RSM333HS – Winter 2023

Corporate Finance

Lecture 1: Capital Budgeting Methods (Chapter 7)

Professor Wayne Adlam

1
Introduction to Capital Budgeting Decisions - Overview

• Types of Capital Projects

• The Capital Budgeting Process
• Initial acceptance and then monitoring
• What is a “project”?

2
Capital Expenditures or “CAPEX” Decisions
• CAPEX: a firm’s investments in long-lived assets. Two main kinds:

TANGIBLE (new factory, machinery) INTANGIBLE (software, marketing costs, larger salesforce)

• Very important to the future direction of the company

• Often involves very significant outlay of money and managerial time
• Often take many years to demonstrate their returns

3
Capital Budgeting: The Decision Process

• The process includes:

1. Identifying investment alternatives
2. Evaluating these alternatives, and
3. Implementing the chosen investment decisions.

• The objective is to choose projects which maximize the value of the firm.

• A good method of project evaluation will:

• Take all incremental project cash flows into consideration
• Discount these cash flows at an appropriate risk-adjusted discount rate

4
What is a “Project”?
• Chapter 7
• Projects can be:
• Equipment replacement / Expansion of current business activities
• New products or processes

• Typical Cash Flow Pattern:

• CFt = the estimated after-tax future incremental cash flows
• CF0 = the initial after-tax incremental cash outlay or “investment” required

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Types of Project Interactions
Capital Budgeting often involves analysis of MULTIPLE projects

1. Independent Projects can be analysed individually and each is accepted / rejected

2. Mutually Exclusive Projects are those where JUST ONE will be selected
• For example, build a bridge, should it be made of wood or steel?
3. Contingent Projects must be done together
• For example, upgrading software requires a hardware change
• Evaluate the two in combination to see if they are acceptable
4. Other types of interactions are possible:
• Synergistic projects are worth more if done together
• For example, build a larger soccer stadium and at the same time invest in better players
• Some projects can also be cannibalistic
• For example, introducing a new toothpaste may reduce sales of existing brands
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Project Evaluation Methods
• Capital Budgeting often involves analysis of a SET of projects
1. Net Present Value (NPV): Incremental value of accepting a project
2. Internal Rate of Return (IRR): Percentage return of a project
• Basic, Modified, and Incremental versions
3. Profitability Index (PI): PV of benefits per dollar invested
4. Payback Period: Time period until the investment is recovered from cash flows
• Basic and Discounted versions

Average Accounting Return (AAR): Average earnings / Average BV of investment

• Used for accounting purposes, but not for project evaluation
• See Lecture 1C for more information

7
Project evaluation methods: Net present value

8
Net Present Value (NPV)

• NPV: Present value of benefits minus present value of costs

• To calculate NPV, need to estimate: initial costs, future cash inflows (amount and timing),
and the appropriate discount rate
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝑵 𝑪𝑭𝒊
• 𝑵𝑷𝑽 = −𝑪𝑭𝟎 + + + ….+ = σ𝒏𝒊=𝟎
𝟏+𝒓 𝟏 𝟏+𝒓 𝟐 𝑰+𝒓 𝑵 𝟏+𝒓 𝒊

• Decision rule: Accept if NPV > 0

• If NPV > 0 , then PV(Benefits) > PV(Costs) and project will create shareholder value

• Ranking projects: Choose the project with the higher NPV

• Project with higher NPV will create more shareholder value.

9
Example: Net Present Value (NPV)

• Investment today = $12,000

• After-tax cash flows:
• Year 1 $5,000
• Year 2 $5,000
• Year 3 $8,000

• Assume the appropriate discount rate is 15%. Should the company accept the project?
𝟓,𝟎𝟎𝟎 𝟓,𝟎𝟎𝟎 𝟖,𝟎𝟎𝟎
• 𝑵𝑷𝑽 = −𝟏𝟐, 𝟎𝟎𝟎 + + + = −12,000 + 13,389 = 𝟏, 𝟑𝟖𝟗
𝟏.𝟏𝟓 𝟏.𝟏𝟓𝟐 𝟏.𝟏𝟓𝟑
• This is > 0, so accept the project!
• In a perfectly efficient market, the total value of the firm should rise by the project’s NPV if the
project is undertaken
• In this example, the $12,000 project should increase the market capitalization of the firm (equity value) by
$1,389. If there are 10,000 shares outstanding, the price of each share should rise by approximately 14
cents ($1,389/10,000) 10
Example: Net Present Value (NPV)
• Chapter 7
• Investment today = $12,000
• After-tax cash flows:
• Year 1 $5,000
• Year 2 $5,000
• Year 3 $8,000

• Assume the appropriate discount rate is 15%. Should the company accept the project?
𝟓,𝟎𝟎𝟎 𝟓,𝟎𝟎𝟎 𝟖,𝟎𝟎𝟎
• 𝑵𝑷𝑽 = −𝟏𝟐, 𝟎𝟎𝟎 + + + = −12,000 + 13,389 = 𝟏, 𝟑𝟖𝟗
𝟏.𝟏𝟓 𝟏.𝟏𝟓𝟐 𝟏.𝟏𝟓𝟑

• This is > 0, so accept the project!

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Why Net Present Value?

• Includes and discounts all project cash flows at an appropriate discount rate and assumes that
interim cash flows during project life are “reinvested” at this rate (sensible)

• Firm value should increase by the NPV of accepted projects

• The TOTAL value of the firm is the sum of the values of the different projects, divisions, or other
entities within the firm (both current and anticipated)

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 Project evaluation methods: Internal rate of return (IRR)

Dana Boyko

13
13
Internal Rate of Return (IRR)

• IRR: If IRR > firm’s cost of capital (or a hurdle rate), the project is acceptable
• How do you calculate IRR?
• Need a financial calculator or Excel
• Iterative process

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Internal Rate of Return (IRR)

• IRR: The discount rate that sets NPV = zero

𝒏
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝑵 𝑪𝑭𝒊
𝟎 = −𝑪𝑭𝟎 + 𝟏 + 𝟏 + 𝑰𝑹𝑹 𝟐 + … . + 𝑰 + 𝑰𝑹𝑹 𝑵 𝒐𝒓 𝟎=෍ 𝒊
𝟏 + 𝑰𝑹𝑹 𝟏 + 𝑰𝑹𝑹
𝒊=𝟎

• Decision rule: Accept if IRR > required rate of return (k)

• Required rate of return = return required on the project, given its risk
• Ranking projects: Choose the project with the higher IRR

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Example: Calculating IRR

• Recall IRR is the discount rate that sets NPV equal to zero
• Consider the following project:
CF t=0 CF t=1 CF t=2 CF t=3
− $200 $50 $100 $150

• What is NPV if money has no time value and the discount rate is zero?
• Just add up the cash flows! NPV = $100
• What is NPV if the discount rate is 12%?
𝟓𝟎 𝟏𝟎𝟎 𝟏𝟓𝟎
• 𝟎 = −𝟐𝟎𝟎 + + + = $𝟑𝟏. 𝟏𝟑 Is IRR above or below 12%?
𝟏.𝟏𝟐 𝟏.𝟏𝟐 𝟐 𝟏.𝟏𝟐 𝟑

• What is NPV if the discount rate is 16%? = $16.52

• What is NPV if the discount rate is 20%? = −$2.08 We’ve gone too far!
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Example: Calculating IRR

• Recall IRR is the discount rate that sets NPV to zero

• Consider the following project:
CF t=0 CF t=1 CF t=2 CF t=3
− $200 $50 $100 $150

• What is NPV if money has no time value and the discount rate is zero?
• Just add up the cash flows! NPV = $100
• What is NPV if the discount rate is 12%?
𝟓𝟎 𝟏𝟎𝟎 𝟏𝟓𝟎
• 𝟎 = −𝟐𝟎𝟎 + + + = $𝟑𝟏. 𝟏𝟑 Is IRR above or below 12%?
𝟏.𝟏𝟐 𝟏.𝟏𝟐 𝟐 𝟏.𝟏𝟐 𝟑

• What is NPV if the discount rate is 16%? = $16.52

• What is NPV if the discount rate is 20%? = −$2.08 We’ve gone too far!
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Example: Calculating IRR

• Recall IRR is the discount rate that sets NPV to zero

• Consider the following project:
CF t=0 CF t=1 CF t=2 CF t=3
− $200 $50 $100 $150

