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Agenda
 Deterministic Capital Budgeting
 NPV & IRR
 Review of NPV & IRR
 IRR with infinite cash flows (using linear interpolation)
 Why NPV is superior to IRR
 OCF & NWC
 PV of CCATS
 Special Cases of DCF Analysis
 Evaluating Cost-cutting Proposals
 Replacing an Asset
 Evaluating Equipment with Different Lives (using EAC )

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Evaluation Criteria

 Any decision rule has to establish the following

 Adjustment for the TVM
 Adjustment for the risk of the investment
 Provide information whether the investment is creating
value for the firm (and thus for its shareholders)

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 NPV & IRR
 NPV (Net Present Value)

CFt = Cash flow at period t r = Cost of capital

I0 = Initial investment outlay n = Project lifetime

 Decision Rules
 If NPV > 0, accept project
 If NPV < 0, reject project

 NPV Profile Example

I0 =$100, CF1 =$120
Calculate NPV for different discount rates
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 NPV & IRR
r PV(CF1) Less I0 NPV
0% $120 $100 $20
5% $114 $100 $14
10% $109 $100 $9
15% $104 $100 $4
20% $100 $100 $0
25% $96 $100 -$4
25

20

15
NPV =0, r= 20%

10
NPV

0
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22%
-5

-10
Discount Rate

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 Computing NPV for the Project
LO1

 A project with three years life has cash flows of $63,120,

$70,800 and $91,080 in first, second and third years
respectively. If the discount rate is 12 percent and cost of the
project is $165,000, what is the NPV?
Using the formulas:
 NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000
= 12,627.42
Using the calculator:
 Use the Cash Flow and NPV functions on the TI BAII Plus
 CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1;
C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41
 Do we accept or reject the project?

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LO2

Payback Period
 How long does it take to get the initial cost back in a
nominal sense?
 Computation
 Estimate the cash flows
 Subtract the future cash flows from the initial cost until
the initial investment has been recovered
 Decision Rule – Accept if the payback period is less
than some preset limit

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 Advantages and Disadvantages of Payback
 Advantages  Disadvantages
 Easy to understand  Ignores the time value
 Adjusts for uncertainty of money
of later cash flows  Requires an arbitrary
 Biased towards liquidity cutoff point
 Ignores cash flows
beyond the cutoff date
 Biased against long-
term projects, such as
research and
development, and new
projects
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LO3

Discounted Payback Period

 Compute the present value of each cash flow and then
determine how long it takes to payback on a
discounted basis
 Compare to a specified required payback period
 Decision Rule - Accept the project if it pays back on
a discounted basis within the specified time

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Advantages and Disadvantages of Discounted Payback

 Advantages  Disadvantages
 Includes time value of
money
 Easy to understand
 Does not accept
negative estimated NPV
investments
 Biased towards liquidity
 May reject positive
NPV investments
 Requires an arbitrary
cutoff point
 Ignores cash flows
beyond the cutoff date
 Biased against long-
term projects, such as
R&D, and new projects

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LO4

Average Accounting Return

 There are many different definitions for average
accounting return
 The one used in the book is:
 Average net income / Average book value
 Note that the average book value depends on how the
asset is depreciated.
 Need to have a target cutoff rate
 Decision Rule: Accept the project if the AAR is
greater than a preset rate.

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Advantages and Disadvantages of AAR

 Advantages  Disadvantages
 Easy to calculate  Not a true rate of return;
 Needed information is
time value of money is
usually available ignored
 Uses an arbitrary
benchmark cutoff rate
 Based on accounting net
income and book
values, not cash flows
and market values

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 NPV & IRR
IRR (Internal Rate of Return)
The discount rate that makes the NPV =0
In the above example, IRR =20%
Calculating IRR
Calculator (CF)
Fluctuating Cash Flows
Constant cash flows, like annuities
Step1. Choose a discount rate, and calculate the
project’s NPV
Step 2. If NPV > 0, choose a higher discount rate, and
repeat the calculation of NPV. Continue until you find
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 NPV & IRR
If NPV <0, choose a lower discount rate, and repeat the
calculation of NPV. Continue until you find NPV > 0
Step 3. When you have one NPV >0 and the other NPV <0,
you can use linear interpolation to yield IRR
r NPV
r1 NPV1 > 0
IRR 0
r2 NPV2 < 0

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 NPV & IRR
Decision Rule for IRR
 If IRR > cost of capital, accept project
 If IRR < cost of capital, reject project
Independent Projects
 Decide on one project at a time.
 Can do either, neither or both.
 IRR & NPV give equivalent results.
Mutually Exclusive Projects
 Rank projects
 Budget constraint
 NPV & IRR do not rank projects the same way
 See NPV & IRR Ranking Problem example below
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LO5

