Chapter 11 provides knowledge of the basics of capital budgeting: Evaluating cash flows. This chapter presents the following content: Overview and “vocabulary”, methods: NPV, IRR, MIRR payback, discounted payback. | Chapter 11 The Basics of Capital Budgeting: Evaluating Cash Flows Topics Overview and “vocabulary” Methods NPV IRR, MIRR Payback, discounted payback What is capital budgeting? Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to firm’s future. Steps in Capital Budgeting Estimate cash flows (inflows & outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows. Independent versus Mutually Exclusive Projects Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other. Cash Flows for Franchise L and Franchise S 10 80 60 0 1 2 3 10% L’s CFs: 70 20 50 0 1 2 3 10% S’s CFs: NPV: Sum of the PVs of all cash flows. Cost often is CF0 and is negative. NPV = ∑ n t = 0 CFt (1 + r)t . NPV = ∑ n t = 1 CFt (1 + r)t . - CF0 . What’s Franchise L’s | Chapter 11 The Basics of Capital Budgeting: Evaluating Cash Flows Topics Overview and “vocabulary” Methods NPV IRR, MIRR Payback, discounted payback What is capital budgeting? Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to firm’s future. Steps in Capital Budgeting Estimate cash flows (inflows & outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows. Independent versus Mutually Exclusive Projects Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other. Cash Flows for Franchise L and Franchise S 10 80 60 0 1 2 3 10% L’s CFs: 70 20 50 0 1 2 3 10% S’s CFs: NPV: Sum of the PVs of all cash flows. Cost often is CF0 and is negative. NPV = ∑ n t = 0 CFt (1 + r)t . NPV = ∑ n t = 1 CFt (1 + r)t . - CF0 . What’s Franchise L’s NPV? 10 80 60 0 1 2 3 10% L’s CFs: = NPVL NPVS = $. Calculator Solution: Enter values in CFLO register for L. -100 10 60 80 10 CF0 CF1 NPV CF2 CF3 I = = NPVL Rationale for the NPV Method NPV = PV inflows – Cost This is net gain in wealth, so accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value. Using NPV method, which franchise(s) should be accepted? If Franchise S and L are mutually exclusive, accept S because NPVs > NPVL . If S & L are independent, accept both; NPV > 0. Internal Rate of Return: IRR 0 1 2 3 CF0 CF1 CF2 CF3 Cost Inflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. NPV: Enter r, solve for NPV. IRR: Enter NPV = 0, solve for IRR. = NPV ∑ n t = 0 CFt (1 + r)t . = 0 ∑ n t = 0 CFt (1 + IRR)t . What’s Franchise L’s IRR? 10 80 60 0 1 2 3 IRR = ? PV3 PV2 PV1 0 = NPV Enter CFs in CFLO, then press IRR:
