Professor Jawad M.

Addoum FIN303: Spring 2013

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Corporate Financial Management
School of Business
Administration
University of Miami
Capital Budgeting
Criteria
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Assigned Readings & Problems
Reading: EFS Chapter 9
EFS Chapter 9:
Questions/Challenging Questions: 3, 4, 5, 7, 8, 10, 11, 12, 13
(4
th
ed)
Problems: B3, B6, B7, B8 (skip c.), B9, B14, B17, C2 (4
th
ed)
Professor Jawad M. Addoum FIN303: Spring 2013
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Objectives
In this lecture, you will learn to assess whether a
new project is an economically sound investment
Specifically, we will:
Define capital budgeting
Use the following capital budgeting criteria to determine
whether a project is a sound investment:
Payback
Discounted Payback
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
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Choose the best/better among these criteria to assess a
particular project(s)
Choose among mutually exclusive projects
Construct NPV profiles
Professor Jawad M. Addoum FIN303: Spring 2013
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Introduction
What is Capital Budgeting?
A process for making prudent capital investment decisions
based on the timing and risk characteristics of available
projects
We generally measure prudence by
Whether the Net Present Value (NPV) of the projects cash
flows are positive or, equivalently, by
Whether the projects cash flows provide a return that at least
equals the risk adjusted cost of capital, WACC!
Capital Budgeting is a critical function of the financial
managers of a firm involving the analysis of potential
additions to fixed assetsThese can be Long-term
decisions involving large expenditures
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Ultimately, well use the following steps for good
Capital Budgeting
* For mutually exclusive project choices and for projects with nonconventional cash flows,
well see IRR is inappropriate. More on that later!
1. Estimate CFs (inflows & outflows)
2. Assess riskiness of CFs
3. Determine WACC for project
4. Find NPV and/or IRR
5. Accept if NPV > 0 and/or IRR > WACC
Subject to the limitations of the
IRR approach*
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Capital Budgeting never should occur in a vacuum!
While our focus will be on decisions rules for
acceptance/rejection, a good capital budgeting system
does more than just make accept-reject decisions.
It must tie into the firms long-range strategic planning process:
the process that chooses the direction of the firms business
including financing, production, marketing and research
It must tie into a procedure for measurement of performance ex
post. Otherwise, the firm has no way of assessing its investment
decision-making
Good strategic planning should include a thorough capital
budgeting analysis
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Methods of Capital Budgeting
Although we emphasize NPV and IRR, there are six
main methods to rank projects and/or decide
whether to provide them capital:
Payback
Discounted Payback
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Profitability Index
Well discuss the profitability
index in a later set of notes
Professor Jawad M. Addoum FIN303: Spring 2013
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Types of Decisions
Independent Project choices: the investment
decision is made without regard to one or more
alternative projects
Mutually Exclusive Project choices: several
alternative project choices are available, of which
only one will be selected
For example: Locate the production facility in Boise, Idaho,
or Des Moines, Iowa
Each mutually exclusive project alternative must be
fundable as an independent project!
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What is the Payback Period?
Payback is simply the number of years required to recover a
projects cost. That is, how long does it take to get the
businesss money back?
Example (Long): Payback for Project L (L=Long: More cash
flow in later years). Assume WACC=10%
80
2 + 30/80 = 2.375 years
10 60
0 1 2 3
-100
=
CF
t
Cumulative
(Unrecovered)
-100 -90 -30 50
Payback
L
0
2.375
Professor Jawad M. Addoum FIN303: Spring 2013
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Example (Short): Project S (S=Short: More cash flow in earlier
years). Assume WACC=10%
70 20 50
0 1 2 3
-100 CF
t
-100 -30 20 40
Payback
S
1 + 30/50 = 1.6 years
0
1.6
=
Cumulative
(Unrecovered)
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For an Independent Project: Accept if Payback Period <
Some Desired Level
To choose between Mutually Exclusive Projects:
Choose the project with the shortest payback period
BUT NEVER DO THIS. NEVER USE PAYBACK TO
CHOOSE AMONG MUTUALLY EXCLUSIVE PROJECTS!
Decision Rules:
Professor Jawad M. Addoum FIN303: Spring 2013
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Assessment of Payback
Strengths of Payback:
Provides an indication of a projects liquidity: Measures
how long an investment will be tied up!
Easy to calculate and understand
Weaknesses of Payback:
Ignores the Time Value of Money!
Ignores Risk
Ignores cash flows occurring after the payback period!
Payback is a disastrous metric for Mutually Exclusive project
selection
The payback for project S is sooner than that of project L but
what if L paid $1 billion in year 4???
