Modified Ppt

Capital Budgeting and Decision Criteria Chapter 9

Learning Goals Discuss the difficulty of finding profitable projects in competitive markets. Determine whether a new project should be accepted using 1. PAYBACK PERIOD 2. NET PRESENT VALUE 3. PROFITABILITY INDEX 4. INTERNAL RATE OF RETURN

The NPV - IRR Relationship Net present value profile

Net present value profile - a graph showing how a project' net present value changes as the discount rate changes.

(IRR - the discount rate that equates the present value of the inflows with the present value of the outflows )

Illustration 1

Initial outlay : Cash flow : Duration :

$105,517 $30,000 5 years

DISCOUNT RATE 0% 15 % 10 % 13% 15% 20% 25%

PROJECT’S NPV $ 44, 483 $ 24, 367 $ 8, 207 $0 -$ 4, 952 -$ 15,799 -$ 24,839

Modified Internal Rate Of Return MIRR

Modified Internal Rate Of Return the discount rate that equates the present value of the free cash outflows with the present value of the project's terminal value.

What does it mean? While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that all cash flows are reinvested at the firm's cost of capital. Therefore, MIRR more accurately reflects the profitability of a project.

Steps in calculating the MIRR 1. Determine the PV of the project's free cash outflows. 1. Determine the terminal value of the project's free cash inflows. 3. Determine the discount rate that equates the PV of the terminal value and the present value of the project's cash outflow.

Sample Problem Galaxy Angels Company is considering two mutually exclusive projects. The firm, which has a 12% cost of capital, has estimated its cash flows as shown below. Requirements: a. NPV of each project b. IRR for each project c. NPV profiles for both projects

CHAPTER 11: CAPITAL BUDGETING AND RISK ANALYSIS

1.

Explain what the appropriate measure of risk is for capital-budgeting purposes.

2.

Determine the acceptability of a new project using both the certainty equivalent and risk-adjusted discount rate methods of adjusting for risk.

3.

Explain the use of simulation and probability trees for imitating the performance under evaluation.

RISK AND THE INVESTMENT DECISION There are two (2) basic issues: 1. What is risk in terms of capital-budgeting decisions, how should it be measured? 2. How should risk be incorporated into capital budgeting analysis?

THREE MEASURES OF RISK 1. Project standing alone risk- it is measured by the variability of the asset’s expected returns. 2. Project’s contribution- to- firm risk- the amount of risk that a project contributes to the firm as a whole. 3. Systematic risk- the risk of a project measured from the point of view of a welldiversified shareholder.

METHODS FOR INCORPORATING RISK INTO CAPITAL-BUDGETING 1. Certainty Equivalent- under this method, the decision maker substitutes a set of equivalent riskless cash flows for the expected cash flows and then discounts these cash flows back to the present. 2. Risk-adjusted discount rate- in this method, the discount rate is adjusted to compensate for risk.

Sample problem: Cer tainty equivalent

ZERO Corporation is studying the long-term impact of the two projects and has gathered the following data for analysis:

A CE 20,000 factor 100%

IO CI 1 2 3 4 5 Discount rate

16,000 8,000 6,000 0 0 12%

95% 92% 86%

B CE 12,000 factor 100% 8,000 5,000 4,000 5,000 4,000 14%

94% 83% 80% 70% 60%

Sample problem. Risk-adjusted discount r ate IO Cash Inflows 1 2 3 4 5 Discount rate Coefficient of variation Risk-adjusted discount rate

Project A 20,000

Project B 12,000

16,000 8,000 6,000 0 0 12% 5% 12.6%

8,000 5,000 4,000 5,000 4,000 14% 20% 16.8%