Capital Budgeting

Chapter 8

© 2009 Cengage Learning/South-Western

 The Capital Budgeting Decision Process

The capital budgeting process involves three basic steps:

• Generating long-term investment proposals;

• Reviewing, analyzing, and selecting from the
proposals that have been granted, and
• Implementing and monitoring the proposals
that have been selected.

Managers should separate investment and

financing decisions.
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 Capital Budgeting Decision Techniques
Accounting rate of return (ARR): focuses on
project’s impact on accounting profits

Payback period: most commonly used

Net present value (NPV): best technique

theoretically; difficult to calculate realistically

Internal rate of return (IRR): widely used with

strong intuitive appeal

Profitability index (PI): related to NPV

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 A Capital Budgeting Process Should:

Account for the time value of money;

Account for risk;

Focus on cash flow;

Rank competing projects appropriately, and

Lead to investment decisions that maximize

shareholders’ wealth.
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 Example: Global Wireless

• Global Wireless is a worldwide provider of

wireless telephony devices.
• Global Wireless is contemplating a major
expansion of its wireless network in two different
regions:
– Western Europe expansion
– A smaller investment in Southeast U.S. to establish a
toehold

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 Global Wireless

Initial Outlay -$250

Year 1 inflow $35
Year 2 inflow $80
Year 3 inflow $130
Year 4 inflow $160
Year 5 inflow $175

Initial Outlay -$50

Year 1 inflow $18
Year 2 inflow $22
Year 3 inflow $25
Year 4 inflow $30

6 Year 5 inflow $32

 Accounting Rate Of Return (ARR)

Can be computed from available accounting data

Average pr ofits after taxes

ARR 
Average in vestment
• Need only profits after taxes and depreciation.
• Average profits after taxes are estimated by
subtracting average annual depreciation from the
average annual operating cash inflows.
Average profits = Average annual – Average annual
after taxes operating cash inflows depreciation

ARR uses accounting numbers, not cash flows;

7 no time value of money.
 Payback Period

The payback period is the amount of time required

for the firm to recover its initial investment.

• If the project’s payback period is less than the

maximum acceptable payback period, accept
the project.
• If the project’s payback period is greater than
the maximum acceptable payback period,
reject the project.

Management determines maximum acceptable

payback period.
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 Payback Analysis For Global Wireless
• Management’s cutoff is 2.75 years.
• Western Europe project: initial outflow of -$250M
– But cash inflows over first 3 years is only $245 million.
– Global Wireless will reject the project (3>2.75).
• Southeast U.S. project: initial outflow of -$50M
– Cash inflows over first 2 years cumulate to $40 million.
– Project recovers initial outflow after 2.40 years.
• Total inflow in year 3 is $25 million. So, the project
generates $10 million in year 3 in 0.40 years ($10 million 
$25 million).
– Global Wireless will accept the project (2.4<2.75).

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 Pros and Cons of the Payback Method

Advantages of payback method:

• Computational simplicity
• Easy to understand
• Focus on cash flow

Disadvantages of payback method:

• Does not account properly for time value of money

• Does not account properly for risk
• Cutoff period is arbitrary
• Does not lead to value-maximizing decisions
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 Discounted Payback
• Discounted payback accounts for time value.
• Apply discount rate to cash flows during payback period.
• Still ignores cash flows after payback period.

• Global Wireless uses an 18% discount rate.

Reject (166.2 < 250) Reject (46.3<50)

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 Net Present Value (NPV)

NPV: The sum of the present values of a project’s

cash inflows and outflows.

Discounting cash flows accounts for the time value

of money.

Choosing the appropriate discount rate accounts for

risk.

CF1 CF2 CF3 CFN

NPV  CF0     ... 
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) N

Accept projects if NPV > 0.

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 Net Present Value (NPV)

CF1 CF2 CF3 CFN

NPV  CF0     ... 
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) N

A key input in NPV analysis is the discount rate.

r represents the minimum return that the

project must earn to satisfy investors.

r varies with the risk of the firm and /or the risk
of the project.
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 NPV Analysis for Global Wireless
• Assuming Global Wireless uses 18% discount
rate, NPVs are:

Western Europe project: NPV = $75.3 million

35 80 130 160 175
NPVWestern Europe  $75.3  250     
(1.18) (1.18) 2 (1.18)3 (1.18) 4 (1.18)5

Southeast U.S. project: NPV = $25.7 million

18 22 25 30 32
NPVSoutheast U .S .  $25.7  50     
(1.18) (1.18) 2 (1.18)3 (1.18) 4 (1.18)5

Should Global Wireless invest in one project or both?

