PRE-READING MATERIAL

1
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 Capital Budgeting
• Capital expenditures are expenditures on fixed assets that will
be used for production over a period of years. As such, in
accounting terms these expenditures are capitalized –
depreciated over a period of years.
• Capital budgeting refers to the process of deciding how to
allocate the firm’s scarce capital resources (land, labor, and
capital) to its various investment alternatives. It considers whether
a project is worth undertaking (i.e., worth its capital expenditures).
• The basic rule of capital budgeting is to accept projects for which
the benefit is greater than or equal to the cost:
– Accept if: Benefit ≥ Cost
– Reject if: Benefit < Cost
3
 What Makes a Good Decision Criteria?
The value of a project must take into account the amount of
cash flows received, the timing of the cash flows received
and the risk associated with receiving those cash flows.
As such, when evaluating a decision criteria, we need to ask
ourselves the following questions:

1. Does the decision rule adjust for time value of money?

2. Does the decision rule adjust for risk?

3. Does the decision rule provide information on whether

and by how much we create value for the firm?
4
 FIN 2704/2704X

Week 9
Capital Budgeting – Part 1
 Learning objectives
• Understand what Capital Budgeting is
• Be able to compute the different decision criteria for capital
budgeting and understand their merits and shortcomings:
– payback period and discounted payback period
– net present value (NPV)
– internal rate of return (IRR) and modified IRR (MIRR)
– profitability index (PI)
– average accounting return (AAR)
• Be able to make a capital budgeting decision based on
some decision criteria
6
 Capital Budgeting: Project A
We will use this project throughout this lesson to compute the
different decision criteria and compare results.

1. The cash flows for the project are:

• Year 0: CF0 = –$144,000
• Year 1: CF1 = $53,120; Net Income1 = $13,620
• Year 2: CF2 = $64,800; Net Income2 = $3,300
• Year 3: CF3 = $81,080; Net Income3 = $29,100

2. Your required return for assets of this risk level is 12%.

7
 Timeline for Project A

t=0 1 2 3
12%

–$144,000 $53,120 $64,800 $81,080

“Cost” “Benefits”

8
Payback Period
 Payback Period
Payback Period is the # of years to recover initial costs, in
other words, how quickly you break-even on a nominal basis.

The Payback Decision Criteria: Steps

1. Estimate the expected future cash flows
2. Add the future cash flows to the initial cost until the initial
investment has been recovered

Payback Period Decision Rule: Accept the project if

the payback period is ≤ some preset limit
(determined arbitrarily)
10
 Computing Payback Period: Project A
Let’s say the firm will accept the project if it pays back within
two years.
Year Cashflow Cumulative Cashflow
0 –$144,000 –$144,000
1 $53,120 −144,000 + 53,120 = −$90,880
2 $64,800 −90,880 + 64,800 = −$26,080
3 $81,080 −26,080 + 81,080 = $55,000

Project pays back in

To be more exact, year 3 because
26080 cumulative cashflow
Payback Period = 2 + = 2.32 years
81080 turns positive

Do we accept or reject the project? Reject

11
 Payback Rule: Merits & Shortcomings

Merits Shortcomings
• Quick and easy to • Ignores time value of money
calculate • Requires an arbitrary preset limit
• Easy to understand • Ignores cash flows beyond the
• Adjusts for uncertainty cutoff date
of later cash flows • Biased against long-term
• Biased towards short- projects, such as research and
term projects development, and new projects

12
Payback Period Example - Deficiency

Cash Flows Project B Project C

Initial Outlay -$10,000 -$10,000

1 $5,000 $5,000
2 $4,000 $5,000
3 $4,000 0
4 $4,000 0
5 $4,000 0

If the desired payback period is 2 years, which project

would you invest in?
Take C instead because payback sooner eventhough B has a higher NPV due to more cash flows
13
Discounted Payback Period
 Discounted Payback Period
Discounted Payback Period is the # of years to recover initial
costs based on discounted cash flows, in other words, how
quickly you break-even on a discounted basis.

