Ch10 Ppt Brighamfm1ce

8/3/2019 Ch10 Ppt Brighamfm1ce

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PowerPoint Presentationprepared by

Traven ReedCanadore College


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chapter10The Basics of Capital

Budgeting: EvaluatingCash Flows


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Copyright 2011 by Nelson Education Ltd. All rights reserved. 10-3

Corporate Valuation andCapital Budgeting


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Topics

Overview ofcapital budgeting

Methods NPV

IRR, MIRR

Profitability Index

Payback, discounted payback

Unequal lives Economic life

Capital rationing


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What is capital budgeting?

Plan and manage capitalexpenditures for long-lived assets.

Analysis of potential projects.

Long-term decisions.

Involve large commitments.

Very important to firms future.


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Steps in Capital Budgeting

Estimate cash flows (inflows &outflows).

Assess risk ofcash flows.

Determine r = WACC for project.

Evaluate cash flows.


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Independent versus MutuallyExclusive Projects

Projects are:

independent, if the cash flows of oneare unaffected by the acceptance ofthe other. Projects stand on their own.

mutually exclusive, if the cash flows of

onecan be adversely impa

cted by t

heacceptance of the other. All other

alternatives are automatically deletedonce a project is choice.


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Cash Flows for Project L andProject S

10 8060

0 1 2 3

10%Ls CFs:-100.00

70 2050

0 1 2 3

10%Ss CFs:

-100.00


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NPV: Sum of the PVs of allcash flows

Cost often is CF0 and is negative.

NPV =

n

t = 0

CFt

(1 + r)t

NPV =n

t = 1

CFt

(1 + r)t. - CF0


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Whats Project Ls NPV?

10 8060

0 1 2 310%

Ls CFs:-100.00

9.09

49.59

60.11

18.79 = NPVL NPVS = $19.98


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Calculator Solution: Project L

-100

10

60

80

10

CF0

CF1

NPV

CF2

CF3

I = 18.78 = NPVL


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Rationale for the NPVMethod

NPV = PV inflows Cost

This is net gain in wealth in dollar

terms ($), so accept project only ifNPV > 0.

Choose between mutually exclusive

projects on basis of

higher NPV.Adds most value.

NPV > 0 implies EVA > 0 and MVA> 0.


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Using NPV method, which project(s)should be accepted?

If Project S and Project L aremutually exclusive, accept S

because NPVs > NPVL .

If S & L are independent, acceptboth because NPV > 0.


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Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3Cost Inflows

IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0


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NPV: Enter r, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

= NPV

n

t = 0

CFt

(1 + r)t

= 0n

t = 0

CFt

(1 + IRR)t


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Whats Project Ls IRR?

10 8060

0 1 2 3IRR = ?

-100.00

PV3

PV2

PV1

0 = NPV Enter CFs in the financialcalculator, then press IRR:IRRL = 18.13%. IRRS = 23.56%


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40 4040

0 1 2 3

-100

Or enter CFs into the financial calculatorand press IRR = 9.70%

3 -100 40 0

9.70%

N I/YR PV PMT FV

INPUTS

OUTPUT

Find IRR if CFs are constant:


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Rationale for the IRR Method

If IRR > WACC, then the projectsrate of return is greater than its cost

adding extra values to stockholders.Accept the project.

IRR is internal to the project anddoes not depend on the marketinterest rate.

Given in %, IRR provides an easymeasure of profitability.


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Decisions on Project S andProject L using IRR

If S and L are independent, acceptboth: IRRS > rWACC and IRRL >

rWACC

If S and L are mutually exclusive,

accept S because IRRS > IRRLgiven IRRS > rWACC . Otherwise,reject both. Cost must be justified.


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Construct NPV Profiles

Enter CFs in the calculator and findNPVL and NPVS at different

discount rates:r NPVL NPVS0 50 40

5 33 29

10 19 20

15 7 12

20 (4) 5


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NPV Profile

-10

0

10

20

30

40

50

0 5 10 15 20 23.6

Discount rate r (%)

NPV(

$)

IRRL = 18.1%

IRRS = 23.6%

CrossoverPoint = 8.7%

S

L


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rWACC > IRRand NPV < 0.

Reject.

NPV

($)

r (%)IRR

IRR > rWACCand NPV > 0

Accept.

NPV and IRR:No conflict for independent projects


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Mutually Exclusive Projects

8.7

NPV

%

IRRS

IRRL

L

S

r < 8.7: NPVL> NPVS , IRRS > IRRLCONFLICT

r > 8.7: NPVS> NPVL , IRRS > IRRLNO CONFLICT


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To Find the Crossover Rate

Find cash flow differences between theprojects. See data at beginning of thecase. Enter these differences in cash flow

register, then press IRR. Crossover rate= 8.68%, rounded to 8.7%

Can subtract S from L or vi

ce versa, buteasier to have first CF negative.

