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Learning Objectives
1. Discuss why capital budgeting decisions are the most important decisions made by a firm’s
management.
2. Explain the benefits of using the net present value (NPV) method to analyze capital
expenditure decisions, and be able to calculate the NPV for a capital project.
3. Describe the strengths and weaknesses of the payback period as a capital expenditure
decision-making tool, and be able to compute the payback period for a capital project.
4. Explain why the accounting rate of return (ARR) is not recommended for use as a capital
5. Be able to compute the internal rate of return (IRR) for a capital project, and discuss the
conditions under which the IRR technique and the NPV technique produce different
results.
I. Chapter Outline
Capital budgeting decisions are the most important investment decisions made by
management.
the firm.
Capital investments are important because they involve substantial cash outlays and,
Imagine you were to start your own business. No matter what type you started, you would have
to answer the following three questions in some form or another:
1. What long-term investments should you take on? That is, what lines of business will
you be in and what sorts of buildings, machinery, and equipment will you need?
2. Where will you get the long-term financing to pay for your investment? Will you bring in
other owners or will you borrow the money?
3. How will you manage your everyday financial activities such as collecting from
customers and paying suppliers?
Capital Budgeting The first question concerns the firm's long-term investments. The process of
planning and managing a firm's long-term investments is called capital budgeting. In capital
budgeting, the financial manager tries to identify investment opportunities that are worth more to
the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow
generated by an asset exceeds the cost of that asset. Regardless of the specific investment under
consideration, financial managers must be concerned with how much cash they expect to receive,
when they expect to receive it, and how likely they are to receive it. Evaluating the size, timing,
and risk of future cash flows is the essence of capital budgeting. In fact, whenever we
evaluate a business decision, the size, timing, and risk of the cash flows will be, by far, the most
important things we will consider.
B. Sources of Information
All this information is then reviewed by the financial managers, who evaluate the
Capital budgeting projects can be broadly classified into three types: (1) independent
1. Independent Projects
3. Contingent Projects
The cost of capital is the minimum return that a capital budgeting project must earn
for it to be accepted.
It is an opportunity cost since it reflects the rate of return investors can earn on
Capital rationing implies that a firm does not have the resources necessary to fund
Thus, the available capital will be allocated to the set of projects that will benefit the
It is a capital budgeting technique that is consistent with the goal of maximizing shareholder
wealth.
The method estimates the amount by which the benefits or cash flows from a project exceeds
Valuing real assets calls for the same steps as valuing financial assets.
However, there are some practical difficulties in following the process for real assets.
First, cash flow estimates have to be prepared in-house and are not readily available
Second, estimates of required rates of return are more difficult than it is for financial
The present value of a project is the difference between the present value of the expected
Projects that have an NPV equal to zero imply that management will be indifferent
The Basic Idea – The NPV measures the increase in firm value, which is also the increase
in the value of what the shareholders own. Thus, making decisions with the NPV rule
facilitates the achievement of our goal – making decisions that will maximize
shareholder wealth.
Estimating Net Present Value: Discounted cash flow (DCF) valuation – finding the
market value of assets or their benefits by taking the present value of future cash flows by
estimating what the future cash flows would trade for in today’s dollars.
Identify and add up all expenses related to the cost of the project.
While we are mostly looking at projects whose entire cost occurs at the start of the
project, we need to recognize that some projects may have costs occurring beyond
2. Estimate the project’s future cash flows over its expected life.
Both cash inflows (CIF) and cash outflows are likely in each year of the project.
Estimate the net cash flow (NCFt) = CIFt – COFt for each year of the project.
Remember to recognize any salvage value from the project in its terminal year.
3. Determine the riskiness of the project and the appropriate cost of capital.
The cost of capital is the discount rate used in determining the present value of the
The riskier the project, the higher the cost of capital for the project.
Determine the difference between the present value of the expected cash flows from
5. Make a decision.
Accept the project if it produces a positive NPV or reject the project if NPV is
negative.
NCFt = Net cash flow cash inflows – cash outflows) in period t, where t =
1, 2, 3,…, n
Example - Compute the Net Present Value (NPV) given a required return of 12% and the following net
cash flows:
Year NCFt
0 ($20,000)
1 $6,000
2 $7,000
3 $8,000
4 $5,000
5 $4,000
NPV $20,000 $22,079.04 $2,079.04 (Since the NPV>0, the project should be accepted).
NPV $20,000 $19,729.45 $270.55 (Since the NPV<0, the project should be rejected).
Note: It is not the rather mechanical process of discounting the cash flows that is important. Once we
NPV is superior to the other methods of analysis presented in the text because it has no serious flaws.
