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1 Unit 11
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3 Tool Kit for The Basics of Capital Budgeting: Evaluating Cash Flows
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5 In this file we use Excel to do most of the calculations explained in Chapter 10. First, we analyze Projects S and L,
6 whose cash flows are shown immediately below in both tabular and a time line formats. Spreadsheet analyses can be
7 set up vertically, in a table with columns, or horizontally, using time lines. For short problems, with just a few years,
8 we generally use the time line format because rows can be added and we can set the problem up as a series of income
statements. For long problems, it is often more convenient to use a tabular layout.
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11 Expected after-tax Project S
12 net cash flows (CF t)
13 Year (t) Project S Project L 0 1 2 3 4
14 0 ($1,000) ($1,000) (1,000) 500 400 300 100
15 1 500 100
16 2 400 300 Project L
17 3 300 400
18 4 100 600 0 1 2 3 4
19 (1,000) 100 300 400 600
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22 Capital Budgeting Decision Criteria
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24 Here are the five key methods used to evaluate projects: (1) payback period, (2) discounted payback period, (3) net
25 present value, (4) internal rate of return, and (5) modified internal rate of return. Using these criteria, financial
26 'analysts seek to identify those projects that will lead to the maximization of the firm's stock price.
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28 Payback Period
29 The payback period is defined as the expected number of years required to recover the investment, and it was the
30 first formal method used to evaluate capital budgeting projects. First, we identify the year in which the cumulative
31 cash inflows exceed the initial cash outflows. That is the payback year. Then we take the previous year and add to
32 it unrecovered balance at the end of that year divided by the following year's cash flow. Generally speaking, the
33 shorter the payback period, the better the investment.
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35 Project S
36 Time period: 0 1 2 3 4
37 Cash flow: (1,000) 500 400 300 100
38 Cumulative cash flow: (1,000) (500) (100) 200 300 Click fx > Logical > AND > OK to get dialog box.
39 FALSE FALSE FALSE TRUE FALSE Use Logical "AND" to determine Then specify you want TRUE if cumulative CF > 0 but the previous CF < 0.
40 0.00 0.00 0.00 2.33 0.00 the first positive cumulative CF. There will be one TRUE.
41 Payback: 2.33 Use Logical IF to find the Payback.Click fx > Logical > IF > OK. Specify that if true, the payback is the previous year plus a fraction, if false, then 0.
42 Use Statistical Max function to Click fx > Statistical > MAX > OK > and specify range to find Payback.
43 Alternative calculation: 2.33 display payback.
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45 Project L
46 Time period: 0 1 2 3 4
47 Cash flow: (1,000) 100 300 400 600
48 Cumulative cash flow: (1,000) (900) (600) (200) 400
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50 Payback: 3.33 Uses IF statement.
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A B C D E F G H I J K L M N O P Q R S T U V W
52 Discounted Payback Period
53 Discounted payback period uses the project's cost of capital to discount the expected cash flows. The calculation of
54 discounted payback period is identical to the calculation of regular payback period, except you must base the
55 calculation on a new row of discounted cash flows. Note that both projects have a cost of capital of 10%.
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57 WACC = 10%
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59 Project S
60 Time period: 0 1 2 3 4
61 Cash flow: (1,000) 500 400 300 100
62 Disc. cash flow: (1,000) 455 331 225 68 Cash Flows Discounted back at 10%.
63 Disc. cum. cash flow: (1,000) (545) (215) 11 79
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65 Discounted Payback: 2.95 Uses IF statement.
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67 Project L
68 Time period: 0 1 2 3 4
69 Cash flow: (1,000) 100 300 400 600
70 Disc. cash flow: (1,000) 91 248 301 410
71 Disc. cum. cash flow: (1,000) (909) (661) (361) 49
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73 Discounted Payback: 3.88 Uses IF statement.
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75 The inherent problem with both paybacks is that they ignore cash flows that occur after the payback period mark.
76 While the discounted method accounts for timing issues (to some extent), it still falls short of fully analyzing projects.
77 However, all else equal, these two methods do provide some information about projects' liquidity and risk.
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79 Net Present Value (NPV)
80 To calculate the NPV, we find the present value of the individual cash flows and find the sum of those discounted
81 cash flows. This value represents the value the project add to shareholder wealth.
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83 WACC = 10%
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85 Project S
86 Time period: 0 1 2 3 4 Notice that the NPV function isn't really a Net present value.
87 Cash flow: (1,000) 500 400 300 100 Instead, it is the present value of future cash flows. Thus, you
88 Disc. cash flow: (1,000) 455 331 225 68 specify only the future cash flows in the NPV function. To find the
89 true NPV, you must add the time zero cash flow to the result of the
90 NPV(S) = $78.82 = Sum disc. CF's. or $78.82 = Uses NPV function. NPV function.
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92 Project L
93 Time period: 0 1 2 3 4
94 Cash flow: (1,000) 100 300 400 600
95 Disc. cash flow: (1,000) 91 248 301 410
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97 NPV(L) = $49.18 $ 49.18 = Uses NPV function.
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The NPV method of capital budgeting dictates that all independent projects that have positive NPV should accepted.
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The rationale behind that assertion arises from the idea that all such projects add wealth, and that should be the
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overall goal of the manager in all respects. If strictly using the NPV method to evaluate two mutually exclusive
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projects, you would want to accept the project that adds the most value (i.e. the project with the higher NPV).