The Discounted Payback Decision Criteria: Steps

1. Estimate the expected future cash flows
2. Compute the PV of each cash flow
3. Add the discounted cash flows to the initial cost until the
initial investment has been recovered

Discounted Payback Decision Rule: Accept the project

if the discounted payback period is ≤ some preset
limit (again arbitrarily selected)
15
Computing Discounted Payback Period: Project A
Let’s say the preset limit is again set at two years.
Year Cashflow Disc. Cashflow Cumulative Disc. Cashflow
0 –$144,000 –$144,000 –$144,000
53,120 −144,000 + 47,428.57
1 $53,120 = $47,428.57
1.12! = −$96,571.43
64,800 −96,571.43 + 51,658.16
2 $64,800 = $51,658.16
1.12" = −$44,913.27
81,080 −44,913.27 + 57,711.14
3 $81,080 = $57,711.14
1.12# = $12,797.88

To be more exact, Project pays back in

44913.27 year 3 because
Discounted Payback Period = 2 + = 2.78 years cumulative
57711.14 discounted cashflow
turns positive
Do we accept or reject the project? Reject
16
Discounted Payback rule: Merits & Shortcomings

Merits Shortcomings
• Includes time value of • Requires an arbitrary cutoff
money point
• Easy to understand • Ignores cash flows beyond
the cutoff point
• Biased towards short-term
projects • Biased against long-term
projects, such as R&D and
new products

17
Net Present Value (NPV)
 Net Present Value (NPV)
• The difference between the intrinsic value of a project and
its cost is the NPV.

• How much value is created from undertaking an

investment?
– If PV(Cash Inflows) > PV(Cash Outflows), taking on the project
will ­ the value of the firm.
– A positive NPV means that the project is expected to add
value to the firm, thereby increasing the wealth of its owners.
– Since the goal of financial managers is to increase the
owners’ wealth, NPV is a direct measure of how well this
project will meet our goal.
19
 Using the NPV: Steps
1. Estimate the expected future cash flows:
• Amount and Timing (Use a time-line)

2. Estimate the Required Return for projects of this risk level

• Use CAPM to calculate

3. Find the present value of the expected future cash flows

and subtract the initial investment.
5
𝐶𝐹2
𝑁𝑃𝑉 = B 2 − 𝐶𝐹6
(1 + 𝑟)
234

NPV Decision Rule: Accept the project if NPV ≥ 0

20
 Computing NPV: Project A
t=0 1 2 3
12%

–$144,000 $53,120 $64,800 $81,080

53120
$47,428.57 (1.12)!
64800
$51,658.16 (1.12)"
81080
(1.12)#
$57,711.14

$12,797.88
53,120 64,800 81,080
𝑁𝑃𝑉 = + + − 144,000 = $𝟏𝟐, 𝟕𝟗𝟕. 𝟖𝟖
(1.12)! (1.12)" (1.12)#
Do we accept or reject the project? Accept
21
 Computing NPV: Project A
Using the Cashflow function
1. <CF> (Initiate Cashflow function)
2. <144000> <+/-> <Enter> <↓> (𝐶𝐹! = −$144,000)
3. <53120> <Enter> <↓> (𝐶𝐹" = $53,120)
4. <1> <Enter> <↓> (No. of consecutive $53,120 = 1)
5. <64800> <Enter> <↓> (𝐶𝐹# = $64,800)
6. <1> <Enter> <↓> (No. of consecutive $64,800 = 1)
7. <81080> <Enter> <↓> (𝐶𝐹$ = $81,080)
8. <1> <Enter> <↓> (No. of consecutive $81,080 = 1)
9. <NPV> (Net Present Value)
10. <12> <Enter> <↓> (I/YR = 12%)
11. <CPT> (Should see NPV = $12,797.88 on screen)
Important: Remember to clear the memory!
1. <CF> (Initiate Cashflow function)
2. <2nd> <CE/C> (Clear the Cashflow function)
22
 Computing NPV: Project A
Using Excel:

1 • Use the NPV formula

• value1 = cashflow in year 1;
value2 = cashflow in year 2, etc.

