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FIN 365 Business Finance

FIN 365 Business Finance. Topic 16: Basics of Capital Budgeting Larry Schrenk, Instructor. Topics. Decision Rules in Capital Budgeting The Decision Rules: Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR)

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FIN 365 Business Finance

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  1. FIN 365 Business Finance Topic 16: Basics of Capital Budgeting Larry Schrenk, Instructor

  2. Topics • Decision Rules in Capital Budgeting • The Decision Rules: • Payback Period • Discounted Payback Period • Net Present Value (NPV) • Internal Rate of Return (IRR) • Modified Internal Rate of Return (MIRR) • Some Additional Issues

  3. Decision Rules in Capital Budgeting • Goal: Only do projects that increase firm value • Criteria: C1) Recognize the time value of money. C2) Incorporate all relevant free cash flows.

  4. Decision Rules in Capital Budgeting • Avoid (if possible): C3) Arbitrary assumptions, C4) The need for data that has great uncertainty, C5) Excessive complexity of calculation, and C6) Technical problems.

  5. The Five Decision Rules

  6. Data • r = 10%

  7. Payback Period • Rule • Do project if total cash flow within the payback period > the required investment.

  8. Payback Period • EXAMPLE: • 3 Year Payback Period Calculation • 300 + 200 + 400 = 900 < 1,000 • Result: $900.00 < $1,000.00 Bad Project

  9. r = 10% Find payback period: 300 + 200 + 400 = 900 < 1,000 < 1,600 = 900 + 700 Period is between 3 and 4 years Amount left to be paid in year 4 = 1,000 – 900 = 100 Cash flow in year 4 = 700 Payback point in year 4 = 100/700 = 0.1429 Payback Period = 3.1429 years Calculate Payback Period

  10. Payback Period • Evaluation • C1) Fails (no discounting) • C2) Fails (not after payback period) • C3) Fails (length of payback period) • C4) Passes • C5) Passes • C6) Passes • Result: Fails

  11. Discounted Payback Period • Rule • Do project if present value of the cash flows within the payback period > the required investment.

  12. Discounted Payback Period • EXAMPLE (r = 10%): • 3 Year Discounted Payback Period Calculation: • Result: $738.54 < $1,000.00 Bad Project

  13. r = 10% Find discounted payback period: 272.73 + 165.29 + 300.53 = 738.54 < 1,000 < 1,216.65 = 900 + 700 Period is between 3 and 4 years Amount left to be paid in year 4 = 1,000 – 738.54 = 261.46 Cash flow in year 4 = 478.11 Payback point in year 4 = 261.46/478.11 = 0.5469 Discounted Payback Period = 3.5469 years Calculate Discounted Payback Period

  14. Discounted Payback Period • Evaluation • C1) Passes • C2) Fails (not after payback period) • C3) Fails (length of payback period) • C4) Passes • C5) Passes • C6) Passes • Result: Fails

  15. T-P-S • If the payback period approach says a project is good, then the discounted payback period will always agree. • True • False • If the discounted payback period approach says a project is good, then the paybackperiod will always agree. • True • False

  16. Net Present Value (NPV) • Rule • Do project if NPV is positive.

  17. Net Present Value (NPV) • NPV is: • The present value of all cash flows (including any required investments).

  18. Net Present Value (NPV) • EXAMPLE (r = 10%): • NPV Calculation: • Result: $216.65 > 0 Good Project

  19. Net Present Value (NPV) • Evaluation • C1) Passes • C2) Passes • C3) Passes • C4) Require estimating long term cash flows • C5) Moderate complexity • C6) Passes • Result: G) Passes

  20. T-P-S • If you apply the discounted payback period, but include all relevant cash flows, would this be an acceptable method? • Yes • No • It would depend on other factors.

  21. NPV on Calculator • What is the NPV of a cash flow that costs $1000 and has the following cash flows: 200, -300, 1,200 (r = 18%)? • Press CF, Input 1000, Press +/-, Press Enter • Press , Input 200, Press Enter • Press , Press Enter (Default Frequency is 1) • Press , Input 300, Press +/-, Press Enter • Press , Press Enter (Default Frequency is 1) • Press , Input 1200, Press Enter • Press NPV, • Input 18, Press Enter • Press, CPT to get 315.61, i.e., $ 315.61 NOTE: Similar to Mixed CF calculation.

  22. NPV on Calculator • What is the NPV of a cash flow that costs $1000 and has the following cash flows: 200, -300, 1,200 (r = 18%)? =npv(18,-1000,{ 200, -300, 1200} Answer = 315.61

  23. Internal Rate of Return (IRR) • Rule • Do project if IRR > required rate of return (r).

  24. Internal Rate of Return (IRR) • IRR is: • The discount rate that makes present value of all cash flows (including any required investments) equal to zero.