The method unambiguously ranks mutually exclusive projects, and can differentiate between projects of
different scale and time horizon. The only drawback to NPV is that it relies on cash flow and discount
rate values that are often estimates and not certain, but this is a problem shared by the other
performance criteria as well.
Suppose the firm uses the NPV decision rule. At a required return of 11 percent, should the firm accept
this project? What if the required return was 16 percent? What if the required return was 27 percent?
The NPV of a project is the PV of the outflows minus by the PV of the inflows. The equation for the
NPV of this project at an 11 percent required return is:
At an 11 percent required return, the NPV is positive, so we would accept the project.
The equation for the NPV of the project at a 16 percent required return is:
At a 16 percent required return, the NPV is positive, so we would accept the project.
The equation for the NPV of the project at a 27 percent required return is:
At a 27 percent required return, the NPV is negative, so we would reject the project.
Recognize that the estimates going into calculating NPV are estimates and not market
The NPV method of determining project viability is the recommended approach for
It is one of the most widely used tools for evaluating capital projects.
The payback period represents the number of years it takes for the cash flows from a
This technique can serve as a risk indicator—the more quickly you recover the cash, the less
Example: Compute the Payback Period (PB) given a required return of 12% and the following net cash
flows:
Year NCFt Cumulative NCF
0 ($20,000)
1 $6,000 $6,000
2 $7,000 $13,000
3 $8,000 $21,000
4 $5,000
5 $4,000
NCF0
Note: The PB period when the cash flows are in the form of an annuity is calculated as: PB
NCFn
Year NCFt
0 ($5,000)
1 $2,000
2 $2,000
3 $2,000
4 $2,000
NCF0 $5,000
PB 2.50 years
NCFn $2,000
There is no economic rationale that links the payback method to shareholder wealth
maximization.
order of their payback rank: projects with the lowest payback period are selected first.
The payback period analysis can lead to erroneous decisions because the rule does not
A rapid payback does not necessarily mean a good investment. See Exhibit 10.6—
Projects D and E.
One weakness of the ordinary payback period is that it does not take into account the
The discounted payback period calculation calls for the future cash flows to be
The major advantage of the discounted payback is that it tells management how long it
However, this method still ignores all cash flows after the arbitrary cutoff period, which
is a major flaw.
Example - Compute the Discounted Payback Period (DPB) given a required return of 12% and the
following net cash flows:
It does not adjust or account for differences in the overall, or total, risk for a project,
The biggest weakness of either the standard or discounted payback methods is their
While the payback period is widely used in practice, it is rarely the primary decision criterion. As
William Baumol pointed out in the early 1960s, the payback rule serves as a crude “risk screening”
device – the longer cash is tied up, the greater the likelihood that it will not be returned. The payback
period may be helpful when comparing mutually exclusive projects. Given two similar projects with
different paybacks, the project with the shorter payback is often, but not always, the better project.
Despite its shortcomings, the payback period rule is often used by large and sophisticated companies
when they are making relatively minor decisions. There are several reasons for this. The primary reason
is that many decisions simply do not warrant detailed analysis because the cost of the analysis would
exceed the possible loss from a mistake. As a practical matter, an investment that pays back rapidly and
has benefits extending beyond the cutoff period probably has a positive NPV.
In addition to its simplicity, the payback rule has two other positive features. First, because it is biased
towards short-term projects, it is biased towards liquidity. In other words, a payback rule tends to
product launches.
This method computes the return on a capital project using accounting numbers—the
project’s net income (NI) and book value (BV) rather than cash flow data.
Average NI
ARR
Average BV
It has a number of major flaws as a tool for evaluating capital expenditure decisions.
First, the ARR is not a true rate of return. ARR simply gives us a number based on
average figures from the income statement and balance sheet. Since it involves
accounting figures rather than cash flows, it is not comparable to returns in capital
markets.
There is no economic rationale that links a particular acceptance criterion to the goal of
from a project.
When we use the IRR, we are looking for the rate of return associated with a project so we
can determine whether this rate is higher or lower than the firm’s cost of capital.
The IRR is the discount rate that makes the NPV to equal zero.
n
NCFt
NPV 0,
t 0 (1 IRR) t
The IRR is an expected rate of return, much like the yield to maturity calculation that
We will need to apply the same trial-and-error method to compute the IRR.
