Topic objectives

This chapter is intended to provide: • An understanding of the importance of capital budgeting in marketing decision making • An explanation of the different types of investment project • An introduction to the economic evaluation of investment proposals • The importance of the concept and calculation of net present value and internal rate of return in decision making • The advantages and disadvantages of the payback method as a technique for initial screening of two or more competing projects

Capital budgeting versus current expenditures
A capital investment project can be distinguished from current expenditures by two features: a) Such projects are relatively large b) a significant period of time (more than one year) elapses between the investment outlay and the receipt of the benefits

Capital budgeting (or investment appraisal) is the planning process used to determine a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects. or Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select

a project is needed. Accept the project if PV of inflows > costs. Payback period B. Determine the appropriate discount rate. Estimate the cash flows 2. Profitability index . 4. IRR > Hurdle Rate and/or Payback < policy Basic Data Expected Net Cash Flow Project L Project S 0 1 2 3 ($100) 10 60 80 ($100) 70 50 20 Year Evaluation Techniques A. Net present value (NPV) C. 5. Assess the riskiness of the cash flows. Internal rate of return (IRR) D. This procedure is called capital budgeting. Basic Steps of Capital Budgeting 1. Modified internal rate of return (MIRR) E. 3. Find the PV of the expected cash flows.

usually expressed in years. Payback is often used as a "first screening method". Ignores cash flows occurring after the payback period . Paybacks = 1.4 years. When deciding between two or more competing projects. the first question to ask is: 'How long will it take to pay back its cost?' The company might have a target payback. PAYBACK PERIOD Payback period is 'the time it takes the cash inflows from a capital investment project to equal the cash outflows.6 years. Project L Expected Net Cash Flow Project L Project S 0 1 2 3 ($100) 10 60 80 ($100) (90) (30) 50 Year Payback = 2 + $30/$80 years = 2. we mean that when a capital investment project is being considered.A. By this. and so it would reject a capital project unless its payback period were less than a certain number of years Payback period = Expected number of years required to recover a project’s cost. the usual decision is to accept the one with the shortest payback.

See also time value of money. to get the NPV. This weakness is eliminated with the discounted payback method. These future cash flows are then discounted to determine their present value. The NPV decision rule is to accept all positive NPV projects in an unconstrained environment. The hurdle rate is the minimum acceptable return on an investment CFt n NPV = ∑ t = 0 (1 + k) t . so selecting the proper rate sometimes called the hurdle rate . accept the one with the highest NPV The NPV is greatly affected by the discounted rate. The method also has the advantage that it involves a quick. This valuation requires estimating the size and timing of all of the incremental cash flows from the project. simple calculation and an easily understood concept NET PRESENT VALUE Each potential project's value should be estimated using a discounted cash flow (DCF) valuation. • It may lead to excessive investment in short-term projects Advantages of the payback method:  Payback can be important: long payback means capital tied up and high investment risk.Weaknesses of Payback: Ignores the time value of critical to making the right decision. These present values are then summed. or if projects are mutually exclusive. to find its net present value (NPV). • It is unable to distinguish between projects with the same payback period.

accept Project S since NPVS > NPVL. If the projects are mutually exclusive. accept both. and NPV rises as k decreases.11 NPVL = $ 18. In most realistic cases. followed by all positive cash flows. This rate means that the present value of the cash inflows for the project would equal the present value of its outflows.Project L 0 − 100.98 If the projects are independent. for mutually exclusive projects. in the usual cases where a negative cash flow occurs at the start of the project.00 9.79 1 10 2 60 3 80 NPVS = $19.  The IRR is found by trial and error The IRR method will result in the same decision as the NPV method for independent (non-mutually exclusive) projects in an unconstrained environment. Nevertheless.09 49. all independent projects that have an IRR higher than the hurdle rate should be accepted. Note: NPV declines as k increases. INTERNAL RATE OF RETURN The internal rate of return (IRR) is defined as the discounted rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. the decision rule of taking the . • The IRR is the break-even discount rate.59 60.

project with the highest IRR . Mathematical proof: for a project to be acceptable. NPV is negative and IRR < k2: reject the project. Figure 6. The IRR equation generally cannot be solved analytically but only via iterations.may select a project with a lower NPV. If cash flows are discounted at k2. several zero NPV discount rates may exist. the NPV must be positive IRR : CFt n = $0 = NPV ∑ t = 0 (1 + IRR ) t . NPV is positive and IRR > k1: accept project. . In some cases.which is often used . But if the signs of the cash flows change more than once. so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. IRR Independent projects If cash flows are discounted at k1.1 NPV vs. there may be several IRRs.

