1) The document discusses various methods for evaluating capital budgeting projects, such as net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), profitability index (PI), and payback period.
2) It notes that NPV is the best method as it directly measures the value added to shareholders, but IRR, MIRR and PI also provide useful information about a project's profitability and "safety margin."
3) Multiple IRRs can be a potential problem with IRR that MIRR and NPV do not have. NPV should be used over IRR when choosing between mutually exclusive projects.
1) The document discusses various methods for evaluating capital budgeting projects, such as net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), profitability index (PI), and payback period.
2) It notes that NPV is the best method as it directly measures the value added to shareholders, but IRR, MIRR and PI also provide useful information about a project's profitability and "safety margin."
3) Multiple IRRs can be a potential problem with IRR that MIRR and NPV do not have. NPV should be used over IRR when choosing between mutually exclusive projects.
1) The document discusses various methods for evaluating capital budgeting projects, such as net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), profitability index (PI), and payback period.
2) It notes that NPV is the best method as it directly measures the value added to shareholders, but IRR, MIRR and PI also provide useful information about a project's profitability and "safety margin."
3) Multiple IRRs can be a potential problem with IRR that MIRR and NPV do not have. NPV should be used over IRR when choosing between mutually exclusive projects.
The Basic of Capital Budgeting; Evaluating Cash Flows
• Corporate Valuation and Capital Budgeting
• the project’s cash flows are discounted at the appropriate risk-adjusted weighted average cost of capital • Subtracting the initial cost of the project from the discounted cash flows gives the project’s net present value (NPV). Overview of Capital Budgeting
• firms generally categorize projects and analyze those in each
category somewhat differently: • Replacement needed to continue profitable operations. • Replacement to reduce costs • Expansion of existing products or markets. • Expansion into new products or markets. • Contraction decisions. • Safety and/or environmental projects. • Mergers. The First Step in Project Analysis the evaluation measures
• 1.Net Present Value (NPV)
• 2. Internal Rate of Return (IRR) • 3. Modified Internal Rate of Return (MIRR) • 4. Profitability Index (PI) • 5. Regular Payback • 6. Discounted Payback Net Present Value (NPV) • The net present value (NPV) is defined as the present value of a project’s expected cash flows (including its initial cost) discounted at the appropriate risk-adjusted rate. Net Present Value (NPV)
• Calculate the present value of each cash flow
discounted at the project’s risk- adjusted cost of capital, • The sum of the discounted cash flows is defined as the project’s NPV. Applying NPV as an Evaluation Measure What should the decision be if Projects S and L are independent? • NPV Decision Rules • Independent projects • Mutually exclusive projects Internal Rate of Return (IRR)
A project’s IRR is the discount rate that forces the PV
of the inflows to equal the initial cost The IRR is an estimate of the project’s rate of return, and it is comparable to the YTM on a bond. Internal Rate of Return A Potential Problem with the IRR: Multiple Internal Rates of Return
• Normal: -+++or --+++or ++--
• Nonnormal: -++++-or -+++-+++ Multiple Internal Rate of Return • One problem with the IRR is that, under certain conditions, a project may have more than one IRR. A Potential Problem with the IRR: Multiple Internal Rates of Return • Potential Problems When Using the IRR to Evaluate Mutually Exclusive Projects
• RESOLVING A CONFLICT BETWEEN THE IRR AND NPV FOR
MUTUALLY EXCLUSIVE PROJECTS: PICK THE PROJECT WITH THE HIGHEST NPV • RESOLVING A CONFLICT BETWEEN THE IRR AND NPV FOR MUTUALLY EXCLUSIVE PROJECTS: PICK THE PROJECT WITH THE HIGHEST NPV • choose the project that provides the greatest increase in wealth • THE CAUSES OF POSSIBLE CONFLICTS BETWEEN THE IRR AND NPV FOR MUTUALLY EXCLUSIVE PROJECTS: TIMING AND SCALE DIFFERENCES Multiple Internal Rate of Return • Reinvestment Rate Assumptions • The NPV calculation is based on the assumption that cash inflows can be reinvested at the project’s risk- adjusted WACC, whereas the IRR calculation is based on the assumption that cash flows can be reinvested at the IRR itself. Modified Internal Rate of Return (MIRR) • The IRR overstates the expected return for accepted projects because cash flows cannot generally be reinvested at the IRR itself • MIRR; assumption that cash flows are reinvested at WACC • discount rate that will cause the PV of the terminal value to equal the cost. That interest rate is defined as the Modified Inter- nal Rate of Return (MIRR). Modified Internal Rate of Return (MIRR)