  25. IRR Diagram -C0 C1 C2 C3 C4 C1/(1+IRR) PV(C4) + C2/(1+IRR)2 PV(C3) + C3/(1+IRR)3 PV(C2) + C4/(1+IRR)4 PV(C1) = IRR is the discount rate that makes Total PV = |C0 | Total PV = |-C0|

  26. Internal Rate of Return (IRR) • EXAMPLE (r = 10%): • IRR Calculation: • Result: 18.1% > 10% Good Project

  27. Internal Rate of Return (IRR) • Evaluation • C1) Passes • C2) Passes • C3) Passes • C4) Requires estimating long term cash flows • C5) Moderate complexity • C6) Technical Problems • 1) Reinvestment Rate Assumption • 2) Multiple IRR Results • 3) Project Comparisons • Result: G) Passes (assuming the technical problems do not occur)

  28. IRR on Calculator • What is the IRR of a cash flow that costs $1000 and has the following cash flows: 200, -300, 1,200? • Press CF, Input 1000, Press +/-, Press Enter • Press , Input 200, Press Enter • Press , Press Enter (Default Frequency is 1) • Press , Input 300, Press +/-, Press Enter • Press , Press Enter (Default Frequency is 1) • Press , Input 1200, Press Enter • Press IRR, , CPT to get 3.34, i.e., 3.34%

  29. IRR on Calculator • What is the IRR of a cash flow that costs $1000 and has the following cash flows: 200, -300, 1,200? =irr(-1000,{ 200, -300, 1200} Answer = 3.34%

  30. Modified Internal Rate of Return • Rule • Do project if MIRR > required rate of return (r). • MIRRis the discount rate that makes • the present value of all cash outflows • equal to • the present value of the terminal value.

  31. ‘Modification’ • Allows the reinvestment rate of cash flows to be specified. • Allows the reinvestment rate of cash flows to be different than the discount rate.

  32. MIRR Diagram -C0 C1 C2 C3 C4 MIRR is the discount rate that makes PV(Total FV) =|C0| FV(C4) + C3(1+rRI) FV(C3) + C2(1+rRI)2 FV(C2) + C1(1+rRI)2 |-C0| FV(C1) = = PV(Total FV) Total FV Total FV (1+MIRR)4

  33. Modified Internal Rate of Return • Steps: • 1) Determine all cash flows. • 2) Find the ‘terminal value’, i.e., the future value, of all cash inflows. • 3) Find the present value of all cash outflows. • 4) Find the MIRR which is the discount rate that makes the present value of all cash outflows equal to the present value of the terminal value.

  34. Modified Internal Rate of Return • EXAMPLE (r = 10%): • MIRR Step 1: Determine Cash Flows • Above

  35. Modified Internal Rate of Return • EXAMPLE (r = 10%): • MIRR Step 2: Calculate Terminal Value (TV), i.e., the future value of cash inflows.

  36. Modified Internal Rate of Return • EXAMPLE (r = 10%): • MIRR Step 3: Find the present value of all cash outflows. • The only cash outflow is at t = 0 and its present value is -1,000.

  37. Modified Internal Rate of Return • EXAMPLE (r = 10%): • MIRR Step 4: Find the MIRR that makes the present value of all cash outflows equal to the present value of the terminal value. • Result: 15.53% > 10% Good Project

  38. Modified Internal Rate of Return • Evaluation • C1) Passes • C2) Passes • C3) Passes • C4) Requires estimating long term cash flows • C5) Most complexity • C6) Passes • Result: G) Passes

  39. Summary of the Five Rules • Undertake Projects when: • Payback Period: Payback period cash flow > investment • Discounted Payback Period: Discounted payback period cash flow > investment • NPV: NPV > 0 • IRR: IRR > r • MIRR: MIRR > r

  40. Some Additional Issues

  41. Some Additional Issues • Comparing NPV and IRR • Using Decision Rules to Compare or Select among Projects • Sign Changes in the Cash Flows and Multiple IRR’s

  42. Comparing NPV, IRR, and MIRR • Assuming no technical problems occur, NPV and IRRalways give the same and the correct answer about whether or not to do one specific project.

  43. Comparing Projects • The IRR and MIRR rules cannot be used to compare projects or select among projects since they do not meaningfully compare the absolute advantage of one project over another. • Instead, the NPV rule must be used to compare or select among projects.

  44. Comparing Projects • EXAMPLE (r = 10%):

  45. Comparing Projects • IRRA • IRRB

  46. Comparing Projects • NPVA • NPVB

  47. Comparing Projects • Results • IRRA = 18.1% < IRRB= 29.6% • NPVA = $216.65 > NPVB= $53.36 • Question: Would you rather have a higher rate of return or a higher dollar return? • In the end it is the dollar return that counts • Project A increases firm value by $216.65. • Project B increases firm value by $53.36. • Project A is worth $163.29 more than B!

  48. Sign Changes and Multiple IRR’s • What is the IRR of the following cash flow?

  49. Sign Changes and Multiple IRR’s • There are multiple correct answers! • This is possible whenever there is more than one sign change in the cash flows!

  50. Sign Changes and Multiple IRR’s • The line crosses the x-axis at each IRR.

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