• What is NPV if money has no time value and the discount rate is zero?
• Just add up the cash flows! NPV = $100
• What is NPV if the discount rate is 12%? Is IRR above or below
12%? 16%? 20%?
𝟓𝟎 𝟏𝟎𝟎 𝟏𝟓𝟎
• 𝟎 = −𝟐𝟎𝟎 + + + = $𝟑𝟏. 𝟏𝟑
𝟏.𝟏𝟐 𝟏.𝟏𝟐 𝟐 𝟏.𝟏𝟐 𝟑

• What is NPV if the discount rate is 16%? = $16.52

• What is NPV if the discount rate is 20%? = −$2.08 We’ve gone too far!
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Graphing the “NPV Profile” of the Project

Graph the NPV vs. discount rates, showing the IRR as the x-axis intercept

Discount Rate NPV

0% $100
1% $93.12
2% $86.48
... ...
12% $31.13
... ...
16% $13.52
... ...

20% −$2.08

Using excel we can calculate the IRR=19.44%

IRR (using IRR

CF0 CF1 CF2 CF3
function = IRR (…)
-$200 $50 $100 $150 19.44%
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A Mathematical Problem with the IRR Method
• If project cash flows of a project change in sign more than once, there will be multiple IRR’s
• Recall that a quadratic formula has 2 roots!
• There are more roots the more sign changes there are

• Example:
• Investment today = $100, Cash Flow 1 = $230, Cash Flow 2 = $ −132
$230 $132
• 𝑁𝑃𝑉 = −$100 + 1+𝑟
− 1+𝑟 2
$230 $132
• Set NPV to zero to find IRR: 0 = −$100 + 1+𝐼𝑅𝑅 − 1+𝐼𝑅𝑅 2
• Quadratic equation of this form: 0 = 𝑎 + 𝑏𝑥 + 𝑐𝑥 2
0 = −100 + 230𝑥 − 132𝑥 2

• The root of a quadratic equation is:

• Hence IRR = 10% and 20%

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Example: Multiple IRRs
There are two IRRs for this project: 0% and 100%
$200 $800

If cash flow signs switch more than once,

0 1 2 3 use NPV to assess project
- $800
-$200
NPV

$100.00 100% = IRR2

$50.00

$0.00
-50% 0% 50% 100% 150% 200%
($50.00)
Discount rate
($100.00)
0% = IRR1
($150.00)

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MIRR (“Modified”) Internal Rate of Return
• IRR calculation assumes that interim cash flows are reinvested at the IRR
• Is this realistic? Will firm be able to reinvest at the project IRR?
• If calculated IRR is greater than the reinvestment rate of interim cash flows, IRR will overstate
returns

• McKinsey report “Internal Rate of Return: A Cautionary Tale”

• Modifying reinvestment rate to firm’s cost of capital can change calculated IRR

• If we use the firm’s cost of capital as the reinvestment rate, that will be the same
assumption NPV uses
Note: The use of Modified IRR to deal with reinvestment of cash flows is not covered in our textbook. Please rely on class
slides and disregard the section called Modified Internal Rate of Return on p.192 of the textbook.

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Example: MIRR

• Back to our earlier example:

CF t=0 CF t=1 CF t=2 CF t=3
−$12,000 $5,000 $5,000 $8,000
• Assume a 15% discount rate, which is the firm’s cost of capital:
$𝟓𝟎𝟎𝟎 $𝟓𝟎𝟎𝟎 $𝟖𝟎𝟎𝟎
𝑵𝑷𝑽 = −$𝟏𝟐, 𝟎𝟎𝟎 +
𝟏.𝟏𝟓
+
𝟏.𝟏𝟓 𝟐
+
𝟏.𝟏𝟓 𝟑
= $1,389
• IRR is about 21%.
• MIRR assumes that you can invest each cash flow at the cost of capital (i.e. 15%) until year 3:
$5000 1.15 2 + $5000 1.15 + $8000 = $20,362.5
• $12000(1+MIRR)(1+MIRR)(1+MIRR) = $20,362.5
• Solving for MIRR = 19.3% > cost of capital (confirming that this is still a good project)

