A B C D E F G H I J K

1 4/2/2005
2
3 Chapter 12. Tool Kit for Capital Budgeting: Decision Criteria
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5
In this file we use Excel to do most of the calculations explained in Chapter 12. First, we analyze Projects S and L,
6 whose cash flows are shown immediately below in both tabular and a time line formats. Spreadsheet analyses can be set
7 up vertically, in a table with columns, or horizontally, using time lines. For short problems, with just a few years, we
8 generally use the time line format because rows can be added and we can set the problem up as a series of income
statements. For long problems, it is often more convenient to use a tabular layout.
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10
11 Expected after-tax Project S
12 net cash flows (CFt)
13 Year (t) Project S Project L 0 1 2 3 4
14 0 ($1,000) ($1,000) (1,000) 500 400 300 100
15 1 500 100
16 2 400 300 Project L
17 3 300 400
18 4 100 600 0 1 2 3 4
19 (1,000) 100 300 400 600
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22 Capital Budgeting Decision Criteria
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24 Here are the five key methods used to evaluate projects: (1) payback period, (2) discounted payback period, (3) net
25 present value, (4) internal rate of return, and (5) modified internal rate of return. Using these criteria, financial
26 'analysts seek to identify those projects that will lead to the maximization of the firm's stock price.
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28 Payback Period
29 The payback period is defined as the expected number of years required to recover the investment, and it was the first
30 formal method used to evaluate capital budgeting projects. First, we identify the year in which the cumulative cash
31 inflows exceed the initial cash outflows. That is the payback year. Then we take the previous year and add to it
32 unrecovered balance at the end of that year divided by the following year's cash flow. Generally speaking, the shorter
33 the payback period, the better the investment.
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35 Project S
36 Time period: 0 1 2 3 4
37 Cash flow: (1,000) 500 400 300 100
38 Cumulative cash flow: (1,000) (500) (100) 200 300
If payback doesn't occur by year
39 % year req. for payback: 1.0000 1.0000 0.3333 0.0000 end, the entire year is needed. If it
40 occurs by year end, calculate the
41 Payback: 2.33 fraction of the year needed.
42 Use the sum function to calculate
43 Alternative calculation: 2.33 this uses a complicated IF statement the total number of years to
44 payback.
45 Project L
46 Time period: 0 1 2 3 4
47 Cash flow: (1,000) 100 300 400 600
48 Cumulative cash flow: (1,000) (900) (600) (200) 400
49 % year req. for payback: 1.0000 1.0000 1.0000 0.3333
50
51 Payback: 3.33
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 A B C D E F G H I J K
53 Discounted Payback Period
54 Discounted payback period uses the project's cost of capital to discount the expected cash flows. The calculation of
55 discounted payback period is identical to the calculation of regular payback period, except you must base the calculation
56 on a new row of discounted cash flows. Note that both projects have a cost of capital of 10%.
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58 WACC = 10%
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60 Project S
61 Time period: 0 1 2 3 4
62 Cash flow: (1,000) 500 400 300 100
63 Disc. cash flow: (1,000) 455 331 225 68 Cash Flows Discounted back at 10%.
64 Disc. cum. cash flow: (1,000) (545) (215) 11 79
65 % year req. for payback: 1.0000 1.0000 0.9533 0.0000
66
67 Discounted Payback: 2.95
68
69 Project L
70 Time period: 0 1 2 3 4
71 Cash flow: (1,000) 100 300 400 600
72 Disc. cash flow: (1,000) 91 248 301 410
73 Disc. cum. cash flow: (1,000) (909) (661) (361) 49
74 % year req. for payback: 1.0000 1.0000 1.0000 0.8800
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76 Discounted Payback: 3.88 Uses IF statement.
77
78 The inherent problem with both paybacks is that they ignore cash flows that occur after the payback period mark.
79 While the discounted method accounts for timing issues (to some extent), it still falls short of fully analyzing projects.
80 However, all else equal, these two methods do provide some information about projects' liquidity and risk.
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82 Net Present Value (NPV)
83 To calculate the NPV, we find the present value of the individual cash flows and find the sum of those discounted cash
84 flows. This value represents the value the project add to shareholder wealth.
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86 WACC = 10%
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88 Project S
89 Time period: 0 1 2 3 4
90 Cash flow: (1,000) 500 400 300 100
91 Disc. cash flow: (1,000) 455 331 225 68
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93 NPV(S) = $78.82 = Sum disc. CF's. or $78.82 = Uses NPV function.
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95 Project L
96 Time period: 0 1 2 3 4
97 Cash flow: (1,000) 100 300 400 600
98 Disc. cash flow: (1,000) 91 248 301 410
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100 NPV(L) = $49.18 $ 49.18 = Uses NPV function.
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 A B C D E F G H I J K
102
103 The NPV method of capital budgeting dictates that all independent projects that have positive NPV should accepted.
104 The rationale behind that assertion arises from the idea that all such projects add wealth, and that should be the overall
goal of the manager in all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you
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would want to accept the project that adds the most value (i.e. the project with the higher NPV). Hence, if considering
106 the above two projects, you would accept both projects if they are independent, and you would only accept Project S if
107 they are mutually exclusive.
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110 Internal Rate of Return (IRR)
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112 The internal rate of return is defined as the discount rate that equates the present value of a project's cash inflows to its
outflows. In other words, the internal rate of return is the interest rate that forces NPV to zero. The calculation for IRR
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can be tedious, but Excel provides an IRR function that merely requires you to access the function and enter the array
114 of cash flows. The IRR's for Project S and L are shown below, along with the data entry for Project S.
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116
117 Expected after-tax
118 net cash flows (CFt)
119 Year (t) Project S Project L
120 0 ($1,000) ($1,000) The IRR function assumes
121 1 500 100 IRR S = 14.49% payments occur at end of
122 2 400 300 IRR L = 11.79% periods, so that function does
123 3 300 400 not have to be adjusted.
124 4 100 600
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126
127
Notice that for IRR you must
128 specify all cash flows, including
129 the time zero cash flow. This
130 is in contrast to the NPV
131 function, in which you specify
132 only the future cash flows.
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140 The IRR method of capital budgeting maintains that projects should be accepted if their IRR is greater than the cost of
141 capital. Strict adherence to the IRR method would further dictate that mutually exclusive projects should be chosen on
142 the basis of the greatest IRR. In this scenario, both projects have IRR's that exceed the cost of capital (10%) and both
143 should be accepted, if they are independent. If, however, the projects are mutually exclusive, we would chose Project S.
144 Recall, that this was our determination using the NPV method as well. The question that naturally arises is whether or
145 not the NPV and IRR methods will always agree.
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147 When dealing with independent projects, the NPV and IRR methods will always yield the same accept/reject result.
148 'However, in the case of mutually exclusive projects, NPV and IRR can give conflicting results. One shortcoming of the
149 internal rate of return is that it assumes that cash flows received are reinvested at the project's internal rate of return,
150 which is not usually true. The nature of the congruence of the NPV and IRR methods is further detailed in a latter
151 section of this model.
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 A B C D E F G H I J K
153 Multiple IRR's
154 Because of the mathematics involved, it is possible for some (but not all) projects that have more than one change of signs in the set
155 of cash flows to have more than one IRR. If you attempted to find the IRR with such a project using a financial calculator, you
156 would get an error message. The HP-10B says "Error - Soln", the HP-17B says '"Many/No Solutions, and the HP12C says Error 3;
157 Key in Guess" when such a project is evaluated. The procedure for correcting the problem isto store in a guess for the IRR, and
158 then the calculator will report the IRR that is closest to your guess. You can then use a different "guess" value, and you should be
159 able to find the other IRR. However, the nature of the mathematics creates a scenario in which one IRR is quite extraordinary
160 (often, a few hundred percent).
161 Consider the case of Project M.
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163 Project M: 0 1 2
164 (1.6) 10 (10)
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166 We will solve this IRR twice, the first time using the default guess of 10%, and the second time we will enter a guess of
167 300%. Notice, that the first IRR calculation is exactly as it was above.
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169 IRR M 1 = 25.0%
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174 IRR M 2 = 400%
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184 The two solutions to this problem tell us that this project will have a positive NPV for all costs of capital between '25%
185 and 400%. We illustrate this point by creating a data table and a graph of the project NPVs.
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187 Project M: 0 1 2
188 (1.6) 10 (10)
189 r = 25.0%
190 NPV = 0.00
191

