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Unformatted text preview: 12/21/2006 Chapter 11. Tool Kit for Basics of Capital Budgeting: Evaluating Cash Flows Expected aftertax Year (t) Project S Project L 0 ($1,000) ($1,000) 1 500 100 2 400 300 3 300 400 4 100 600 Panel A: Project Cash Flows and Cost of Capital Project S: 0 1 2 3 4     $1,000 $500 $400 $300 $100 Project L: 0 1 2 3 4     $1,000 $100 $300 $400 $600 Project cost of capital = r = 10% Panel B: Summary of Selected Evaluation Criterion Project S L NPV: $78.82 $49.18 IRR: 14.5% 11.8% MIRR: 12.1% 11.3% PI: 1.08 1.05 r = 10% Project S Time period: 0 1 2 3 4 Cash flow: (1,000) 500 400 300 100 Disc. cash flow: (1,000) 455 331 225 68 In this file we use Excel to do most of the calculations explained in Chapter 11. First, we analyze Projects S and L, whose cash flows are shown immediately below in both tabular and a time line formats. Spreadsheet analyses can be set up vertically, in a table with columns, or horizontally, using time lines. For short problems, with just a few years, we generally use the time line format because rows can be added and we can set the problem up as a series of income statements. For long problems, it is often more convenient to use a tabular layout. net cash flows (CF t ) Figure 111: Net Cash Flows and Selected Evaluation Criteria for Projects S and L (CF t ) NET PRESENT VALUE (NPV) (Section 11.2) To calculate the NPV, we find the present value of the individual cash flows and find the sum of those discounted cash flows. This value represents the value the project add to shareholder wealth. A B C D E F G H I J K 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 NPV(S) = $78.82 = Sum disc. CF's. or $78.82 = Uses NPV function. Project L Time period: 0 1 2 3 4 Cash flow: (1,000) 100 300 400 600 Disc. cash flow: (1,000) 91 248 301 410 NPV(L) = $49.18 $49.18 = Uses NPV function. A B C D E F G H I J K 60 61 62 63 64 65 66 67 68 Expected aftertax Year (t) Project S Project L 0 ($1,000) ($1,000) The IRR function assumes 1 500 100 14.49% payments occur at end of 2 400 300 11.79% periods, so that function does 3 300 400 not have to be adjusted. 4 100 600 NPV Profiles Net Cash Flows Year Project S Project L WACC = 10.0%$1,000$1,000 Project S Project L 1 $500 $100 NPV = $78.82 $49.18 2 $400 $300 IRR = 14.49% 11.79% 3 $300 $400 Crossover = 7.17% 4 $100 $600 Data Table The NPV method of capital budgeting dictates that all independent projects that have positive NPV should accepted. The rationale behind that assertion arises from the idea that all such projects add wealth, and that should be the overall goal of the manager in all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you would want to accept the project that adds the most value (i.e. the project with the higher NPV). Hence, if considering the above two projects, you would accept both projects if they are independent, and you would only accept Project S if...
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This note was uploaded on 06/15/2011 for the course FI515 FI515 taught by Professor Fi515 during the Spring '10 term at Keller Graduate School of Management.
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