MF Chapter 6 Capital Budgeting Techniques Certain

Chapter 6
Capital Budgeting Techniques: Certainty and Risk
Copyright © 2006 Pearson Addison-Wesley. All rights

reserved.
Learning Goals
1. Understand the role of capital

budgeting techniques in the capital budgeting process.
2. Calculate, interpret, and evaluate the payback period.
3. Calculate, interpret, and evaluate the net present value (NPV).

reserved. 6-2
Learning Goals (cont.)
4. Calculate, interpret, and evaluate the internal rate of return (IRR).

5. Use net present value profiles to compare NPV and IRR
techniques.
6. Discuss NPV and IRR in terms of conflicting rankings and the
theoretical and practical strengths of each approach.

reserved. 6-3
7. Understand the importance of recognizing risk in the analysis of

capital budgeting projects.
8. Discuss breakeven cash flow, sensitivity and scenario analysis,
and simulation
as behavioral approaches for dealing with risk.
9. Discuss the unique risks that multinational companies face.

reserved. 6-4
10. Describe the determination and use of risk-

adjusted discount rates (RADRs), portfolio
effects, and the practical aspects of RADRs.
11. Select the best of a group of mutually
exclusive projects using annualized net present
values (ANPVs).
12. Explain the role of real options and the objective
and procedures for selecting projects under
capital rationing.

reserved. 6-5
Capital Budgeting Techniques
• Chapter Problem
Bennett Company is a medium sized metal fabricator

that is currently contemplating two projects: Project A
requires an initial investment of $42,000, project B an
initial investment of $45,000. The relevant operating
cash flows for the two projects are presented in Table
9.1 and depicted on the time lines in Figure 9.1.

reserved. 6-6
Capital Budgeting Techniques (cont.)

reserved. 6-7
Capital Budgeting Techniques (cont.)

reserved. 6-8
Payback Period
• The payback method simply measures how long (in

years and/or months) it takes to recover the initial
investment.
• The maximum acceptable payback period is
determined by management.
• If the payback period is less than the maximum
acceptable payback period, accept the project.
• If the payback period is greater than the maximum
acceptable payback period, reject
the project.
reserved. 6-9
Net Present Value (NPV)
• Net Present Value (NPV): Net Present Value is found by subtracting

the present value of the after-tax outflows from the present value of
the after-tax inflows.

reserved. 6-10
Net Present Value (NPV) (cont.)
• Net Present Value (NPV): Net Present Value is found by subtracting the
present value of the after-tax outflows from the present value of the
after-tax inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
reserved. 6-11
Using the Bennett Company data from Table 9.1, assume

the firm has a 10% cost of capital. Based on the given
cash flows and cost of capital (required return), the NPV
can be calculated as shown in Figure 9.2

reserved. 6-12

reserved. 6-13

reserved. 6-14

reserved. 6-15
Internal Rate of Return (IRR)
• The Internal Rate of Return (IRR) is the discount

rate that will equate the present value of the
outflows with the present value of
the inflows.
• The IRR is the project’s intrinsic rate of return.

reserved. 6-16
Internal Rate of Return (IRR) (cont.)
• The Internal Rate of Return (IRR) is the discount

rate that will equate the present value of the
outflows with the present value of
the inflows.
• The IRR is the project’s intrinsic rate of return.
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
reserved. 6-17

reserved. 6-18

reserved. 6-19
Net Present Value Profiles
• NPV Profiles are graphs that depict project NPVs for various discount
rates and provide an excellent means of making comparisons
between projects.
To prepare NPV profiles for Bennett Company’s

projects A and B, the first step is to develop a number
of discount rate-NPV coordinates and then graph
them as shown in the following table and figure.

reserved. 6-20
Net Present Value Profiles (cont.)

reserved. 6-21
Net Present Value Profiles (cont.)

reserved. 6-22
Conflicting Rankings
• Conflicting rankings between two or more projects using

NPV and IRR sometimes occurs because of differences in the
timing and magnitude of cash flows.
• This underlying cause of conflicting rankings is the implicit
assumption concerning the reinvestment of intermediate
cash inflows—cash inflows received prior to the termination
of the project.
• NPV assumes intermediate cash flows are reinvested at the
cost of capital, while IRR assumes that they are reinvested at
the IRR.

reserved. 6-23
Conflicting Rankings (cont.)
A project requiring a $170,000 initial investment is

expected to provide cash inflows of $52,000, $78,000
and $100,000. The NPV of the project at 10% is
$16,867 and it’s IRR is 15%. Table 9.5 on the following
slide demonstrates the calculation of the project’s future
value at the end of it’s 3-year life, assuming both a 10%
(cost of capital) and 15% (IRR) interest rate.

reserved. 6-24

reserved. 6-25
If the future value in each case in Table 9.5 were

viewed as the return received 3 years from today from
the $170,000 investment, then the cash flows would be
those given in Table 9.6 on the following slide.

