The Basics of Capital Investment

Decisions: Evaluating Cash Flows

What is capital budgeting?
Plan and manage capital expenditures for long-lived
assets.
Analysis of potential projects.
Long-term decisions.
Involve large commitments.
Very important to firms future.

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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Independent versus Mutually Exclusive Projects

Projects are:
independent, if the cash flows of one are unaffected by
the acceptance of the other. Projects stand on their own.
mutually exclusive, if the cash flows of one can be
adversely impacted by the acceptance of the other. All
other alternatives are automatically deleted once a
project is chosen.
NPV: Sum of the PVs of all cash flows
n

NPV =
t =0

CF t

( 1+r )t

Cost is often
n

NPV =
t=1

CF t

( 1+r )t

CF 0

and is negative.

CF 0

Example 1
Given the following data and the opportunity cost of
capital is 10%.
Year
Project X
Project Y
0
-$100
-$100
1
10
70
2
60
50
3
80
20
Find the NPV of project X and of project Y.

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Rationale for the NPV Method

NPV = PV inflows Cost
This is net gain in wealth in dollar terms ($), so
accept project only if NPV > 0.
Choose between mutually exclusive projects on
basis of higher NPV. Adds most value.
NPV > 0 implies EVA > 0 and MVA > 0.
Using NPV method, which project(s) should be accepted?
If Project X and Project Y are mutually exclusive,
accept X because NPVx > NPVy .
If X & Y are independent, accept both because NPV
> 0.
Internal Rate of Return: IRR
IRR is the discount rate that forces PV inflows = cost.
This is the same as forcing NPV = 0
NPV: Enter r, solve for NPV.
n

(
t=0

CF t
1+ r )

=NPV

IRR: Enter NPV = 0, solve for IRR.

n

(
t=0

CF t
1+ IRR )

=0

Example 2
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Find the IRRs of project X and of project Y.

Example 3: Find IRR if CFs are constant:

Given the following data:
Year
Cash flows
0
-$100
1
40
2
40
3
40

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Rationale for the IRR Method

If IRR > WACC, then the projects rate of return is
greater than its cost adding extra values to
stockholders. Accept the project.
IRR is internal to the project and does not depend on
the market interest rate.
Given in %, IRR provides an easy measure of
profitability.

Decisions on Project X and Project Y using IRR

If X and Y are independent, accept both: IRRx >
WACC and IRRy > WACC
If X and Y are mutually exclusive, accept X because
IRRx > IRRy given IRRx > WACC . Otherwise, reject
both. Cost must be justified.

Construct NPV Profiles and cross over rate

Enter CFs in the calculator and find NPVx and NPVy
at different discount rates: To Find the Crossover
Rate
Find cash flow differences between the projects from
each corresponding year starting from t = 0 to t = n.
Enter these differences in cash flow register, then
press IRR.

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Example 4
Refer to example 1 data, if r = 0%; 5%; 10%, 15%;
20%; Find the NPVx and NPVy respectively. Sketch the
NPV profile and find the crossover rate.

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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 favours small projects.
Timing differences. Project with faster payback
provides more CF in early years for reinvestment. If r
is high, early CF especially good, NPVx > NPVy
Reinvestment Rate Assumptions
NPV assumes reinvest at r (opportunity cost of
capital, WACC).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, r, is more realistic, so
NPV method is best. NPV should be used to choose
between mutually exclusive projects if a conflict
exists.
Normal vs. Nonnormal Cash Flows
Normal Cash Flow Project:
o Cost (negative CF) followed by a series of
positive cash inflows.
o One change of signs.
Nonnormal Cash Flow Project:
o Two or more changes of signs.

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Why use MIRR versus IRR?

MIRR also avoids the problem of multiple IRRs.
MIRR correctly assumes reinvestment at opportunity
cost = WACC.
Managers like using rates of return for comparisons,
and MIRR is better for this than IRR.
Modified Internal Rate of Return (MIRR)
MIRR is the discount rate which causes the PV of a
projects terminal value (TV) to equal the PV of costs.
TV is found by compounding inflows at WACC.
MIRR assumes cash inflows are reinvested at WACC
which is reasonable.
MIRR is unique.
Accept the project if MIRR > WACC.
First, find PV and TV at given WACC.
Second, find discount rate that equates PV and TV

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Example 5
Refer to example 1, find the MIRR of project X and
project Y.

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Profitability Index
The profitability index (PI) is the present value of
future cash flows divided by the initial cost.
PI =

PV future CF
Initial Cost

PI is the scale-version of NPV.

To accept a project, PI > 1.
PI > 1 is equivalent to NPV > 0.
Example 6
Refer to example 1, what is the PI of X and of Y?

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Payback Methods
Payback period is the number of years required to
recover a projects cost, or how long it takes to get
the businesss money back.
Firms establish a benchmark payback period;
projects whose payback exceeds this benchmark are
rejected.
Strengths:
o Provides an indication of a projects risk and
liquidity.
o Easy to calculate and understand.
Weaknesses:
o Ignores the time value of money.
o Ignores CFs occurring after the payback period.
Example 7
Refer to example 1, find the payback period for project X and
project Y.

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Discounted Payback
Uses discounted rather than raw CFs.
Example 8
Refer to example 1, find the discounted payback period of
project X and project Y.

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Capital Budgeting Process: Remarks

Quantitative methods provide valuable information,
but they should not be used as the sole criteria for
accept/reject decisions in capital budgeting process.
NPV is the single most important method showing
the absolute profitability.
IRR is ranked second of importance.
Payback is still used significantly among small
businesses.

Mutually Exclusive Projects with unequal lives: Equivalent

Annual Annuity Approach (EAA)
Convert the PV into a stream of annuity payments
with the same PV.

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Example 9
Which project should be adopted given they are mutually
exclusive and the opportunity cost of capital is15%?
Year
Project
Project D
C
First Cost
-$40,000 -$65,000
(year 0)
Annual cost -$10,000 -$12,000
(from year1)
Salvage
$12,000 $25,000
Value
Life, Years
3
6

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Optimal Capital Budget

Finance theory says to accept all positive NPV
projects.
Two problems can occur when there is not enough
internally generated cash to fund all positive NPV
projects:
o An increasing marginal cost of capital.
o Capital rationing.

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