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Project evaluation methods: Profitability index

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Profitability Index (PI)
•Measures the PV of the benefits vs. the PV of the investment cost so it is a “relative”
• Aprofitability
test measure

𝑷𝑽 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘𝒔
• 𝑷𝑰 = Higher is better!
𝑷𝑽 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒇𝒍𝒐𝒘𝒔

• Decision Rule: Accept projects with PI > 1 (positive NPVs)

• Useful aid if investment funds are limited (NPV assumes all good projects can be
funded)
• Easy to understand as it is a “benefit-to-cost” ratio

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Example: Profitability Index

• Back to our earlier example:

CF t=0 CF t=1 CF t=2 CF t=3
−$12,000 $5,000 $5,000 $8,000

𝑷𝑽 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘𝒔 13,389

• If the discount rate is 15%, 𝑷𝑰 = = = 1.116
𝑷𝑽 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒇𝒍𝒐𝒘𝒔 12,000

• For independent projects, PI is fine as it makes the same accept/reject decisions

as NPV.
• For mutually exclusive projects, NPV may be a better tool
• Calculate total NPV of all feasible project combinations and take highest NPV

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Project evaluation method: Payback Period

Dana Boyko

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Payback Period

• Payback Period: Number of years to recover initial investment CF0 based on cash inflows
the project will generate
• Decision rule: Accept only projects that pay back initial investment faster than “cutoff” set by
management. SHORTER is BETTER if ranking projects

• Two versions: BASIC and DISCOUNTED

• The basic payback approach ignores the time value of money and does not consider all project cash
flows.
• Why useful?
• Simple
• Addresses liquidity and control concerns not captured by more sophisticated DCF (discounted cash
flow) techniques

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Example: Basic Payback Period
• A project has an initial investment cost of $500,000. Annual cash flows are as follows:
Year 1: $125,000
Year 2: $180,000
Year 3: $220,000
Year 4: $240,000
What is the payback period?

• SOLUTION: $500,000 − $125,000 − $180,000 − $195,000 = 0

• Payback period for the project takes 2.89 years
$195,000
• Year 1 CF + Year 2 CF + Year 3 CF (0.89= $220.000)
• Note: can assume cash flows occur “end of year” or “during the year”
• If during the year: payback = 2.89 years
• If end of year: payback = 3 years
• If company accepts only projects that pay off in 2 years, this project would be rejected.

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Example: Discounted Payback Period

• This time we discount the cash flows before calculating the Payback Period

• Assume you have the following information on Project X:

• Initial outlay: −$1,000; Required rate of return = 10%

• Annual cash flows and their PVs are as follows:

Year Cash flow PV of Cash flow Accumulated Discounted Cash flow
1 $ 200 $ 182 $ 182
2 400 331 $ 513
3 700 526 1,039
4 300 205 1,244

• Discounted payback period is just under 3 years.

• This incorporates time value of money but has all the other weaknesses of the regular payback
rule.

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Assessing the Payback Period Method

• A test

Disadvantages Advantages
• Ignores the time value of money • Easy to understand
• Ignores cash flows after the payback • Biased toward liquidity
period
• Biased against long-term projects
• Arbitrary acceptance criteria (how is
the “cutoff” selected?)
• A project based on the payback criteria
may not have a positive Net Present
Value

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 IRR and NPV – scale, timing of cash flows

Dana Boyko

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IRR vs NPV: Projects of Different Scale

• Project 1 : invest 100 to get 200 in year 1 (small project)

• Project 2 : invest 500 to get 750 in year 1 (much larger project)

• If k = 15% are these acceptable projects?

• NPV(Project 1) = -100 + 200 / 1.15 = 73.91 >0  Go !
• NPV(Project 2) = -500 + 750 / 1.15 = 152.17 >0  Go !
• WHICH IS BETTER? NPV is higher for Project 2

➢ How does IRR Rank the two projects?