• Note the difference

2
between the NPV formula
in Excel and the NPV
function in the calculator –
the NPV formula in Excel
requires a separate
subtraction of the cost!
23
Internal Rate of Return (IRR)
 Internal Rate of Return (IRR)
• IRR is the discount rate that makes NPV = 0.

• It is often used in practice and is intuitively appealing.

• It is based entirely on the estimated cash flows and is

independent of interest rates found elsewhere.

IRR Decision Rule:

Accept the project if the IRR is ≥ the required return

25
 Computing IRR: Project A
t=0 1 2 3
IRR%

–$144,000 $53,120 $64,800 $81,080

53120
(1 + 𝐼𝑅𝑅)! 64800
X
(1 + 𝐼𝑅𝑅)" 81080
Y
(1 + 𝐼𝑅𝑅)#
Z
0
53,120 64,800 81,080
𝑁𝑃𝑉 = + + − 144,000 = 𝟎
(1 + 𝐼𝑅𝑅)" (1 + 𝐼𝑅𝑅)# (1 + 𝐼𝑅𝑅)$

The IRR is the discount rate that makes NPV equal to zero.
If you do not have a financial calculator or a spreadsheet, then
this becomes a trial and error process. 26
 Computing IRR: Project A
Using the Cashflow function
1. <CF> (Initiate Cashflow function)
2. <144000> <+/-> <Enter> <↓> (𝐶𝐹! = −$144,000)
3. <53120> <Enter> <↓> (𝐶𝐹" = $53,120)
4. <1> <Enter> <↓> (No. of consecutive $53,120 = 1)
5. <64800> <Enter> <↓> (𝐶𝐹# = $64,800)
6. <1> <Enter> <↓> (No. of consecutive $64,800 = 1)
7. <81080> <Enter> <↓> (𝐶𝐹$ = $81,080)
8. <1> <Enter> <↓> (No. of consecutive $81,080 = 1)
9. <IRR> <CPT> (Should see 16.75 on screen)
Important: Remember to clear the CF memory!

IRR = 16.75% > 12%

Do we accept or reject the project? Accept
27
 Computing IRR: Project A
Using Excel:

1 • Use the IRR formula

• values = Reference the entire
stream of cashflows
• guess is often not necessary as
it only serves to speed up the
iteration process. If omitted, it is
assumed to be 10%.
2

28
NPV Profile: Project A

never straight line, just slight curve

IRR = 16.75%

29
 NPV vs. IRR: Project A

NPV = $12,797.88

IRR = 16.75%

anything on the left of IRR, NPV is positive. IRR aim is to get NPV to 0

NPV and IRR will generally give us the same decision.

However, there are a few exceptions that we should note. 30
 NPV vs. IRR Exceptions
1. Non-conventional cash flows – cash flow signs (+/–)
change more than once

2. Mutually exclusive projects, where

a) Initial investments are substantially different
b) Timing of cash flows is substantially different

Projects are:
• Independent, if the cash flows of one are unaffected by the
acceptance of the other.
• Mutually exclusive, if the cash flows of one can be adversely
impacted by the acceptance of the other (usually due to
limitation of available funds)
31
 IRR and Non-Conventional Cash Flows
• When a project’s cash flows signs change more than once,
there can be more than one IRR or none at all.
• When you solve for IRR, you are solving for the root of the NPV
equation (recall IRR is the discount rate that makes NPV=0).
• When cash flows signs change more than once, the NPV profile
may cross the x-axis more than once. This results in more than
one return that solves the equation.
• Sometimes, the NPV profile may not cross the x-axis at all. This
results in a case of no IRR since NPV never equals to zero.
• If you have more than one IRR, which one do you use to make
your decision? This becomes unclear.
• If you have no IRR, then the return of the investment is
unknown. You should simply not undertake this project. 32
Non-Conventional Cash Flows: Project D
• Suppose you are considering Project D that will require an
initial investment of $90,000 and will generate the following
future expected cash flows:
Year 1: CF1 = $132,000
Year 2: CF2 = $100,000
Year 3: CF3 = –$150,000 (Decommissioning costs)

• The required return for assets of this risk level is 15%.

