Capital Budgeting Process

# Capital Budgeting Process

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## Capital Budgeting Process

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1. Capital Budgeting Process • 1. Estimate the cash flows. • 2. Assess the riskiness of the cash flows. • 3. Determine the appropriate discount rate. • 4. Find the PV of the expected cash flows. • 5. Accept the project if PV of inflows > costs.

2. Capital Budgeting • 1. Basic Data • Expected Net Cash Flow • Year Project L Project S • 0 (\$100) (\$100) • 1 10 70 • 2 60 50 • 3 80 20 • 2. Evaluation Techniques • A. Payback period • B. Discounted payback period • C. Net present value (NPV) • D. Internal rate of return (IRR) • E. Modified internal rate of return (MIRR)

3. Capital Budgeting - Illustration • I. Basic Data • Expected Net Cash Flow • YearProject LProject S • 0 (\$100) (\$100) • 1 10 70 • 2 60 50 • 3 80 20

4. Capital Budgeting • Weakness of Payback: • 1. Ignores the time value of money. This weakness is eliminated with the discounted payback method. • 2. Ignores cash flows occurring after the payback period.

5. Capital Budgeting • NPV = CFt • (1+k) • Project L: • 0 10% 1 2 3 • -100.00 10 60 80 • 9.09 • 49.59 • 60.11 • NPVL= 18.79 NPVS = \$19.98 • If the projects are independent, accept both. • If the projects are mutually exclusive, accept Project S since NPVS > NPVL t

6. Capital Budgeting • IRR = CFt = \$0 = NPV • (1+IRR) • Project L: • 0 IRR 1 2 3 • -100.00 10 60 80 • 8.47 • 43.02 • 48.57 • 0.06 = \$0 IRRL=18.1% IRRS=23.6% • If the projects are independent, accept both because IRR>k. • If the projects are mutually exclusive, accept Project S since IRRS > IRRL t

7. Capital Budgeting • Project L: • 0 10% 1 2 3 • -100.00 10 60 80.00 • 66.00 • 12.10 • 100.00 MIRR = 16.5% \$158.10 • \$0.00 = NPV TVof • inflows • PV outflows = \$100 • TV inflows =\$158.10 \$100=158.10 (pvif)

8. Capital Budgeting - Illustration • II. Evaluation Techniques • A. Payback period • B. Discounted payback period • C. Net present value (NPV) • D. Internal rate of return (IRR) • E. Modified internal rate of return • (MIRR)

9. Capital Budgeting - Payback Period • Payback period = Expected number of • years required to recover a project’s cost. • Project L • Expected Net Cash Flow • YearAnnualCumulative • 0 (\$100) (\$100) • 1 10 (90) • 2 60 (30) • 3 80 50

10. Capital Budgeting - Payback Period • PaybackL= 2 + \$30 / \$80 years • = 2.4 years • PaybackS= 1.6 years. • Weaknesses of Payback: • 1. Ignores the time value of money. This weakness is eliminated with the discounted payback period. • 2. Ignores cash flows occurring after the payback period.

11. Capital Budgeting - Net Present Value (NPV) • n • NPV = S CFt • Project L: t=0 (1+k)t • 0 10% 1 2 3 • -100.00 10 60 80 • 9.09 • 49.59 • 60.11 • NPVL= \$18.79

12. Capital Budgeting - Net Present Value (NPV) • n • NPV = S CFt • Project S: t=0 (1+k)t • 0 10% 1 2 3 • -100.00 70 50 20 • 63.64 • 41.32 • 15.03 • NPVS= \$19.99

13. Capital Budgeting - Net Present Value (NPV) • NPVS = \$19.99 NPVL= \$18.79 • If the projects are independent, accept both. • If the projects are mutually exclusive, accept Project S since NPVS > NPVL. • Note: • NPV declines as k increases and NPV rises as k decreases.

