Notes to accompany the PP transparencies chap 9

T9-3 capital budgeting ;investment decisions concerning fixed assets of the firm.
Capital :long term assets used in production.
Budget; is a plan that details projected inflows and outflows during some future period
capital budget: outline of planned investments in Fixed assets.
Capital budgeting :analysis of projects and deciding which one to include in the capital
budget.
Capital budgeting is the most important function financial managers must perform
because its results will require a long time forecast.
Depend on : firm’s flexibility
Based on forecast
Will determine strategic direction of firm.

Firm’s flexibility: since the results of capital budgeting decisions continue for many
years, the firm loses some of its flexibility. For example a decision to invest in a project
with an economic life of 10 years locks in the firm for 10 years.
Based on forecasts: asset expansion is based on expected future sales, a decision to buy
an asset that is expected to last 10 years requires 10-years sales forecast.
The capital budgeting decision define its strategic directions, so moves into new
products, services or markets must be preceded by capital expenditures.

T9-4 Error in forecast of asset requirement can have serious consequences. For example,
excessive investment will incur unnecessarily high depreciation and other expenses, at
the same time if the company does not invest enough, it may create a two problems:
Equipment and computer software may not be sufficiently modern to enable firm to
produce competitively.
If the firm has inadequate capacity it may lose market share to rivals firm and regaining
lost customers requires heavy selling expenses, price reductions…etc.
Timing is also important: capital assets must be available when they are needed.
(forecast demand, plan capacity requirements and plan the financing way in advance).
Effective budgeting can improve both the timing and quality of asset acquisitions.

T9-5 Capital budgeting projects are created by the firm.

"A firm's growth , its ability to remain competitive and to survive , depends on a constant
flow of new products, better products and lower operating costs."
Strategic business plan: a long run plan that outlines in broad terms the firm's basic
strategy for the next five to ten years.
Projects classifications:
1. Replacement : maintenance of businessà no elaborate decision making is needed.
2. Replacement : cost reductionà a fairly detailed analysis is required.
3. Expansion of existing products or markets:à a detailed analysis is required.
4. Expansion into new products or markets:à requires strategic decisions and large
expenditures of money.
5. Safety and environmental projectsà mandatory investments, involve nonrevenue –
producing projects.

1
T9-7 Note: Independent projects : projects whose cash flows are independent of one
another.
Mutually exclusive projects :is a set of projects where only one can be accepted.

T9-13.This example will be used for each of the decision rules so that the students can
compare the different rules and see that conflicts can arise. This illustrates the importance
of recognizing which decision rules provide the best information for making decisions
that will increase owner wealth.

T 9-14 We learn how to estimate the cash flows in chapter 10

We learn how to estimate the required return in chapter 13.
NPV method relies on the DCF techniques
NB: Sum of the PVs of all cash inflows and outflows of a projectà NPV=PV of
inflows –cost=Net gain in wealth.

NB: When NPV>0 ->project is generating more cash than is needed to service its debt
and to provide the required rate of return to shareholders, this excess cash accrues solely
to the firm’s shareholders.
If projects are mutually exclusive, accept projects with the highest positive NPV, those
that add the most value.
Independent projects – if the cash flows of one are unaffected by the acceptance of the
other.
Mutually exclusive projects – if the cash flows of one can be adversely impacted by the
acceptance of the other. So we can only accept one project. We cannot accept both
projects.
Example of mutually exclusive projects: project A involve a decision to build an
apartment house on the corner lot you own, and project B might be a decision to build a
movie theater on the same lot.
Which project to choose?
Independent projects :accept if the project NPV>o.
Mutually exclusive projects :accept projects with the highest positive NPV

T9-16 Again, the calculator used for the illustration is the TI- BA-II plus. The basic
procedure is the same, you start with the year 0 cash flow and then enter the cash flows in
order. F01, F02, etc. are used to set the frequency of a cash flow occurrence. Many of the
calculators only require you to use that if the frequency is something other than 1.