Conflicts Between NPV and IRR

 NPV directly measures the increase in value to the
firm
 Whenever there is a conflict between NPV and
another decision rule, you should always use NPV
 IRR is unreliable in the following situations
 Mutually exclusive projects
 Non-conventional cash flows

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 NPV & IRR Ranking Problem
$160.00
$140.00
NPVA > NPVB
$120.00
$100.00 IRRA= 19.43%
$80.00 IRRB = 22.17%
NPV

A
$60.00 Crossover Point = 11.8% B
$40.00
$20.00 IRRB > IRRA
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate

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 Why NPV is superior to IRR
Example:
Project CF0 = -100, CF1 = 230, CF2 = -132, find IRR.
230 132
 100   0
1 1 R (1  R) 2

Let X= 1 R

−100 + 230X− 132X2 = 0

132X2 − 230X +100 = 0
Using quadratic formula to solve X.

X1 = 1/1.1 , X2 = 1/1.2  X1 
1

1
   R  0.1
1 R 1  .1

IRR1 = 0.1 , IRR2 = 0.2

If cost of capital = 15%, should you accept or reject the project?
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 Why NPV is superior to IRR
 IRR assumes that reinvestment is made at the IRR
 NPV assumes that cash inflows are
reinvested at the cost of capital,
whereas IRR assumes reinvestment at
project’s IRR.

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Why NPV is superior to IRR
Non-conventional cash flows :
A series of inward and outward cash flows over
time in which there is more than one change in
the cash flow direction.
There might be multiple IRRs from non-
conventional cash flows.

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 MIRR
Three Methods of Calculation

1) Discounting Approach
2) Reinvestment Approach
3) Combining Approach

Controversial:
One end: MIRRs are sup0erior to IRRs (avoids multiple
IRR)

Opponents interpret this as:

Meaningless Internal Rate of Return
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IRR Rule Advantages and
Disadvantages
Advantages Disadvantages

1. Closely related to NPV, 1. May result in multiple

generally leading to answers or no answer with
identical decisions non-conventional cash
flows
2. Easy to understand and 2. May lead to incorrect
communicate decisions in comparisons
of mutually exclusive
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Profitability Index (PI)
 Present value of an investment’s future cash flows
divided by it’s initial cost.
 Also known as benefit/cost ratio.
 If a project has positive NPV, PV of all the future CFs is
bigger than I0, the PI is greater than 1.00.
 Size of the project is ignored (Project A: cost $5, PV
$10, PI 2.0, NPV $5; Project B: Cost $100, PV $150, PI 1.5,
NPV $50)

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Profitability Index Rule
Advantages Disadvantages

1. Closely related to NPV, 1. May lead to incorrect

generally leading to decisions in comparisons
identical decisions of mutually exclusive
investments
2. Easy to understand and
communicate
3. May be useful when
available investments are
limited
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 NPV Calculation (Chapter 10)
10.1 Project Cash Flows
Incremental cash flow (difference in CF with and without
project)
10.2 Incremental Cash Flows: Avoid Common Pitfalls
 Ignore sunk costs

 Consider opportunity costs

 Include spillovers (side effects)

Positive side effects – benefits to other projects

Negative side effects /Erosion – CF comes at
expense of another product line
 Solvency or Net Working Capital
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 NPV Calculation
 Financing costs are analyzed separately and are
reflected in the project’s required rate of return
 Adjust for inflation
 Include taxes or subsidies from government

 Cash flows are analyzed on an after-tax basis

 The timing of cash flows is important

10.3 Pro Forma FS and Project CFs

Project Cash Flow = Project operating cash flow (OCF)
− Project additions to net working capital (NWC)
− Project capital spending
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 Operating Cash Flow (OCF)
 Basic Approach
OCF = EBIT + Depreciation – Taxes
EBIT = Sales – Variable Costs – Fixed Costs –
Depreciation
 Bottom-Up Approach (ignore financing expenses)
OCF = Net Income + depreciation
 Top-Down Approach
OCF = Sales – Costs – Taxes
 Tax Shield Approach
OCF = (Sales – Costs)(1 – Tc ) + Depreciation × Tc
Tc –> Corporate tax rate
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 10.4 Net Working Capital (NWC)
 Net working capital = current assets – current liabilities
 Normally, a project requires a firm invest in NWC as well
as long-term assets.
 The firm’s investment in project NWC resembles a loan.
The firm supplies working capital at the beginning and
recovers it toward the end. In other words, the same
number needs to appear with the opposite sign at the end
of project lifetime.
 An increase in NWC (start of project) is a cash outflow
and a decrease in NWC (end of project) is cash inflow.
 Including additions to NWC has the effect of adjusting for
the discrepancy between accounting sales & costs and
actual cash receipts & payments.
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 PV of CCATS
 Depreciation is a non-cash expenses. The only
cash flow effect from depreciation is to reduce
corporations’ taxes.
 Depreciation tax shield = DxT
D = depreciation expense
T = tax rate
 CCA tax shield: tax savings that result from Capital
Cost Allowance (CCA) deduction
 The PV of CCATS formula is based on the idea that
tax shields from CCA continue in perpetuity as long as
there are assets remaining in the CCA class.

