11 Chapter model

5/6/13 9:38 PM

2/15/2006

Chapter 11. The Basics of Capital Budgeting

We used this model to create most of the chapter exhibits (Tables and Figures). We pasted in a few dialog boxes for specific Excel functions and features and show them off to the right of where they apply, but in general we encourage students who want to know more about Excel to use the Excel Tutorial and refer to it as necessary. We also like to let students know that Excel models can be used to create tables and graphs that can then be copied into Word documents, which is the way we prepared the text manuscript for submission to the publisher. That procedure is used often in business to prepare reports. Although we did not create the model for use in lectures, it could be used as such in a classroom where a projector is attached to a computer. The instructor could scroll through the model and lecture on points as they come up. This would be more useful if the students have some familiarity with Excel, but that is not really necessary because everything the model does can also be done with a financial calculator.

NET PRESENT VALUE & INTERNAL RATE OF RETURN (Sections 11.3 & 11.4)
The Net Present Value (NPV) method estimates how much a potential project contributes to shareholder wealth and is the primary capital budgeting decision criterion. While other capital budgeting tools are important and provide valuable information, the NPV is clearly the dominant metric used to evaluate projects. We use cash flow data for two projects (S and L) to illustrate NPV concepts and calculate NPV and IRR. Project S's cash flows come in sooner than Ls. We assume that the projects are equally risky and that the end-of-year net cash flows have been adjusted to reflect taxes, depreciation, and salvage values.

Figure 11-1 Net Cash Flows for Projects S and L

Expected After-Tax Net Cash Flows, CFt Project S Project L $ (1,000) $ (1,000) (Initial cost in Year 1) 500 100 400 300 300 400 100 675 1 | $500 1 | $100 2 | $400 2 | $300 3 | $300 3 | $400 4 | $100 4 | $675

Year (t) 0 1 2 3 4 0 | -$1,000 0 | -$1,000

Project S

Project L

These cash flows (either in table or time line form) can be used to quickly solve for NPV by finding the PV of each cash flow, or by using the NPV function. To find the internal rate of return, you must use Excel's IRR function.

NPV and IRR Calculations for Projects S and L

Expected After-Tax Net Cash Flows, CFt Project S Project L $ (1,000) $ (1,000) (Initial cost in Year 1) 500 100 400 300 300 400 100 675

Year (t) 0 1 2 3 4 WACC = 10% 0 | -$1,000 $454.55 $330.58 $225.39 $68.30 $78.82

Project S

1 | $500

2 | $400

3 | $300

4 | $100

NPV =

14.49% $78.82 14.49% 2 | $300 3 | $400 4 | $675

Using Excel's NPV function: NPV = Using Excel's IRR function: IRR =

Project L

NPV =

0 | -$1,000 $90.91 $247.93 $300.53 $461.03 $100.40

1 | $100

13.55% $100.40 13.55%

Using Excel's NPV function: NPV = Using Excel's IRR function: IRR =

COMPARISON OF THE NPV AND IRR METHODS (Section 11.5)

Note, that the NPV and IRR methods can provide conflicting results when used to evaluate mutually exclusive projects. Therefore, it is important that you understand the IRR method and know how it is related to the NPV. An NPV profile helps analyze the situation better.

An NPV profile is a graph that plots a projects NPV against the discount rate. To create an NPV profile, first we construct a data table that calculates NPV at various costs of capital. Notice, we have used increments of 5% and added Project S's IRR.

Figure 11-2. NPV Profile for Project S

Data for the Graph: Cost of Capital NPVS $78.82 0% 5% 10% 14.49% 15% 20% $300.00 180.42 78.82 0.00 -8.33 -83.72
300 NPV = 0, so IRRS = 14.49%. IRR > r = 10%, so accept. * For a primer on making data At r = 10%, NPV > 0, so accept

200

IRRS =

100

tables, refer to the Excel Tutorial.

0 0% -100 Cost of Capital (%) 5% 10% 15% 20%

When comparing mutually exclusive projects whose cash flows differ with respect to size or timing, conflicts arise between the NPV and IRR methods (as indicated by calculations above). NPV profiles of two such projects would intersect at some point. The cost of capital at which the profiles cross (and the projects have the same NPV) is called the crossover rate . A data table and graph below shows results for Projects S and L. Again, increments of 5% are used, but the IRR for each project and the crossover rate between the projects are used. The crossover rate is calculated immediately below the figure, but for now assume it is correct.

