CH 12 - The Basics of Capital Budgeting
CH 12 - The Basics of Capital Budgeting
CH 12 - The Basics of Capital Budgeting
Mei 2021
12.1 An Overview of Capital Budgeting
• Indicator/Criteria
• NPV (Nett Present Value)
• Internal Rate of Return (IRR)
• Modified Internal Rate of Return (MIRR)
• Regular Payback
• Discounted Payback
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12.2 Net Present Value (NPV)
Nett
Present Value : A method of rangking investment proposals using the NPV, Which Equal to the present value of the
project’s free cash flows discounted at the cost of capital
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12.3 Internal Rate of Return (IRR)
Internal Rater of Return (IRR) : is the discount rate that forces the PV of its inflows to equal its cost. This is equivalent to forcing
the NPV to equal zero. The IRR is an estimate of the projects rate of return and it is comparable to the YTM on a bond
Investment Criteria : IRR > WACC, if mutually exclusive chose the highest IRR and >WACC
Example :
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12.4 Multiple Internal Rates of Return
Multiple IRR : The Situation where a project has two or more IRR
Normal - + + + + + or - - - + + + + +
Non Normal - + + + + - or - + + + - + + +
• NPV Equal 0 when IRR 5% and IRR 85% (the project has
two IRR)
• Graph is constructed by plotting the project NPV at different
discount rate
• it can caused a dilemma, so NPV can better used rather than
IRR
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12.5 Reinvestment Rate Assumptions
NPV Calculation is based on the assumption that cash inflows can be reinvested at the project risk adjusted WACC, whereas the IRR
calculation is based on the assumption that cash flow can be reinvested at the IRR
Example : future value $100 and interest rate 5%
0 1 2 3
5% 5% 5%
• Going PV to FV PV = 100 105 110.25 115,76 =FV
0 1 2 3
5% 5% 5%
• Going FV to PV PV = 100 105 110.25 115,76 =FV
The NPV and IRR have different reinvestment rate assumptions. The NPV has no reinvestment rate assumption; therefore, the reinvestment
rate will not change the outcome of the project. The IRR has a reinvestment rate assumption that assumes that the company will reinvest cash
inflows at the IRR's rate of return for the lifetime of the project. If this reinvestment rate is too high to be feasible, then the IRR of the project
will fall. If the reinvestment rate is higher than the IRR's rate of return, then the IRR of the project is feasible.
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12.6 Modified Internal Rate of Return (MIRR)
MIRR : The discount rate at which the present value of a projects cost is equal to the present value of its terminal value. Where the terminal
value is found as the sum of the future value of the cash inflows, compounded at the firm's cost of capital
Example :
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12.7 Net Present Value (NPV) Profiles
Nett Present Value Profiles : A graph showing the relationships between a project’s NPV and the firms cost of capital
Example :
Crossover rate is the cost of capital at which the net present values of two projects are equal. It is the point at which the NPV
profile of one project crosses over (intersects) the NPV profile of the other project.
Crossover rate is useful in capital budgeting analysis because it tells the investing company about the cost of capital at which
both of the mutually-exclusive projects are equally good. If the company's cost of capital crosses the crossover rate, the
relative attractiveness of mutually-exclusive projects changes i.e. if Project A is preferable at a discount rate below the
crossover rate, Project B becomes feasible as soon as the cost of capital crosses the crossover rate. 8
12.8 Payback Period
Payback Period : The length of time required for an investments cash flows to cover its cost
Example :
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12.8 Discounted Payback
Discounted Payback Period : The length of time required for an investments cash flows, discounted at the investment’s cost of capital to
cover its cost
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12.9 Conclusion on Capital Budgeting Methods
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