Chapter 11 Flashcards
What is capital budgeting?
- Analysis of potential additions to fixed assets
- Long-term decisions; involve large expenditures
- Very important to firm’s future
Steps to Capital Budgeting
- 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
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
Normal Cash Flow Stream
- Cost (negative CF) followed by a series of positive cash inflows
- One change of signs
***Cost (negative CF), then string of positive CFs, then cost to close project
Nonnormal Cash Flow Stream
Two or more changes of signs
Net Present Value (NPV)
Sum of the PVs of all cash inflows and outflows of a project
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 project with the highest positive NPV, one that adds the most value
How is a project’s IRR similar to a bond’s 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
Rationale for the IRR Method
- If IRR > WACC, the project’s return exceeds its costs and there is some return left over to boost stockholders’ returns
- If IRR > WACC, accept project
- If IRR < WACC, reject project
Independent Projects (NPV/IRR)
NPV and IRR always lead to the same accept/reject decision for any given independent project
Finding the Crossover Rate
- Find cash flow differences between the projects. See Slide 11-8
- Enter the CFs in CFj register, then press IRR
- If profiles don’t cross, one project dominates the other
Reasons Why NPV Profiles Cross
- Size (scale) differences: The smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high WACC favors small projects
- Timing differences: The project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF especially good, NPVS > NPVL
Reinvestment Rate Assumptions
- NPV method assumes CFs are reinvested at the WACC
- 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
Managers prefer the IRR to the NPV method; is there a better IRR measure?
- Yes, MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC
- MIRR assumes cash flows are reinvested at the WACC
Why use MIRR versus IRR?
- MIRR assumes reinvestment at the opportunity cost = WACC. MIRR also avoids the multiple IRR problem
- Managers like rate of return comparisons, and MIRR is better for this than IRR
What is the payback period?
- The number of years required to recover a project’s cost, or “How long does it take to get our money back?”
- Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive
Discounted Payback Period
Uses discounted cash flows rather than raw CFs
Strengths of Payback
- Provides an indication of a project’s risk and liquidity
- Easy to calculate and understand
Weaknesses of Payback
- Ignores the time value of money (TVM)
- Ignores CFs occurring after the payback period
- No relationship between a given payback and investor wealth maximization
***Discounted payback considers TVM, but other 2 flaws remain
Why are there multiple IRRs?
- At very low discount rates, the PV of CF2 is large and negative, so NPV < 0
- At very high discount rates, the PV of both CF1and CF2 are low, so CF0 dominates and again NPV < 0
- In between, the discount rate hits CF2 harder than CF1, so NPV > 0
When to use the MIRR instead of the IRR?
When there are nonnormal CFs and more than one IRR, use MIRR
