OPENING

10-1

Case presents a situation where we have to decide the best possible option to invest $1 million. The two possible options are below1.Franchise L ( Lisas soup, salads) 2.Franchise S ( Fried Chicken) Few Facts Ls cash flow will start of slowly but will increase quickly because of the health awareness among the people Ss cash flow will start quickly but will trail off once other chicken competitors enter the market and people start avoiding fried chicken

10-2

The investment is for 3 years Both franchises have risk that require a return of 10%

We are to decide whether one or both the franchises should be accepted

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Problem Evaluation

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What is capital budgeting?

Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firms future.

10-5

Steps to capital budgeting

1. 2. 3. 4. 5.

Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC.

10-6

What is the difference between independent and mutually exclusive projects?

Independent projects if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other.

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What is the payback period?

The number of years required to recover a projects cost, or How long does it take to get our money back? Calculated by adding projects cash inflows to its cost until the cumulative cash flow for the project turns positive.

10-8

CALCULATING PAYBACK
Project L CFt Cumulative PaybackL Project S CFt Cumulative PaybackS 0 -100 -100 = 2 = 0 -100 -100 == 1 + + 1 70 -30 1 10 -90 2 2.4 3

60 100 80 -30 0 50

30/ 80 = 2.375 years 1.6 2 3 20 40

10-9

100 5 0 0 20

30/ 50 = 1.6 years

What is the rationale for the payback method? According to the payback criterion, which franchise or franchises should be accepted if the firms maximum acceptable payback is two years and if franchises L and S are independent? If they are mutually exclusive?

10-10

Sol: In mutually exclusive projects the one with shorter payback period is chosen. If L and S are independent projects then Franchise S is accepted because its payback period is less than 2 years(max). If L and S are mutually exclusive projects then Franchise S would be chosen because S has the shorter payback period.

10-11

What is the difference between the regular and discounted payback periods?
Sol. Simple payback method do not care about the time-value of money principle while discounted payback period do take care of this principle in calculation.

10-12

What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decision?
Sol. The main disadvantages are: Ignores the time value of money. Ignores CFs occurring after the payback period.

10-13

Define the term NPV? What is each franchises NPV?

Sol. Net Present Value (NPV) Sum of the PVs of all cash inflows and outflows of a project: n

CFt NPV ! t t !0 ( 1  k )

Where, CFt is the expected net cash flow at period t. r is the projects cost of capital. N is its life.

10-14

Project L and S NPV

Year 0 1 2 3 CFt -100 10 60 80 NPVL = PV of CFt -$100 9.09 49.59 60.11 $18.79

NPVS = $19.98

10-15

Solving for NPV: Financial calculator solution

Enter CFs into the calculators CFLO register. CF0 = -100 CF1 = 10 CF2 = 60 CF3 = 80 Enter I/YR = 10, press NPV button to get NPVL = $18.78.

10-16

Rationale for the NPV method

NPV= PV of inflows Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. In this example, would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent.

10-17

Would the NPVs change if the cost of capital is changed?

Sol: Yes the NPV would change because due to change in cost of capital, the hurdle rate will change which will lead to change in NPV.

10-18

Internal rate of return (IRR)

IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

CFt 0! ( 1  IRR ) t t !0
Solving for IRR with a financial calculator: Enter CFs in CFLO register. Press IRR; IRRL = 18.13% and IRRS = 23.56%.

10-19

How is a projects IRR similar to a bonds YTM?

They are the same thing. Think of a bond as a project. The YTM on the bond would be the IRR of the bond project. EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20. Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

10-20

What is the logic behind the IRR method? According to IRR which franchises should be accepted if they are independent? Mutually exclusive?
Sol:

If IRR > WACC, the projects rate of return is greater than its costs. There is some return left over to boost stockholders returns.

10-21

IRR ACCEPTANCE CRITERIA

If IRR > k, accept project. If IRR < k, reject project. If projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept S, because IRRs > IRRL.

10-22

Would the franchises IRR change if the cost of capital is changed?

Sol: No, because IRR is the rate and is not affected by the change in cost of capital.

10-23

NPV PROFILES
A graphical representation of project NPVs at various different costs of capital. k 0 5 10 15 20 NPVL ($) 50 33 19 7 (4) NPVS ($) 40 29 20 12 5

10-24

DRAWING NPV PROFILES

NPV 60 ($)
50

. 40 .
30 20 10 0

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

. .
15

5 -10

20

. .

.
23.6

IRRS = 23.6% Discount Rate (%)

10-25

Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6% ?

10-26

If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive If k > crossover point, the two methods lead to the same decision and there is no conflict. If k < crossover point, the two methods lead to different accept/reject decisions. At 23.6% cost of capital, project S is accepted as IRR> COC and project L will be rejected.

10-27

What is the underlying cause of ranking conflicts between NPV and IRR?
Sol: Two basic conditions of conflict When project size or scale differences exist, meaning that the cost of one project is greater than that of other. When timing differences exist. Cash flows in previous or later years.

10-28

Reinvestment rate assumptions

NPV method assumes CFs are reinvested at k, the opportunity cost of capital. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.

10-29

Which method is the best and why?

NPV is the more reliable method because the projects cash flows can be reinvested at the cost of capital, not at the IRR. NPV method should be used for mutually exclusive projects especially those that differ in scale or timing.