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Discounted Payback
Discounted Payback: Uses discounted rather than
raw CFs
Example (Long): Discounted Payback for Project L. Assume
WACC=10%
Recover investment + capital costs in 2.7 yrs.
10 80 60
0 1 2 3
CF
t
Cumulative
(Unrecovered)
-100 -90.91 -41.32 18.79
Discounted
payback
2 + 41.32/60.11 = 2.7 yrs
PVCF
t
-100
-100
9.09* 49.59** 60.11***
=
2.7
Calculator Solutions
* FV=10, I=10, N=1, PMT=0, PV?-9.09
** FV=60, I=10, N=2, PMT=0, PV?-49.59
***FV=80, I=10, N=3, PMT=0, PV=?-60.11
Professor Jawad M. Addoum FIN303: Spring 2013
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Assessment of Discounted
Payback
Strengths of Discounted Payback:
Provides an indication of a projects liquidity: Measures
how long an investment will be tied up!
Easy to calculate and understand?
Accounts for Time Value of Money and Risk during
payback period
Weaknesses of Discounted Payback:
Still ignores cash flows occurring after the payback period!
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Net Present Value (NPV)
NPV is the Sum of the PVs of inflows and outflows of
a project
The initial cash flow is often an outflow denoted as
CF
0
(negative) and represents a large capital
Investment
Professor Jawad M. Addoum FIN303: Spring 2013
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Example (Long): Whats Project Ls NPV? Assume
WACC=10%
10 80 60
0 1 2 3
-100.00
9.09
49.59
60.11
18.79 = NPV
L
NPV
S
= $19.98
Not calculated here
Calculator Solution
CF
0
=-100
CF
1
=10
CF
2
=60
CF3=80
I=10
NPV=?18.79
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Rationale for the NPV Method:
NPV = PV inflows PV outflows
= Net gain in wealth!
For an Independent Project, Accept if NPV > 0
To choose between Mutually Exclusive Projects,
Choose the higher NPV Project (assuming at least one
project has a positive NPV)
Decision Rules:
Professor Jawad M. Addoum FIN303: Spring 2013
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Examples (Long & Short): Using NPV method,
which project(s) should be accepted?
If Projects S and L are Mutually Exclusive:
Accept S: NPV
S
> NPV
L
> 0
If S & L are Independent:
Accept both: NPV
L
> 0, NPV
S
> 0
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Where Do Positive NPVs Come
From?
Economic Rents
Profits that more than cover the opportunity cost of capital are
known as Economic Rents. They are generally temporarythe
case of an industry not yet in long-run equilibrium
Life cycle story
The manager may be smart or lucky enough to be the first to the
market with a new, improved product: Valuable New Ideas!
Customers will pay a premium until new competitors enter and
squeeze the managers margins
Over time, an industry generally settles into a long-run
competitive equilibrium: all its assets earn their opportunity costs
of capital:
If the assets earned more, firms in the industry would expand or firms
outside the industry would try to enter!
The NPV of an investment is simply the discounted value of
economic rents
Professor Jawad M. Addoum FIN303: Spring 2013
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Sustainable Economic Rents: Comparative Advantage
Competitors may not be able to enter
Barriers to Entry
A firm may have a patent, proprietary technology or production cost
advantage
Firm may have a contractual advantage with a supplier or distributor
Prof. Michael Porters book Comparative Advantage: Creating and
Sustaining Superior Performance, a classic, describes three sources of
comparative advantage
1. Cost Advantage
2. Differentiation Advantage
3. Focus
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Internal Rate of Return (IRR)
IRR is the discount rate that forces
Alternatively, IRR is the discount rate that forces
NPV = 0
0 1 2 3
CF
0
CF
1
CF
2
CF
3
Cost Inflows
PV Inflows = PV Outflows
Professor Jawad M. Addoum FIN303: Spring 2013
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NPV: Enter WACC, solve for NPV
IRR: Enter NPV = 0, solve for IRR
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Example: Whats Project Ls IRR?
10 80 60
0 1 2 3
-100.00
PV
3
PV
2
PV
1
0 = NPV
IRR
L
= 18.13%
IRR
S
= 23.56%
Not calculated here
Calculator Solution
CF
0
=-100
CF
1
=10
CF
2
=60
CF3=80
IRR=?18.13
Professor Jawad M. Addoum FIN303: Spring 2013
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Discussion/Question: How is IRR related to a
bonds YTM (with annual coupon payments)?
