Chapter 10 - Capital Budgeting

interanl rate of return method

(IRR) - the discount rate that equatres the repsent value of the expected future cash inflows and outflows. IRR Measures the rate of return on a project, but it assumes that all cash flows can be reinvested at the IRR rate. defined as the discount rate that forces a project's NPV to equal zero. The project should be accepted if the IRR is greater than the cost of capital.

net presente value method

(Net present value) - The present valueof the proects expected future cash flows, discounted at the approopriate cost of capital. NPV is a direct measure of the project to shareholders. method? is calculated by discounting of the project's cash flows at the project's cost of capital and then summing those cash flows. The project should be accepted if the NPV is positive because such a project increases shareholders' value.

What are some possible reasons that a pojects might have a high NPV?

1)The project has a competitive edge above other projects from other projects of competitors and hence higher free cash flow will be generated which will result in higher NPV. 2) When the WACC of a project is low if the company gets access to cheaper source of debt and equity then NPV will be higher

What three flwas does the regular payback method have? Does the discounted payback method correct all these flaws?

1. All dollars received in different years are given in the same weight (biased against long term projects) 2. Cash flows beyond the payback year are given no consideration regardless of how large they might be 3. Unlike the NPV, which tells us how much wealth a project adds, and the IRR, which tells us how much a project yields over the cost of capital, the payback merely tells us when we will recover an investment 4. May reject positive NPV projects

Describe in words how an NPV profile is constructed. How do you determine the intercepts ofr the x axis and the y axis?

1. Find the project's NPV at a number of different discount rates and then plot those values to create a graph 2. Y-Intercept: A zero cost of capital, NOV is net total of undercounted cash flows 3. X-Intercept: Discount rate at which the profile crosses the horizontal axis is the project's IRR

Whats the primary difference between the MIRR and the regular IRR?

1. MIRR: Discount rate at which present value of its terminal value is found as the sum of the future values of the cash inflows, compounded at the firm's cost of capital. 2. It is similar to the IRR except that it is based on the assumption that cash flows are reinvested at the WACC (or some other explicit rate that is a more reasonable assumption)

What two characteristic can lead to conflict between the NPV and the IRR when evaluating mutually exclusive projects?

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, 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 profiles crossing and a resulting conflict

replacement chain

A method of comparing mutually exclusive projects that have unequal lives. Each project is replicated so that they will both terminate in a common year. If projects with lives of 3 years and 5 years are being evaluated, then the 3 year project would be replicated 5 times and the 5 year project replicated 3 times, thus; both projects would terminate in 15 years.

normal cash flow projects

A project with one or more cash outflows (costs) followed by a series of cash inflows. Note that signs of the cash flows change only once, when they go from negative or positive ( or from positive to negative)

modified internal rate of return (MIRR)

Assumes that cash flows from all projects are reinvested at the cost of capital, not at the projects own IRR. This makes the modified interregnal rate of return a better indicator of a proejcts true profitbability. Unlike the IRR, a project never has more than one modified IRR (MIRR). MIRR requires finding the terminal value of the cash inflows, compounding them at the firm's cost of capital, and then determining the discount rate that forces the present value of the TV to equal the present value of the outflows.

What is the crossover rate, and how does it interact with the cost of capital to determine whether or not a conflict exists between NPV and IRR?

Crossover rate: cost of capital at which the NPV profiles of two projects cross and thus, at which the project's NPV's are equal. Calculated by IRR of differences in projects' cash flows

multiple IRRs

Existence of more than one internal rate of return based on projects cash flows and can occur when a project has nonnormal cash flows. In this situation, none of the calculated IRRs provide useful information.

NPV Profile

Graph showing a project's NPV on the y axis for different costs of capital on the x axis.

Briefly describe the replacement chain (commenad life) approach, and then differentiate it from the equivalent annual annuity (EAA) approach

If mutually exclusive projects have unequal lives, it may be necessary to adjust the analysis to put the projects on an equal-life basis. This can be done using the replacement chain (common life) approach or the equivalent annual annuity (EAA) method. replacement chain - EAA -

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.

