CHAPTER 10

The Basics of Capital Budgeting:

Evaluating Cash Flows

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 Topics

• Overview and “vocabulary”

• Methods
• NPV
• IRR, MIRR
• Profitability Index
• Payback, discounted payback
• Unequal lives
• Economic life
• Optimal capital budget
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 The Big Picture:
The Net Present Value of a Project

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 What is capital budgeting?

• Analysis of potential projects.

• Long-term decisions; involve large expenditures.
• Very important to firm’s future.

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 Steps in Capital Budgeting

• Estimate cash flows (inflows & outflows).

• Assess risk of cash flows.
• Determine r = WACC for project.
• Evaluate cash flows.

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 Capital Budgeting Project Categories

1. Replacement to continue profitable operations

2. Replacement to reduce costs
3. Expansion of existing products or markets
4. Expansion into new products/markets
5. Contraction decisions
6. Safety and/or environmental projects
7. Mergers
8. Other

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 Independent versus Mutually Exclusive Projects

• Projects are:
• independent, if the cash flows of one are unaffected by the
acceptance of the other.
• mutually exclusive, if the cash flows of one can be adversely
impacted by the acceptance of the other.

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Cash Flows for Franchises L and S

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NPV: Sum of the PVs of All Cash Flows

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 What’s Franchise L’s NPV?

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Calculator Solution: Enter Values in CFLO
Register for L

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 Rationale for the NPV Method

• NPV = PV inflows – Cost

• This is net gain in wealth, so accept project if NPV > 0.
• Choose between mutually exclusive projects on basis
of higher positive NPV. Adds most value.

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 Using the NPV measure, which franchise(s)
should be accepted?
• If Franchises S and L are mutually exclusive, accept S
because NPVs > NPVL.
• If S & L are independent, accept both; NPV > 0.
• NPV is dependent on cost of capital.

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 Internal Rate of Return: IRR

• IRR is the discount rate that forces

• PV inflows = cost. This is the same
• as forcing NPV = 0.

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 NPV: Enter r, solve for NPV.

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 IRR: Enter NPV = 0, Solve for IRR

• IRR is an estimate of the project’s rate of return, so it

is comparable to the YTM on a bond.

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 What’s Franchise L’s IRR?

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How is the IRR on a project related to the yield to
maturity (YTM) on a bond?
• IRR: The discount rate that forces the present value of
a project’s expected future cash flows to equal the
initial cash flow.
• YTM: The discount rate that forces the present value of
a bondscash flows (i.e., coupons and maturity value) to
equal the price of the bond.

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Finding IRR if CFs are Constant (Use the Excel RATE
function as though the project were a bond.)
• IRR = RATE(3,40,100) = 9.7%
• Alternatively:

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 Rationale for the IRR Method

• If IRR > r, then the project’s rate of return is greater

than its cost-- some return is left over to boost
stockholders’ returns.
• Example:
r= 10%, IRR = 15%.
• So this project adds extra return to shareholders.

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 Decisions on Franchises S and L per IRR

• If S and L are independent, accept both: IRRS > r and

IRRL > r.
• If S and L are mutually exclusive, accept S because
IRRS > IRRL.
• IRR is not dependent on the cost of capital used.

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 Construct NPV Profiles

• Enter CFs in CFLO and find NPVL and NPVS at

different discount rates:
r NPVL NPVS
0 50 40
5 33 29
10 19 20
15 7 12
20 (4) 5

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 NPV Profile

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NPV and IRR: No conflict for independent
projects.

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 Mutually Exclusive Projects

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 To Find the Crossover Rate

• Find cash flow differences between the projects. See

data at beginning of the case.
• Enter these differences in CFLO register, then press
IRR. Crossover rate = 8.68%, rounded to 8.7%.
• Can subtract S from L or vice versa and consistently,
but easier to have first CF negative.
• If profiles don’t cross, one project dominates the other.

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 Two Reasons NPV Profiles Cross

• Size (scale) differences. Smaller project frees up funds

at t = 0 for investment. The higher the opportunity cost,
the more valuable these funds, so high r favors small
projects.
• Timing differences. Project with faster payback
provides more CF in early years for reinvestment. If r
is high, early CF especially good, NPVS > NPVL.

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 Modified Internal Rate of Return (MIRR)

• 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.
• Thus, MIRR assumes cash inflows are reinvested at
WACC.

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MIRR for Franchise L (r = 10%) using the Excel
RATE function.
A B C D
1 r= 10%
2 Year Year Year Year
3 0 1 2 3
4 (100) 10 60 80
5
6 MIRR = MIRR(A4:D4,B4,B4)
7 MIRR = 16.50%

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Alternative Method to Find MIRR for Franchise L:
First, find PV and TV (r = 10%).

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Second, find discount rate that equates PV and
TV.

