positive CFs,then cost to close project.Nuclear power plant, st

20、rip mine.,Inflow (+) or Outflow (-) in Year,0,1,2,3,4,5,N,NN,-,+,+,+,+,+,N,-,+,+,+,+,-,NN,-,-,-,+,+,+,N,+,+,+,-,-,-,N,-,+,+,-,+,-,NN,Pavilion Project: NPV and IRR?,5,000,-5,000,0,1,2,r = 10%,-800,Enter CFs in CFLO, enter I = 10.,NPV = -386.78,IRR = ERROR. Why?,We got IRR = ERROR because there are 2

21、IRRs. Nonnormal CFs-two signchanges. Heres a picture:,NPV Profile,450,-800,0,400,100,IRR2 = 400%,IRR1 = 25%,r,NPV,Logic of Multiple IRRs,1.At very low discount rates, the PV of CF2 is large & negative, so NPV 0.4.Result: 2 IRRs.,Could find IRR with calculator:1.Enter CFs as before.2.Enter a “guess”

22、as to IRR by storing the guess. Try 10%:10STO IRR = 25% = lower IRRNow guess large IRR, say, 200:200STO IRR = 400% = upper IRR,When there are nonnormal CFs and more than one IRR, use MIRR:,0,1,2,-800,000,5,000,000,-5,000,000,PV outflows 10% = -4,932,231.40.,TV inflows 10% = 5,500,000.00.,MIRR = 5.6%

23、,Accept Project P?,NO. Reject because MIRR = 5.6% r = 10%.Also, if MIRR NPVS. But is L better?Cant say yet. Need to perform common life analysis.,Note that Project S could be repeated after 2 years to generate additional profits.Can use either replacement chain or equivalent annual annuity analysis

24、to make decision.,Project S with Replication:,NPV = $7,547.,Replacement Chain Approach (000s),0,1,2,3,4,Project S:(100) (100),60 60,60(100) (40),6060,6060,Compare to Project L NPV = $6,190.,Or, use NPVs:,0,1,2,3,4,4,1323,4157,547,4,132,10%,If the cost to repeat S in two years rises to $105,000, whic

25、h is best? (000s),NPVS = $3,415 NPVL = $6,190.Now choose L.,0,1,2,3,4,Project S:(100),60,60(105) (45),60,60,Year0123,CF ($5,000) 2,100 2,000 1,750,Salvage Value $5,000 3,100 2,000 0,Consider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage v

26、alue.,1.75,1. No termination2. Terminate 2 years3. Terminate 1 year,(5)(5)(5),2.12.15.2,24,0,1,2,3,CFs Under Each Alternative (000s),NPV(no)= -$123.NPV(2)= $215.NPV(1)= -$273.,Assuming a 10% cost of capital, what is the projects optimal, or economic life?,The project is acceptable only if operated f

27、or 2 years.A projects engineering life does not always equal its economic life.,Conclusions,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 incre

28、asing marginal cost of capital.Capital rationing,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.),If external fu

29、nds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.,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 expenditur

30、es that it will make in the upcoming year.,(More.),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 pos

31、itive NPV with the higher cost of capital.,(More.),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 be

32、lieve 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.,