CHAPTER 5

Part I
The Basics of Capital Budgeting

Should we
build this
plant?
What is capital budgeting?
 Analysis of potential additions to fixed
assets.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.
 Managers use to identify those projects
that add value to the firm
Steps to capital budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
What is the difference between independent and
mutually exclusive projects?

 Independent projects – if the cash flows of one

are unaffected by the acceptance of the other.
 Mutually exclusive projects – if the cash flows
of one can be adversely impacted by the
acceptance of the other.
What is the difference between normal and
nonnormal cash flow streams?

 Normal cash flow stream – Cost (negative CF)

followed by a series of positive cash inflows.
One change of signs.
 Nonnormal cash flow stream – Two or more
changes of signs. Most common: Cost
(negative CF), then string of positive CFs, then
cost to close project. Nuclear power plant, strip
mine, etc.
Methods of capital budgeting Decisions
 Payback period
 Discounted payback Period
 Net Present Value
 Internal Rate of Return (IRR)
 Modified Internal Rate of Return (MIRR)
 Profitability Index (PI)
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.
 Calculating payback
0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

Strengths and weaknesses of payback
 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.
Discounted payback period

 Uses discounted cash flows rather than raw

CFs.
0 10% 1 2 2.7 3
CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years
Net Present Value (NPV)
 Sum of the PVs of all cash inflows and outflows
of a project:

n
CFt
NPV   t
t 0 ( 1  k )
What is Project L’s NPV?
Year CFt PV of CFt
0 -100 -$100
1 10 9.09
2 60 49.59
3 80 60.11
NPVL = $18.79

NPVS = $19.98
Rationale for the NPV method
NPV = PV of inflows – Cost
= Net gain in wealth
 If projects are independent, accept if the
project NPV > 0.
 If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.
 In this example, would accept S if mutually
exclusive (NPVs > NPVL), and would accept
both if independent.
Internal Rate of Return (IRR)
 IRR is the discount rate that forces PV of inflows equal
to cost, and the NPV = 0:
n
CFt
0 t
t 0 ( 1  IRR )
 Solving for IRR with a financial calculator:
 Enter CFs in CFLO register.
 Press IRR; IRRL = 18.13% and IRRS = 23.56%.
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.
IRR Acceptance Criteria
 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.
NPV Profiles
 A graphical representation of project NPVs at
various different costs of capital.

k NPVL NPVS
0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5
Drawing NPV profiles

NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

.. S IRRS = 23.6%
10
L . .
0 . Discount Rate (%)
5 10 15 20 23.6
-10
Comparing the NPV and IRR methods

 If projects are independent, the two

methods always lead to the same
accept/reject decisions.
 If projects are mutually exclusive …
 If k > crossover point, the two methods lead
to the same decision and there is no conflict.
 If k < crossover point, the two methods lead
to different accept/reject decisions.
Finding the crossover point
1. Find cash flow differences between the projects
for each year.
2. Enter these differences in CFLO register, then
press IRR. Crossover rate = 8.68%, rounded to
8.7%.
3. Can subtract S from L or vice versa, but better to
have first CF negative.
4. If profiles don’t cross, one project dominates the
other.
Reasons why NPV profiles cross

 Size (scale) differences – the smaller project

frees up funds at t = 0 for investment. The
higher the opportunity cost, the more valuable
these funds, so high k favors small projects.
 Timing differences – the project with faster
payback provides more CF in early years for
reinvestment. If k is high, early CF especially
good, NPVS > NPVL.
Reinvestment rate assumptions
 NPV method assumes CFs are reinvested at k, the
opportunity cost of capital.
 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.
 Perhaps a hybrid of the IRR that assumes cost of capital
reinvestment is needed.
 Since managers prefer the IRR to the NPV
method, is there a better IRR measure?
 Yes, MIRR is the discount rate that causes the PV
of a project’s terminal value (TV) to equal the PV
of costs.
 TV is found by compounding inflows at WACC.
 MIRR assumes cash flows are reinvested at the
WACC.
Calculating MIRR
0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% 12.1
MIRR = 16.5%
158.1
-100.0 $158.1 TV inflows
$100 =
PV outflows
(1 + MIRRL)3
MIRRL = 16.5%
Why use MIRR versus IRR?

 MIRR correctly assumes reinvestment at

opportunity cost = WACC. MIRR also
avoids the problem of multiple IRRs.
 Managers like rate of return comparisons,
and MIRR is better for this than IRR.
Project P has cash flows (in 000s): CF0 = -$800, CF1 =
$5,000, and CF2 = -$5,000. Find Project P’s NPV and
IRR.

0 1 2
k = 10%

-800 5,000 -5,000

 Enter CFs into calculator CFLO register.

 Enter I/YR = 10.
 NPV = -$386.78.
 IRR = ERROR Why?
Multiple IRRs

NPV NPV Profile

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
Why are there multiple IRRs?

