IFM10 Ch12 Lecture

# IFM10 Ch12 Lecture - Chapter 12 Capital Budgeting Decision...

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Chapter 12 Capital Budgeting: Decision Criteria 1

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Topics Overview and “vocabulary” Methods NPV IRR, MIRR Profitability Index Payback, discounted payback Unequal lives Economic life 2
What is capital budgeting? Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to firm’s future. 3

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Steps in Capital Budgeting Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows. 4
Independent versus Mutually Exclusive Projects Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other. 5

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Cash Flows for Franchise L and Franchise S 6 10 80 60 0 1 2 3 10% L’s CFs: -100.00 70 20 50 0 1 2 3 10% S’s CFs: -100.00
NPV: Sum of the PVs of all cash flows. 7 Cost often is CF 0  and is negative. NPV =   Σ N t = 0 CF t (1 + r) t NPV =   Σ N t = 1 CF t (1 + r) t - CF 0

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What’s Franchise L’s NPV? 8 10 80 60 0 1 2 3 10% L’s CFs: -100.00 9.09 49.59 60.11 18.79 = NPV L NPV S = \$19.98.
Calculator Solution: Enter values in CFLO register for L. 9 -100 10 60 80 10 CF 0 CF 1 NPV CF 2 CF 3 I/YR = 18.78 = NPV L

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Rationale for the NPV Method NPV = PV inflows – Cost This is net gain in wealth, so accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value. 10
Using NPV method, which franchise(s) should be accepted? If Franchise S and L are mutually exclusive, accept S because NPV s > NPV L . If S & L are independent, accept both; NPV > 0. 11

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Internal Rate of Return: IRR 12 0 1 2 3 CF 0 CF 1 CF 2 CF 3 Cost Inflows IRR is the discount rate that forces PV inflows = cost.  This is the same as forcing NPV = 0.
NPV: Enter r, solve for NPV. 13 IRR:  Enter NPV = 0, solve for IRR. = NPV   Σ N t = 0 CF t (1 + r) t = 0   Σ N t = 0 CF t (1 + IRR) t

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What’s Franchise L’s IRR? 14 10 80 60 0 1 2 3 IRR = ? -100.00 PV 3 PV 2 PV 1 0 = NPV Enter CFs in CFLO, then press  IRR: IRR L  = 18.13%. IRR S  =  23.56%.
Find IRR if CFs are constant: 15   40 40   40 0 1 2 3 -100 Or, with CFLO, enter CFs and press  IRR = 9.70%. 3  -100      40         0         9.70% N I/YR PV PMT FV INPUTS OUTPUT

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If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns. Example: WACC = 10%, IRR = 15%. So this project adds extra return to shareholders. 16
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IFM10 Ch12 Lecture - Chapter 12 Capital Budgeting Decision...

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