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Hence, if considering the above two projects, you would accept both projects if they are independent, and you would
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only accept Project S if they are mutually exclusive.
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A B C D E F G H I J K L M N O P Q R S T U V W
106
107 Internal Rate of Return (IRR)
108 The internal rate of return is defined as the discount rate that equates the present value of a project's cash inflows to
109 its outflows. In other words, the internal rate of return is the interest rate that forces NPV to zero. The calculation
110 for IRR can be tedious, but Excel provides an IRR function that merely requires you to access the function and
111 enter the array of cash flows. The IRR's for Project S and L are shown below, along with the data entry for Project
112 S.
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114 Expected after-tax
115 net cash flows (CF t)
116 Year (t) Project S Project L
117 0 ($1,000) ($1,000) The IRR function assumes
118 1 500 100 IRR S = 14.49% payments occur at end of
119 2 400 300 IRR L = 11.79% periods, so that function does
120 3 300 400 not have to be adjusted.
121 4 100 600
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Notice that for IRR you must
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specify all cash
126 flows, including the time zero
127 cash flow. This is in contrast
128 to the NPV function, in which
129 you specify only the future
130 cash flows.
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134
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137 The IRR method of capital budgeting maintains that projects should be accepted if their IRR is greater than the cost
138 of capital. Strict adherence to the IRR method would further dictate that mutually exclusive projects should be
139 chosen on the basis of the greatest IRR. In this scenario, both projects have IRR's that exceed the cost of capital
140 (10%) and both should be accepted, if they are independent. If, however, the projects are mutually exclusive, we
141 would chose Project S. Recall, that this was our determination using the NPV method as well. The question that
142 naturally arises is whether or not the NPV and IRR methods will always agree.
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144 When dealing with independent projects, the NPV and IRR methods will always yield the same accept/reject result.
145 'However, in the case of mutually exclusive projects, NPV and IRR can give conflicting results. One shortcoming of
146 the internal rate of return is that it assumes that cash flows received are reinvested at the project's internal rate of
147 return, which is not usually true. The nature of the congruence of the NPV and IRR methods is further detailed in a
148 latter section of this model.
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A B C D E F G H I J K L M N O P Q R S T U V W
150 Multiple IRR's
151 Because of the mathematics involved, it is possible for some (but not all) projects that have more than one change of signs in the
152 set of cash flows to have more than one IRR. If you attempted to find the IRR with such a project using a financial calculator,
153 you would get an error message. The HP-10B says "Error - Soln", the HP-17B says '"Many/No Solutions, and the HP12C says
154 Error 3; Key in Guess" when such a project is evaluated. The procedure for correcting the problem isto store in a guess for the
155 IRR, and then the calculator will report the IRR that is closest to your guess. You can then use a different "guess" value, and
156 you should be able to find the other IRR. However, the nature of the mathematics creates a scenario in which one IRR is quite
157 extraordinary (often, a few hundred percent).
158 Consider the case of Project M.
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160 Project M: 0 1 2
161 (1.6) 10 (10)
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163 We will solve this IRR twice, the first time using the default guess of 10%, and the second time we will enter a guess
164 of 300%. Notice, that the first IRR calculation is exactly as it was above.
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1
166 IRR M = 25.0%
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171 IRR M 2 = 400%
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181 The two solutions to this problem tell us that this project will have a positive NPV for all costs of capital between
182 '25% and 400%. We illustrate this point by creating a data table and a graph of the project NPVs.
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184 Project M: 0 1 2
185 (1.6) 10 (10)
186 r = 25.0%
187 NPV = 0.00
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A B C D E F G H I J K L M N O P Q R S T U V W
189 NPV
190 r $0.0 Multiple Rates of Return
191 0% (1.60)
192 25% 0.00 $1.50
193 50% 0.62
194 75% 0.85 $1.00
195 100% 0.90 Max.
196 125% 0.87 $0.50
197 150% 0.80
198 175% 0.71 $0.00
199 200% 0.62 -100% 0% 100% 200% 300% 400% 500%
200 225% 0.53 -$0.50
201 250% 0.44
202 275% 0.36 -$1.00
203 300% 0.28
204 325% 0.20 -$1.50
205 350% 0.13
206 375% 0.06 -$2.00
207 400% 0.00
208 425% (0.06)
209 450% (0.11)
210 475% (0.16)
211 500% (0.21)
212 525% (0.26)
213 550% (0.30)
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215 NPV Profiles
216 NPV profiles graph the relationship between projects' NPVs and the cost of capital. To create NPV profiles for
217 Projects S and L, we create data tables of NPV at different costs of capital.
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219 Net Cash Flows
220 Year Project S Project L WACC = 10.0%
221 0 -$1,000 -$1,000 Project S Project L
222 1 $500 $100 NPV = $78.82 $49.18
223 2 $400 $300 IRR = 14.49% 11.79%
224 3 $300 $400 Crossover = 7.17%
225 4 $100 $600
226 Data Table used to make graph:
227 Project NPVs
228 Project S's Both Projects' Profiles S L
NPV Profile
229 WACC $78.82 $49.18
230 $400 $600 0% $300.00 $400.00
231 Conflict 5% $180.42 $206.50
NPVs No conflict
232 $300 $400 NPVL 7.17% $134.40 $134.40
Accept Reject
233 10% $78.82 $49.18
$200
234 $200 11.79% $46.10 $0.00
NPV
NPV