If profiles dont cross, one projectdominates the other.


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Two Reasons NPV Profiles Cross

Size (scale) differences. Smaller projectfrees up funds at t = 0 for investment.

The higher the opportunity cost, themore valuable these funds, so high rfavours small projects.

Timing differences. Project with faster

payback provides more CF in early yearsfor reinvestment. If r is high, early CFespecially good, NPVS > NPVL


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Reinvestment RateAssumptions

NPV assumes reinvest at r(opportunity cost ofcapital, WACC).

IRR assumes reinvest at IRR.

Reinvest at opportunity cost, r, ismore realistic, so NPV method is

best. NPV should be used tochoose between mutually exclusiveprojects if a conflict exists.


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Normal vs. Nonnormal Cash Flows

Normal Cash Flow Project:

Cost (negative CF) followed by a series ofpositive cash inflows.

One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs.

Mostcommon: Cost (negative CF), t

henstring of positive CFs, then cost to close

project.

For example, nuclear power plant or stripmine.


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Cash flow Patterns in YearsInflow (+) or Outflow (-)

0 1 2 3 4 5 N NN

- + + + + + N

- + + + + - NN

- - - + + + N

+ + + - - - N

- + + - + - NN


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Pavilion Project:NPV and IRR?

5,000 -5,000

0 1 2r = 10%

-800

Enter CFs in the calculator. Enter I = 10

NPV = -386.78

IRR = ERROR. Why?


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NPV Profile

450

-800

0 400100

IRR2 = 400%

IRR1 = 25%

r

NPV

Nonnormal CFs--two signchanges, two IRRs


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Logic of Multiple IRRs

At very low discount rates, the PVof CF2 is large & negative, so NPV

< 0 At very high discount rates, the PV

of both CF1 and CF2 are low, soCF0 dominates and again NPV < 0

In between, the discount rate hitsCF2 harder than CF1, so NPV > 0

Result: 2 IRRs


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1. Enter CFs as before.

2. Enter a guess as to IRR by

storing the guess. Try 10%:10 STO

IRR = 25% = lower IRR

3. Now guess large IRR, say, 200:

200 STO

IRR = 400% = upper IRR

Finding Multiple IRRs withCalculator


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Why use MIRR versus IRR?

MIRR also avoids the problem ofmultiple IRRs.

MIRR correctly assumesreinvestment at opportunity cost =WACC.

Managers like using rates of returnforcomparisons, and MIRR isbetter for this than IRR.


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Modified Internal Rate ofReturn (MIRR)

MIRR is the discount rate whichcausesthe PV of a projects terminal value (TV)

to equal the PV ofcosts. TV is found by compounding inflows at

WACC.

MIRR assumes cash inflows are

reinvested at WACC which is reasonable

MIRR is unique.

Accept the project if MIRR > rWACC.


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Second, find discount ratethat equates PV and TV

MIRR = 16.5% 158.1

0 1 2 3

-100.0

TV inflowsPV outflows

MIRRL = 16.5%

$100 = $158.1(1+MIRRL)3


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MIRR calculator solution:Step 1 - find PV of Inflows

First, entercash inflows in the financialcalculator register:

CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

Second, enter I = 10

Third, find PV of inflows:

Press NPV = 118.78


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Step 2 - find TV of inflows

Enter PV = -118.78, N = 3, I = 10,PMT = 0.

Press FV = 158.10 = FV of inflows.


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Step 3 - find PV of outflows

For this problem, there is only oneoutflow, CF0 = -100, so the PV of

outflows is -100 For other problems there may be

negative cash flows for several

years, and you must find thepresent value for all negative cashflows.


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Step 4 - find IRR of TV ofinflows and PV of outflows

Enter FV = 158.10, PV = -100, PMT= 0, N = 3

Press I = 16.50% = MIRR


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0 1 2

-800,000 5,000,000 -5,000,000

PV outflows @ 10% = -4,932,231.40TV inflows @ 10% = 5,500,000.00

MIRR = 5.6%

When there are nonnormal CFs andmore than one IRR, use MIRR:


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Should this Project beaccepted?

NO. Reject because MIRR = 5.6%< r = 10%

Also, if MIRR < r, NPV will benegative: NPV = -$386,777


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Profitability Index

The profitability index (PI) is thepresent value of future cash flows

divided by the initial cost. PI is the scale-version of NPV.

It measures the bang for the buck.

To accept a project, PI > 1.

PI > 1 is equivalent to NPV > 0.


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Project Ls PV of FutureCash Flows

10 8060

0 1 2 310%

Project L:

9.09

49.59

60.11118.79


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Project Ls Profitability Index

PIL =PV future CF

Initial Cost

$118.79=

PIL = 1.1879

$100

PIS = 1.1998


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Payback Methods

Payback period is the number ofyears required to recover a projects

cost, orhow long it takes to get thebusinesss money back.