Answer: They are the same thing: An annual interest-
paying bonds YTM is just the IRR if you invest in the bond
Example: Lets calculate the YTM of a bond with a
market price of $1,134.2 and coupons of 9% paid
annually
90 1,090 90
0 1 2 10
-1,134.2
...
Calculator Solution
PV=-1134.2
PMT=90
FV=1000
N=10
I=?7.08
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Rationale for the IRR Method: If IRR > WACC, then
the projects rate of return is greater than its cost*
Some return is left over to boost stockholders returns
above the risk-adjusted required return
If IRR>WACC, Accept Project
If IRR<WACC, Reject Project
* More on this later when we talk about MIRR. This explanation is imprecise but
intuitive
Decision Rules for Independent Projects:
Professor Jawad M. Addoum FIN303: Spring 2013
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Comparing NPV and IRR
In almost all respects, the NPV method is better
than the IRR method
Still, IRR is widely entrenched in industry and is
perhaps more intuitive
So, well compare the two methods and identify
the relative shortcomings of IRR
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The NPV Profile
An NPV Profile is the plot of the NPV of a project for
different levels of WACC
IRR
NPV ($)
WACC (%)
0
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The NPV profile is the best method to use in
evaluating a project because it provides a
complete picture of the project and incorporates
both the NPV and the IRR
The NPV profile also shows the sensitivity of the
value of the project to the required return
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Comparing NPV and IRR
IRR criterion for acceptance is that the cost of
capital is less than IRR (to the left of the dotted line)
NPV criterion for acceptance is that NPV>0 which
occurs only when the cost of capital is less than IRR
IRR
NPV ($)
WACC (%)
IRR > WACC
and NPV > 0
Accept
0
WACC > IRR
and NPV < 0.
Reject
Professor Jawad M. Addoum FIN303: Spring 2013
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NPV and IRR lead to the same accept/reject
decision for independent projects with normal cash flows
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Shortcomings of IRR
Example: NPV Profiles for Projects L(ong) and
S(hort)
8.7
NPV
WACC %
L
S
NPV
L
> NPV
S
IRR
S
> IRR
L
CONFLICT!!
NPV
S
> NPV
L
, IRR
S
> IRR
L
NO CONFLICT
IRR
L
= 18.13%
IRR
S
= 23.56%
0
Crossover
Point = 8.7%
WACC
0
5
10
15
20
NPV
L
50
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19
7
(4)
NPV
S
40
29
20
12
5
Professor Jawad M. Addoum FIN303: Spring 2013
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0 1 2 3 4
- 100 0 0 0 160
0 1 2 3 4
- 100 150 0 0 0
WACC
0
10
NPV
60
9.28
WACC
0
10
NPV
50
36.36
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IRR may lead to the wrong choice between two (or more)
Mutually Exclusive Projects when there are cash-flow
timing differences
Professor Jawad M. Addoum FIN303: Spring 2013
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Shortcomings of IRR
Super Simple Example: Consider a Project 1 which
requires a 1 investment and pays off 5 one year
from now. Its IRR is 400%! Now compare this to
Project 2 which requires a $1M investment and
returns $1.25M one year from now. This projects IRR
is 25%.
If these projects were mutually exclusive, which one would
you take??
Project 2 earns you !M where as Project 1 earns you only
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Example: Perma-Filter is considering two mutually
exclusive one-year projects, whose cash flows are
shown below. The cost of capital for either project
is 12%. Compute the NPV and IRR for each project
and indicate which one should be taken
CF
0
CF
1
($1,000)
($10,000)
$1,200
$12,000
NPV @ 12% IRR
$71.429
$714.29
20%
20%
Project Alpha
Project Beta
A Fundamental Problem with IRR is that it captures
only the Return Dimension of a projects cash flows,
not the Size Dimension of those cash flows!
Professor Jawad M. Addoum FIN303: Spring 2013
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IRR may lead to the wrong choice between two (or more)
Mutually Exclusive Projects when there are
project size differences
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Shortcomings of IRR
Example: WACC = 10%
We got IRR = ERROR because there are 2 IRRs. The Cash
Flows are Nonconventional or Nonnormalthere are two or
more sign changes!
Most common example: Initial cost (negative CF
0
), then a
string of positive CFs, then a cost to close down a project,
for example, a nuclear power plant or strip mine
5,000 -5,000
0 1 2
-800
NPV = -386.78 IRR = ERROR. Why?
Professor Jawad M. Addoum FIN303: Spring 2013
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Example (continued): Heres a picture:
NPV Profile
450
-800
0
400 100
IRR
2
= 400%
IRR
1
= 25%
WACC
NPV
The IRR is not always unique. There may be multiple IRRs
with nonnormal cash flows!!