Figure 11-3. NPV Profiles for Projects S and L

Data for the Graph: Cost of Capital 0% 5% 10% 11.97% 13.55% 14.49% 15% 20% NPVS $78.82 $300.00 180.42 78.82 42.84 15.64 0.00 -8.33 -83.72 NPVL $100.40 $475.00 268.21 100.40 42.84 0.00 -24.37 -37.26 -151.33

Crossover = IRRL = IRRS =

500 400 300 200 100 0 0% -100 5%

L S

At r = 10%, NPVL > NPVS, but IRRS > IRRL, so there is a conflict.

Crossover rate. Conflict if r is to the left, no conflict if r is to the right.

IRRS

10% IRRL Cost of Capital (%)

15%

20%

CALCULATING THE CROSSOVER RATE (not in text)

Note, that the NPV and IRR methods can provide conflicting results when used to evaluate mutually exclusive projects. Therefore, it is important that you understand the IRR method and know how it is related to the NPV. An NPV profile helps analyze the situation better. Since the crossover rate is the cost of capital at which two projects have the same NPV, the rate is found by finding the CF differential between the projects for each year and finding the IRR of this differential CF stream.

Year (t) 0 1 2 3 4

Expected After-Tax Net Cash Flows, CFt Project S Project L -$1,000 -$1,000 500 100 400 300 300 400 100 675 11.97%

CF differential $0 400 100 -100 -575

Crossover rate =

MULTIPLE IRRs (Section 11.6)

If a project has nonnormal cash flows (more than one sign change), the project may have multiple IRRs. Consider Project M below, which has nonnormal cash flows. Construct an NPV profile for Project M and determine its IRRs.

Multiple IRRs: NPV profile and IRR calculation

WACC 10% Project M CFs -$2 10 -10

Year (t) 0 1 2 NPV -$0.77

NPV ($)

Figure 11-5. Multiple IRRs

Data for the Graph: -$0.77 0% -$1.60 10% -$0.77 20% -$0.21 30% $0.18 50% $0.62 100% $0.90 200% $0.62 300% $0.28 400% $0.00 500% -$0.21

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 0% 100% 200% 300% 400% 500%

Cost of capital

The NPV profile crosses the x-axis, so there are two IRRs. To find each IRR, we must calculate the IRR twice, but the second calculation will insert a very high value for a guess (to find the higher IRR shown above). IRR1 = IRR2 = 25% 400%

MODIFIED IRR (Section 11.7)

The MIRR calculates a project's expected rate of return based upon the assumption that cash flows are reinvested at the cost of capital, rather than the IRR. The MIRR uses a better reinvestment assumption than the IRR and is immune to the multiple IRR problem. For these reasons, many analysts believe it is a better indicator of relative profitability. MIRR can be found by finding the FV of the cash inflows (called the terminal value, or TV) and the PV of the cash outflows (costs) and solving for the RATE that makes the PV of these values equal. On the other hand, Excel has an MIRR function that requires you to specify the discount (finance) rate and the reinvestment rate (both are the WACC).

MIRR Calculations for Projects S and L

WACC = 10% 0 | -$1,000 1 | $500 2 | $400 3 | $300 4 | $100.00 330.00 484.00 665.50 $1,579.50

Project S

PV(costs) =

-$1,000.00 12.11% 12.11% 2 | $300

TV =

Using the RATE function: MIRR = Using the MIRR function: MIRR =

Project L

0 | -$1,000

1 | $100

3 | $400

PV(costs) =

-$1,000.00 12.66% 12.66%

TV =

4 | $675 440.00 363.00 133.10 $1,611.10

Using the RATE function: MIRR = Using the MIRR function: MIRR =

PAYBACK PERIOD (Section 11.8)

The payback period is defined as the number of years required to recover a projects cost from operating cash flows and is the earliest selection criterion.

Figure 11-5. Payback Calculations Project S

Years Cash Flow Cumulative Cash Flow Payback S = 2 + 100/300 = 0 | -1,000 -1,000 2.33 1 | 500 -500 2 | 400 -100 3 | 300 200 4 | 100 300

Project L

Years Cash Flow Cumulative Cash Flow

0 | -1,000 -1,000 3.30

1 | 100 -900

2 | 300 -600

3 | 400 -200

4 | 675 475

Payback L =

3 + 200/675

However, the payback period ignores cash flows occurring after the cost is recovered and it ignores the time value of money. In an effort to alleviate the second concern, the discounted payback was developed, which incorporates the present value of cash flows received.