10-30

Define the term modified IRR (MIRR). Find the MIRRs for Franchises L and S.
MIRR value is always unique given that we have at least one negative and one positive net cash flow. The modified internal rate of return is a geometric average of the compounded future value of positive cash flows over the discounted present value of negative cash flows. MIRR Formula

10-31

CALCULATING MIRR

0 -100.0

10%

1 10.0
10% MIRR = 16.5%

2 60.0
10%

3 80.0 66.0 12.1 158.1

TV inflows

-100.0
PV outflows

$100 =

$158.1 (1 + MIRRL)3

MIRRL = 16.5%
10-32

What are the MIRRs advantages and disadvantages vis--vis the regular IRR? What are the MIRRs advantages and disadvantages vis--vis the NPV?
 MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR.  NPV method is still the best way to choose among competing projects because it provides the best indication of how much each project will add to the value of the firm.
10-33

As a separate project (Project P), you are considering sponsoring a pavilion at the upcoming Worlds Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project Ps expected net cash flows look like this (in millions of dollars): Year Net Cash Flows 0 ($0.8) 1 5.0 2 (5.0) The project is estimated to be of average risk, so its cost of capital is 10%. (1) What are normal and non normal cash flows?
10-34

Normal cash flows

Cost (negative CF) followed by a series of positive cash inflows. One change of signs.

Non normal cash flows

Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. .

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Inflow (+) or Outflow (-) in Year 0 + 1 + + + + 2 + + + + 3 + + + 4 + + + + 5 + + N N NN

10-36

N N

NN

NN

What is project Ps NPV? What is its IRR? Its MIRR?

0 -800

r = 10%

1 5,000

2 -5,000

Enter CFs in CFLO, enter I = 10. NPV = -386.78 IRR = ERROR. Why?
10-37

We got IRR = ERROR because there are 2 IRRs. Non-normal CFs--two sign changes. Heres a picture:
NPV

NPV Profile
IRR2 = 400%

450 0 -800 100 IRR1 = 25%

10-38

400

Logic of multiple IRRs

1. 2. 3. 4. At very low discount rates, the PV of CF2 is large & negative, so NPV < 0. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0. In between, the discount rate hits CF2 harder than CF1, so NPV > 0. Result: 2 IRRs.

10-39

Could find IRR with calculator:

1. Enter CFs as before. 2. Enter a guess as to IRR by storing the guess. Try 10%: 10 STO IRR = 25% = lower IRR Now guess large IRR, say, 200: 200 STO IRR = 400% = upper IRR
10-40

When there are non-normal CFs and more than one IRR, use MIRR:
0 -800,000 1 5,000,000 2 -5,000,000

PV outflows @ 10% = -4,932,231.40. TV inflows @ 10% = 5,500,000.00. MIRR = 5.6%

10-41

ACCEPT PROJECT P?
NO. Reject because MIRR = 5.6% < r = 10%. Also, if MIRR < r, NPV will be negative: NPV = -$386,777.

10-42

S and L are mutually exclusive and will be repeated. r = 10%. Which is better? (Thousands)
0 Project S: (100) Project L: (100) 1 2 3 4

60 33.5

60 33.5 33.5 33.5

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CF0 CF1 Nj I NPV

S -100,000 60,000 2 10 4,132

L -100,000 33,500 4 10 6,190

NPVL > NPVS. But is L better? Cant say yet. Need to perform common life analysis.

10-44

Note that Project S could be repeated after 2 years to generate additional profits. Can use either replacement chain or equivalent annual annuity analysis to make decision.

10-45

What is each projects equivalent annual annuity?

The equivalent annual annuity formula is used in capital budgeting to show the net present value of an investment as a series of equal cash flows for the length of the investment. The net present value(NPV) formula shows the present value of an investment that has uneven cash flows. Project S - Rs. -2,380.95 Project L - Rs. -1,952.92

10-46

Replacement Chain Approach (Thousands)

FRANCHISE S WITH REPLICATION: 0 1 2 3 4

Franchise S: (100) 60 (100) 60

60 (100) (40)

60 60

60 60

NPV = $7,547.
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Or, use NPVs:

0 4,132 3,415 7,547

2 4,132

10%

Compare to Franchise L NPV = $6,190.

Project S should be chosen as its extended NPV is more than that of project L.
10-48

If the cost to repeat S in two years rises to $105,000, which is best? (Thousands)
0 1 2 3 4

Franchise S: (100) 60

60 (105) (45)

60

60

NPVS = $3,415 < NPVL = $6,190. Now choose L.

10-49

k. You are also considering another project that has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the projects estimated cash flows:
Year 0 1 2 3 CF ($5,000) 2,100 2,000 1,750 Salvage Value $5,000 3,100 2,000 0

10-50

Using the 10% cost of capital, what is the projects NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the projects optimal (economic) life?

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CFs Under Each Alternative (Thousands)

1. No termination 2. Terminate 2 years 3. Terminate 1 year

0 (5) (5) (5)

1 2.1 2.1 5.2

2 2 4

3 1.75

10-52

Assuming a 10% cost of capital, what is the projects optimal, or economic life?
NPV(no) NPV(2) NPV(1) = -$123. = $215. = -$273.

The project is acceptable only if operated for 2 years. A projects engineering life does not always equal its economic life.

10-53

After examining all the potential projects, you discover that there are many more projects this year with positive NPVs than in a normal year. What two problems might this extra large capital budget cause?
(1) Increasing marginal cost of capital and (2) Capital rationing.

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CLOSURE

10-55

Capital Budgeting - Analysing which of the two franchises is to be selected Various methods used for analysis are1.NPV 2.IRR 3.MIRR 4.Pay Back 5.Profitability Index

10-56

NPV helps in deciding the project which adds most wealth to the share holders and in this case NPV of S>L IRR is an indicator of safety margin and in this case IRR of S>L PI measures the profitability relative to any project and here also S>L Payback tells about the liquidity and risk of the project and we find S>L
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In our view project S seems to be more profitable than L Also, because the NPVS of the two projects are positive so both can be selected

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