it does not have the drawbacks of the ARR and the payback period.1% 18. while the IRR method is easy and understandable. but it uses cash flows and recognizes the time value of money.57 $ 0.1% 43. Suppose the cutoff rate is 11% and the IRR is calculated as 40%.1% 48.47 18. • The main problem with the IRR method is that it often gives unrealistic rates of return. the IRR method is more popular than • • • the NPV approach. accept both because IRR > k. in practice. like the NPV.00 10 60 80 8.6% If the projects are independent.02 18. In other words.Project L 0 1 2 3 − 100. . both of which ignore the time value of money. Does this mean that the management should immediately accept the project because its . ADVANTAGES AND DISADVANTAGES OF IRR AND NPV • A number of surveys have shown that. The reason may be that the IRR is straightforward.1% IRRS = 23.06 ≈ $0 IRRL = 18.

$600. In this case.500. Simply speaking. $700. the use of the NPV and the IRR methods may give different results. . despite its popularity in the business world. it should not be used as a yardstick to accept or reject a project. A project selected according to the NPV may be rejected if the IRR method is used. $500. Another problem with the IRR method is that it may give different rates of return. X and Y. Suppose there are two alternative projects. $300. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. entails more problems than a practitioner may think.IRR is 40%. an IRR of 40% is too good to be true! So unless the calculated IRR is a reasonable rate for reinvestment of future cash flows. WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS When comparing two projects. The initial investment in each project is $2. Project X will provide annual cash flows of $500 for the next 10 years. $200. The purpose is to let you know that the IRR method. an IRR of 40% is suspect. $800. $400. The answer is no! An IRR of 40% assumes that a firm has the opportunity to reinvest future cash flows at 40%. Project Y has annual cash flows of $100. If past experience and the economy indicate that 40% is an unrealistic rate for future reinvestments. which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs.

Project X should be preferred because its IRR is 4% more than the IRR of Project Y. . Project X is preferred because of a higher NPV. at a 5% discount rate. Actually.000. even two projects of the same length may have different patterns of cash flow. don’surprised if you get different selection results. Using the trial and error method explained before you find that the IRR of Project X is 17% and the IRR of Project Y is around 13%. and $1.000 in the same period. short-term project. The cash flow of one project may continuously increase over time. the large project could be thought of as ten small projects. A 10-year project with an initial investment of $100.$900. whereas project selection using the NPV method depends on the discount rate chosen PROJECT SIZE AND LIFE There are reasons why the NPV and the IRR are sometimes in conflict: the size and life of the project being studied are the most common ones. DIFFERENT CASH FLOWS Furthermore. For instance. If you use the IRR. Project Y has a higher NPV than X does. long-term project with a small. So if you insist on using the IRR and the NPV methods to compare a big.000 can hardly be compared with a small 3-year project costing $10. But what happens to your decision if the NPV method is used? The answer is that the decision will change depending on the discount rate you use. But at a discount rate of 8%. The purpose of this numerical example is to illustrate an important distinction: The use of the IRR always leads to the selection of the same project.

00 12.while the cash flows of the other project may increase.00 66. please note that the MIRR is not used as widely as the IRR in practice.00 $ 0. stop. For example. decrease.00 TV -100. or become negative. Project L 0 1 2 3 80. Modified IRR (MIRR) The MIRR is similar to the IRR. As soon as you change the discount rate to 15%.10 $158. to be equal to the firm’s investment at time zero. and if the discount rate is changed when using the NPV approach. Calculate the future value of all cash inflows at the last year of the project’s life. However.00 = NPV 10 60 = PVcosts =PV outflows n $100 (1 + MIRR ) TV inflows = $158. There are 3 basic steps of the MIRR: (1) (2) Estimate all cash flows as in IRR. the result will probably be different orders of ranking. This discount rate is know as the MIRR. Project B may be more attractive D. at 10% the NPV of Project A may be higher than that of Project B. but is theoretically superior in that it overcomes twoweaknesses of the IRR.10 = TV of Inflows 100. (3) Determine the discount rate that causes the future value of all cash Inflows determined in step 2. These two projects have completely different forms of cash flow.10. 10% . The MIRR correctly assumes reinvestment at the project’scost of capital and avoids the problem of multiple IRRs.