• Should we accept or reject the project?

33
 NPV Profile: Project D
NPV = $1,769.54 rule of thumb: if the cash flow is non conventional, then dont use the IRR

Discount Rate

IRR = 10.11% and 42.66%

10.11 reject 42.66 accept

• The NPV is positive at a required return of 15%, so you should Accept.

• Your financial calculator and Excel would give an IRR of 10.11% which
would tell you to Reject.
• Therefore, you need to first realize that there are non-conventional
cash flows and look at the NPV profile to make the correct decision. 34
Non-Conventional Cash Flows: Project E
• Suppose you are considering Project E that will require an
initial investment of $50,000 and will generate the following
future expected cash flows:
Year 1: CF1 = $120,000
Year 2: CF2 = –$75,000 (Decommissioning costs)

• The required return for assets of this risk level is 15%.

• Should we accept or reject the project?

35
 NPV Profile: Project E

• There is no IRR! The NPV Profile does not cross the x-axis at all.
• Your financial calculator will give “Error” while Excel will give the answer
of “0%” for the IRR formula.
• Again, non-conventional cash flows in projects makes the IRR Rule
unreliable. It is best not to use this decision criteria for such cases. 36
 IRR and Mutually Exclusive Projects

• Mutually exclusive projects

– If you choose one, you can’t choose the other
– Example: You can choose to attend graduate school next
year at either Harvard or Stanford, but not both at the
same time

• Intuitively, you would use the following decision rules:

– NPV: Choose the project with the higher NPV
– IRR: Choose the project with the higher IRR

37
Example With Mutually Exclusive Projects

Year Project F Project G

0 -500 -400
The required return for
1 325 325 both projects is 10%.
2 325 200

IRR 19.43% 22.17% Which project should

you accept and why?
NPV 64.05 60.74

38
NPV Profiles: Projects F and G

Crossover Point = 11.80%

IRRG = 22.17%

Discount Rate

Project G
Project F
IRRF = 19.43%

indifferent because NPV will be same

39
 Reasons Why NPV Profiles Cross
1. Size (scale) differences
– At discount rate = 0%, the NPV of the smaller project (Project G) is
less than that of the larger project (Project F). This means the y-
intercept of the NPV profile for Project F is above that of Project G.
– However, smaller projects can end up with the higher IRR, as we
shall see in point 2 below.

2. Timing differences
– The project with larger cash flows (in relation to the initial cost) in the
earlier years is less sensitive to changes in the discount rate. If the
discount rate is high, projects with larger early cashflows will have
higher NPVs.
– In this example, NPVG > NPVF when discount rates are high.
– Consequently, IRRG > IRRF.
40
 Conflicts Between NPV and IRR
• NPV directly measures the increase in value to the firm.

• Whenever there is a ranking conflict between decisions

using NPV and another decision rule, i.e., NPV decision
criteria says choose Project F but another decision rule
says choose Project G, you should use the NPV decision
criteria as the final rule.

• IRR is unreliable in the following situations

– Non-conventional cash flows
– Mutually exclusive projects

• For this example, we should choose Project F.

41
 IRR rule: Merits and Shortcomings
Merits
• Adjusts for time value of
money and risks of the cash
flows
• Provides indication of
increase in value to the firm
in percentage return form.
• Intuitive presentation.
• Gives same decision as NPV
rule for independent projects.
Shortcomings
• Should not be used when
projects have non-
conventional cash flows.
• Can result in ranking conflict
with NPV rule when
comparing mutually exclusive
projects of significantly
different size and timing of
cash flows.
42
Modified Internal Rate of Return
(MIRR)
 Modified Internal Rate of Return (MIRR)
• There are a number of different ways to derive the MIRR. Our
textbook reviews (i) the discounting approach, (ii) the
reinvestment approach and (iii) the combination approach.

• We will only be using the combination approach

– The project’s Terminal Value (TV) is found by compounding positive
cash flows at the firm’s WACC to the end of the project life.
– By compounding the cashflows at the firm’s WACC, MIRR assumes
cash flows are reinvested at the WACC.
– PV of costs is found by discounting negative cash flows at the firm’s
WACC to time period zero.
– Finally, the MIRR is the discount rate that causes the PV of the
project’s TV to equal the PV of its costs.
44
 Computing MIRR: Project D
• Recall Project D that had non-conventional cash flows:
CF0 = –$90,000; CF1 = $132,000; CF2 = $100,000; CF3 = –$150,000
• The required return for assets of this risk level is 15%.
1. compound all + CF
2. discount all - CF
0 1 2 3
3. add them up
15% 4. find the interest rate

–90,000 132,000 100,000 –150,000

100,000(1.15)
115,000
132,000(1.15)!
−150,000 174,570
1.15"
–98,627.44
–188,627.44 289,570
$289,570
PV outflows $188,627.44 = TV inflows
(1 + MIRR)3

MIRR = 15.36% > 15% therefore Accept 45

 Computing MIRR: Projects F and G
Now let’s compute the MIRR for Projects F and G:
0 1 2
10%

Project F: –500 325 325

325(1.1) 357.50
–500 682.50
$682.50
$500 =
(1 + MIRR)2 à MIRRF = 16.83%
0 1 2
10%

Project G: –400 325 200

325(1.1) 357.50
–400 557.50
$557.50
$400 =
(1 + MIRR)2 à MIRRG = 18.06%
Since MIRRG > MIRRF, MIRR decision rule will still say choose Project G.
In other words, MIRR decision criteria does not resolve the ranking conflict. 46
 Computing MIRR: Project A
Finally, let’s compute the MIRR for Project A:

0 1 2 3
12%
–144,000 53,120 64,800 81,080
64,800(1.12)
72,576
53,120(1.12)!
66,633.73
–144,000 220,289.73
$220,289.73
PV outflows $144,000 = TV inflows
(1 + MIRR)3

MIRR = 15.22% > 12%

Do we accept or reject the project? Accept
47
 Why Use MIRR vs. IRR?

• MIRR also avoids the problem of multiple IRRs since

there will no longer be non-conventional cash flows.
• However, MIRR does not resolve ranking conflicts that
might arise with NPV decision rule.

48
 MIRR rule: Merits and Shortcomings
Merits Shortcomings
• Adjusts for time value of • Can result in ranking conflict
money and risks of the cash with NPV rule when
flows comparing mutually exclusive
projects of significantly
• Provides indication of
different size and timing of
increase in value to the firm
cash flows.
in percentage return form.
• Intuitive presentation.
• Gives same decision as NPV
rule for independent projects.

49
Profitability Index
 Profitability Index (PI)
• Also know as a “benefit-cost” ratio
• Steps to compute PI:
– Find the PV of future expected cash flows
– Divide this PV by the initial cost of the project
“benefits”
Total PV of future expected cash Vlows
PI =
Initial Cost
“costs”

• A profitability index of 1.1 implies that for every $1 of investment,

we create an additional $0.10 in value
Profitability Index Decision Rule: Accept the project if PI ≥ 1
Note: This measure can be very useful in situations where we have
limited capital à Select the project with the highest PI
51
 Computing PI: Project A
t=0 1 2 3
12%