Multiple Rates of Return

$1.50

$1.00

$0.50

$0.00
-100% 0% 100% 200% 300% 400% 500%

-$0.50

-$1.00

-$1.50

-$2.00
 A B C D E F G H I J K
192 NPV
193 r $0.0 Multiple Rates of Return
194 0% (1.60) $1.50
195 25% 0.00
196 50% 0.62
$1.00
197 75% 0.85
198 100% 0.90 Max.
125% 0.87 $0.50
199
200 150% 0.80
201 175% 0.71 $0.00
202 200% 0.62 -100% 0% 100% 200% 300% 400% 500%
203 225% 0.53 -$0.50
204 250% 0.44
205 275% 0.36 -$1.00
206 300% 0.28
207 325% 0.20
-$1.50
208 350% 0.13
209 375% 0.06
210 400% 0.00 -$2.00
211 425% (0.06)
212 450% (0.11)
213 475% (0.16)
214 500% (0.21)
215 525% (0.26)
216 550% (0.30)
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218 NPV Profiles
219 NPV profiles graph the relationship between projects' NPVs and the cost of capital. To create NPV profiles for Projects
220 S and L, we create data tables of NPV at different costs of capital.
221
222 Net Cash Flows
223 Year Project S Project L WACC = 10.0%
224 0 -$1,000 -$1,000 Project S Project L
225 1 $500 $100 NPV = $78.82 $49.18
226 2 $400 $300 IRR = 14.49% 11.79%
227 3 $300 $400 Crossover 7.17%
228 4 $100 $600
229 Data Table used to make graph
230
231 Project S's Both Projects' Profiles
NPV Profile WACC
232
233 $400 $600 0%
Conflict
234 NPVs No conflict 5%
235 $300 $400 NPVL 7.17%
Accept Reject
236 10%
$200
237 $200 11.79%
238 14.49%
NPV

