1. CAPITAL BUDGETING

5. B. An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river. Projects are: mutually exclusive , if the cash flows of one can be adversely impacted by the acceptance of the other. Projects are: independent , if the cash flows of one are unaffected by the acceptance of the other.

10. Payback for Project L 10 80 60 0 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback 2 + 30/80 = 2.375 years 0 100 2.4

11. Project S 70 20 50 0 1 2 3 -100 CF t Cumulative -100 -30 20 40 Payback S 1 + 30/50 = 1.6 years 100 0 1.6 =

12. C.2. Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity . 2. Easy to calculate and understand. C.2. Weaknesses of Payback: 1. Ignores the TVM (time value of money) . 2. Ignores CFs occurring after the payback period.

14. 10 80 60 0 1 2 3 CF t Cumulative -100 -90.91 -41.32 18.79 Discounted payback 2 + 41.32/60.11 = 2.7 yrs Discounted Payback: Uses discounted rather than raw CFs. PVCF t -100 -100 10% 9.09 49.59 60.11 = Recover invest. + cap. costs in 2.7 yrs.

15. NPV: Sum of the PVs of inflows and outflows. Cost often is CF 0 and is negative.

16. What’s Project L’s NPV? 10 80 60 0 1 2 3 10% Project L: -100.00 9.09 49.59 60.11 18.79 = NPV L

17. Rationale for the NPV Method NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

19. Internal Rate of Return: IRR 0 1 2 3 CF 0 CF 1 CF 2 CF 3 outflow Inflows IRR is the discount rate that equates the present value of cash inflows and present value of cash outflow. This is the same as forcing NPV = 0.

20. NPV: Enter k, solve for NPV. IRR: Enter NPV = 0, solve for IRR.

21. Rationale for the IRR Method If IRR > WACC, then the project’s rate of return is greater than its cost-some return is left over to boost stockholders’ returns. Example : WACC = 10%, IRR = 15%. Profitable.