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Lecture 16 FIN 625: Class Notes THE BASICS OF CAPITAL BUDGETING What is the Capital Investment Decision? Project Evaluation Models Focus on: Payback Period NPV IRR MIRR Comparing Payback Period, IRR, and NPV What is Capital Budgeting and Why is it Important? capital investments: Why are these important decisions? 1. scarce financial resources for assets which cannot be liquidated easily 2. they define the firm’s line of business 3. they affect the firm’s cash flows for many years 4. bad decisions can cause the firm’s downfall capital budgeting : - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Steps in the Capital Budgeting Process 1. Identify and estimate current and expected future cash flows. 2. Establish a decision rule (NPV, IRR, etc.) 3. Evaluate and rank the proposed projects. 4. Make a decision and monitor results. Project Types Mutually exclusive - a project whose selection depends on whether or not another project is selected Independent - a project whose selection does not depend on whether or not another project is selected Project Evaluation Models 1. Payback period or PBP 2. Net Present Value or NPV 3. Internal Rate of Return or IRR 4. Modified Internal Rate of Return or MIRR As always, only cash flow matters! Payback Period - the expected number of years it takes to recover a project’s initial investment. - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Example: You have a project with the following forecasted cash flows: Year Cash Flow 0 -$40,000 1 $20,000 2 $15,000 3 $10,000 4 $ 5,000 What is the project’s payback period? Example: As the Chief Financial Analyst at D/A Industries, you are presented with the following possible projects for investment. Compute the payback period for each project. Year Proj. A Proj. B Proj. C Proj. D 0 -$90,000 -$90,000 -$90,000 -$90,000 1 $90,000 $65,000 $45,000 $30,000 2 $45,000 $35,000 $30,000 3 $25,000 $30,000 4 $25,000 $30,000 - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Deficiencies of the Payback Period method ignores the time value of money no consideration of cash flows occurring after the payback period no economic rationale for target payback periods - Calculate the Payback Period for Example 3, Example 4, and the Practice problems from the previous Lecture Net Present Value - the most theoretically correct model for evaluating investment opportunities; the measure of value a project adds to the firm. NPV = PV{cash inflows} - PV{cash outflows} CFt n NPV t 0 (1 r ) t or, CFt n NPV t 0 (1 WACC ) t CFt = forecasted after-tax operating Cash Flow (CF) at the end of year t r = the required risk-adjusted rate of return n = the economic life of the project WACC = the appropriate weighted average cost of capital for the project - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes The decision rules associated with NPV analysis: NPV > $0 accept project NPV < $0 reject project NPV = $0 indifferent to project Example: Gamma Industries is analyzing a new project with the following information: Initial investment = $306,000 Annual after-tax operating cash flows: Year CF 1-3 $80,000 4-6 $90,000 In addition, the equipment being purchased will have an after-tax salvage value of $25,000 at the end of the project. If the firm’s weighted average cost of capital is 15%, should Gamma undertake the project? Timeline: CFt t 0 (1 WACC ) t n NPV - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Note that we used Gamma’s existing weighted average cost of capital (WACC) as the appropriate discount rate. What does this assume about the project and its financing? How can we compute the NPV of risk-changing investments? arbitrary adjustment, i.e., “fudging” CAPM approach rproject = rRF + ( rM – rRF) βproject Important: The CAPM approach gives us the cost of common stock for a company. If we use rproject as the firm's WACC, we are assuming an all equity financed firm. If the firm has debt in its capital structure, you will need to recalculate the firm's WACC using rproject in place of the company's usual rS. Question: Where could we obtain a βproject? - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Example: The CFO of Henderson-Cincinnati Corp. is evaluating the following projects: Project beta Forecast Return A 1.9 17.5% B 1.2 14.0% C 0.8 12.0% The risk-free rate is 5% and the market return is 12%. If the firm’s overall WACC is 13% (assuming an all equity financed firm), which projects should be accepted? rproject = rRF + (rM – rRF) βproject Question: What part does the company’s overall WACC of 13% play in this problem? - Calculate the NPV for Example 3 (assume 12% WACC), Example 4 (assume 12% WACC), and the Practice problems from the previous Lecture. - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Internal Rate of Return (IRR) - the annualized rate of return a project generates on the funds invested in it. The IRR is the interest rate that equates the PV of cash inflows with the PV of cash outflows for any project or investment. IRR is conceptually the same as YTM. What is the NPV if PV{inflows} = PV{outflows}? Thus, CFt n NPV 0 t 0 (1 IRR) t or, CFt Initial Investment Outlay t 1 n (1 IRR) t How can we solve for IRR? Example: You can buy a truck today for $5,200. You will use it in a delivery business for one year and earn an after-tax Cash Flow (CF) of $3,800. At the end of the year, the after-tax cash flow from the sale of the truck is $2,000. What is the IRR of this investment? TIMELINE: - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Example: DCH Machine Tools is considering a new stamping machine. The machine costs $340,000 today and generates after-tax CFs of $65,000 at the end of each of the next 6 years. What is the IRR of this investment? CFt Initial Investment Outlay t 1 n (1 IRR) t Practice: You are analyzing a project with the following cash flows. What is the project’s IRR? Time Period Cashflow 0 -$550,000 1 $200,000 2 $400,000 3 $250,000 4 $ 50,000 5 $ 10,000 What is the project’s IRR? CFt Initial Investment Outlay t 1 n (1 IRR) t - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Example: Sallinger’s Inc. is considering a new refrigerated truck that costs $25,000. It increases the firm’s after-tax cash flow by $4,000 in years 1-3, and by $10,000 in years 4-6. What is the NPV of buying the truck if the appropriate discount rate (WACC) is 9%? What is the investment’s IRR? IRR Decision Rule: if the project’s IRR > WACC, the required risk-adjusted return, accept the project if the project’s IRR < WACC, reject the project if the project’s IRR = WACC, we are indifferent to the project - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Potential problems with IRR: multiple IRRs assumes reinvestment at the IRR - Calculate the IRR for Example 3, Example 4, and the Practice problems from the previous Lecture. Modified Internal Rate of Return (MIRR) – the discount rate at which the present value of a project’s cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm’s cost of capital. MIRRs main advantage over IRR is that it no longer assume reinvestment at the IRR. Funds are now assumed to be reinvested at the firm’s WACC (this is generally a more reasonable assumption). N CIFt 1 r N t COFt TV t 0 1 r t t 01 MIRRN N 1 MIRRN where, COF = Cash outflows CIF = Cash inflows TV = terminal value (the compounded value of the inflows assuming reinvestment at the WACC. - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Calculate the MIRR for the previous problem (Sallinger’s). - Calculate the MIRR for Example 3, Example 4, and the Practice problems from the previous Lecture. - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Practice: You are the financial manager for a large and highly profitable manufacturing company. You are currently evaluating a project proposal involving the construction of a new product line. The proposed project will have a 5-year life and will require the purchase of new capital equipment with a total purchase price of $175,000. In addition, the project will require an initial $15,000 investment in supplies and spare parts for the equipment, with 40% of this amount financed with accounts payable. The new product line is expected to increase annual cash sales by $80,000 and increase annual cash operating expenses by $10,000. The new equipment will have a 3-year MACRS class life. At the end of five years, you expect to terminate the project, liquidate the supplies and parts, and sell the equipment for $10,000. Assume the marginal tax rate is 34 percent. Calculate the IRR and MIRR (assume a WACC of 10%) for this project. - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Comparing NPV and IRR Under the following assumptions, NPV and IRR will accept and reject the same projects: 1. independent projects 2. no capital rationing Under the following assumptions, NPV and IRR may disagree regarding the ordering of projects: 1. mutually exclusive projects 2. capital rationing - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University Lecture 16 FIN 625: Class Notes Causes of potential disagreement between NPV and IRR: project size (scale) differences timing differences (Note: A comparison of MIRR with NPV yields similar conclusions to IRRs comparison relative to NPV.) - Richard T. Bliss, Babson University and Terry D. Nixon, Miami University

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