FINA Chapter 11

Reinvestment Rate Assumptions

-NPV calc is based on assumption that cash inflows can be reinvested at projects risk adjusted WACC -IRR calculation is based on assumption that cash flows can be invested at IRR -When we calculate PV we are assuming that CF's can be reinvested at a specified interest rate

Project Categories

-Replacement needed to continue operations -Replacement: cost reduction -Expansion of existing products & markets -Expansion into new products or markets -Safety and/or environmental projects -Other Projects -Mergers

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?"

Non-Normal 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.

Crossover Rate

the cost of capital at which the NPV profiles of the two projects cross and the projects NVPs are equal

IRR

(internal rate of return) is the discount rate that forces PV of inflows equal to cost, and the NPV = 0

NPV

(net present value) the difference between the present value of cash inflows and the present value of cash outflows.

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.

3 Flaws of Payback

1) All $ received in different years receives the same weight 2) Cash flows beyond period are given no consideration 3) Unlike NPV and IRR, payback only tells us when we are going to recover our investment.

What causes NPV profiles to cross?

1) Timing differences If most of the cash flows from one project come in early while most of those from the other project come in later, as occurred with Projects S and L, the NPV profiles may cross and result in a conflict. 2) Project size (or scale) differences If the amount invested in one project is larger than the other, this too can lead to profile crossing and a resulting conflict. -if projects don't cross then one dominates the other

NPV Profile

A graph showing the relationship between a projects NPV and the firms cost of capital

Normal Cash Flow Stream

Cost (negative CF) followed by a series of positive cash inflows. One change of signs.

IRR Method Rationale

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

NPV Method Rationale

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.

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.

Discounted Payback

Length of time required for an investments CF's discounted at the investments cost of capital to cover its costs -a "break even" calculation

5 Capital Budgeting Methods

Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Payback Discounted Payback

S/W 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.

MIRR (modified)

The discount rate that causes the PV of a project's terminal value (TV) to equal the PV of costs. assumes cash flows are reinvested at the WACC -avoids multiple IRR problem

Capital Budgeting

analyzing projects & deciding which ones to pursue. (to include in capital budget) Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm's future.