Chapter 11 Capital Budgeting

whereas the IRR calculation is based on the assumption that cash flows can be reinvested at

the IRR

if projects are mutually exclusive and they differ in size, conflicts can arise. In such cases,

the NPV is best because it selects the project that maximizes value

The shorter the payback,

the better the project.

Three flaws to payback

(1) All dollars received in different years are given the same weight (i.e., the time value of money is ignored); (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 our investment. There is no necessary relationship between a given payback and investor wealth maximization, so we do not know what an acceptable payback is. The firm might use 2 years, 3 years, or any other number as the minimum acceptable payback; but the choice is arbitrary.

Our overall conclusions are that

(1) The MIRR is superior to the regular IRR as an indicator of a project's "true" rate of return. (2) NPV is better than IRR and MIRR when choosing among competing projects.

net present value profile

A graph showing the relationship between a project's NPV and the firm's cost of capital.

Calculating IRR on FC

Calculator solution. Enter the cash flows in the calculator's cash flow register just as we did to find the NPV; then press the button labeled "IRR."

The MIRR has two significant advantages over the regular IRR.

First, whereas the regular IRR assumes that the cash flows from each project are reinvested at the IRR, the MIRR assumes that cash flows are reinvested at the cost of capital (or some other explicit rate). Because reinvestment at the IRR is generally not correct, the MIRR is generally a better indicator of a project's true profitability. Second, the MIRR eliminates the multiple IRR problem—there can never be more than one MIRR, and it can be compared with the cost of capital when deciding to accept or reject projects.

measure profitability expressed as a percentage rate of return, which is useful to decision makers.

IRR and MIRR

is the single best criterion because it provides a direct measure of value the project adds to shareholder wealth.

NPV

crossover rate

The cost of capital at which the NPV profiles of two projects cross and, thus, at which the projects' NPVs are equal.

modified IRR (MIRR)

The discount rate at which the present value of a project's cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm's cost of capital.

internal rate of return (IRR)

The discount rate that forces a project's NPV to equal zero

payback period

The length of time required for an investment's cash flows to cover its cost.

discounted payback

The length of time required for an investment's cash flows, discounted at the investment's cost of capital, to cover its cost.

Two basic conditions cause NPV profiles to cross and thus lead to conflicts:

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. 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.

The NPV calculation is based on the assumption that cash inflows can be reinvested .

at the project's risk-adjusted WACC,

The discounted payback does consider capital costs, but it still

disregards cash flows beyond the payback year, which is a serious flaw.

PAYBACK METHODS PROVIDE information about

liquidity and risk

Problem with IRR

may have more than 1

MIRR stands for

modified internal rate of return

payback period formula =

number of years prior to full recovery+ (unrecovered cost at start of year/cash flow during full recovery year)

For independent projects with normal cash flows, the NPV, IRR, and MIRR always

reach the same accept/reject conclusion, so in these circumstances the three criteria are equally good.