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 PV of CCATS
 Our derivation uses the following terms:

I = total capital investment in the asset which is added to

the pool
d = CCA rate for the asset class
Tc = company’s marginal tax rate
k = discount rate
Sn = salvage or disposal value of the asset in year n
n = asset life in years

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 PV of CCATS
 Use the dividend formula to derive the PVCCATS.
 Recall that when dividends grow at a constant rate, the
stock price is:
D1
P0 
kg

 This formula can be generalized for any growing

perpetuity.
 We temporarily ignore the half year rule and
therefore the growth rate in CCA payments is –d, since
the declining UCC value implies negative growth.
 The 1st year tax shield can be given as IdTc
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 PV of CCATS
We can now develop the formula:

IdTc IdTc
PV of CCA tax shield = 
k  (d ) kd

In Canada, we need to adjust for the half year rule.

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 PV of CCATS
1 IdTc 1 IdTc 1
PV of CCATS     
2 k  d 2 k  d (1  k)

IdTc 1  0.5k
PV of CCATS  
k  d 1 k
Adjust for salvage value
S n dTc
PV (Salvage CCATS) at time n 
k d
S n dTc 1
PV (Salvage CCATS) at time 0  
k  d (1  k ) n
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 PV of CCATS
IdTc 1  0.5k S n dTc 1
PV of CCATS    
k  d 1 k k  d (1  k ) n

I = Capital Cost d = CCA rate

k = Discount rate Tc = Corporate tax rate
Sn = Salvage value at time n n = Project lifetime

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 PV of CCATS

 Using the PV of CCATS formula for the MMCC

example
(page 259 -268 in the textbook)
 You can determine the PV of CCATS by manually summing
up the tax shields over the project life, or by using the PV of
CCATS formula.
 The formula is more accurate whenever the salvage value
of the asset differs from its UCC
 The formula takes into account the future CCA on this
difference
(page 268 in the textbook)

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 10.7 Special Cases of DCF Analysis
 Evaluating Cost-Cutting Proposals (ignore NWC)
 Upgrade existing facilities
 Compare cost savings with capital expenditure
NPV = −Investment + PV of after-tax savings
+ PV of CCATS

 Replacing an Asset (usually ignore NWC)

NPV = −Net addition to the asset pool
+ PV of after-tax savings
+ PV of CCATS
+ PV of net salvage (Salvage of new – salvage
forgone of old)
The PV of CCATS is simplified by looking at only the net addition to the
asset poolRyerson
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salvage.
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 Special Cases of DCF Analysis
 Equipment with Different Lives
 Need to place projects on a common horizon for comparison
 Hold benefits constant and find the least-cost alternatives.
This is known as Cost-Effectiveness Analysis 
Determination of ‘Equivalent Annual Cost’
 Example

Machine A Machine B
Initial Cost = $100 Initial Cost = $140
$10 per year to operate $8 per year to operate
Expected life is 2 years Expected life is 3 years

The machine chosen will be replaced indefinitely and neither

machine will have a differential impact on revenue. The required return
is 10%, Which machine should you buy?
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 Special Cases of DCF Analysis
PV of Costs (Machine A) PV of Costs (Machine B)
= -100 – 10/1.1 – 10/1.12 = -140 – 8/1.1 – 8/1.12 – 8/1.13
= -117.36 = -159.89
•It appears that Machine A has lower costs .
•However what we have really discovered so far is that
Machine A effectively provides 2 years of service for
$117.36, while Machine B effectively provides 3 years of
service for $159.89.
•These are not directly comparable because of the
difference in service periods.
•We need to work out a cost per year for these 2
alternatives
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Special Cases of DCF
Analysis
 What amount, paid each year over the life of the machine,
has the same PV of costs?
 This amount is called the Equivalent Annual Cost (EAC).
Machine B
Machine A
EAC/PMT x PVIFA(3,10%)
EAC/PMT x PVIFA(2,10%) =159.89
=117.36 EAC = 64.29
EAC = 67.62

As the EAC of Machine B is lower, we choose

Machine B

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 NPV of Replacement Continued

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