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Capital Budgeting: Decision Criteria

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Capital Budgeting: Decision Criteria
Capital Budgeting:
Decision Criteria
Brigham and Daves Ch. 12
Christopher B. Alt CFA PhD

What Is Capital Budgeting?






Analysis of potential additions to fixed assets Long-term decisions typically involving large $ expenditures
Making the ‘right’ capital budgeting decisions is enormously important to a firm’s future
Should we build this plant? All rights reserved - Christopher B. Alt

2

Key Steps in Capital Budgeting
 Estimate CFs (inflows & outflows)
 Assess riskiness of CFs
 Determine the appropriate cost of capital  Find NPV and/or IRR
 Accept if NPV > 0 and/or IRR >
WACC

All rights reserved - Christopher B. Alt

3

Independent vs. 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 All rights reserved - Christopher B. Alt

4

Normal vs. Nonnormal Cash Flow
Streams




Normal cash flow stream: Usually, 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.
All rights reserved - Christopher B. Alt

5

Capital Budgeting Techniques








Net present value (NPV)
Internal rate of return (IRR)
Modified IRR (MIRR)
Payback
Discounted payback

All rights reserved - Christopher B. Alt

6

Net Present Value (NPV)


Sum of the PVs of all cash inflows and outflows of a project:
N

CFt
NPV   t t 0 ( 1  r )

All rights reserved - Christopher B. Alt

7

Capital Budgeting Example
Choice between two projects:
Cash Flow
Year

L

S

CF

0

-100

-100

0

1

10

70

-60

2

60

50

10

3

80

20

60

CF is the difference between CFL and
CFS
All rights reserved - Christopher B. Alt

8

What Is Project L’s NPV?
WACC = 10%
Year
0
1
2
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