 At very low discount rates, the PV of CF2 is

large & negative, so NPV < 0.
 At very high discount rates, the PV of both CF1
and CF2 are low, so CF0 dominates and again
NPV < 0.
 In between, the discount rate hits CF2 harder
than CF1, so NPV > 0.
 Result: 2 IRRs.
When to use the MIRR instead of the
IRR? Accept Project P?
 When there are nonnormal CFs and more than
one IRR, use MIRR.
 PV of outflows @ 10% = -$4,932.2314.
 TV of inflows @ 10% = $5,500.
 MIRR = 5.6%.

 Do not accept Project P.

 NPV = -$386.78 < 0.
 MIRR = 5.6% < k = 10%.
 Part II
Cash Flow Estimation and Risk
Analysis

 Relevant cash flows

 Incorporating inflation
 Types of risk
 Risk Analysis
Proposed Project
 Total depreciable cost  Effect on operations
 Equipment:$200,000  New sales: 100,000
 Shipping: $10,000 units/year @ $2/unit
 Installation: $30,000  Variable cost: 60% of
 Changes in working sales
capital  Life of the project
 Inventories will rise by  Economic life: 4 years
$25,000  Salvage value: $40,000
 Accounts payable will  Tax rate: 30%
rise by $5,000  WACC: 10%
Determining project value
 Estimate relevant cash flows
 Calculating annual operating cash flows.
 Identifying changes in working capital.
 Calculating terminal cash flows.
0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
NCF0 NCF1 NCF2 NCF3 NCF4
 Initial year net cash flow
 Find Δ NOWC.
 ⇧ in inventories of $25,000
 Funded partly by an ⇧ in A/P of $5,000
 Δ NOWC = $25,000 - $5,000 = $20,000
 Combine Δ NOWC with initial costs.

Equipment -$200,000
Installation -40,000
Δ NOWC -20,000
Net CF0 -$260,000
Determining annual depreciation
expense
Year Rate* x Basis Depr
1 4/10 x $200 $ 80
2 3/10 x 200 60
3 2/10 x 200 40
4 1/10 x 200 20

1.00 $200

*The depreciation is calculated based on double-

declining method
Annual operating cash flows
1 2 3 4
Revenues 200 200 200 200
- Op. Costs (60%) -120 -120 -120 -120
- Deprn Expense 80 60 40 20
Oper. Income (BT) 0 20 40 60
- Tax (40%) - 8 16 24
Oper. Income (AT) 0 12 24 36
+ Deprn Expense 80 60 40 20
Operating CF 80 72 64 56
Terminal net cash flow

Recovery of NOWC $20,000

Salvage value 40,000
Tax on SV (40%) -16,000
Terminal CF $44,000

Q. How is NOWC recovered?

Q. Is there always a tax on SV?
Q. Is the tax on SV ever a positive cash
flow?
Should financing effects be
included in cash flows?
 No, dividends and interest expense should not be
included in the analysis.
 Financing effects have already been taken into
account by discounting cash flows at the WACC
of 10%.
 Deducting interest expense and dividends would
be “double counting” financing costs.
Should a $50,000 improvement cost from
the previous year be included in the
analysis?
 No, the building improvement cost is a
sunk cost and should not be considered.
 This analysis should only include
incremental investment.
If the facility could be leased out for
$25,000 per year, would this affect the
analysis?
 Yes, by accepting the project, the firm foregoes a
possible annual cash flow of $25,000, which is
an opportunity cost to be charged to the project.
 The relevant cash flow is the annual after-tax
opportunity cost.
 A-T opportunity cost = $25,000 (1 – T)
= $25,000(0.6)
= $15,000
If the new product line were to decrease the sales
of the firm’s other lines, would this affect the
analysis?

 Yes. The effect on other projects’ CFs is an

“externality.”
 Net CF loss per year on other lines would be a cost to
this project.
 Externalities can be positive (in the case of
complements) or negative (substitutes).
Proposed project’s cash flow time line

0 1 2 3 4

-260 80 72 64 56
Terminal CF → 46
102

 Enter CFs into calculator CFLO register,

and enter I/YR = 10%.
 NPV =-$10.02 thousand
 IRR = 8.3%
What is the project’s MIRR?
0 10% 1 2 3 4

-260.0 80 72 64 102
70.4
87.1
106.5
-260.0 366
PV outflows $366 TV inflows
$260 =
(1 + MIRR)4
MIRR = 9.8% < k = 10%, reject the project
If this were a replacement rather than a new
project, would the analysis change?

 Yes, the old equipment would be sold, and new

equipment purchased.
 The incremental CFs would be the changes from the
old to the new situation.
 The relevant depreciation expense would be the
change with the new equipment.
 If the old machine was sold, the firm would not
receive the SV at the end of the machine’s life. This
is the opportunity cost for the replacement project.
What if there is expected annual
inflation of 5%, is NPV biased?