Example - Compute the Internal Rate of Return (IRR) given a required return of 12% and the following
cash flows:
Year CFt
0 ($20,000)
1 $6,000
2 $7,000
3 $8,000
4 $5,000
5 $4,000
o Set the NPV equation equal to zero and solve for the IRR:
o At this point, unless you are using a financial calculator or spreadsheet, solving for
the IRR is a trial and error process. That is, we would “plug” in different estimates
for the IRR, work through the calculations, and determine if we have found the rate
that causes NPV to equal $0. We have already computed the NPV of this project at a
12% discount rate and found the NPV to be positive. In addition, we computed the
NPV of the project at a discount rate of 17% and found NPV to be negative.
o Since the IRR > k (16.38% > 12%), the project should be accepted.
Note: The calculation of the project’s IRR does not depend upon the required rate of return. The IRR is
compared to the required rate of return to determine whether to accept or reject the project. Also, if a
project’s NPV is positive, its IRR will exceed the required rate of return. If a project’s NPV is negative,
its IRR will be below the required rate of return.
Year NCFt
0 ($32,000)
1 $14,000
2 $14,000
3 $14,000
4 $14,000
Looking down the period column to four periods, we then move to the right to find the interest rate that
corresponds to the PVIFA of 2.285714. This occurs somewhere between 24% and 28%. With a
financial calculator, we find the exact IRR to be 26.86%.
.
The two methods will always agree when the projects are independent and the projects’
After the initial investment is made (cash outflow), all the cash flows in each future year
The point at which the project’s NPV profile intersects with the x-axis is by definition the project’s
IRR, since the NPV at this point is equal to $0.
The IRR and NPV methods can produce different accept/reject decisions if a project
either has unconventional cash flows or the projects are mutually exclusive.
Future cash flows from a project could include both positive and negative cash
flows.
A cash flow stream that looks similar to a conventional cash flow stream except
makes the result unreliable and should not be used in deciding about accepting or
rejecting a project.
When you are comparing two mutually exclusive projects, the NPVs of the two
projects will equal each other at a certain discount rate. This point at which the NPVs
intersect is called the crossover point. Depending on whether the required rate of
return is above or below this crossover point, the ranking of the projects will be
A second situation arises when you compare projects with different costs. While IRR
gives you a return based on the dollar invested, it does not recognize the difference in
Expected after-
tax net cash
flows (NCFt)
Cash flow
Year (t) Project S Project L differential
0 ($100) ($100) 0
1 50 20 30
2 40 30 10
3 30 50 (20)
4 30 65 (35)
Mutually Exclusive Investments Even if there is a single IRR, another problem can arise concerning mutually
exclusive investment decisions, a If two investments, X and Y, are mutually exclusive, then taking one of them
means that we cannot take the other. Given two or more mutually exclusive investments, which one is the best?
A major weakness of the IRR compared to the NPV method is the reinvestment rate
assumption.
IRR assumes that the cash flows from the project are reinvested at the IRR, while the
NPV assumes that they are invested at the firm’s cost of capital.
This optimistic assumption in the IRR method leads to some projects being accepted
The compounded values are summed up to get the project’s terminal value.
The MIRR is the interest rate that equates the project’s cost to the terminal value at the
1) Using the required rate of return as the compounding rate, find the terminal value (future value) of all
of the net cash inflows (positive net cash flows) at the end of the project life.
2) Using the required rate of return as the discounting rate, find the present value at t = 0 of all of the net
cash outflows (negative net cash flows).
Example - Compute the Modified Internal Rate of Return (MIRR) given a required return of 12% and
the following net cash flows:
Year NCFt
0 ($20,000)
1 $6,000
2 $7,000
3 $8,000
4 $5,000
5 $4,000
2) PVoutflows = $20,000
For Project S:
For Project L:
While the IRR has an intuitive appeal to managers because the output is in the form of a
On the other hand, decisions made based on the project’s NPV are consistent with the
goal of shareholder wealth maximization. In addition, the result shows management the
dollar amount by which each project is expected to increase the value of the firm.
For these reasons, the NPV method should be used to make capital budgeting decisions.
The Profitability Index - present value of the future cash flows divided by the initial investment (both
PVinflows
PI
PVoutflows
Decision rule
An investment should be accepted if the PI > 1.0 and rejected if the PI < 1.0.
Example - Compute the Profitability Index (PI) given a required return of 12% and the following net
cash flows:
Year CFt
0 ($20,000)
1 $6,000
2 $7,000
3 $8,000
4 $5,000
5 $4,000
PVoutflows $20,000
$22,079.04
PI 1.104
$20,000
choice.
In the late 1950s, less than 20 percent of managers used the NPV or IRR methods.
By 1981, over 65 percent of financial managers surveyed used the IRR, but only 16.5
In a recent study of Fortune 1000 managers, 85 percent of managers used the NPV while
77 percent used the IRR. Surprisingly, over 50 percent of managers used the payback
method.