MIRR avoids the problem of multiple IRRs. if the net present value is negative. PI = PVCF Initial investment In this method.MIRR = 16. E. 2. Therefore. Note that the PI method is closely related to the NPV approach. On the other hand. or PI. In other words.9%. therefore. the PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project. MIRR is better than IRR because 1. the PI will be greater than 1. a project with a PI greater than 1 is accepted. whether the net present value or the PI is used. if the present value of cash flows exceeds the initial investment. MIRR correctly assumes reinvestment at project’s cost of capital. the project will have a PI of less than 1. In fact.5% MIRRS = 16. if the net present value of a project is positive. PROFITABILITY INDEX (PI) The profitability index. method compares the present value of future cash inflows with the initial investment on a relative basis. but a project is rejected when its PI is less than 1. The same conclusion is reached. there .

indicating that the project is acceptable. Reject if PI < 1. EQUIVALENT ANNUAL ANNUITY What do you do when project lives vary significantly? An easy and intuitively appealing approach is to compare the “equivalent annual annuity” among all the a positive net present value and a PI greater than 1.0 F.00 PV1 PV2 PV3 9.79 =1.11 118.09 49.59 60.79 PI = PV of cash flows initial coast 10% 1 10 2 60 3 80 = 118 . Projects of equal size but different life can be ranked directly by their equivalent . Project L 0 -100. PI is also known as a benefit/cash ratio.10 100 Accept project if PI > 1. The equivalent annuity is the level annual payment across a project’s specific life that has a present value equal to that of another cash-flow stream.

The following are some general guidelines to orient the decision maker in these situations. Focus on cash flows. Thus one wants to focus on the changes in cash flows affected by the project. The analysis may require some careful thought: a project decision identified as a simple go/no-go question may hide a subtle substitution or choice among alternatives. The point of the whole analytical exercise is to judge whether the firm will be better off or worse off if it undertakes the project. This approach is also known as equivalent annual cost. Accounting profits contain many kinds of economic fiction. equivalent annual cash flow. not profits. 1.annuity. 2. are economic facts. The equivalent annual annuity is solved for by this equation: Equivalent Annuity = PV (Cash Flows) / (present value factor of n-year annuity IV. Focus on incremental cash flows. The most common of these is the simple “yes” versus “no” choice about a capital investment. a proposal to invest in an automated machine should trigger many questions: Will . or simply equivalent annuity approach. For instance. One wants to get as close as possible to the economic reality of the project. PROJECT DECISION ANALYSIS MAKING GO/NO-GO PROJECT DECISION Virtually all general managers face capital-budgeting decisions in the course of their careers. on the other hand. Flows of cash.

higher quality. Not all projects present the same level or risk. Account for time. Time is money. The goal should be to identify the value-maximizing bundle of projects. more operational flexibility)? The key economic question asked of project proposals should be. 4. worse.e. One wants to be compensated with a higher return for taking more risk. Possible causes:  Banks and investors say “NO”  Managerial conservatism • Analysis is required. rather than individual projects. The way to control for variations in risk from project to project is to use a discount rate to value a flow of cash that is consistent with the risk of that flow A. • The danger is that the capital-rationing constraint heightens the influence of nonfinancial considerations. or “bundles”. Quite simply.g. be better or worse) if we undertake the project?” 3. or choose not to. Account for risk. NPV can be interpreted as the amount by which the market value of the firm’s equity will change as a result of undertaking the project. one that destroys value! .. accept all value-creating investment projects. CAPITAL RATIONING • Exists whenever enterprises cannot. One must consider sets of projects. such as the following:  Competition among alternative strategies  Corporate politics  Bargaining games and psychology The outcome could be a sub-optimal capital budget.the machine expand capacity (and thus permit us to exploit demand beyond our current limits)? Will the machine reduce costs (at the current level of demand) and thus permit us to operate more efficiently than before we had the machine? Will the machine create other benefits (e. or. “How will things change (i.. Use NPV as the technique to summarize the quantitative attractiveness of the project. We prefer to receive cash sooner rather than later.

 Manage the process rather than the outcomes.• Some remedies are the following:  Relax and eliminate the budget constraint. Develop a corporate culture committed to value creation .