 Yes, inflation causes the discount rate to be

upwardly revised.
 Therefore, inflation creates a downward bias on
PV.
 Inflation should be built into CF forecasts.
Annual operating cash flows, if expected
annual inflation = 5%

1 2 3 4
Revenues 210 220 232 243
Op. Costs (60%) -126 -132 -139 -146
- Deprn Expense -80 -60 -40 -20
- Oper. Income (BT) 4 28 53 77
- Tax (40%) 2 11 21 31
Oper. Income (AT) 2 17 32 46
+ Deprn Expense 80 60 40 20
Operating CF 82 77 72 66
Considering inflation:
Project net CFs, NPV, and IRR
0 1 2 3 4

-260 82. 77 72.0 66

Terminal CF → 46
112
 Enter CFs into calculator CFLO register, and enter
I/YR = 10%.
 NPV = $8774
 IRR = 11.48%.
 MIRR = 10.9%
 PI = 1.034
What are the 3 types of project
risk?

 Stand-alone risk
 Corporate risk
 Market risk
What is stand-alone risk?

 The project’s total risk, if it were operated

independently.
 Usually measured by standard deviation
(or coefficient of variation).
 However, it ignores the firm’s
diversification among projects and
investor’s diversification among firms.
What is corporate risk?
 The project’s risk when considering the
firm’s other projects, i.e., diversification
within the firm.
 Corporate risk is a function of the
project’s NPV and standard deviation
and its correlation with the returns on
other projects in the firm.
What is market risk?
 The project’s risk to a well-diversified
investor.
 Theoretically, it is measured by the
project’s beta and it considers both
corporate and stockholder diversification.
Which type of risk is most
relevant?
 Market risk is the most relevant risk for
capital projects, because management’s
primary goal is shareholder wealth
maximization.
 However, since total risk affects creditors,
customers, suppliers, and employees, it
should not be completely ignored.
Which risk is the easiest to
measure?
 Stand-alone risk is the easiest to measure.
Firms often focus on stand-alone risk when
making capital budgeting decisions.
 Focusing on stand-alone risk is not
theoretically correct, but it does not
necessarily lead to poor decisions.
Are the three types of risk
generally highly correlated?

 Yes, since most projects the firm

undertakes are in its core business, stand-
alone risk is likely to be highly correlated
with its corporate risk.
 In addition, corporate risk is likely to be
highly correlated with its market risk.
What is sensitivity analysis?
 Sensitivity analysis measures the effect of
changes in a variable on the project’s NPV.
 To perform a sensitivity analysis, all variables
are fixed at their expected values, except for
the variable in question which is allowed to
fluctuate.
 Resulting changes in NPV are noted.
What are the advantages and disadvantages
of sensitivity analysis?

 Advantage
 Identifies variables that may have the greatest
potential impact on profitability and allows
management to focus on these variables.
 Disadvantages
 Does not reflect the effects of diversification.
 Does not incorporate any information about the
possible magnitudes of the forecast errors.
Perform a scenario analysis of the project, based
on changes in the sales forecast
 Suppose we are confident of all the variable estimates,
except unit sales. The actual unit sales are expected to
follow the following probability distribution:

Case Probability Unit Sales

Worst 0.25 75,000
Base 0.50 100,000
Best 0.25 125,000
Scenario analysis
 All other factors shall remain constant and the NPV
under each scenario can be determined.

Case Probability NPV

Worst 0.25 ($27.8)
Base 0.50 $15.0
Best 0.25 $57.8
Determining expected NPV, NPV, and CVNPV from
the scenario analysis

 E(NPV) = 0.25(-$27.8)+0.5($15.0)+0.25($57.8)
= $15.0

 NPV = [0.25(-$27.8-$15.0)2 + 0.5($15.0-

$15.0)2 + 0.25($57.8-$15.0)2]1/2
= $30.3.

 CVNPV = $30.3 /$15.0 = 2.0.

If the firm’s average projects have CV NPV ranging
from 1.25 to 1.75, would this project be of high,
average, or low risk?

 With a CVNPV of 2.0, this project would be

classified as a high-risk project.
 Perhaps, some sort of risk correction is
required for proper analysis.
Is this project likely to be correlated with the firm’s
business? How would it contribute to the firm’s
overall risk?

 We would expect a positive correlation with the

firm’s aggregate cash flows.
 As long as correlation is not perfectly positive (i.e.,
ρ  1), we would expect it to contribute to the
lowering of the firm’s total risk.
If the project had a high correlation with the
economy, how would corporate and market risk
be affected?
 The project’s corporate risk would not be directly
affected. However, when combined with the
project’s high stand-alone risk, correlation with the
economy would suggest that market risk (beta) is
high.
If the firm uses a +/- 3% risk adjustment for the cost
of capital, should the project be accepted?

 Reevaluating this project at a 13% cost of capital

(due to high stand-alone risk), the NPV of the
project is -$2.2 .
 If, however, it were a low-risk project, we would
use a 7% cost of capital and the project NPV is
$34.1.
What subjective risk factors should be
considered before a decision is made?

 Numerical analysis sometimes fails to capture

all sources of risk for a project.
 If the project has the potential for a lawsuit, it is
more risky than previously thought.
 If assets can be redeployed or sold easily, the
project may be less risky.