$100
NPV

239 $0 15.0%
240 $0 20%
Crossover 25%
241 IRRS = 14.49% -$200 = 7.17%
242 -$100

243 -$400
-$200
244 0% 5% 10% 15% 20% 25%
0% 5% 10% 15% 20% 25%
245 %
WACC WACC
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247
248 Points about the graphs:
249 1. In Panel a, we see that if WACC < IRR, then NPV > 0, and vice versa.
250 2. Thus, for "normal and independent" projects, there can be no conflict between NPV and IRR rankings.
251 3. However, if we have mutually exclusive projects, conflicts can occur. In Panel b, we see that IRRS is
 A B C D E F G H I J K
252 always greater than IRRL, but if WACC < 11.56%, then IRRL > IRRS, in which case a conflict occurs.
253 4. Summary: a. For normal, independent projects, conflicts can never occur, so either method can be used.
254 b. For mutually exclusive projects, if WACC > Crossover, no conflict, but if WACC < Crossover,
255 then there will be a conflict between NPV and IRR.
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 A B C D E F G H I J K
257
258 Previously, we had discussed that in some instances the NPV and IRR methods can give conflicting results. First, we
259 should attempt to define what we see in this graph. Notice, that the two project profiles (S and L) intersect the x-axis at
260 costs of capital of 14% and 12%, respectively. Not coincidently, those are the IRR's of the projects. If we think about
261 the definition of IRR, we remember that the internal rate of return is the cost of capital at which a project will have an
262 NPV of zero. Looking at our graph, it is a logical conclusion that the IRR of a project is defined as the point at which its
263 profile intersects the x-axis.
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265 Looking further at the NPV profiles, we see that the two project profiles intersect at a point we shall call the crossover
266 point. We observe that at costs of capital greater than the crossover point, the project with the greater IRR (Project S,
267 in this case) also has the greater NPV. But at costs of capital less than the crossover point, the project with the lesser
268 IRR has the greater NPV. This relationship is the source of discrepancy between the NPV and IRR methods. By
269 looking at the graph, we see that the crossover appears to occur at approximately 7%. Luckily, there is a more precise
270 way of determining crossover. To find crossover, we will find the difference between the two projects cash flows in each
271 year, and then find the IRR of this series of differential cash flows.
272
273 Expected after-tax
274 net cash flows (CFt) Cash flow Alternative: Use Tools > Goal Seek to find WACC when NPV(S) =
275 Year (t) Project S Project L differential NPV(L). Set up a table to show the difference in NPV's, which we
276 0 ($1,000) ($1,000) 0 want to be zero. The following will do it, getting WACC = 7.17%.
277 1 500 100 400 Look at B57 for the answer, then restore B57 to 10%.
278 2 400 300 100 NPV S = $ 78.82
279 3 300 400 (100) NPV L = $ 49.18
280 4 100 600 (500) S - L = $ 29.64
281
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G277
284 IRR = Crossover rate = 7.17%
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291 The intuition behind the relationship between the NPV profile and the crossover rate is as follows: (1) Distant cash
292 flows are heavily penalized by high discount rates--the denominator is (1+r)t, and it increases geometrically, hence gets
very large at high values of t. (2) Long-term projects like L have most of their cash flows coming in the later years, when
293 the discount penalty is largest, hence they are most severely impacted by high capital costs. (3) 'Therefore, Project L's
294 NPV profile is steeper than that of S. (4) Since the two profiles have different slopes, they cross one another.
295
296
297 Modified Internal Rate of Return (MIRR)
298 The modified internal rate of return is the discount rate that causes a project's cost (or cash outflows) to equal the
299 'present value of the project's terminal value. The terminal value is defined as the sum of the future values of the
300 'project's cash inflows, compounded at the project's cost of capital. To find MIRR, calculate the PV of the outflows 'and
301 the FV of the inflows, and then find the rate that equates the two. Or, you can solve using the MIRR function.
302
 A B C D E F G H I J K
303 WACC = 10% MIRRS = 12.11%
304 Project S MIRRL = 11.33% B304:F304
305 10%
B300
306 0 1 2 3 4
307 (1,000) 500 400 300 100 B300
308
309 Project L
310
311 0 1 2 3 4
312 (1,000) 100 300 400 600
313 440.0
314 363.0
315 133.1
316 PV: (1,000) Terminal Value: 1,536.1
317
318 The advantage of using the MIRR, relative to the IRR, is that the MIRR assumes that cash flows received are reinvested
319 at the cost of capital, not the IRR. Since reinvestment at the cost of capital is more likely, the MIRR is a 'better
320 indicator of a project's profitability. Moreover, it solves the multiple IRR problem, as a set of cash flows can have but
321 one MIRR .
322
323 Note that if negative cash flows occur in years beyond Year 1, those cash flows would be discounted at the cost of capital
324 and added to the Year 0 cost to find the total PV of costs. If both positive and negative flows occurred in some year, the
325 negative flow should be discounted, and the positive one compounded, rather than just dealing with the net cash flow.
326 This makes a difference.
327
328 Also note that Excel's MIRR function allows for discounting and reinvestment to occur at different rates. Generally,
329 MIRR is defined as reinvestment at the WACC, though Excel allows the calculation of a special MIRR where
330 reinvestment occurs at a different rate than WACC.
331
332
333 Finally, it is stated in the text, when the IRR versus the NPV is discussed, that the NPV is superior because (1) the NPV
334 assumes that cash flows are reinvested at the cost of capital whereas the IRR assumes reinvestment at the IRR, and (2) it
is more likely, in a competitive world, that the actual reinvestment rate is more likely to be the cost of capital than the
335 IRR, especially if the IRR is quite high. The MIRR setup can be used to prove that NPV indeed does assume
336 reinvestment at the WACC, and IRR at the IRR.
337
 A B C D E F G H I J K
338
339 Project S
340 WACC = 10%
