Discuss one of the topics below. Minimum of 250 words and 1-3 references required. Selected tutor will be provided the reading material.Internal Rate of Return including the Modified IRRPayback and Discounted Payback MethodsCapital Budgeting -Preparing the Cash Flow ModelNet Present ValuePayback method explained:

Discounted payback method in Excel
payback_example_in_excel.xlsx

mirr_explained.xlsx

npv_and_irr_example.xls

bh_ffm13_ppt_ch11.ppt

Unformatted Attachment Preview

WACC: 6.4% (Same as our project!)
Cash Flows:
Year 0: -690,000
Year 1: 105,000
Year 2: 125,000
Year 3: 210,000
Year 4: 109,000
Yera 5: 255,000
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
(000) Balance
-690
-690
105
-585
125
-460
210
-250
109
-141
255
WACC does not matter for the payback method. But we would use it in the
discounted payback method.
Years
Create this balance column in Excel
As each cash flow is earned, deduct that CF from the previous balance forward
Note how many periods in which your CF is less than the balance forward
record those years in the last column to the right
Once your CF is greater than the absolute value of the balance forward – stop
We have 4 full years plus some percentage of a year left.
We calculate that percentage year by taking the balance forward and dividing
by the remaining cash flow. In this case 141/255 or .55 of one year.
This means that the payback on this project is 4 years and .55/100 of a year.
0
1
2
3
4
-0.55294
4.55
-5000
2000
2000
2000
9.70%
9.70%
Cash flow Year 0
Cash Flow Year 1
Cash Flow Year 2
Cash Flow Year 3
IRR
MIRR
=MIRR(A1:A4,0.097,0.097)
Note: no change in IRR to MIRR when finance rate and reinvest rate are the same as IRR.
Notice what happens when we change the finance rate to 12%
9.70% Nothing =MIRR(A1:A4,0.12,0.097)
Notice what happens when we change the reinvest rate to 6%
8.39%
The reinvest rate is what we invest the proceed cash flows if different from the cost of capital.
cost of capital.
If you have an initial cash out flow of $1000 pays back $400 the first year, $300 the second year and $390 the third year, $500
CF0
CF1
CF2
CF3
CF4
i/y
NPV
CF
-1000
400
300
390
500
PV
-1000.000
363.6364
247.9339
293.0128
341.5067
Forumla
=B9
=B3/(1+$B$8)
=B4/((1+$B$8)^2)
=B5/((1+$B$8)^3)
=B6/((1+$B$8)^4)
10%
246.09 =NPV(B8,B3:B6)+B9
246.090 =SUM(D5:D9)
Decision for NPV is: If NPV is greater than zero then accept.
IRR is equal to the rate of return where NPV = 0; therefore we know IRR rate will be more than 10%
Excel is the best way.
For this the cash flows must be in order beginning with CF0
CF0
CF1
CF2
CF3
CF4
IRR
-1000
400
300
390
500
20.43% =IRR(B23:B27)
Decision is: If IRR is greater than the Cost of Capital (hurdle rate, internal expected rate, or we
year and $390 the third year, $500 the fourth year you have a rate of return of 10%. The calculations are as followed:
e as followed:
Chapter 11
The Basics of Capital Budgeting
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Regular Payback
Discounted Payback
11-1
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What is capital budgeting?



Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
11-2
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Steps to Capital Budgeting
1.
Estimate CFs (inflows & outflows).
2.
Assess riskiness of CFs.
3.
Determine the appropriate cost of capital.
4.
Find NPV and/or IRR.
5.
Accept if NPV > 0 and/or IRR > WACC.
11-3
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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.
11-4
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What is the difference between normal and
nonnormal cash flow streams?


Normal cash flow stream: Cost (negative CF)
followed by a series of positive cash inflows. One
change of signs.
Nonnormal 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.
11-5
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Net Present Value (NPV)

Sum of the PVs of all cash inflows and outflows of a
project:
N
CFt
NPV = 
t
(
1
+
r
)
t =0
11-6
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Example
Projects we’ll examine:
Year
0
1
2
3
Cash Flow
L
S
-100
-100
10
70
60
50
80
20
CF
0
-60
10
60
CF is the difference between CFL and CFS. We’ll use
CF later.
11-7
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What is Project L’s NPV?
WACC = 10%
Year
0
1
2
3
CFt
-100
10
60
80
PV of CFt
-$100.00
9.09
49.59
60.11
NPVL = $ 18.79
Excel: =NPV(rate,CF1:CFn) + CF0
Here, CF0 is negative.
11-8
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What is Project S’ NPV?
WACC = 10%
Year
0
1
2
3
CFt
-100
70
50
20
PV of CFt
-$100.00
63.64
41.32
15.02
NPVS = $ 19.98
Excel: =NPV(rate,CF1:CFn) + CF0
Here, CF0 is negative.
11-9
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Solving for NPV:
Financial Calculator Solution
Enter CFs into the calculator’s CFLO register.
CF0 = -100
CF1 = 10
CF2 = 60
CF3 = 80
Enter I/YR = 10, press NPV button to get NPVL = $18.78.
11-10
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Rationale for the NPV Method



NPV = PV of inflows – Cost
= Net gain in wealth
If projects are independent, accept if the project
NPV > 0.
If projects are mutually exclusive, accept projects
with the highest positive NPV, those that add the
most value.
In this example, accept S if mutually exclusive
(NPVS > NPVL), and accept both if independent.
11-11
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Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of inflows
equal to cost, and the NPV = 0:
N
CFt
0=
t
(1
+
IRR)
t =0


Solving for IRR with a financial calculator:


Enter CFs in CFLO register.
Press IRR; IRRL = 18.13% and
IRRS = 23.56%.
Solving for IRR with Excel:
=IRR(CF0:CFn,guess for rate)
11-12
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How is a project’s IRR similar to a bond’s YTM?