Describe the advantages and disadvantages of the six capital budgetnig methods

NPV IRR MIRR PI payback discounted payback.

Should capital budgeting decisions be made solely on teh basic of a projects NPV, with no regard to the other criteria?

It is easy to calculate all of them, all should be considered when capital budgeting decisions are made. For most decisions, the greatest weight should be given to NPV, but it would be foolish to ignore the information by other criteria

What condition regatding cash flows would cause more than one IRR to exist?

One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life.

independent projects

Projects that can be accpeted or rejected individually The NPV and IRR methods make the same accept/reject decisions for independent projects,

mutually excusive projects

Projects that cannot be performed at the same time. A company could choose either Porject 1 or Proehct 2, or it can rehect both but it acnnot accept both projects. if projects are mutually exclusive, then ranking conflicts can arise. In such cases, the NPV method should generally be relied upon.

nonnormal cash flow projects

Projects with cash flows that change signs more than once. For example, cash flow is negative at beginning of the project, it becomes positive, and then becomes negative again. Nonnormal cash flows can have multiple internal rates of return.

Why is NPV the primary capital budgeting decision criterion?

Tells us how a project contributes to shareholder wealth - the alrger the PNV, the mroe value the project adds, and added value measn a higher stock price.

Reinvestment rate assumtion

The basic cause of the conflict is differing reinvestment rate assumptions between NPV and IRR: NPV assumes that cash flows can be reinvested at the cost of capital, whereas IRR assumes that reinvestment yields the (generally) higher IRR. The high reinvestment rate assumption under IRR makes early cash flows especially valuable, so short-term projects look better under IRR.

crossover rate

The cost of capital at which the NPV profiles for two projects intersect. One project has a higher NPV below the crossover rate but the other projects has a higher NPV above the crossover rate.

discounted payback period

The number of eyars it takes a firm to recover its project invesment based on discounted cash flows. similar to the regular payback except that it discounts cash flows at the project's cost of capital. It considers the time value of money, but it still ignores cash flows beyond the payback period.

economic life

The number of years a project should be operated to maximize its net present value; often less then the maximum potential life.

payback period

The number of years it takes a firm to recover its project investment. Payback does not capture a project's entire cash flow stream and it thus not the preferred evaluation method. Note, however, that the payback does measure a project's liquidity, so many firms use it as a risk measure. as the number of years required to recover a project's cost. The regular payback method has three flaws: It ignores cash flows beyond the payback period, it does not consider the time value of money, and it doesn't give a precise acceptance rule. The payback method does, however, provide an indication of a project's risk and liquidity because it shows how long the invested capital will be tied up.

Capital Budgeting

The whole process of analyzing projects and deciding whether they should be included in the planned expedntiures on fixed assets is the process of analyzing potential projects. Capital budgeting decisions are probably the most important ones that managers must make.

In what sense is a projects IRR similiat to the YTM on a bond?

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.

equivalent annual annuity (EAA)

Use to compare mutually exclusive prjects with different lifespans. Convert the unequal annual cash flows of a project into a constant cash flow stream (Ie, an annuity) whose NPV is equal to the NPV of the initial stream. Do for both projects and compare the annuities.

Differentiate between a projects physical life and its economic life

a project's true value may be greater than the NPV based on its physical life if it can be terminated at the end of its economic life.

what factors can lead to an increasing marginal cost of capital? How might this affect capital budgeting?

cost of capital may increase as the capital budget increases—this is called an increasing marginal cost of capital

profitability index (PI)

found by dividing the projects present value of furutre cash flows by its initial cost. A profitbabilty index greater than 1 is equivalent toa poecjts positive net present value is calculated by dividing the present value of cash inflows by the initial cost, so it measures relative profitability—that is, the amount of the present value per dollar of investment.

What is capital rationing?

occurs when management places a constraint on the size of the firm's capital budget during a particular period.

capital rationing

occurs when management places a constraint on the size of the firm's capital budget during a particular period.

What are three explantionas for capital rationing? How might firms otherwise handle these situations?

reluctance to issue new stock, constraints on nonmonetary resources, controlling estimation bias.

What is the first step in project analysis?

to estimate the project's expected cash flows.