Professional Documents
Culture Documents
Should we
build this
plant?
10-1
Learning Outcomes
Explain the capital budgeting process.
Learn different methods of capital budgeting
(NPV, IRR, MIRR, Payback period, Discounted
Payback & Profitability index.
Difference between independent project and
Mutually exclusive project.
Conflict between IRR and NPV decision.
Multiple IRR problem (mutually exclusive
project with different cash flow pattern/ projects
of different scale)
10-2
10-3
3.
4.
5.
10-4
Payback Period
Discounted Payback Period
Modified Internal Rate of Return (MIRR)
Profitability Index
10-5
10-6
Payback Period
The payback period is the number of years
required to recover the original investment in a
project. The payback period is based on cash
flows.
Payback
Period:
10-7
Calculating payback
Project L
CFt
Cumulative
PaybackL
Project S
CFt
Cumulative
PaybackS
0
-100
-100
== 2
2.4
10
-90
60
-30
100
0
80
30 / 80
1.6
-100
-100
== 1
70
-30
= 2.375 years
2
100 50
0 20
30 / 50
50
3
20
40
= 1.6 years
10-8
-100
-100
-100
Disc PaybackL ==
10
9.09
-90.91
+
60
49.59
-41.32
41.32 / 60.11
80
60.11
18.79
= 2.7 years
10-9
Self Test
Which of the following statements about the
payback period is NOT correct?
A) The payback method considers all cash flows
throughout the entire life of a project.
B) The payback period provides a rough measure of
a project's liquidity and risk.
C) The payback period is the number of years it
takes to recover the original cost of the investment.
The correct answer is A.
The payback period does not take any cash flows
after the payback point into consideration
10-10
Self Test
A company is considering the purchase of a copier that costs
$5,000. Assume a cost of capital of 10 percent and the following
cash flow schedule:
Year 1: $3,000
Year 2: $2,000
Year 3: $2,000
Determine the project's payback period and discounted payback
period.
Payback Period
Discounted Payback Period
A) 2.0 years
1.6 years
B) 2.0 years
2.4 years
C) 2.4 years
1.6 years
The correct answer is B
10-11
CFt
NPV
t
t 0 ( 1 k )
n
10-12
CFt
-100
10
60
80
NPVL =
PV of CFt
-$100
9.09
49.59
60.11
$18.79
NPVS = $19.98
10-13
= 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, would accept S if
mutually exclusive (NPVs > NPVL), and
would accept both if independent.
10-14
Self Test
A firm is reviewing an investment opportunity that
requires an initial cash outlay of $336,875 and promises
to return the following irregular payments:
Year 1: $100,000, Year 2: $82,000, Year 3: $76,000
Year 4: $111,000, & Year 5: $142,000
If the required rate of return for the firm is 8%, what is
the net present value of the investment?
Cash Flow PV of Cash flow at 8%
Year
A) $99,860.
-336,875.00
-336,875.00
0
100,000.00
92,592.59
1
B) $86,133.
82,000.00
70,301.78
2
76,000.00
60,331.25
3
C) $64,582.
111,000.00
81,588.31
4
142,000.00
96,642.81
5
The correct answer is C) $64,582.Net Present Value
64,581.74
In order to determine the net present value of the
investment, given the required rate of return; we can
discount each cash flow to its present value, sum the
present value, and subtract the required investment.
10-15
Self Test
Tapley Acquisition, Inc., is considering the purchase of
Tangent Company. The acquisition would require an initial
investment of $190,000, but Tapley's after-tax net cash flows
would increase by $30,000 per year and remain at this new
level forever. Assume a cost of capital of 15%. Should Tapley
buy Tangent?
A) No, because k > IRR.
B) Yes, because the NPV = $30,000.
C) Yes, because the NPV = $10,000.
The correct answer is C) Yes, because the NPV = $10,000.
This is perpetuity.
PV = PMT / I = 30,000 / 0.15 = 200,000
200,000 190,000 = 10,000
10-16
Self Test
An analyst has gathered the following data about a company
with a 12% cost of capital:
Cost
Life
Cash Flows
Project A
$15,000
5 Years
$5,000/Yr
Project B
$25,000
5 years
$7,500/Yr
CFt
0
t
(
1
IRR
)
t 0
n
10-18
Example: IRR
10-19
10-20
10-21
10-22
Self Test
10-23
NPV Profiles
A graphical representation of project NPVs at
various different costs of capital.
k
0
5
10
15
20
NPVL
$50
33
19
7
(4)
NPVS
$40
29
20
12
5
10-24
.
40 .
50
30
.
.
20
10
IRRL = 18.1%
..
0
5
10
15
.
.
20
IRRS = 23.6%
Discount Rate (%)
23.6
-10
10-25
10-26
Self Test
The underlying cause of ranking conflicts between the net present
value (NPV) and internal rate of return (IRR) methods is the
underlying assumption related to the:
A) initial cost.
B) cash flow timing.
C) reinvestment rate.
The correct answer is C) reinvestment rate.
The IRR method assumes all future cash flows can be reinvested at
the IRR. This may not be feasible because the IRR is not based on
market rates. The NPV method uses the weighted average cost of
capital (WACC) as the appropriate discount rate.
10-28
10-29
Calculating MIRR
0
10%
-100.0
10.0
60.0
80.0
66.0
12.1
10%
10%
MIRR = 16.5%
-100.0
PV outflows
$100 =
$158.1
(1 + MIRRL)3
158.1
TV inflows
MIRRL = 16.5%
10-30
10-31
10-32
10-33