Fundamentals of Corporate

Finance, 2/e

ROBERT PARRINO, PH.D.

DAVID S. KIDWELL, PH.D.
THOMAS W. BATES, PH.D.
Chapter 10: The Fundamentals of
Capital Budgeting
 Introduction to Capital Budgeting
o THE IMPORTANCE OF CAPITAL BUDGETING
• Capital-budgeting decisions
are the most
important investment
decisions made by
management. a firm’s
These decisions determine the long-term
productive assets that will create wealth
for owner(s).
Exhibit 10.1: Key Reasons for
Making Capital Expenditures
 Introduction to Capital Budgeting
o THE IMPORTANCE OF CAPITAL BUDGETING
• Capital investments are large cash
outlays, long-
term commitments, not easily
reversed, and
• primary factors in a firm’s long-
run
performance
Capital-budgeting techniques
help management
systematically analyze potential
opportunities in
 Introduction to Capital Budgeting
o CLASSIFICATION OF INVESTMENT PROJECTS
• Capital budgeting projects can be
classified asprojects
1. Independent
2. Mutually exclusive projects
3. Contingent projects
 Introduction to Capital Budgeting
o CLASSIFICATION OF INVESTMENT PROJECTS
1. Independent projects
Projects for which the decision to accept or reject is not
influenced by decisions about other projects being
considered by the firm.
 Introduction to Capital Budgeting
o CLASSIFICATION OF INVESTMENT PROJECTS
2. Mutually exclusive projects
Projects for which the decision to accept one project is
simultaneously a decision to reject another project.
These projects typically perform the same function.
 Introduction to Capital Budgeting
o CLASSIFICATION OF INVESTMENT PROJECTS
3. Contingent projects
Projects for which the decision to accept one
project depends on acceptance of another project.
–Types of contingent projects
»mandatory projects
»optional projects
 Introduction to Capital Budgeting
o BASIC CAPITAL BUDGETING TERMS
• Capital a firm with limited
rationing: funds
chooses the best projects to
• undertake
Capital asset: a long-term
asset
 Net Present Value
o NET PRESENT VALUE (NPV)
• Is the best capital-budgeting It
technique. is
consistent with goal of maximizing
shareholder
• wealth.
The method compares the present
value
to theof expected
present benefits
value of the and cash
I
flows from
expected a are
project
costs.
the benefits larger, the f
project is feasible.
Exhibit 10.2: Sample Worksheet for
Net Present Value Analysis
 Net Present Value
o VALUATION OF REAL ASSETS
• Valuing real assets requires the
same steps as in
valuing financial assets
estimate future cash flows
estimate cost of capital/required rate-of-return
calculate present value of future cash flows
 Net Present Value
o VALUATION OF REAL ASSETS
• Practical difficulties in valuing real
assets
Cash-flow estimates must be prepared in-house and
are not as readily available as those for financial assets
with legal contracts.
Estimating required rates-of-return for real assets is
more difficult than estimating required returns for
financial assets because no market data is available for
real assets.
 Net Present Value
o NPV – THE BASIC CONCEPT
• The net present value of a
project is the
difference between the present
values of its
• expected cash inflows and
expected cash
outflo
• ws
Positive NPV projects increase
shareholder wealth and negative
NPV projects decrease
shareholder wealth
 Net Present Value
o FRAMEWORK FOR CALCULATING NPV
• The NPV calculation uses the
discounted cash
flow technique
Compute the expected net cash flow (NCFt) associated
with a project for each time period t, where
NCFt = (Cash inflows − Cash outflows)
 Net Present Value
NPV Equation