14. Internal Rate of Return (IRR) • n • IRR = S CFt = \$0 = NPV • Project L: t=0 (1+IRR)t • 0 IRR 1 2 3 • -100.00 10 60 80 • 8.47 18.13% • 43.00 18.13% • 48.54 18.13% • \$ 0.01 » \$0

15. Internal Rate of Return (IRR) • n • IRR = S CFt = \$0 = NPV • Project S: t=0 (1+IRR)t • 0 IRR 1 2 3 • -100.00 70 50 20 • 56.65 23.56% • 32.75 23.56% • 10.60 23.56% • \$ 0.00

16. Internal Rate of Return (IRR) • IRRL = 18.13% • IRRS = 23.56% • If the projects are independent, accept both because IRR > k. • If the projects are mutually exclusive, accept Project S since IRRS > IRRL. • Note: • IRR is independent of the cost of capital.

17. Capital Budgeting - NPV Profiles k NPVL NPVS 0% \$50 \$40 5 33 29 10 19 20 15 7 12 20 (4) 5

18. Modified IRR (MIRR) • Project L: • 0 10% 1 2 3 • -100 10 60 80.00 • 66.00 • 12.10 • \$158.10 =TV of • 100.00 MIRR=16.5% inflows • \$ 0.00 = NPV

19. Modified IRR (MIRR) • Project S: • 0 10% 1 2 3 • -100 70 50 20.00 • 55.00 • 84.70 • \$159.70 =TV of • 100.00 MIRR=16.9% inflows • \$ 0.00 = NPV

20. Modified IRR (MIRR) • PV outflows = \$100 • TV inflows = \$158.10 • \$100 = \$158.10 (PVIFMIRRL,3) • MIRRL = 16.5% • MIRRS = 16.9%

21. Modified IRR (MIRR) • Project L: • 0 5% 1 2 3 • -100 10 60 80.00 • 63.00 • 11.03 • \$154.03 =TV of • 100.00 MIRR=15.48% inflows • \$ 0.00 = NPV

22. Modified IRR (MIRR) • Project S: • 0 5% 1 2 3 • -100 70 50 20.00 • 52.50 • 77.18 • \$149.68 =TV of • 100.00 MIRR=14.39% inflows • \$ 0.00 = NPV

23. Modified IRR (MIRR) • MIRR is better than IRR because: • 1. MIRR correctly assumes reinvestment at project’s cost of capital. • 2. MIRR avoids the problem of multiple IRRs.

24. NPV Profile: Nonnormal Project P with Multiple IRRs Year Cash Flow (‘000) 0 (\$800) 1 5,000 2 (5,000) NPV @10% = -\$386,777. Do not accept; NPV < 0. IRR = 25% and 400%. MIRR = 5.6%. Do not accept; MIRR < k.

25. Debt • Bank • Equity \$120 \$100 1 year IRR = 20% wacc=10% \$100 % A=20% 20% IOS wacc = 10% MCC \$ 100 0 IF IRR > WACC THEN ACCEPT PROJECT

26. Debt • Bank • Equity • PV(CASH IN) = 100 = CASH OUTFLOW \$110 \$100 1 year IRR = 10% wacc=10% \$100

27. IN 120 • PV(IN) = 109.09 PV(IN) = 100 • PV(OUT) = 100 PV(0UT) = 100 • NPV = 9.09 NPV = 0 • CF0= -100 i=10% CF0= -100 i=10% • CF1= 120 CF1= 110 • NPV = 9.09 NPV = 0 IN 110 1 YEAR 1 YEAR WACC = 10% WACC = 10% 100 OUT 100 OUT

28. IRR NPV • CF0 = -100 PV(IN) = 95.45 • CF1 = 105 PV(OUT) = 100 • IRR = 5% NPV = -4.55 • CF0 = -100 CF1=105 • i = 10% NPV = -4.55 10% IN 105 WACC = 10% 100 OUT