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Modified Internal Rate of
Return (MIRR)
MIRRs approach is to:
Move all cash that flows out (Costs) to the present at a
discount rate of WACC
Move all cash that flows in (Revenues) to the project
termination, t=T, at WACC
Find a discount rate, MIRR, that makes these TWO values
equal in present value
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Often there is only one negative cash flow at t=0.
Then the left-hand side is just CF
0
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Why all this MIRR complication?
Suppose youre interested in the return that you
earn on a project.
You can just look at the IRR, right?
WRONG!
IRR implicitly moves positive (negative) cash flows
to the end (start) of the project at the IRR ratenot
the true opportunity cost of capital, which is WACC
Modified IRR provides the true rate of return
on a project
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Example: Consider the following project and its
cash flows ($000). The WACC is 10%:
Do you really earn 25% from investing in this project?
IRR = 25%
0 1 2
- 100 25 125
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Details of borrowing & repayment
0 1 2
- 100
25 125
Borrow
Invest in (pay down)
capital structure
Net Cash Flow - 100 0 + 152.5
Calculator Solution
PV=-100
PMT=0
FV=152.5
N= 2
I23.49%
-25
2.5 Interest (=25 x 10%)
25.0 Principal
Rate of return is 23.49%
Receive
So:cJ Rcturn to In:cstors = 2S
E
I
r
L
+2S

I
r

1 -I
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Now with MIRR.
-100.0
MIRR = 23.49%
FV@10% 1 year
152.5
0 1 2
- 100 25 125
27.5
152.5
Calculator Solution
PV=-100
PMT=0
FV=152.5
N= 2
I=? MIRR=23.49%
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Why all this MIRR complication?
Second,
Modified IRR Fixes the Multiple IRR problem
Decision Rules for Independent Projects:
If IRR>WACC, Accept Project
If IRR<WACC, Reject Project
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Example (slide 35): WACC = 10%
5,000 -5,000
0 1 2
-800
FV@10% 1 year
PV@10% 2 years
5,500
-4,132.2
-4,932.2
MIRR = 5.60%<WACC
5,500
Calculator Solution
PV=-4132.2
PMT=0
FV=5500.0
N= 2
I=? MIRR=5.60%
NPV = -386.78
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Does MIRR fix the Mutually Exclusive Project
problems of IRR?
NO!!!
Technical Note: if the projects are of identical size (identical present values of
negative cash flows (never happens) and positive cash flows for each project are
future valued to the latest period among all projects, then MIRR can fix the cash flow
timing difference problem
Professor Jawad M. Addoum FIN303: Spring 2013
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Advice for choosing between Mutually Exclusive
Projects:
Always choose NPV over both MIRR and IRR
when deciding between mutually exclusive projects!!
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Major points
As always, know how to work the assigned
homework problems as well as the types of
numerical examples in the notes
What is capital budgeting?
What are the following investment criteria? What
are their relative advantages? Disadvantages?
Payback
Discounted Payback
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Professor Jawad M. Addoum FIN303: Spring 2013
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Relative to NPV, what are the relative shortcomings
of the other investment criteria?
What is the weakness of IRR in choosing between mutually
exclusive projects? Projects with nonconventional cash
flows?
How do NPV profiles provide additional insight in the
investment analysisespecially as compared to IRR
analysis?
How is MIRR useful?
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Appendix: Another MIRR
Example
Example: Consider Project H and its cash flows
($000). The WACC is 10%:
What is Project Hs MIRR?
NPV = $81,573.
0 1 2 3 4
- 260 107 -11.8 89 117
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Example (continued):
-269.75
MIRR = ?
117.0
97.9
142.4
FV@10%
PV@10%
FV@10%
357.3
-9.75
0 1 2 3 4
- 260 107 -11.8 89
Calculator Solution
PV=-269.75
PMT=0
FV=357.3
N= 4
I=? MIRR=7.28%
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Math Solution
MIRR = 7.28%
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1a. Enter positive CFs:
CF
0
=0
CF
1
=107
CF
2
=0
CF
3
=89
CF
4
=117
I = 10
NPV =?244.1
STO 1
2. (RCL 1) PV =-244.1 N = 4, I = 10 PMT = 0; FV =?357.3 STO 3
3. (RCL 2 ) PV=-269.75 (RCL 3) FV=357.3 N = 4 PMT= 0; I = ?
MIRR = 7.28%
Pure Calculator Solution (messy!)
1b. Enter negative CFs:
CF
0
=260
CF
1
=0
CF
2
=11.8
CF
3
=0
CF
4
=0
I = 10
NPV =?$269.75
STO 2