NCF NCF NCF

NPV  NCF   ...
1 2 n
(10.1)
1 k (1 k)  (1 k)
0
2 n


NCF

n
t

 (1 k)
t

t0
Pocket Pizza Project Timeline and
Cash Flows
Self-Rising Pizza Dough Project
Timeline and Cash Flows
 Net Present Value
o A FIVE-STEP APPROACH FOR CALCULATING
NPV
1 Estimate project cost
. Identify and add the present value of expenses related
to the project.
There are projects whose entire cost occurs at the start
of the project, but many projects have costs occurring
beyond the first year.
The cash flow in year 0 (NCF0) on the timeline is
negative, indicating an outflow.
 Net Present Value
o A FIVE-STEP APPROACH FOR CALCULATING
NPV
2 Estimate project net cash flows
. Both cash inflows (CIF) and cash outflows (COF) are
likely in each year of the project. Estimate the net cash
flow (NCFn) = CIFn – COFn for each year.
Include salvage value of the project in its terminal year.
 Net Present Value
o A FIVE-STEP APPROACH FOR CALCULATING
NPV
3 Determine project risk and
. estimate cost of
capital
The cost of capital is the discount rate used to
determine the present value of expected net cash
flows.
The riskier a project, the higher its cost of capital.
 Net Present Value
o A FIVE-STEP APPROACH FOR CALCULATING
NPV
4 Compute the project’s NPV
. Determine the difference between the present values
of the expected net cash flows from the project and the
expected cost of the project.
5 Make a decision
. Accept a project if it has a positive NPV, reject it if the
NPV is negative.
 Net Present Value
o NPV EXAMPLE
• Find the net present value of the
example in
Exhibit 10.3
$80 $80 $80 $80 $80
P $300  $30    
(1.15) (1.15) (1.15) (1.15) (1.15)
B
1 2 3 4 5


$300  $69.57  $60.49  $52.60  $45.74 
54.69

$16.91
NPV Example – Excel Solution
Net Present Value
 Payback Period
o THE PAYBACK PERIOD
• Is the amount of time it takes for ne
the sum of the t
cash flows from a project to equal
• the project’s
initial investment
Says an acceptable project has a
•
payback period
project’s cost is recovered, the less
shorter than a certain amount of
• risky
time
the project
Is one of the most widely used tools
Can serve as a risk indicator – the
for evaluating
quicker a
capital projects
 Payback Period
o COMPUTING THE PAYBACK PERIOD
• To compute the payback period,
estimate a
project’s cost and its future net
cash flows
Equation 10.2 shows how to compute the payback
PB period.