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 To find MIRR with financial calculator:
(1 of 2)
• Step 1, Find PV of inflows
• First, enter cash inflows in CFLO register:
CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80
• Second, enter I/YR = 10.
• Third, find PV of inflows: Press NPV = 118.78
• Step 2, Find TV of PV of inflows from Step 1.
• Enter PV = -118.78, N = 3, I/YR = 10, PMT = 0.
• Press FV = 158.10 = FV of inflows.
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 To find MIRR with financial calculator:
(2 of 2)
• Step 3, Find PV of outflows.
• For this problem, there is only one outflow:
CF0 = -100, so the PV of outflows is -100.
• For other problems there may be negative cash flows for
several years, and you must find the present value for all
negative cash flows.
• Step 4, Find “IRR” of TV of inflows and PV of outflows.
• Enter FV = 158.10, PV = -100, PMT = 0, N = 3.
• Press I/YR = 16.50% = MIRR.

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 Profitability Index

• The profitability index (PI) is the present value of future

cash flows divided by the initial cost.
• It measures the “bang for the buck.”

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Franchise L’s PV of Future Cash Flows

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Franchise L’s Profitability Index

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 What is the payback period?

• The number of years required to recover a project’s

cost,
• or how long does it take to get the business’s money
back?

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 Payback for Franchise L

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 Payback for Franchise S

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 Strengths and Weaknesses of Payback

• Strengths:
• Provides an indication of a project’s risk and liquidity.
• Easy to calculate and understand.
• Weaknesses:
• Ignores the TVM.
• Ignores CFs occurring after the payback period.
• No specification of acceptable payback.

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Discounted Payback: Uses Discounted CFs

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 Normal vs. Nonnormal Cash Flows

• Normal Cash Flow Project:

• Cost (negative CF) followed by a series of positive cash
inflows.
• One change of signs.
• Nonnormal Cash Flow Project:
• Two or more changes of signs.
• Most common: Cost (negative CF), then string of positive
CFs, then cost to close project.
• For example, nuclear power plant or strip mine.

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 Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN

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 Pavilion Project: NPV and IRR?

• Enter CFs in CFLO, enter I/YR = 10.

• NPV = -386,777
• IRR = ERROR. Why?

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Nonnormal CFs—Two Sign Changes, Two IRRs

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 Logic of 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.

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 Finding Multiple IRRs with Calculator

• 1. Enter CFs as before.

• 2. Enter a “guess” as to IRR by storing the guess.
Try 10%:
10 STO
IRR = 25% = lower IRR
(See next slide for upper IRR)

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 Finding Upper IRR with Calculator

Now guess large IRR, say, 200:

200 STO
IRR = 400% = upper IRR

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When there are nonnormal CFs and more than
one IRR, use MIRR.

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 Accept Project P?

• NO. Reject because

MIRR = 5.6% < r = 10%.
• Also, if MIRR < r, NPV will be negative: NPV = -
$386,777.

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Projects T (for two years) and F (for four years) are
mutually exclusive and will be repeated; r = 10%.

0 1 2 3 4

T: -100 60 60

F: -100 33.5 33.5 33.5 33.5

Note: CFs shown in $ Thousands

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NPVF > NPVT, but which is better? T can be repeated!

T F
CF0 -100 -100
CF1 60 33.5
NJ 2 4
I/YR 10 10
NPV 4.132 6.190

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 Equivalent Annual Annuity Approach (EAA)

• Convert the PV into a stream of annuity payments with

the same PV.
• T: N=2, I/YR=10, PV=-4.132, FV = 0. Solve for PMT =
EAAT = $2.38.
• F: N=4, I/YR=10, PV=-6.190, FV = 0. Solve for PMT =
EAAF = $1.95.
• T has higher EAA, so it is a better project.

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 Replacement Chain

• Note that Project T could be repeated after 2 years to

generate additional profits.
• Use replacement chain to put on common life.

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Replacement Chain Approach: F with Replication
($ thousands)

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 Or, Use NPVs

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Suppose the cost to repeat T in two years rises to
$105,000?

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 Economic Life versus Physical Life (1 of 2)

• Consider another project with a 3-year life.

• If terminated prior to Year 3, the machinery will have
positive salvage value.
• Should you always operate for the full physical life?
• See next slide for cash flows.

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Economic Life versus Physical Life (2 of 2)

Year CF Salvage
Value
0 -$5,000 $5,000
1 2,100 3,100
2 2,000 2,000
3 1,750 0

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CFs Under Each Alternative (000s)

Years: 0 1 2 3
1. No termination -5 2.1 2 1.75
2. Terminate 2 -5 2.1 4
years
3. Terminate 1 year -5 5.2

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 NPVs under Alternative Lives
(Cost of Capital = 10%)
• NPV(3 years) = -$123.
• NPV(2 years) = $215.
• NPV(1 year) = -$273.

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 Conclusions

• The project is acceptable only if operated for 2 years.

• A project’s engineering life does not always equal its
economic life.

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