–$144,000 $53,120 $64,800 $81,080

53120
$47,428.57 (1.12)!
64800
$51,658.16 (1.12)"
81080
(1.12)#
$57,711.14

$156,797.88
$156,797.88
PI = = 𝟏. 𝟎𝟗
$144,000
Do we accept or reject the project? Accept
52
 PI Rule: Merits and Shortcomings
Merits Shortcomings
• Closely related to NPV, • May lead to incorrect decisions
generally leading to identical in comparisons of mutually
decisions exclusive investments
• Easy to understand and Project H Project J
communicate CF0 = –$30m CF0 = –$50m

• Useful when available NPV = $6m NPV = $8m

investment funds are limited (30 + 6) (50 + 8)
𝑃𝐼 = 𝑃𝐼 =
30 50
= 1.2 = 1.16
- Project J has the higher NPV but the
lower PI
- If there was no need for capital
if not worried about the money, always go with the higher NPV, project J rationing, i.e. if $50m was available to
if can spend that 50 million spend, then we should pick Project J.
53
Average Accounting Return (AAR)
 Average Accounting Return (AAR)
• There are several definitions for AAR.
• We shall adopt the one used in your textbook, that is:

Average Net Income

Average Accounting Return =
Average Book Value

– Note: the average book value will depend on how the

asset is depreciated.

Average Accounting Return Decision Rule:

Accept the project if the AAR is ≥ some preset rate
(determined arbitrarily)
55
 Computing AAR: Project A
Let’s say the firm will accept the project if the average accounting
return is above 25% and the initial investment is fully depreciated
using straight-line depreciation methodology.
Annual Depreciation Year Book Value of Investment
144,000 − 0 0 $144,000
= = $48,000
3 1 $96,000
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐁𝐨𝐨𝐤 𝐕𝐚𝐥𝐮𝐞 straight line always 2 $48,000
144,000 + 96,000 + 48,000 + 0 3 $0
=
4
= $𝟕𝟐, 𝟎𝟎𝟎 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐢𝐧𝐠 𝐑𝐞𝐭𝐮𝐫𝐧
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞* from the previous slide
$15,340
= = 𝟐𝟏. 𝟑%
13,620 + 3,300 + 29,100 $72,000
=
3 Do we accept or reject the project?
= $𝟏𝟓, 𝟑𝟒𝟎
*Refer to Slide 5 for the Net Income figures.
Reject 56
 AAR rule: Merits and Shortcomings
Merits Shortcomings
• Easy to calculate • Not a true rate of return as
time value of money is
• Needed information will
ignored
usually be available set limit

• Uses an arbitrary cutoff rate

• Based on accounting net
income and book values,
not cash flows and
intrinsic/market values

57
Final Decision
 Project A:
Summary of Capital Budgeting Decisions
TLDR: follow NPV, if NPV say accept then accept

Decision Criteria Decision

Net Present Value (NPV) Rule Accept
Payback Period Rule Reject
Discounted Payback Period Rule Reject
Average Accounting Return (AAR) Rule Reject
Internal Rate of Return (IRR) Rule Accept
Modified Internal Rate of Return (MIRR) Rule Accept
Profitability Index (PI) Rule Accept

Do we accept or reject the project?

59
 Which Decision Criteria?
• The NPV, IRR, MIRR and PI decision criteria adjust for
time value of money, adjust for risk and provide information
on whether and by how much we create value for the firm.

• However, the IRR, MIRR and PI decision criteria can lead

to incorrect decisions for mutually exclusive projects.

• This makes the NPV method the primary decision criteria

for capital budgeting.

• In this case, based on the NPV criteria, we should accept

Project A. 1. adjust for time value of money

Why NPV compared to the rest? 2. adjust for risk when discounting

3. it provide information
60
 Overall Summary
• Capital budgeting refers to the process of deciding how to
allocate the firm’s scarce capital resources to its various
investment alternatives.
• In general, we accept projects that give us benefits that equal or
exceed their costs.
• There are several decision criteria for capital budgeting:
– net present value (NPV)
– payback period and discounted payback period
– average accounting return (AAR)
– internal rate of return (IRR) and modified IRR (MIRR)
– profitability index (PI)
• The NPV method is the primary decision criteria for capital
budgeting decisions.
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