FIN 327 Week 9

Capital Budgeting
NPV vs IRR
Break-even Analysis and Forecasting
Case: Airbus A3XX
Addl background reading: Break-
even analysis for Lockheeds Tristar
(no need to do the math but focus on
understanding figures)
Objectives
Review basic principles concerning evaluation of
investment projects and prepare to apply these
principles and concepts to a real investment project

Review of investment analysis and criteria for best
investment decisions

Review the difference between accounting and
economic break-even

Risk and capital investment decisions and implications
for the selection of a discount rate appropriate for
project present value calculations

Capture the possible link between price and quantity
when forecasting cash flows

Role of capital rationing in corporate investment
decisions and relation to value creation of the firm
Financial management
There are three fundamental functions of a
financial manager
Capital Budgeting: Identify real assets to
invest in and avoid those that do not create
value
Raising Capital: Issue financial assets to
finance real investments
Working Capital management

The NPV and IRR Rules
The Basics: Three step procedure:
Estimate future expected cash flows using
accounting data and other sources
Compute a discount rate or target rate of
return
Calculate NPV or internal rate of return
accept positive NPV projects (or projects with
internal rates of return above the target rate of
return)
reject negative NPV projects (or project with IRRs
below the target rate of return)

Pitfalls of IRR
The internal rate of return is not the best
criterion for ranking projects. Why?
It suffers from possible mathematical problems
(non-uniqueness, non-existence)
There are problems in application (mutually
exclusive projects, borrowing v. lending
issues).
It also ignores the information contained in the
yield curve.
(Side issue: the yield curve; need to freshen
up?)
Example:
Consider two mutually exclusive projects:
Project A involves an initial outlay of $5 and
repays $10 next year
Project B involves an initial outlay of $20 and
repays $30 next year
What is the IRR of project A? Project B?
At a 10% discount rate, what would you
do?
Target Rate of Return
Many corporations use a target rate of
return or cutoff rate to value projects
In many cases, the target rate is the cutoff
rate = the firms weighted-average cost of
capital (WACC)
Firms entering new businesses or investing in
new strategies may be changing the firms risk
from levels assumed in a firm-wide WACC
Project risk or is the relevant risk to have
reflected in WACC.

Pitfalls of WACC
Use of firm WACC instead of project WACC
leads to acceptance of bad projects or
rejection of good projects
Finding beta (risk premium); For example,
should we take domestic or international market
perspective?
Risk is a forward-looking variable; measures
of risk are often backward looking
Inflation. We will look at this issue in case
Break-Even Analysis
Different break-even analyses
Accounting break-even: sales volume at
which net income = 0
Cash break-even: sales volume at which
operating cash flow = 0
Financial (economic) break-even: sales
volume at which net present value = 0
Which one is the best condition for value
being created?
Capital Rationing
Capital rationing: Two types
Hard: The firm cannot obtain outside capital
to fund all its positive NPV projects
This typically applies to small, growing firms with
high insider ownership where there may be
significant agency costs
Soft: To control managers or to have
balanced divisional growth, a firm may limit
the funds available for project investment
even if it can raise funds from the capital
markets

Capital Rationing contd
Seemingly obvious rules like NPV>0,
IRR>WACC, etc may not apply when
there is capital rationing.
Some projects yield first-mover
advantages and may free up capital for
use in other projects later on, so just
picking the highest NPV project may not
be correct.
Rather, we have to consider combinations
of projects that maximize NPV.
Later we will also see how Real Options
affect NPVrule.

Lockheed Tri-Star*

* Source: U.E. Reinhardt, Break-Even Analysis for
Lockheeds Tri Star: An Application of Financial Theory,
Journal of Finance, 1973
Lockheed decided to go ahead with development of L-
1011 Tri-Star in 1968 with development costs estimated
at around $800mm to $1 billion to compete with
McDonnell Douglas DC-10
Production costs of planes decline with production
(learning curve) and L-1011s are to be sold at around
$15mm-$16mm each
In 1971, Lockheed applied for government guarantee on
debt to complete program and Lockheed management in
Congressional hearings estimated break-even at
around 200 aircraft

Analysis of Break-Even: k = WACC