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Capital Budgeting Process

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. Capital Budgeting. 1. Basic Data

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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

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