• MIRR has two significant advantages
• MIRR assumes that cash flows are reinvested at the cost of capital • MIRR eliminates the multiple IRR problem • Is MIRR as good as the NPV? • For independent projects, the NPV, IRR, and MIRR always reach the same accept–reject conclusion • if projects are mutually exclusive and if they differ in size, conflicts can arise. In such cases the NPV is best because it selects the project that maximizes value. Modified Internal Rate of Return (MIRR)
(1) the MIRR is superior to the regular IRR as an indicator of a project’s
“true” rate of return, but (2) NPV is better than either IRR or MIRR when choosing among competing projects. If managers want to know the ex- pected rates of return on projects, it would be better to give them MIRRs than IRRs because MIRRs are more likely to be the rates that are actually earned if the projects’ cash flows are reinvested in future projects. Profitability Index (PI) • The profitability index (PI) measures how much value a project creates for each dollar of the project’s cost. • A project is acceptable if its PI is greater than 1.0; and the higher the PI, the higher the project’s ranking Profitability Index (PI) Payback Period • defined as the number of years required to recover the funds invested in a project from its operating cash flows. • We start with the project’s cost, a negative number, and then add the cash inflow for each year until the cumulative cash flow turns positive. The payback year is the year prior to full recovery, plus a fraction equal to the shortfall at the end of the prior year divided by the cash flow during the year when full recovery occurs Payback Period Payback Period • The regular payback has three flaws: • (1) Dollars received in different years are all given the same weight—that is, the time value of money is ignored. • (2) Cash flows beyond the payback year are given no consideration whatsoever, regardless of how large they might be. • (3) Unlike the NPV or the IRR, which tell us how much wealth a project adds or how much a project’s rate of return exceeds the cost of capital, the payback merely tells us how long it takes to recover our investment. discounted payback, where cash flows are discounted at the WACC, and then those discounted cash flows are used to find the payback. A Comparison of the Methods • NPV is the single best criterion because it provides a direct measure of the value a project adds to shareholder wealth. • IRR and MIRR measure profitability expressed as a percentage rate of return, which decision makers like to consider. • The PI also measures profitability but in relation to the amount of the investment. • IRR, MIRR, and PI all contain information concerning a project’s “safety margin.” • One cannot know at Time 0 the exact cost of future capital or the exact future cash flows. These inputs are simply estimates, and if they turn out to be incorrect then so will be the calculated NPVs and IRRs. Conclusion On Capital Budgeting Method • All companies would have the same opportunities, and competition would quickly eliminate any positive NPV. The existence of positive- NPV projects must be predicated on some imperfection in the marketplace, and the longer the life of the project, the longer that imperfection must last • managers should be able to identify the imperfection and explain why it will persist before accepting that a project will really have a positive NPV • 1) If you can’t identify the reason a project has a positive projected NPV, then its actual NPV will probably not be positive. • (2) Positive NPV projects don’t just happen—they result from hard work to develop some competitive advantage. • (3) Some competitive advantages last longer than others, with their durability depending on competitors’ ability to replicate them. Decision Criteria Used n Practice Other Issues in Capital Budgeting
(1) how to deal with mutually exclusive projects whose lives
differ; (2) the potential advantage of terminating a project before the end of its physical life; and (3) the optimal capital budget when the cost of capital rises as the size of the capital budget increases. Mutually Exclusive Projects with Unequal Lives REPLACEMENT CHAINS The key to the replacement chain (common life) approach for projects that will have to be repeated in the future is to analyze both projects over an equal life. Economic Life versus Physical Life The Optimal Capital Budget