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.
11-13
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Rationale for the IRR Method

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. If projects are independent, accept both projects, as both IRR > WACC = 10%.
If projects are mutually exclusive, accept S, because
IRRs > IRRL.
11-14
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NPV Profiles

A graphical representation of project NPVs at
various different costs of capital.
WACC
0
5
10
15
20
NPVL
$50
33
19
7
(4)
NPVS
$40
29
20
12
5
11-15
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Independent Projects
NPV and IRR always lead to the same accept/reject
decision for any given independent project.
NPV ($)
IRR > r
and NPV > 0
Accept.
r > IRR
and NPV < 0. Reject. r = 18.1% IRRL = 18.1% r (%) 11-16 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Mutually Exclusive Projects If r < 8.7%: NPVL > NPVS
IRRS > IRRL
CONFLICT
NPV
L
If r > 8.7%: NPVS > NPVL ,
IRRS > IRRL
NO CONFLICT
S
r
8.7
%
r
IRRL
IRRs
11-17
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Finding the Crossover Rate



Find cash flow differences between the projects.
See Slide 11-7.
Enter the CFs in CFj register, then press
◼ IRR. Crossover rate = 8.68%, rounded to 8.7%.
If profiles don’t cross, one project dominates the
other.
11-18
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Reasons Why NPV Profiles Cross


Size (scale) differences: the smaller project frees up
funds at t = 0 for investment. The higher the
opportunity cost, the more valuable these funds, so
a high WACC favors small projects.
Timing differences: the project with faster payback
provides more CF in early years for reinvestment. If
WACC is high, early CF especially good, NPVS >
NPVL.
11-19
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Reinvestment Rate Assumptions




NPV method assumes CFs are reinvested at the
WACC.
IRR method assumes CFs are reinvested at IRR.
Assuming CFs are reinvested at the opportunity cost
of capital is more realistic, so NPV method is the
best. NPV method should be used to choose
between mutually exclusive projects.
Perhaps a hybrid of the IRR that assumes cost of
capital reinvestment is needed.
11-20
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Since managers prefer the IRR to the NPV method, is
there a better IRR measure?


Yes, MIRR is the discount rate that causes the PV of
a project’s terminal value (TV) to equal the PV of
costs. TV is found by compounding inflows at
WACC.
MIRR assumes cash flows are reinvested at the
WACC.
11-21
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Calculating MIRR
0
10%
-100.0
1
2
3
10.0
60.0
80.0
10%
10%
-100.0
PV outflows
MIRR = 16.5%
$158.1
$100 =
(1 + MIRRL)3
MIRRL = 16.5%
66.0
12.1
158.1
TV inflows
Excel: =MIRR(CF0:CFn,Finance_rate,Reinvest_rate)
We assume that both rates = WACC.
11-22
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Why use MIRR versus IRR?


MIRR assumes reinvestment at the opportunity cost
= WACC. MIRR also avoids the multiple IRR
problem.
Managers like rate of return comparisons, and
MIRR is better for this than IRR.
11-23
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What is 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?”
Calculated by adding project’s cash inflows to its
cost until the cumulative cash flow for the project
turns positive.
11-24
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Calculating Payback
Project L’s Payback Calculation
0
1
2
3
CFt
-100
10
60
80
Cumulative
-100
-90
-30
50
PaybackL = 2 + 30 / 80
= 2.375 years
PaybackS = 1.600 years
11-25
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Strengths and Weaknesses of Payback

Strengths

Weaknesses
– Provides an indication of a project’s risk and liquidity.
– Easy to calculate and understand.
– Ignores the time value of money.
– Ignores CFs occurring after the payback period.
11-26
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Discounted Payback Period
Uses discounted cash flows rather than raw CFs.
0
10%
1
2
3
10
60
80
CFt
-100
PV of CFt
-100
9.09
49.59
60.11
Cumulative
-100
-90.91
-41.32
18.79
Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years
11-27
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Find Project P’s NPV and IRR
Project P has cash flows (in 000s): CF0 = -$800, CF1 =
$5,000, and CF2 = -$5,000.
0
WACC = 10%
-800




1
2
5,000
-5,000
Enter CFs into calculator CFLO register.
Enter I/YR = 10.
NPV = -$386.78.
IRR = ERROR
Why?
11-28
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Multiple IRRs
NPV
IRR2 = 400%
450
0
-800
100
400
WACC
IRR1 = 25%
11-29
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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.
11-30
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When to use the MIRR instead of the IRR? Accept
Project P?


When there are nonnormal CFs and more than one
IRR, use MIRR.
– PV of outflows @ 10% = -$4,932.2314.
– TV of inflows @ 10% = $5,500.
– MIRR = 5.6%.
Do not accept Project P.
– NPV = -$386.78 < 0. – MIRR = 5.6% < WACC = 10%. 11-31 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. ... Purchase answer to see full attachment