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 The NPV Rule and Shareholder Wealth

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 Pros and Cons of NPV

NPV is the “gold standard” of investment decision

rules.

Key benefits of using NPV as decision rule:

• Focuses on cash flows, not accounting earnings

• Makes appropriate adjustment for time value of money
• Can properly account for risk differences between
projects

Though best measure, NPV has some drawbacks:

• Lacks the intuitive appeal of payback, and

1 • Doesn’t capture managerial flexibility (option value) well.
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 Internal Rate of Return (IRR)

IRR: the discount rate that results in a zero NPV for

a project.

CF1 CF2 CF3 CFN

NPV  0  CF0     .... 
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) N

The IRR decision rule for an investing project is:

• If IRR is greater than the cost of capital, accept

the project.
• If IRR is less than the cost of capital, reject the
project.
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 NPV Profile and Shareholder Wealth

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 IRR Analysis for Global Wireless

Global Wireless will accept all projects with at least

18% IRR.

Western Europe project: IRR (rWE) = 27.8%

35 80 130 160 175
0  250     
(1  rWE ) (1  rWE ) 2
(1  rWE ) 3
(1  rWE ) 4
(1  rWE )5

Southeast U.S. project: IRR (rSE) = 36.7%

18 22 25 30 32
0  50     
(1  rSE ) (1  rSE ) 2 (1  rSE )3 (1  rSE ) 4 (1  rSE )5

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 Pros and Cons of IRR

Advantages of IRR:

• Properly adjusts for time value of money

• Uses cash flows rather than earnings
• Accounts for all cash flows
• Project IRR is a number with intuitive appeal

Disadvantages of IRR:

• “Mathematical problems”: multiple IRRs, no real

solutions
• Scale problem
2 • Timing problem
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 Multiple IRRs

IRR

IRR

When project cash flows have multiple sign changes, there can
be multiple IRRs.

2 Which IRR do we use?

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 No Real Solution

Sometimes projects do not have a real IRR solution.

Modify Global Wireless’s Western Europe project to

include a large negative outflow (-$355 million) in
year 6.

• There is no real number that will make NPV=0, so

no real IRR.

Project is a bad idea based on NPV. At r =18%,

project has negative NPV, so reject!

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 Conflicts Between NPV and IRR:
The Scale Problem

NPV and IRR do not always agree when ranking

competing projects.

The scale problem:

Project IRR NPV (18%)

Western Europe 27.8% $75.3 mn

Southeast U.S. 36.7% $25.7 mn

• The Southeast U.S. project has a higher IRR, but

doesn’t increase shareholders’ wealth as much as
the Western Europe project.
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 Conflicts Between NPV and IRR:
The Scale Problem

Why the conflict?

• The scale of the Western Europe expansion is
roughly five times that of the Southeast U.S.
project.
• Even though the Southeast U.S. investment
provides a higher rate of return, the opportunity
to make the much larger Western Europe
investment is more attractive.

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 Conflicts Between NPV and IRR:
The Timing Problem

• The product development proposal generates a higher

NPV, whereas the marketing campaign proposal offers a
higher IRR.
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 Conflicts Between NPV and IRR:
The Timing Problem

Because of the
differences in the timing
of the two projects’ cash
flows, the NPV for the
Product Development
proposal at 10%
exceeds the NPV for the
Marketing Campaign.

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 Profitability Index

Calculated by dividing the PV of a project’s cash

inflows by the PV of its initial cash outflows.
CF1 CF2 CFN
  ... 
(1  r ) (1  r ) 2
(1  r ) N
PI 
CF0
Decision rule: Accept project with PI > 1.0, equal to NPV > 0
Project PV of CF (yrs1-5) Initial Outlay PI

Western Europe $325.3 million $250 million 1.3

Southeast U.S. $75.7 million $50 million 1.5

• Both PI > 1.0, so both acceptable if independent.

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Like IRR, PI suffers from the scale problem.
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 Capital Budgeting

Methods to generate, review, analyze, select, and

implement long-term investment proposals:
• Accounting rate of return
• Payback Period
• Discounted payback period
• Net Present Value (NPV)
• Internal rate of return (IRR)
• Profitability index (PI)

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