341 0 1 2 3 4
342 (1,000) 500 400 300 100
343 330.0
344 484.0 Reinvestment at WACC = 10%
345 665.5
346 PV outflows -$1,000.00 Terminal Value: 1,579.5
347 PV of TV $1,078.82
348 NPV $ 78.82 Thus, we see that the NPV is consistent with reinvestment at WACC.
349
350
351 Now repeat the process using the IRR, which is G118 as the discount rate.
352
353 Project S
354 IRR = 14.49%
355 0 1 2 3 4
356 (1,000) 500 400 300 100
357 343.5
358 524.3 Reinvestment at IRR = 14.49%
359 750.3
360 PV outflows -$1,000.00 Terminal Value: 1,718.1
361 PV of TV $1,000.00
362 NPV $0.00 Thus, if compounding is at the IRR, NPV is zero. Since the
363 definition of IRR is the rate at which NPV = 0, this demonstrates
364 that the IRR assumes reinvestment at the IRR.
365
366 Profitability Index (PI)
367 The profitability index is the present value of all future cash flows divided by the intial cost. It measures
368 the PV per dollar of investment.
369
370 For project S:
371 PI(S) = PV of future cash flows ÷ Initial cost
372 PI(S) = $ 1,078.82 ÷ $ 1,000.00
373 PI(S) = 1.079
374
375 For project L:
376 PI(L) = PV of future cash flows ÷ Initial cost
377 PI(L) = $ 1,049.18 ÷ $ 1,000.00
378 PI(L) = 1.049
379
380
381 PROJECTS WITH UNEQUAL LIVES
382
383 If two mutually exclusive projects have different lives, and if the projects can be repeated, then it is necessary to deal explicitly with
384 those unequal lives. We use the replacement chain (or common life) approach. This procedure compares projects of unequal lives
385 by equalizing their lives by assuming that each project can be repeated as many times as necessary to reach a common life span.
386 The NPVs over this life span are then compared, and the project with the higher common life NPV is chosen. To illustrate, suppose
387 a firm is considering two mutually exclusive projects, either a conveyor system (Project C) or a fleet of forklift trucks (Project F) for
388 moving materials. The firm's cost of capital is 12%. The cash flow timelines are shown below, 'along with the NPV and IRR for
389 each project.
390
391 Project C WACC: 11.5%
392 End of Period:
393
394 0 1 2 3 4 5 6
 A B C D E F G H I J K
395 ($40,000) $8,000 $14,000 $13,000 $12,000 $11,000 $10,000
396
397 NPV $7,165
398 IRR 17.5%
399
400 Project F
401 End of Period:
402
403 0 1 2 3
404 ($20,000) $7,000 $13,000 $12,000
405
406 NPV $5,391
407 IRR 25.2%
408
409 Initially, it would appear that Project C is the better investment, based upon its higher NPV. However, if the firm chooses Project
410 F, it would have the opportunity to make the same investment three years from now. Therefore, we must reevaluate Project F 'using
411 extended common life of 6 years. The time lines are shown below. Note that only F's is changed.
412
413 Common Life Approach
414
415 Project C
416 End of Period:
417
418 0 1 2 3 4 5 6
419 ($40,000) $8,000 $14,000 $13,000 $12,000 $11,000 $10,000
420
421 NPV $7,165
422 IRR 17.5%
423
424 Project F
425
426 0 1 2 3 4 5 6
427 ($20,000) $7,000 $13,000 $12,000
428 ($20,000) $7,000 $13,000 $12,000
429 ($20,000) $7,000 $13,000 ($8,000) $7,000 $13,000 $12,000
430
431 NPV $9,281
432 IRR 25.2%
433
434 On the basis of this extended analysis, it is clear that Project F is the better of the two investments (with both the NPV
435 and IRR methods).
436
437 Equivalent Annual Annuity (EAA) Approach (See the Chapter 12 Web Extension for details.)
438
439 Here are the steps in the EAA approach.
440 1. Find the NPV of each project over its initial life (we already did this in our previous analysis).
441 NPVC= 7,165
442 NPVF= 5,391
443
444 2. Convert the NPV into an annuity payment with a life equal to the life of the project.
445 EEAC= 1,718 Note: we used the Function Wizard for the PMT function.
446 EEAF= 2,225
447
448 Project F has a higher EEA, so it is a better project.
449
450 ECONOMIC LIFE VS. PHYSICAL LIFE
451
452
Sometimes an asset has a physical life that is greater than its economic life. Consider the following asset
453 which has a physical life of three years. During its life, the asset will generate operating cash flows.
454 However, the project could be terminated and the asset sold at the end of any year. The following table
shows the operating cash flows and the salvage value for each year-- all values are shown on an after-tax
basis.
 A B C D E F G H I J K
457
Operating Salvage
458
Year Cash Flow Value
459 0 ($4,800) $4,800
460 1 $2,000 $3,000
461 2 $2,000 $1,650
462 3 $1,750 $0
463
464 The cost of capital is 10%. If the asset is operated for the entire three years of its life, its NPV is:
465
PV of PV of
466 3-Year NPV = Intial Cost + Operating + Salvage
Cash Flow Value
467 = ($4,800.00) + $4,785.88 + $0.00
468 3-Year NPV = ($14.12)
469
470 The asset has a negative NPV if it is kept for three years. But even though the asset will last three years, it
471 might be better to operate the asset for either one or two years, and then salvage it.
472
PV of PV of
473 2-Year NPV = Intial Cost + Operating + Salvage
Cash Flow Value
474 = ($4,800.00) + $3,471.07 + $1,363.64
475 2-Year NPV = $34.71
476
PV of PV of
477 1-Year NPV = Intial Cost + Operating + Salvage
Cash Flow Value
478 = ($4,800.00) + $1,818.18 + $2,727.27
479 1-Year NPV = ($254.55)
 L M N O P Q R S
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scounted back at 10%.
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Notice that the NPV function isn't really a Net present value.
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Instead, it is the present value of future cash flows. Thus, you specify
91 only the future cash flows in the NPV function. To find the true
92 NPV, you must add the time zero cash flow to the result of the NPV
93 function.
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 L M N O P Q R S
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Data Table
229 used to make graph:
230 Project NPVs
231 S L
232 $78.82 $49.18
233 $300.00 $400.00
234 $180.42 $206.50
235 $134.40 $134.40
236 $78.82 $49.18
237 $46.10 $0.00
238 $0.00 -$68.02
239 -$8.33 -$80.14
240 -$83.72 -$187.50
241 -$149.44 -$277.44
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 L M N O P Q R S
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 L M N O P Q R S
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304 B304:F304
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