reserved. 6-26

reserved. 6-27
Bennett Company’s projects A and B were found to have

conflicting rankings at the firm’s 10% cost of capital as
depicted in Table 9.4. If we review the project’s cash inflow
pattern as presented in Table 9.1 and Figure 9.1, we see
that although the projects require similar investments, they
have dissimilar cash flow patterns. Table 9.7 on the
following slide indicates that project B, which has higher
early-year cash inflows than project A, would be preferred
over project A at higher discount rates.
reserved. 6-28

reserved. 6-29
Which Approach is Better?
• On a purely theoretical basis, NPV is the better

approach because:
• NPV assumes that intermediate cash flows are reinvested
at the cost of capital whereas IRR assumes they are
reinvested at the IRR,
• Certain mathematical properties may cause a project with
non-conventional cash flows to have zero or more than
one real IRR.
• Despite its theoretical superiority, however,
financial managers prefer to use the IRR because of
the preference for rates of return.
reserved. 6-30
Recognizing Real Options
• Real options are opportunities that are embedded in capital

projects that enable managers to alter their cash flows and
risk in a way that affects project acceptability (NPV).
• Real options are also sometimes referred to as strategic
options.
• Some of the more common types of real options are
described in the table on the following slide.
Copyright © 2006 Pearson Addison-Wesley. All rights 6-31

reserved.
Recognizing Real Options (cont.)

reserved. 6-32
NPVstrategic = NPVtraditional + Value of Real Options
Assume that a strategic analysis of Bennett Company’s

projects A and B (see Table 10.1) finds no real options
embedded in Project A but two real options embedded
in B:
1. During it’s first two years, B would have downtime that
results in unused production capacity that could be used
to perform contract manufacturing;
2. Project B’s computerized control system could control two
other machines, thereby reducing labor costs.
reserved. 6-33
Bennett’s management estimated the NPV of the contract manufacturing
option to be $1,500 and the NPV of the computer control sharing option to
be $2,000. Furthermore, they felt there was a 60% chance that the
contract manufacturing option would be exercised and a 30% chance that
the computer control sharing option would be exercised.
Value of Real Options for B = (60% x $1,500) + (30% x $2,000)

$900 + $600 = $1,500
NPVstrategic = $10,924 + $1,500 = $12,424
NPVA = $12,424; NPVB = $11,071; Now choose A over B.

reserved. 6-34
Capital Rationing
• Firm’s often operate under conditions of capital rationing—

they have more acceptable independent projects than they
can fund.
• In theory, capital rationing should not exist—firms should
accept all projects that have positive NPVs.
• However, research has found that management internally
imposes capital expenditure constraints to avoid what it
deems to be “excessive” levels of new financing, particularly
debt.
• Thus, the objective of capital rationing is to select the group
of projects within the firm’s budget that provides the highest
overall NPV or IRR.
reserved. 6-35
Capital Rationing
Tate Company, a fast growing plastics company with a

cost of capital of 10%, is confronted with six projects
competing for its fixed budget of $250,000. The initial
investment and IRR for each project are shown below:

reserved. 6-36
Capital Rationing: IRR Approach

reserved. 6-37
Capital Rationing: NPV Approach

reserved. 6-38
Behavioral Approaches
for Dealing with Risk
• In the context of the capital budgeting projects discussed in
this chapter, risk results almost entirely from the uncertainty
about future cash inflows, because the initial cash outflow is
generally known.
• These risks result from a variety of factors including
uncertainty about future revenues, expenditures and taxes.
• Therefore, to asses the risk of a potential project, the analyst
needs to evaluate the riskiness of the cash inflows.

reserved. 6-39
Behavioral Approaches for Dealing
with Risk: Risk and Cash Inflows
Treadwell Tire, a tire retailer with a 10% cost of capital, is
considering investing in either of two mutually exclusive
projects, A and B. Each requires a $10,000 initial
investment, and both are expected to provide equal
annual cash inflows over their 15-year lives. For either
project to be acceptable, NPV must be greater than zero.
We can solve for CF using the following:

reserved. 6-40
with Risk: Risk and Cash Inflows (cont.)

reserved. 6-41
with Risk: Risk and Cash Inflows (cont.)

reserved. 6-42
with Risk: Sensitivity Analysis
The risk of Treadwell Tire Company’s investments can be

evaluated using sensitivity analysis as shown in Table 10.2
on the following slide. For this example, assume that the
financial manager made pessimistic, most likely, and
optimistic estimates of the cash inflows for each project.

reserved. 6-43
with Risk: Sensitivity Analysis (cont.)

reserved. 6-44
with Risk: Scenario Analysis
• Scenario analysis is a behavioral approach similar to
sensitivity analysis but is broader in scope.
• This method evaluates the impact on the firm’s return of
simultaneous changes in a number of variables, such as cash
inflows, outflows, and the cost of capital.
• NPV is then calculated under each different set of variable
assumptions.