Firms establish a benchmark

payback period; projects whosepayback exceeds this benchmarkare rejected.


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Payback for Project L

10 8060

0 1 2 3

-100

=

CFtCumulative-100 -90 -30 50

PaybackL 2 + 30/80 = 2.375 years

0

2.4


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Payback for Project S

70 2050

0 1 2 3

-100CFt

Cumulative -100 -30 20 40

PaybackS 1 + 30/50 = 1.6 years

0

1.6

=


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Strengths and Weaknessesof Payback

Strengths:

Provides an indication of a projects

risk and liquidity. Easy to calculate and understand.

Weaknesses:

Ignores the time value of money. Ignores CFs occurring after the

payback period.


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10 8060

0 1 2 3

CFt

Cumulative -100 -90.91 -41.32 18.79

Discountedpayback 2 + 41.32/60.11 = 2.7 yrs

PV(CFt) -100-100

10%

9.09 49.59 60.11

=

Recover investment capital costs in 2.7 yrs.

Discounted Payback: Usesdiscounted rather than raw CFs


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Capital Budgeting Process:

Conclusion

Quantitative methods provide valuableinformation, but they should not be used

as the sole criteria for accept/rejectdecisions in capital budgeting process

NPV is the single most important methodshowing the absolute profitability

IRR is ranked second of importance

Payback is still used significantly amongsmall businesses



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Mutually Exclusive Projects withunequal lives. r = 10%.

0 1 2 3 4

Project S:(100)

Project L:(100)

60

33.5

60

33.5 33.5 33.5


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NPVL > NPVS. But is ProjectL really better?

Inputs S L

CF0 -100 -100

CF1 60 33.5

N 2 4

I 10 10

NPV 4.132 6.190

E i l A l A i


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Equivalent Annual AnnuityApproach (EAA)

Convert the PV into a stream ofannuity payments with the same

PV. S: N=2, I/YR=10, PV=-4.132, FV =

0. Solve for PMT = EAAS = $2.38

L: N=4, I/YR=10, PV=-6.190, FV =0. Solve for PMT = EAAL = $1.95

S has higher EAA, so it is a betterproject.

E i Lif


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Economic Life versusPhysical Life

Projects are normally analyzedunder the assumption that the firm

will operate the asset till its end. Consider a project with a 3-year life.

If terminated prior to Year 3, themachinery will have positivesalvage value.

Should you always operate for thefull physical life?

E i Lif


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Economic Life versusPhysical Life (contd)

Year CF SalvageValue

0 ($4,800) $4,800

1 2,000 3,000

2 2,000 1,650

3 1,750 0

CF U d E h Alt ti


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CFs Under Each Alternative(000s)

0 1 2 3

1. No termination (4.8) 2 2 1.75

2. Terminate 2 years (4.8) 2 4

3. Terminate 1 year (4.8) 5


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Economic Life versus Physical Life(contd)

NPVs under alternative lives:

NPV(3) @10% = -$14.12

NPV(2) @10% = $34.71

NPV(1) @10% = -$254.55

The project is acceptable only if

operated for 2 years. A projects engineering life does not

always equal its economic life.


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Optimal Capital Budget

Finance theory says to accept allpositive NPV projects.

Two problems can occur whenthere is not enough internallygenerated cash to fund all positive

NPV projects: An increasing marginal cost ofcapital.

Capital rationing.


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Increasing Marginal Cost of Capital

Externally raised capital can have largeflotation costs, which increase the cost of

capital. Investors often perceive large capital

budgets as being risky, which drives up thecost ofcapital.

If external funds will be raised, then theNPV of all projects should be estimatedusing this higher marginal cost ofcapital.


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Capital Rationing

Capital rationing occurs when acompany chooses not to fund all

positive NPV projects. The company typically sets an

upper limit on the total amount of

capital expenditures that it willmake in the upcoming year.


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Reason: Reluctance to issue newstock. Firms want to avoid the direct

costs (i.e., flotation costs) and theindirect costs of issuing new capital.

Solution: Increase the cost ofcapital by enough to reflect all ofthese costs, and then accept allprojects that still have a positiveNPV with the highercost ofcapital.

Capital Rationing (contd)


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Reason: Constraints onnonmonetary resources. Firms do

not have enough managerial,marketing, or engineering staff toimplement all positive NPV projects.

Solution: Use linear programmingto maximize NPV subject to notexceeding the constraints onstaffing.



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Reason: Controlling estimate bias. Firmsbelieve that the projects managers

forecast unreasonably highcash flowestimates, so companies filter out theworst projects by limiting the totalamount of projects that can be accepted.

Solution: Implement a post-auditprocess and tie the managerscompensation to the subsequentperformance of the project.


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Ch10 Ppt Brighamfm1ce