Management should systematically review the status of all ongoing capital projects and
In a postaudit review, management compares the actual results of a project with what
The review should challenge the business plan, including the cash flow projections
Management must also evaluate people responsible for implementing a capital project.
Multiple Choice
Identify the choice that best completes the statement or answers the question.
a. $1,802,554
b. $197,446
c. -$1,802,554
d. -$197,446
2. Net present value: Gao Enterprises plans to build a new plant at a cost of $3,250,000. The plant is
expected to generate annual cash flows of $1,225,000 for the next five years. If the firm's required rate
of return is 18 percent, what is the NPV of this project?
a. $2,875,000
b. $3,830,785
c. $580,785
d. $2,1225,875
3. Payback: Binder Corp. has invested in new machinery at a cost of $1,450,000. This investment is
expected to produce cash flows of $640,000, $715,250, $823,330, and $907,125 over the next four
years. What is the payback period for this project?
a. 2.12 years
b. 1.88 years
c. 4.00 years
d. 3.00 years.
4. Discounted payback: Roswell Energy Company is installing new equipment at a cost of $10 million.
Expected cash flows from this project over the next five years will be $1,045,000, $2,550,000,
$4,125,000, $6,326,750, and $7,000,000. The company's discount rate for such projects is 14 percent.
What is the project's discounted payback period?
a. 4.2 years
b. 4.4 years
c. 4.8 years
d. 5.0 years
5. Internal rate of return: Modern Federal Bank is setting up a brand new branch. The cost of the project
will be $1.2 million. The branch will create additional cash flows of $235,000, $412,300, $665,000 and
$875,000 over the next four years. The firm's cost of capital is 12 percent. What is the internal rate of
return on this branch expansion? (Round to the nearest percent.)
a. 20%
b. 23%
c. 25%
d. 27%
a. 10%
b. 12%
c. 14%
d. 16%
7. Modified internal rate of return: Jamaica Corp. is adding a new assembly line at a cost of $8.5
million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and
$5 million over the next four years. Its cost of capital is 16 percent.
What is the MIRR on this project?
a. 18.6%
b. 19.8%
c. 20.2%
d. 21.4%
MULTIPLE CHOICE
1. ANS: D
Learning Objective: LO 2
Level of Difficulty: Medium
Feedback: Initial investment = $2,000,000
Length of project = n = 3 years
Required rate of return = k = 10%
Net present value = NPV
2. ANS: C
Learning Objective: LO 2
Level of Difficulty: Medium
Feedback: Initial investment = $3,250,000
Annual cash flows = $1,225,000
Length of project = n = 5 years
Required rate of return = k = 18%
Net present value = NPV
3. ANS: A
Learning Objective: LO 3
Level of Difficulty: Medium
Feedback:
Binder Corp.
Year CF Cumulative CF
0 $(1,450,000) $(1,450,000)
1 640,000 (810,000)
2 715,250 (94,750)
3 823,330 728,580
4 907,125 1,635,705
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year
= 2 + ($94,750 / $823,330)
= 2.12 years
Prepared by Jim Keys 32
4. ANS: A
Learning Objective: LO 3
Level of Difficulty: Medium
Feedback:
Roswell Energy
i = 14%
Cumulative PVCF
Year CF PVCF
0 $(10,000,000) $(10,000,000) $(10,000,000
1 1,045,000 916,667 (9,083,333)
2 2,550,000 1,962,142 (7,121,191)
3 4,125,000 2,784,258 (4,336,934)
4 6,326,750 3,745,944 (590,990)
5 7,000,000 3,635,581 3,044,591
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year
= 4 + ($590,990/ $3,635,581)
= 4.16 years
5. ANS: B
Learning Objective: LO 5
Level of Difficulty: Medium
Feedback: Initial investment = $1,200,000
Length of project = n = 4 years
To determine the IRR, the trial-and-error approach can be used. Set NPV = 0.
Try IRR =23.1%.
The IRR of the project is 23.1 percent. Using a financial calculator, we find that the IRR is 23.119 percent.
6. ANS: B
Learning Objective: LO 5
Level of Difficulty: Medium
Feedback: Initial investment = $1,875,000
Annual cash flows = $415,350
Length of investment = n = 7 years
To determine the IRR, the trial-and-error approach can be used. Set NPV = 0.
Try IRR =12.3%.
7. ANS: B
Refer To: Ref 10-3
Learning Objective: LO 5
Level of Difficulty: Medium
Feedback: Initial investment = $8,500,000
Length of investment = n = 4 years
Cost of capital = k = 16%