• IRR(Project 1) = 100% > 15%  Go !
• IRR(Project 2) = 50% > 15%  Go !
• Agree they are good projects BUT WHICH IS BETTER?
• IRR is higher for Project 1

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Timing of Cash Flows
Which Project has the higher Net Present Value?
• % > cost of capital confirming that this is a GOOD PROJECT

$10,000 $1,000 $1,000

Project A
0 1 2 3

-$10,000
$1,000 $1,000 $12,000

Project B
0 1 2 3

-$10,000

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NPV Profiles for Project A and Project B
Which is higher when the NPV profiles intersect? It depends on the discount rate!
• % > cost

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 IRR with Incremental Cash Flows: Calculating the Crossover Rate

Compute the IRR for either Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000) $0 $0
project “A− B” or “B − A” 1 $10,000 $1,000 $9,000 ($9,000)
2 $1,000 $1,000 $0 $0
3 $1,000 $12,000 ($11,000) $11,000
Project A−B
9000/(1+IRR) − 11,000/(1+IRR)3 = 0
Project B−A
$3,000.00
−9000/(1+IRR) + 11,000/(1+IRR)3 = 0 10.55% = IRR
$2,000.00
$1,000.00

NPV
So A-B
$0.00
B-A
9000/(1+IRR) = 11,000/(1+IRR)3 ($1,000.00) 0% 5% 10% 15% 20%
($2,000.00)
($3,000.00)
IRR = 10.55%
Discount rate

36
36
 Putting it All Together
IRR (using IRR
Why is NPV(Project B) CF0 CF1 CF2 CF3 function = IRR (…)
Project A -10,000 10,000 1,000 1,000 16.04%
higher at lower In both cases,
Project B -10,000 1,000 1,000 12,000 12.94%
discount rates? A-B 0 9,000 0 -11,000 10.55% crossover rate = 10.55%
B-A 0 -9,000 0 11,000 10.55%

$3,000.00 10.55% = IRR

$2,000.00
$1,000.00

NPV
A-B
$0.00
B-A
($1,000.00) 0% 5% 10% 15% 20%
($2,000.00)
($3,000.00)
Discount rate

37
NPV vs IRR and PI

• The IRR is the discount rate that sets the NPV of a project to zero

• NPV and IRR make the SAME accept/reject decision because:

• If NPV >0 then IRR > appropriate discount rate for the project
• Also PI > 1 because PV of benefits exceeds (PV of) costs

• NPV is the “dollar value” of accepting a project while IRR is the percentage rate of return
on the project and PI is the PV of benefits per dollar of costs

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When Would a Firm Have to Rank Projects?

• If they are mutually exclusive so you MUST pick one of a set

• If you have a limited capital budget and have to pick only the most desirable projects
• Could be financial constraints, limit on available funds
• Could have limits on other resources such as skilled workers

• There may also be strategic reasons to accept/reject certain projects

• Could be managerial choice to limit growth of a division to a certain level
• May want to pursue a lower return project for competitive reasons

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How to Rank Independent Projects?

Consider a firm that has six different capital investment proposals this year. Each project
has its after tax cash flows (ATCF’s), IRR, NPV, PI and initial cost as shown in the table
below. Each project has the same risk as the firm as a whole.

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
A $1,500,000 $290,000 7 -$88,159 8.19% 0.94
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
D $70,000 $20,000 7 $27,368 21.08% 1.39
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
F $960,000 $200,000 8 $106,985 12.99% 1.11

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40
How to Rank Independent Projects?
If Decision Rule = NPV
Firm's Cost of Capital = 10.00%
Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
F $960,000 $200,000 8 $106,985 12.99% 1.11
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
D $70,000 $20,000 7 $27,368 21.08% 1.39
$9,030,000 $811,835
A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Acceptable: C, F, E, B, D (NPV > 0)

Unacceptable: A (NPV<0)
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How to Rank Independent Projects?
If Decision Rule = IRR

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
D $70,000 $20,000 7 $27,368 21.08% 1.39
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
F $960,000 $200,000 8 $106,985 12.99% 1.11
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
$9,030,000 $811,835

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Acceptable: D, C, E, F, B (IRR >10%)

Unacceptable: A (IRR<10%)
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42
 How to Rank Independent Projects?
If Decision Rule = PI
Firm's Cost of Capital = 10.00%
Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
D $70,000 $20,000 7 $27,368 21.08% 1.39
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
F $960,000 $200,000 8 $106,985 12.99% 1.11
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
$9,030,000 $811,835

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Acceptable: D, C, E, F, B (PI >1)