Since we have a positive NPV, we should accept the project.

T-9-17 The answer to all of these questions is yes

The risk of the cash flows is accounted for through the choice of the discount rate.

T9-18 Click on the Excel icon to go to an embedded Excel worksheet that has the cash
flows along with the right and wrong way to compute NPV. Click on the cell with the
solution to show the students the difference in the formulas.

2
T9-19 Payback period: the expected number of years required to recover a project’s
cost, or “How long does it take to get our money back?”
Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for
the project turns positive.

Payback method: The no of years it takes to recover the initial investment from the
cumulative cash flows.

Payback = year before full recovery + (uncovered cost at start of year/cash flow during
year).
The shorter the payback period the better. ,the greater the project’s liquidity.
Limitation_> the regular payback period does not consider the cost of capital…

T9-20 The payback period is year 3 if you assume that the cash flows occur at the end of
the year as we do with all of the other decision rules.

If we assume that the cash flows occur evenly throughout the year, then the project pays
back in 2.34 years.

Payback=2+ 31,080 = 2.34 Years.

91,080

->Either way, the payback rule would say to reject the project.

T9-21 The answer to all of these questions is no.

T9-23 The discounted payback method: is the length of time required for an
investment’s cash flows , discounted at the investment’s cost of capital to cover its cost-
>provides an improvement of the simple payback method in the sense that it uses the
discounted cash flows. However, the following two criticisms still apply.
Provides information on how long funds will be tied up in a project so the shorter the
payback period, the greater the project’s liquidity.
NB: since the cash flows expected in the distant future are generally riskier than near-
term cash flows, the payback is often an indicator of a project’s riskiness.

T9-24 No – it doesn’t pay back on a discounted basis within the required 2 year period

T9-25 The answer to the first two questions is yes.

The answer to the third question is no because of the arbitrary cut-off date.
Since the rule does not indicate whether or not we are creating value for the firm, it
should not be the primary decision rule.

3
T9-27 AAR = some measure of average accounting profit
some measure of average accounting value

The example in the book uses straight line depreciation to a zero salvage; that is why you
can take the initial investment and divide by 2. If you use MACRS, you need to compute
the BV in each period and take the average in the standard way.

NB: as long as we use straight line depreciation the average investment or average book
value will always be equal one half of the initial investment.

T9-28 NB: the flaw in this method is that the 25% required return is arbitrary , and this
is one of the drawbacks of this rule. There is no good objective theory for determining
what the return should be. We generally just use some rule of thumb.

This rule would indicate that we reject the project.

T9-29 The answer to all of these questions is no. In fact, this rule is even worse than the
payback rule in that it doesn’t even use cash flows for the analysis. It uses net income and
book value. The AAR is not a rate of return in any meaningful economic sense since it is
a ratio of accounting numbers and is not comparable to the returns offered in financial
markets.

By taking average figures for NI This methods ignores the fact that these figures occurred
at different periods of time.

T9-31 IRR :is the discount rate that gives us a NPV of zero. It is the % return on an
investment. The IRR rule is very important. Management, and individuals in general,
often have a much better feel for percentage returns and the value that is created, than
they do for dollar increases. A dollar increase doesn’t appear to provide as much
information if we don’t know what the initial expenditure was. Whether or not the
additional information is relevant is another issue.

T9-32 The IRR can be seen as the discount rate at which the project would just
break even, i.e. the discount rate that ensures that the discounted expected cash flows
just cover the initial investment. PV (Inflows)=PV (Investment costs)
Calculated by finding the discount rate that equates the present value of future cash
inflows to the project’s costs.
Calculating the IRR is equivalent to solving a polynomial of order T.
Trial and error
Financial calculator
It is also possible to calculate IRR in Excel and Lotus123 by using the functions
IRR/XIRR and @IRR respectively.