Remaining cost to recover
Years before cost recovery  (10.2)
Cash flow during the year
Payback Period Cash Flows and
Calculations
 Payback Period
o COMPUTING THE PAYBACK PERIOD
• Projects with shorter payback
periods
desirab are
Cashmore
flows occurring
le. after the
payba period are not considered.
• ck no economic rationale that
There makes the method
is
wealth consistent with shareholder
payba
maximization.
ck
Payback Period with Various Cash
Flow Patterns
 Payback Period
o DISCOUNTED PAYBACK PERIOD
• Future cash flows are discounted by
the firm’s
• cost of capital
The major advantage of the
discounted payback is that it tells
management how long it takes a
project to reach a positive NPV
Discounted Payback Period Cash
Flows and Calculations
 Payback Period
o EVALUATING THE PAYBACK RULE
• The ordinary payback period is i
widely used n
business
It provides a simple measure of an investment’s
liquidity risk.
It provides a simple measure of an investment’s
liquidity risk.
It ignores the time value of money.
 Payback Period
o EVALUATING THE PAYBACK RULE
• Payback period does not account for
differences
• in the overall risk of projects
The biggest weakness of the
ordinary and discounted payback
methods is their failure to
consider cash flows after the
payback period
Payback Period
 Internal Rate of Return
o INTERNAL RATE OF RETURN
• The IRR technique compares a
firm’s cost of
capital to the rate-of-return that
makes the net
• cash flows from a project equal to
the project’s
cost
•
A project is acceptable if its IRR is
greater than
the firm’s cost-of-
capital
 Internal Rate of Return
o INTERNAL RATE OF RETURN
• The NPV and IRR techniques are
similar in
• that both utilize discounted cash
flows
The IRR is an important and
legitimate
alternative to the NPV method
 Internal Rate of Return
o INTERNAL RATE OF RETURN
• The IRR is much like the yield-to-
maturity on a
bond
Time Line and Expected Net Cash
Flows for the Ford Project
Using Excel - Internal Rate of Return
 Internal Rate of Return
o WHEN IRR AND NPV METHODS AGREE
• Th methods will always agree
e when projectsand the cash
are independent
flows are
conventional
A conventional project has an initial outflow to begin
and net inflows each year thereafter.
NPV Profile for the Ford Project
 Internal Rate of Return
o WHEN IRR AND NPV METHODS DISAGREE
• The IRR and NPV methods can
produce
different accept/reject decisions if a
project has
unconventional cash flows or
projects are
mutually exclusive
 Internal Rate of Return
o UNCONVENTIONAL CASH FLOWS
• Unconventional cash flows may
exhibit many
patterns
Positive initial cash flow followed by negative net cash
flows.
Positive and negative net cash flows.
Conventional except for a negative net cash flow at the
end of a project’s life.
 Internal Rate of Return
o UNCONVENTIONAL CASH FLOWS
• With unconventional cash flows,
the IRR
technique
retur This may provide
makes the more than
unrelia
one rate
n.
and of
it calculation
should not be used toble
determine whether
a project should be accepted or
rejected
NPV Profile for Gold-Mining
Operation
 Internal Rate of Return
o MUTUALLY EXCLUSIVE PROJECTS
• There is a discount rate at which
the NPVS of
two mutually exclusive projects will
• be equal.
That rate is the crossover point.
Depending on whether the required
• rate of return is higher or lower
than the crossover rate, the
ranking of the projects will be
different.
It is easy to identify the superior
project based on NPV, but it
 Internal Rate of Return
o MUTUALLY EXCLUSIVE PROJECTS
• When projects differ in scale, the
IRR technique
may suggest choosing a small
project that
• generates a net cash flow of
$10,000 over a larger
one that has $50,000 in net cash
shareholder Using NPV would
flow.
wealth. lead to
The larger cash flow project
its selection.
should be chosen because of its
greater contribution to
NPV Profiles for Two Mutually
Exclusive Projects
 Modified Internal Rate of Return
o MODIFIED INTERNAL RATE OF RETURN (MIRR)
• A major weakness of the IRR
compared to the
NPV method is the reinvestment
rate
assumption
IRR assumes that cash flows from a project are
reinvested to earn the IRR while NPV assumes that they
are reinvested and earn the firm’s cost of capital.
This optimistic assumption in the IRR method leads to
some projects being accepted when they should not.
– The reinvested cash flows cannot earn the IRR.
 Modified Internal Rate of Return
o MODIFIED INTERNAL RATE OF RETURN (MIRR)
• In the modified internal rate of
return (MIRR)
technique, cash flow is
• assumed to be
reinvested at the firm’s cost
of capital
The compounded values are
•
summed to get a
project’s terminal value (TV) at
the end of its
life
 Modified Internal Rate of Return
o MIRR EQUATION

TV
PV  (10.5)
(1 MIRR)
Pr oject Cost
n
 Modified Internal Rate of Return
o MIRR EXAMPLE
• A project costs $1,200.00 and will
generate
cash net of $400 for
inflows Calcul
four years. ate
the MIRR of the project.
continued on next slide
 Modified Internal Rate of Return
o MIRR EXAMPLE
TV  $400(1.08)  $400(1.08)  $400(1.08) 
3 2 1

$400(1.08)
n
0

 $1,802.44
$1,802.44
$1,200.00
 (1 MIRR ) 4

$1,802.44
 (1
$1,200.00 MIRR ) 4

4
1.5020  1 MIRR 
1.1071
MIRR  0.1071or
10.71%
IRR versus NPV: A Final Comment