reserved. 6-45
with Risk: Simulation
• Simulation is a statistically-based behavioral
approach that applies predetermined probability
distributions and random numbers to estimate risky
outcomes.
• Figure 10.1 presents a flowchart of the simulation
of the NPV of a project.
• The use of computers has made the use of
simulation economically feasible, and the resulting
output provides an excellent basis for decision-
making.
reserved. 6-46
Behavioral Approaches
for Dealing with Risk

reserved. 6-47
International Risk Considerations
• Exchange rate risk is the risk that an unexpected change in

the exchange rate will reduce NPV of a project’s cash flows.
• In the short term, much of this risk can be hedged by using
financial instruments such as foreign currency futures and
options.
• Long-term exchange rate risk can best be minimized by
financing the project in whole or in part in the local
currency.

reserved. 6-48
International
Risk Considerations (cont.)
• Political risk is much harder to protect against once a project
is implemented.
• A foreign government can block repatriation of profits and
even seize the firm’s assets.
• Accounting for these risks can be accomplished by adjusting
the rate used to discount cash flows—or better—by
adjusting the project’s cash flows.

reserved. 6-49
International
Risk Considerations (cont.)
• Since a great deal of cross-border trade among MNCs takes place
between subsidiaries, it is also important to determine the net
incremental impact of a project’s cash flows overall.
• As a result, it is important to approach international capital projects
from a strategic viewpoint rather than from a strictly financial
perspective.

reserved. 6-50
Risk-Adjusted Discount Rates
• Risk-adjusted discount rates are rates of return that

must be earned on given projects to compensate
the firm’s owners adequately—that is, to maintain
or improve the firm’s share price.
• The higher the risk of a project, the higher the
RADR—and thus the lower a project’s NPV.

reserved. 6-51
Risk-Adjusted Discount Rates:
Review of CAPM

reserved. 6-52
Using CAPM to Find RADRs

reserved. 6-53
Risk-Adjusted Discount Rates: Applying
RADRs
Bennett Company wishes to apply the Risk-Adjusted

Discount Rate (RADR) approach to determine whether to
implement Project A or B. In addition to the data
presented earlier, Bennett’s management assigned a
“risk index” of 1.6 to project A and 1.0 to project B as
indicated in the following table. The required rates of
return associated with these indexes are then applied as
the discount rates to the two projects to determine NPV.
reserved. 6-54
RADRs (cont.)

reserved. 6-55
RADRs (cont.)

reserved. 6-56
RADRs (cont.)

reserved. 6-57
RADRs (cont.)

reserved. 6-58
RADRs in Practice

reserved. 6-59

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Chapter 6

Capital Budgeting Techniques: Certainty and Risk

Copyright © 2006 Pearson Addison-Wesley. All rights

1. Understand the role of capital

Copyright © 2006 Pearson Addison-Wesley. All rights

4. Calculate, interpret, and evaluate the internal rate of return (IRR).

Copyright © 2006 Pearson Addison-Wesley. All rights

7. Understand the importance of recognizing risk in the analysis of

Copyright © 2006 Pearson Addison-Wesley. All rights

10. Describe the determination and use of risk-

Copyright © 2006 Pearson Addison-Wesley. All rights

Bennett Company is a medium sized metal fabricator

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

• The payback method simply measures how long (in

• Net Present Value (NPV): Net Present Value is found by subtracting

Copyright © 2006 Pearson Addison-Wesley. All rights

Using the Bennett Company data from Table 9.1, assume

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

• The Internal Rate of Return (IRR) is the discount

Copyright © 2006 Pearson Addison-Wesley. All rights

• The Internal Rate of Return (IRR) is the discount

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

To prepare NPV profiles for Bennett Company’s

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

• Conflicting rankings between two or more projects using

Copyright © 2006 Pearson Addison-Wesley. All rights

A project requiring a $170,000 initial investment is

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

If the future value in each case in Table 9.5 were

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Bennett Company’s projects A and B were found to have

Copyright © 2006 Pearson Addison-Wesley. All rights

• On a purely theoretical basis, NPV is the better

• Real options are opportunities that are embedded in capital

Copyright © 2006 Pearson Addison-Wesley. All rights 6-31

Copyright © 2006 Pearson Addison-Wesley. All rights

NPVstrategic = NPVtraditional + Value of Real Options

Assume that a strategic analysis of Bennett Company’s

Value of Real Options for B = (60% x $1,500) + (30% x $2,000)

NPVstrategic = $10,924 + $1,500 = $12,424

NPVA = $12,424; NPVB = $11,071; Now choose A over B.

• Firm’s often operate under conditions of capital rationing—

Tate Company, a fast growing plastics company with a

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

The risk of Treadwell Tire Company’s investments can be

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights

Copyright © 2006 Pearson Addison-Wesley. All rights