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23 views26 pages

JamilAhmed - 2355 - 16664 - 1 - Lecture007-Capital Budgeting Decisions

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bilal baloshi
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We take content rights seriously. If you suspect this is your content, claim it here.
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Lecture 5

Capital Budgeting
Decisions

Jamil Ahmed
Assistant Professor
Steps in the Process

1. Proposal Generation

2. Review and Analysis

3. Decision Making

4. Implementation

5. Follow-up

2
Net Present Value

Recall that net present value (NPV) is the difference


between what something is worth and what it costs.
Suppose you notice a run-down house for sale near
your own house. The price is $150,000. The house
requires $110,000 in repairs, which would take a year.
You estimate that you could then sell the house for
$300,000. Having this house fixed up would increase
the value of your house by $15,000. If the cost of
capital is 10%, what is the NPV of this project?
Calculating NPV

You invest $260,000 (= 150 + 110). If your cost of


capital is 10%, the project’s NPV is $26,363.64:

$315,000
NPV  260,000  $26,363.64
(1.10)
Internal Rate of Return
 The internal rate of return is the discount rate
that sets NPV of the expected cash flows to
zero.
 The internal rate of return is the project’s
expected return.
 Undertake a project if the IRR exceeds r, the
project’s cost of capital.
Calculating IRR
Recall that the IRR is the project’s expected return. Usually—
but not always—if the IRR exceeds the cost of capital, the NPV is
positive. This is always true for independent, conventional
projects.
Example: A project costs $100,000 and is expected
to generate a $28,600 cash flow per year for six
years. What is the project’s IRR?
IRR = 18.0123%
N=6 PV=-100,000 PMT=28,600 FV=0 i=18.0123

NPVL
IRR iL  (iU  iL )[ ]
NPVL  NPVU
Using NPV and IRR

 Most of the time NPV and IRR are both


valuable guides to making decisions.
 There are occasions, however, where NPV
and IRR disagree.
 When in doubt, go with NPV.
NPV Profile
 An NPV profile plots the project’s NPV as a function
of the discount rate.

 It shows both the NPV and the IRR of the project.

 It can be used to identify the range of cost of capital


at which the project would add value to the firm.
NPV Profile: Example

Consider a 10-year project with these cash flows:


Cash Flow

Initial Investment -$3,985,000

Cash Flow in years 1 to 5 $806,000

Cash Flow in years 6 to 9 $926,000

Cash Flow in year 10 $1,151,000


NPV Profile
$6,000

$5,000 The project has a positive


NPV ($ thousands)

NPV at discount rates less


$4,000
than 16.95%
$3,000 And a negative NPV at
$2,000
discount rates more than
R
16.95%
IR

%
$1,000

.9 5
16
$-
0% 5% 10% 15% 20% 25%

$(1,000)

$(2,000)
Discount Rate
Types of Projects

 A conventional project is one that has an initial cash


outflow, followed by one or more expected future
net cash inflows.
 Buying a stock or bond.
 A non-conventional project may have several net
cash outflows and inflows.
 Some net cash outflows may occur in the future.
 For example, an environmental clean up cost at the end of
a project or a major overhaul during the project’s life.
Types of Projects
 Two projects are independent if undertaking one
does not affect the other.
 IRR and NPV methods agree for conventional,
independent projects.

 Two projects are mutually exclusive if undertaking


one precludes taking the other.
 IRR and NPV methods can yield conflicting decisions
when choosing between mutually exclusive projects.
When IRR and NPV Can Disagree

 Mutually exclusive projects with:


 Differences in size.
 Differences in cash flow timing.
 Reverse conventional projects.
Projects Of Different Size

A firm is considering two mutually exclusive one-year projects, with the cash
flows shown below. The cost of capital for both projects is 12%. Compute the
NPV and IRR for each project and indicate which one should be undertaken.
Project CF0 CF1 NPV IRR
Small -1,000 +1,200 71.43 20%
Big -8,000 +9,200 214.29 15%

Take the higher-NPV project, Big.


