UNIVERSITY OF TECHNOLOGY, JAMAICA

SCHOOL OF BUSINESS ADMINISTRATION

CORPORATE FINANCE
Unit 2 Study Guide

Capital Budgeting

What is capital budgeting?

• Analysis of potential additions to fixed assets.

• Long-term decisions; involve large expenditures.
• Very important to firm’s future.

Capital budgeting involves the decision making process with respect to the investment in fixed assets;
specifically, it involves measuring the incremental cash flows associated with investment proposals
and evaluating the attractiveness of these cash flows relative to the project's costs.

Capital Budgeting: The process of planning for purchases of long-term assets.

For example: Suppose our firm must decide whether to purchase a new plastic molding
machine for $125,000. How do we decide?

 Will the machine be profitable?

 Will our firm earn a high rate of return on the investment?

Decision-making Criteria in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected?

 The ideal evaluation method should:

a) include all cash flows that occur during the life of the project,
b) consider the time value of money, and
c) incorporate the required rate of return on the project.

Steps to Capital Budgeting

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.

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.

What is the difference between normal and nonnormal cash flow streams?

• Normal cash flow stream: Cost (negative CF) followed by a series of positive cash
inflows. One change of signs.
• Nonnormal cash flow stream: Two or more changes of signs. Most common: Cost
(negative CF), then string of positive CFs, then cost to close project. Examples include
nuclear power plant, strip mine, etc.

Net Present Value (NPV)

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 • Sum of the PVs of all cash inflows and outflows of a project:

N
CF t
NPV =∑
t=0 ( 1 + r )t
Example

Projects we’ll examine:

Cash Flow
Year L S DCF
0 -100 -100 0
1 10 70 -60
2 60 50 10
3 80 20 60

DCF is the difference between CFL and CFS. We’ll use DCF later.

What is Project L’s NPV?

WACC = 10%

What is Project S’ NPV?

WACC = 10%

Year CFt PV of CFt

0 100 $100.00
1 70 63.64
2 50 41.32
3 20 15.02
NPV=S$ 19.98

Solving for NPV:

Financial Calculator Solution

Enter CFs into the calculator’s CFLO register.

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

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 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, accept S if mutually exclusive (NPVS > NPVL), and accept both if
independent.

Internal Rate of Return (IRR)

• IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:
N
CF t
0 =∑
t=0 (1 + IRR )t
Solving for IRR with a financial calculator:

– Enter CFs in CFLO register.

– Press IRR; IRRL = 18.13% and
IRRS = 23.56%.

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.

• EXAMPLE: Suppose a 10-year bond with a 9% annual coupon and $1,000 par value sells
for $1,134.20.
– Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

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.
• If projects are independent, accept both projects, as both IRR > WACC = 10%.
• If projects are mutually exclusive, accept S, because IRRs > IRRL.

NPV Profiles

• A graphical representation of project NPVs at various different costs of capital.

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 Independent Projects

NPV and IRR always lead to the same accept/reject decision for any given independent project.

Mutually Exclusive Projects

Finding the Crossover Rate

• Find cash flow differences between the projects.

• Enter the DCFs in CFj register, then press
n IRR. Crossover rate = 8.68%, rounded to 8.7%.
• 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.

Since 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.

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 Calculating MIRR

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?” How long will it take for the project to generate enough cash to pay
for itself?
• Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for
the project turns positive.

Calculating Payback

 Is a 2.375 year or 1.600 year payback period good?

 Is it acceptable?
 Firms that use this method will compare the payback calculation to some standard set by
the firm.
 If senior management had set a cut-off of 5 years for projects like ours, what would be
our decision?
 Accept the project.

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 Strengths and Weaknesses of Payback

• Strengths
– Provides an indication of a project’s risk and liquidity.
– Easy to calculate and understand.

• Weaknesses
– Ignores the time value of money.
– Ignores CFs occurring after the payback period.
– Firm cutoffs are subjective.
– Does not consider any required rate of return.

Discounted Payback Period

Uses discounted cash flows rather than raw CFs.

Discounted Payback

 Discounts the cash flows at the firm’s required rate of return.

 Payback period is calculated using these discounted net cash flows.
Problems:
 Cutoffs are still subjective.
 Still does not examine all cash flows.

Find Project P’s NPV and IRR

Project P has cash flows (in 000s): CF0 = -$800, CF1 = $5,000, and CF2 = -$5,000.

• Enter CFs into calculator CFLO register.

• Enter I/YR = 10.
• NPV = -$386.78.
• IRR = ERROR Why?

Multiple IRRs

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 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 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.

When to use the MIRR instead of the IRR? Accept Project P?

• When there are nonnormal CFs and more than one IRR, use MIRR.
– PV of outflows @ 10% = -$4,932.2314.
– TV of inflows @ 10% = $5,500.
– MIRR = 5.6%.

• Do not accept Project P.

– NPV = -$386.78 < 0.
– MIRR = 5.6% < WACC = 10%.

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 Unit 2 Tutorial

1. Define the reinvestment rate assumption. What is the underlying assumption for NPV and
IRR? Which assumption is most acceptable? How does the MIRR adjust the reinvestment
rate assumption of IRR?
2. How is a project classification scheme (for example, replacement, expansion into new
markets, and so forth) used in the capital budgeting process?

3. What does it mean for projects to be mutually exclusive? How should managers rank
mutually exclusive projects?

4. A firm has a $100 million capital budget. It is considering two projects that each cost $100
million. Project A has an IRR of 20 percent, an NPV of $9 million, and will be terminated
after 1 year at a profit of $20 million, resulting in an immediate increase in EPS. Project B,
which cannot be postponed, has an IRR of 30 percent and an NPV of $50 million. However,
the firm’s short-run EPS will be reduced if it accepts Project B, because no revenues will be
generated for several years.

a. Should the short-run effects on EPS influence the choice between the two projects?
b. How might situations like this influence a firm’s decision to use payback?

5. Project K costs $52,125, its expected net cash inflows are $12,000 per year for 8 years, and
its WACC is 12 percent.

a. What is the project’s NPV?

b. What is the project’s IRR?

c. What is the project’s MIRR?

d. What is the project’s payback?

e. What is the project’s discounted payback?

6. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions
and an individual’s investment decisions?

7. What is the difference between independent and mutually exclusive projects? Between projects
with normal and nonnormal cash flows?