The basics of capital budgeting (chapter 11)

1. The basics of capital budgeting (chapter 11) Should we build this plant?

2. What is capital budgeting? • Analysis of potential additions to fixed assets • Long-term decisions; involve large expenditures • Independent projects – if the cash flows of one are unaffected by the acceptance of the other (see text page 372) • Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other (see text page 372)

3. Steps to capital budgeting • Estimate CFs (inflows & outflows). • Assess riskiness of CFs. • Determine the appropriate cost of capital. • Find NPV and/or IRR. • Accept if NPV > 0 and/or IRR > WACC.

4. What is the payback period? • The number of years required to recover a project’s cost, or “How long does it take to get our money back?” • Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive. • Strengths • Provides an indication of a project’s risk and liquidity. • Easy to calculate and understand. • Weaknesses • Ignores the time value of money. • Ignores CFs occurring after the payback period.

5. 2.4 3 0 1 2 Project L 80 CFt-100 10 60 100 Cumulative -100 -90 0 50 -30 30 80 PaybackL = 2 + / = 2.375 years = 1.6 3 0 1 2 Project S CFt-100 70 100 20 50 Cumulative -100 0 20 40 -30 30 50 PaybackS = 1 + / = 1.6 years = Calculating payback

6. 2.7 3 0 1 2 10% CFt -100 10 60 80 PV of CFt -100 9.09 49.59 60.11 Cumulative -100 -90.91 18.79 -41.32 Disc PaybackL = 2 + / = 2.7 years = 41.32 60.11 Discounted payback period • Uses discounted cash flows rather than raw CFs.

7. Net Present Value (NPV) • Sum of the PVs of all cash inflows and outflows of a project: Advantages: 1. Uses cash flows 2. Uses ALL cash flows of the project 3. Discounts ALL cash flows properly • Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate • The BEST capital budgeting method

8. What is Project L’s NPV? YearCFtPV of CFt 0 -100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPVL = $18.79 NPVS = $19.98

9. Solving for NPV:Financial calculator solution • Enter CFs into the calculator’s CF register. • For Texas Instruments: • Press CF key • CF0 = -100 Enter  • C01 = 10 Enter  • F01 = 1 Enter  • C02 = 60 Enter  • F02 = 1 Enter  • CF3 = 80 Enter  • Press NPV key • 10 (I) Enter •  CPT • to get NPVL = $18.78.

10. Internal Rate of Return (IRR) • IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0: • Solving for IRR with a financial calculator: - Enter CFs in CF register. - Press IRR key - CPT - to get IRRL = 18.13% and IRRS = 23.56%.

11. Rationale for the IRR method • If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns. • If IRR > k, accept project. • If IRR < k, reject project. • If projects are independent, accept both projects, as both IRR > k = 10%. • If projects are mutually exclusive, accept S, because IRRs > IRRL • Advantages: • Easy to understand and communicate • Disadvantages: • IRR may not exist or there may be multiple IRR • Problems with mutually exclusive investments

12. The Scale Problem Mutually exclusive vs independent projects Would you rather make 100% or 50% on your investments? What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment? IRR method assumes CFs are reinvested at IRR Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best NPV method should be used to choose between mutually exclusive projects

13. Learning objectives • Know the steps to capital budgeting • Know how to calculate payback period, discounted payback period, NPV, IRR; the advantages and disadvantages of each method • Sections 11.6, 11.7 will NOT be on the exam • Recommended end-of-chapter questions: 11-2,11-3, 11-4, 11-8 • Recommended end-of-chapter problems:ST-2 (without MIRR); 11-1, 11-2,11-4, 11-5, 11-6, 11-7 (without MIRR), 11-10,11-11,11-12;