Chapter 11:THE BASICS OFCAPITALBUDGETINGShould we build thisplant?

Topic OverviewTopic OverviewProject TypesCapital Budgeting Decision Criteria◦Net Present Value (NPV)◦Internal Rate of Return (IRR)◦Modified Internal Rate of Return (MIRR) ◦Payback Period ◦Discounted Payback Period

Learning ObjectivesLearning ObjectivesUnderstand how to calculate and use the 5 capital budgeting decision techniques:, NPV, IRR, MIRR, Payback, & Discounted Payback. Understand the advantages and disadvantages of each technique.Understand which project to select when there is a ranking conflict between NPV and IRR.

Think about this as we cover Chapter 11 Think about this as we cover Chapter 11 Capital Budgeting Decision Methods.Capital Budgeting Decision Methods.Which of the following investment opportunities would you prefer?#1) Give me $1 now and I’ll give you $2 at the end of class.#2) Give me $100 now and I’ll give you $150 at the end of class.

WHAT IS CAPITAL WHAT IS CAPITAL BUDGETING?BUDGETING?Analysis of potential additions to fixed assets.Long-term decisions; involve large expenditures.Very important to firm’s future.

Capital Budgeting Steps:Capital Budgeting Steps:1. Estimate CFs (inflows & outflows).2. Assess riskiness of CFs.3. Determine k = WACC (adj.).4. Find NPV and/or IRR.5. Accept if NPV > 0 and/or IRR > WACC.

Types of ProjectsTypes of ProjectsBrand new line of businessExpansion of existing line of businessReplacement of existing assetIndependent vs. Mutually ExclusiveNormal vs. Non-normal

An Example of Mutually An Example of Mutually Exclusive Projects:Exclusive Projects:BRIDGE VS. BOAT TO GET PRODUCTS ACROSS A RIVER.

Normal vs. Nonnormal Normal vs. Nonnormal ProjectsProjectsNormal Project:◦Cost (negative CF) followed by a series of positive cash inflows. Onechange of signs.Non-normal Project:◦Twoor more changes of signs.◦Most common: Cost (negative CF), then string of positive CFs, then cost to close project.◦Nuclear power plant, strip mine.

Inflow (+) or Outflow (-) in Year012345NNN-+++++N-++++-NN---+++N+++---N-++-+-NN

Our Case StudyOur Case StudyWe want to help Marge Simpson analyze the following business opportunities by using the following cash flow information. Assume Marge's cost of capital is 12%.TimeFalafel-FullHow 'Bout A Pretzel?0(20,000)(20,000)115,0002,000215,0002,500313,0003,00043,00050,000

Net Present Value (NPV)Net Present Value (NPV)NPV = PV of inflows minus Cost = Net gain in wealth.Acceptance of a project with a NPV > 0 will add value to the firm.Decision Rule: ◦Accept if NPV >0, ◦Reject if NPV < 0

(29NPVCFktntt=∑+=01.NPV: Sum of the PVs of inflows and outflows.(29.101CFkCFNPVttnt-+=∑=Cost often is CF0and is negative.

Marge’s NPVs: k = 12%Marge’s NPVs: k = 12%TimeFalafel-FullPV(CF)How 'Bout A Pretzel?PV(CF)0(20,000)(20,000)(20,000)(20,000)115,00013,3932,0001,786215,00011,9582,5001,993313,0009,2533,0002,13543,0001,90750,00031,776NPV16,51017,690Calculator Steps. Falafel-Full: CF0 = -20,000, C01 = 15,000, F01 = 2, C02 = 13,000, F02 = 1, C03 = 3,000.