Figure 11-6. Discounted Payback Calculations at 10% Cost of Capital Project S

Years Cash Flow Discounted Cash Flow Cumulative Discounted CF Discounted Payback S = 2 + 215/225 = 0 | -1,000 -1,000 -1,000 2.95 1 | 500 455 -545 2 | 400 331 -215 3 | 300 225 11 4 | 100 68 79

Project L

Years Cash Flow Discounted Cash Flow Cumulative Discounted CF

0 | -1,000 -1,000 -1,000 3.78

1 | 100 91 -909

2 | 300 248 -661

3 | 400 301 -361

4 | 675 461 100

Discounted Payback L = 3 + 361/461 =

SECTION 11.3
SOLUTIONS TO SELF-TEST QUESTIONS 2 What are the NPVs of Projects SS and LL if both have a 10% cost of capital and the indicated cash flows? WACC 10% Expected After-Tax Net Cash Flows, CFt Project SS Project LL -$700 -$700 500 100 300 300 100 600

Year (t) 0 1 2 3 NPVSS = NPVLL = $77.61 $89.63

*** If mutually exclusive, accept Project LL. If independent, accept both.

SECTION 11.4
SOLUTIONS TO SELF-TEST QUESTIONS 2 What are the NPVs of Projects SS and LL if both have a 10% cost of capital and the indicated cash flows? Expected After-Tax Net Cash Flows, CFt Project SS Project LL -$700 -$700 500 100 300 300 100 600

Year (t) 0 1 2 3 IRRSS = IRRLL = 18.0% 15.6%

*** If mutually exclusive, accept Project SS. If independent, accept both.

SECTION 11.6
SOLUTIONS TO SELF-TEST QUESTIONS

2 Project MM has the cash flows shown below. Calculate MMs NPV at discount rates of 0%, 10%,12.2258%, 25%, 122.1470%, and 150%. What are MMs IRRs? If the cost of capital were 10%, should the project be accepted or rejected? Project MM CFs -$1,000 2,000 2,000 -3,350 -$350.00 -$45.83 $0.00 $164.80 $0.00 -$94.40 WACCs 0% 10% 12.23% 25% 122.15% 150%

Year (t) 0 1 2 3 NPVMM (0%) = NPVMM (10%) = NPVMM (12.2258%) = NPVMM (25%) = NPVMM (122.1470%) = NPVMM (150%) = IRRMM,1 = IRRMM,2 = 12.23% 122.15%

*** A quick scatter plot graph shows a sketch of the NPV profile of MM and its two IRRs.
NPV ($) 200 100 0 -100 -200 -300 -400 Cost of capital 0% 50% 100% 150%

Multiple IRRs: Project MM

SECTION 11.7
SOLUTIONS TO SELF-TEST QUESTIONS

4 Projects S and L have the following cash flows, and their cost of capital is 10%. What are the projects IRRs, MIRRs, and NPVs? Which project would each method select? WACC 10% Expected After-Tax Net Cash Flows, CFt Project SS Project LL $ (1,000) $ (1,000) 1,150 100 100 1,300 Proj L 19.1% 18.7% $165.29 Accept? Accept S Accept L Accept L

Year (t) 0 1 2 Proj S 23.1% 16.8% $128.10

IRR = MIRR = NPV =

SECTION 11.8
SOLUTIONS TO SELF-TEST QUESTIONS 3 Project P has a cost of $1,000 and cash flows of $300 per year for 3 years plus another $1,000 in Year 4. The projects cost of capital is 15%. What are Ps regular and discounted paybacks? If the company requires a payback of 3 years or less, would the project be accepted? Would this be a good accept/reject decision, considering the NPV and/or the IRR?

Regular payback
Years Cash Flow Cumulative Cash Flow 0 | -1,000 -1,000 1 | 300 -700 2 | 300 -400 3 | 300 -100 4 | 1,000 900

Reg PB =

3.10

Discounted payback
WACC 15% Years Cash Flow Discounted Cash Flow Cumulative Discounted CF Disc PB = NPV = IRR = 3.55 $256.72 24.78% 0 | -1,000 -1,000 -1,000 1 | 300 261 -739 2 | 300 227 -512 3 | 300 197 -315 4 | 1,000 572 257

The payback rule of 3 years leads to a reject decision, which would conflict with both the NPV and IRR criteria, which would suggest accepting the project.