Cash Flow Timing Differences

 The conflict between the NPV and the IRR arises


because of differences in each method’s assumption
regarding the reinvestment rate.
 The NPV method assumes that future cash flows
from the project will be reinvested at the project’s
cost of capital.
 The IRR method assumes that future cash flows
from the project will be reinvested at the IRR.
Cash Flow Timing Differences

A firm is considering two mutually exclusive


projects, L and H. Their cash flows are shown in
the table.
 Plot each project’s NPV profile.
 Find each project’s IRR.
 If each project has a cost of capital of 10%,
which project should be selected?
 If each project has a cost of capital of 17%,
which project should be selected?
Cash Flows for Projects L and H

Year Project L Project H


0 -$12,000 -$12,000
1 $2,000 $6,000
2 $3,000 $5,000
3 $4,000 $4,000
4 $5,000 $2,000
5 $8,000 $2,000
IRR and NPV for L and H

Project L Project H
IRR 19.06% 22.59%
NPV @ 10% $3,685 $3,200
NPV @ 12.93% $2,330 $2,330
NPV @ 17.00% $716 $1,258
NPV Profiles for L and H
$12,000

$10,000
Project L

$8,000
NPV

$6,000

$4,000 Project H

$2,000

$0
0% 5% 10% 15% 20%

($2,000) Discount Rate


IRRs and Non-Conventional Projects
 Consider this project:
Year Cash flows
0 -$252
1 1,431
2 -3,035
3 2,850
4 -1,000
What is the IRR?
NPV = 0 at 25.00%; at 33.33%; at 42.86%, and at 66.67%
The IRR rule breaks down.
IRRs and Non-Conventional Projects

NPV

$0.06

$0.04

IRR =
$0.02 25%

$0.00

($0.02) IRR = IRR =


33% 67%
IRR =
($0.04) 43%

($0.06)

($0.08)

0.2 0.28 0.36 0.44 0.52 0.6 0.68


Discount rate
Modified IRR: MIRR
The MIRR is the return that equates the future
value of all the project’s cash flows reinvested at
the cost of capital to the present value of all
those cash flows.

Decision Rule:
Undertake the project if the MIRR exceeds
the cost of capital.
Modified IRR: MIRR
A project with a 12% cost of capital costs $2,000, and is expected to return
$600 per year for five years plus a salvage value of $700 at the end of five
years. The MIRR = 17.6690% (IRR = 21.5226%):

N=5 I=12 PV=0 PMT=600 FV=-3,811.71

3,811.71 + 700 = 4,511.71

N=5 PV=-2,000 PMT=0 FV=4,511.71 I=17.6690

N=5 PV=-2,000 PMT=600 FV=700 I=21.5226


Scaling Difference
Example: Renewable Energy, Inc. is considering
investing in two projects: Solar Park or Wind Farm.
Setup of the solar park will cost $20 million and will
generate $7.5 million per annum for 5 years. The wind
farm will cost $35 million and will generate $8 million
for 10 years. If the company’s cost of capital is 10%,
determine which project should the company invest in,
using the annual net present value (equivalent annual
annuity) method and replacement chain (common life)
method.

1-24
 Equivalent Annual Annuity Approach

EAAA = NPV/Annuity Discount Factor for Project Life

Solar Park: $2.24=8.43/3.908

Wind Farm: $2.304=14.16/6.1446

1-25
Replacement Chain Method
Year 0 1 2 3 4 5 6 7 8 9 10 NPV
Solar
Park
Cash
7.50 7.50 7.50 7.50 7.50 7.50 7.50 7.50 7.50 7.50
flows
Investme
-20 -20
nt

Net cash
-20 7.50 7.50 7.50 7.50 -12.5 7.50 7.50 7.50 7.50 7.50
flows

PV
1 0.91 0.83 0.75 0.68 0.62 0.56 0.51 0.47 0.42 0.39
Factor
PV -20 6.82 6.20 5.63 5.12 -7.76 4.23 3.85 3.50 3.18 2.89 13.7

Wind
Farm

Cash
8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00
flows
Investme
-35
nt

Net cash
-35 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00
flows

PV
1 0.91 0.83 0.75 0.68 0.62 0.56 0.51 0.47 0.42 0.39
Factor
PV -35 7.27 6.61 6.01 5.46 4.97 4.52 4.11 3.73 3.39 3.08 14.2

1-26

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