IRR is simply the expected rate of return on the project. So if internal rate of return
exceeds the cost of funds used to finance the project (the hurdle rate ), then a surplus of

4
funds remains after paying for the capital and this surplus accrues to the firm’s
shareholders.

NB: Accept project if IRR> hurdle rate/cost of capital( needed to finance the project)
If you are comparing between two projects:
àIf the projects are independent ,accept both because IRR>K
àIf the projects are mutually exclusive accept the project with the highest IRR.

So which method is better NPV or IRR, before we do the comparison let’s define NPV
profiles.

T9-33 Many of the financial calculators will compute the IRR as soon as it is pressed;
others require that you press compute.

T9-34 NPV profile: a graph showing the relationship between a project’ s NPV and the
firm cost of capital (a negative relationship exists).
At K=0% the NPV is simply the total of the projects undiscounted cash flows.
IRR is the point where the NPV profile crosses the X axis ie where NPV=0 (remember
that IRR is the discount rate at which NPV =0)

T9-35 The answer to all of these questions is yes, although it is not always as obvious.

V imp:
-The IRR rule accounts for time value because it is finding the rate of return that equates
all of the cash flows on a time value basis.
-The IRR rule accounts for the risk of the cash flows because you compare it to the
required return, which is determined by the risk of the project.
-The IRR rule provides an indication of value because we will always increase value if
we can earn a return greater than our required return.
We should consider the IRR rule as our primary decision criteria, but as we will see, it
has some problems that the NPV does not have. That is why we end up choosing the
NPV as our ultimate decision rule.

T9-36 You should point out, however, that if you get a very large IRR that you should go
back and look at your cash flow estimation again. In competitive markets, extremely high
IRRs should be rare.

Also, since the IRR calculation assumes that you can reinvest future cash flows at the
IRR, a high IRR may be unrealistic.

T9-37 So what should we do – we have two rules that indicate to accept and three that
indicate to reject.

T9-38 Click on the Excel icon to go to an embedded spreadsheet so that you can illustrate
how to compute IRR on the spreadsheet.

5
T9-39 NB: 1.NPV and IRR will give us conflicting results whenever a projects has non
normal cash flows (ie multiple IRR ) remember that a non normal project calls for a
large cash outflow sometimes during or at the end of its life. In that case base your
decision on the NPV rule.
2.Whenever the NPV profiles of two projects cross we have a conflict below the
crossover rate IRR will tell you to choose project X whereas NPV will tell you to reject
it in that case use NPV rule.

T9-40 Nonnormal projects with multiple IRRs:

A project with normal cash flows is one that has one or more cash outflows (costs)
followed by a series of cash inflows. If however, a project calls for a large cash outflow
sometime during or at the end of its life then a project has nonnormal cash flows (change
sign)..--> Limitations of the IRR method when evaluating projects with nonnormal cash
flows multiple IRRs

T9-41 NPV = 132,000 / 1.15 + 100,000 / (1.15)2 – 150,000 / (1.15)3 – 90,000 = 1,769.54

Calculator: CF0 = -90,000; C01 = 132,000; F01 = 1; C02 = 100,000; F02 = 1; C03 = -
150,000; F03 = 1; I = 15; CPT NPV = 1769.54

If you compute the IRR on the calculator, you get 10.11% because it is the first one that
you come to.

So, if you just blindly use the calculator without recognizing the uneven cash flows, NPV
would say to accept and IRR would say to reject.

T 9-42 You should accept the project if the required return is between 10.11% and
42.66%.

In our example, the cash flows change sign twice, from negative to positive and then
back to negative. There are also two different solutions. So in case the project have
different IRR, the IRR rule is not valid. MIRR solves the solution of multiple rate of
return.
When there are nonnormal CFs and more than one IRR, use the MIRR or NPV
rule

T9-45 As long as we do have limited capital, we should choose project A. Students will
often argue that you should choose B because then you can invest the additional $100 in
another good project, say C. The point is that if we do not have limited capital, we can
invest in A and C and still be better off.

