Chapter 9

Capital Budgeting Techniques

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Learning Outcomes
Chapter 9
Describe the importance of capital budgeting decisions and the general
process that is followed when making investment (capital budgeting)
decisions.
Describe how (a) the net present value (NPV) technique and (b) the
internal rate of return (IRR) technique are used to make investment
(capital budgeting) decisions.
Compare the NPV technique with the IRR technique, and discuss why the
two techniques might not always lead to the same investment decisions.
Describe how conflicts that might arise between NPV and IRR can be
resolved using the modified internal rate of return(MIRR) technique.
Describe other capital budgeting techniques

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What is Capital Budgeting?
The process of planning and evaluating
expenditures on assets whose cash flows are
expected to extend beyond one year
Analysis of potential additions to fixed assets
Long-term decisions; involve large expenditures
Very important to firms future

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Generating Ideas for Capital Projects
A firms growth and its ability to remain
competitive depend on a constant flow of
ideas for new products, ways to make
existing products better, and ways to produce
output at a lower cost.
Procedures must be established for
evaluating the worth of such projects.

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Project Classifications
Replacement Decisions: whether to purchase capital
assets to take the place of existing assets to maintain or
improve existing operations
Expansion Decisions: whether to purchase capital
projects and add them to existing assets to increase
existing operations
Independent Projects: Projects whose cash flows are
not affected by decisions made about other projects
Mutually Exclusive Projects: A set of projects where the
acceptance of one project means the others cannot be
accepted

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The Post-Audit
Compares actual results with those predicted by
the projects sponsors and explains why any
differences occurred
Two main purposes:
To improve forecasts
To improve operations

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Similarities between Capital Budgeting
and Asset Valuation
Estimate the cash flows expected from the project.
Evaluate the riskiness of cash flows.
Compute the present value of the expected cash flows to
obtain as estimate of the assets value to the firm.
Compare the present value of the future expected cash
flows with the initial investment.

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Net Present Value:
Sum of the PVs of Inflows and Outflows

NPV Decision Rule:

A project is acceptable if NPV > $0

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Net Cash Flows for Project S and Project L?

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What is Project Ss NPV?

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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.
Which adds most value?

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Using NPV method, which project(s)
should be accepted?
If Projects S and L are mutually exclusive,
accept S because
NPVS = 161.33 > NPVL = 108.67.

If S & L are independent,

accept both; NPV > 0.

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Calculating IRR

IRR Decision Rule: A project is acceptable if

IRR > r

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What is Project Ss IRR?
Financial Calculator Method
Enter the cash flows sequentially, and then
press the IRR button

For Project S, IRRS = 13.1%.

For Project L, IRRL = 11.4%.

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Rationale for the IRR Method
If IRR (projects rate of return) > the firms
required rate of return, r, then some return is
left over to boost stockholders returns.

Example: r = 10%, IRR = 15%.

Profitable.

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Decisions on Projects S and L per IRR
If S and L are independent, accept both.
IRRS > IRRL > r = 10%.

If S and L are mutually exclusive, based on

IRR, Project S is more acceptable because
IRRS > IRRL.

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NPV Profiles for Project S and Project L
NPV Profiles for Project S and Project L
To Find the Crossover Rate:
Find cash flow differences between the projects.

Enter these differences in CF register, then press

IRR. Crossover rate = 8.11, rounded to 8.1%.

Can subtract S from L or vice versa.

If profiles dont cross, one project dominates the

other.

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Two Reasons NPV Profiles Cross:
Size (scale) differences. Smaller project frees
up funds at t = 0 for investment. The higher
the opportunity cost, the more valuable these
funds, so high r favors small projects.

Timing differences. Project with faster

payback provides more CF in early years for
reinvestment.

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Reinvestment Rate Assumptions
NPV assumes reinvest at r.

IRR assumes reinvest at IRR.

Reinvest at opportunity cost, r, is more

realistic, so NPV method is best. NPV should
be used to choose between mutually
exclusive projects.

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Multiple IRRs
Suppose a project exists with the following
cash flow pattern:
Year Cash Flow
0 $(1,600,000)
1 10,000,000
2 (10,000,000)

Two IRRs exist for this project.

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NPV Profile for Project M

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Modified Internal Rate of Return
A better indicator of relative profitability
Better for use in capital budgeting

MIRR Rule:
A project is acceptable if MIRR > r

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Traditional Payback Period
The length of time it takes to recover the
original cost of an investment from its
expected cash flows
Payback period =

PB Decision Rule: A project is acceptable if

PB < n* (years determined by the firm)

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Discounted Payback Period
The length of time it takes for a projects
discounted (PV of) cash flows to repay the
cost of the investment
DPB Decision Rule: A project is acceptable if
DPB < Projects useful life

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