Unacceptable: A (PI<1)
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Project Rankings via Various Capital Budgeting Models:

Criteria
Project NPV IRR PI

1 C D D
2 F C C
3 E E F
4 B F E
5 D B B

Capital Budget 9,030,000 9,030,000 9,030,000

Total NPV 811,835 811,835 811,835

• All methods identify the value improving projects

• But they rank them differently
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44
What if the Capital Budget is $6 Million?
If Decision Rule = NPV
Firm's Cost of Capital = 10.00%

Capital Annual ATCF Useful

Project Initial Cost Benefits Life NPV IRR PI
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
F $960,000 $200,000 8 $106,985 12.99% 1.11
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
$5,960,000 $735,785
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
D $70,000 $20,000 7 $27,368 21.08% 1.39

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Acceptable: C, F, E
NPV = $735,785 given the constraint
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What if the Capital Budget is $6 Million?
If Decision Rule = IRR
Firm's Cost of Capital = 10.00%
Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
D $70,000 $20,000 7 $27,368 21.08% 1.39
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
$5,070,000 $656,168
F $960,000 $200,000 8 $106,985 12.99% 1.11
B $3,000,000 $700,000 6 $48,682 10.55% 1.02

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Acceptable: D, C, E
NPV = $656,168 given the constraint
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What if the Capital Budget is $6 Million?
If Decision Rule = PI

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
D $70,000 $20,000 7 $27,368 21.08% 1.39
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
F $960,000 $200,000 8 $106,985 12.99% 1.11
$5,030,000 $663,824
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
B $3,000,000 $700,000 6 $48,682 10.55% 1.02

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Acceptable: D, C, F
NPV = $663,824 given the constraint
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What if the Capital Budget is $6 Million: Summary
Criteria
Project NPV IRR PI

1 C D D
2 F C C
3 E E F

Capital Budget 5,960,000 5,070,000 5,030,000

Total NPV 735,785 656,168 663,824
• Given this set of projects, NPV ranking will ensure maximization of shareholder wealth.
• The cost of the $6 million capital budget constraint?
• It is $811,835 (unconstrained NPV) minus the best NPV available under the
constraint of $735,785 (i.e. $76,050)
• General rule: select combination of projects with highest NPV, given the constraint

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Capital Budgeting Methods: Insights

• Net Present Value: measure of dollar profitability

• Sensitive to estimates of discount rate and cash flows.
• Internal Rate of Return: discount rate where NPV = 0
• Provides insight as to margin for error in estimate of appropriate discount rate (observed in NPV profile).
• Provides insight as to margin for error on estimated cash flows e.g. IRR of 41% vs cost of capital of 8%
indicates a greater margin than 10% IRR vs. 8% cost of capital (also known as “hurdle rate”)
• Payback Period: Time period until initial investment recovered from cash flows
• Provides insight about liquidity and risk. More difficult to forecast cash flows in distant future.
• Profitability Index: PV of benefits per dollar invested – “bang for the buck”
• Provides insight as to margin for error in your estimates. For example, a high PI indicates a greater
margin for error in estimates of revenues and costs before the project becomes unprofitable than a project
with a low PI.

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Capital Budgeting: Review

• Objective is to maximize value of the firm

• NPV is often the starting point in ranking individual projects; IRR affected by scale & timing of cash
flows; PI affected by scale of project.
• Issues
• Capital budgeting involves long time horizons
• Requires forecasts (risk of being wrong)

Managers often use different models in combination because they give different types of insights

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Which Capital Budgeting Techniques are used by
Corporations?
• Survey of US Chief Financial Officers asked how often they relied on different capital budgeting
techniques.
• Percent who always or almost always relied on different methods:
• IRR ( 75.7%); NPV (74.9%); payback (56.7%); profitability index (12%)
• Larger firms more likely to use NPV

• Similar results in survey of Canadian managers:

• IRR (87.7%); NPV (94.2%)

• Graham and Harvey, “The theory and practice of corporate finance: Evidence from the field” Journal of Financial Economics 60 (2001); 187-243
• Benouna, Meredith, and Marchant, “Improved capital budgeting decision making: Evidence from Canada” Management Decision 8 (2010); 225-247

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