If we have limited capital, then we will need to examine what combinations of projects
with A provide the highest NPV and what combinations of projects with B provide the
highest NPV. You then go with the set that will create the most value. If you have limited
capital and a large number of mutually exclusive projects, then you will want to set up a

6
computer program to determine the best combination of projects within the budget
constraints.

The important point is that we DO NOT use IRR to choose between projects regardless of
whether or not we have limited capital.

T9-46 If we plot the NPV profile of the two projects A and B using various discount rates we notice
that project A profile has a steeper slope than B meaning NB: Project A’s NPV is more sensitive to
changes in cost of capital than project B’s NPV since it has steeper slope indicating hat a given change
in K has a larger effect on NPVA than on NPVB. In other words the impact of an increase in the cost
of capital is much greater on the project with the larger scale. Remember that A has the greater
sensitivity because it has the largest cash outflow – 500 than B

Cross-over rate is the cost of capital at which the two projects cross and thus at
which the two project’s NPVs are equal.

So how to choose between the above projects:

If projects are independent, ->Both methods lead to the same decisions.
If projects are mutually exclusive …___>
If k > crossover point, the two methods lead to the same decision and there is no conflict.
NPVB>NPVA and IRRB>IRRA ( choose B)
If k < crossover point, the two methods lead to different accept/reject decisions.
NPVA>NPVB, but IRRB>IRRA, so different results.
In conflict, choose the NPV method since it selects the project that adds the most to
shareholder’s wealth.

*If the required return is less than the crossover point of 11.8%, then you should choose A

*If the required return is greater than the crossover point of 11.8%, then you should choose B

T9-48 To find the cross-over rate we find cash flow differences between the projects for
each year and then we find the IRR for those cash flow difference.

NB:There are two reasons that cause NPV profiles to cross, and thus conflict to arise
between NPV and IRR:
(1)projects size or scale differ
(2)timing differences exist for cash flows
This implies reinvestment rate issue with the rate of return at which differential cash
flows can be invested as a critical issue.

Reinvestment rate assumption: assumes that cash flow s from a project can be
reinvested at the cost of capital if using NPV, and at the internal rate of return if using
IRR (emphasis is placed on the first assumption).

Conclusion: when evaluating mutually exclusive projects , especially those that

differ in terms of scale and timing -> choose NPV method!

7
T9-50 NPV method is still the best method since it provides the best indication of how
much each project will increase the value of the firm.!

T9-52 Profitability index (PI) the present value of an investment future cash flows
divided by its initial cost .Also benefit –cot ratio.
NB: whenever the Profitability index is higher than one it means that the PV of future
cash flows must be bigger than the initial investment  NPV is positive
And whenever PI<1  NPV< 0
PI measures the value created per dollar invested. Usually used as a measure of
performance for government and other not for profit organizations.
When capital is scarce -> allocate it to projects with the highest PI

T9-54 Even though payback and AAR should not be used to make the final decision, we
should consider the project very carefully if they suggest rejection.( look to the reasons
why we have conflicting signals (a positive NPV ,along payback and a low ARR for ex)
There may be more risk than we have considered or we may want to pay additional
attention to our cash flow estimations. Thus we should assess whether the estimated NPV
is reliable…For this reason firms would typically use multiple criteria for evaluating a
project. Sensitivity and scenario analysis can be used to help us evaluate our cash flows.
The next two chapters will teach us how to evaluate NPV estimates in more details.

The fact that payback is commonly used as a secondary criteria may be because short
paybacks allow firms to have funds sooner to invest in other projects without going to the
capital markets.

NB: A survey conducted with CFO of both large and small firms in the USA revealed
that IRR and NPV are the two most widely used techniques at larger firms whereas in
smaller firms payback is used just about as much as NPV and IRR.

T9-58 Payback period = 4 years

The project does not pay back on a discounted basis.
NPV = -2758.72
IRR = 7.93%