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Capital Budgeting Principles

and Techniques
Lecture 3
Net Present Value (NPV)
Net present value (NPV) is the sum of the
present values of the projects future cash flows
minus the cost of the project.
Projects with positive NPVs add to shareholder
wealth; those with negative NPVs reduce
shareholder wealth.
The net present value investment decision
rule is invest in positive NPV projects and
reject negative NPV projects!
If two projects are mutually exclusive, accept
the one with higher net present value.
Net Present Value Decision Rule
The NPV rule is implemented as follows: Calculate the
present value of the expected cash flows generated by
the investment, using an appropriate discount rate, and
subtract from this present value the initial net cash outlay
for the project.
By taking into account all cash flows (and only cash
flows), the time value of money, and risk (which is
incorporated in the discount rate) NPV evaluates the
projects the same way that investors do. Therefore, it is
consistent with the objective of shareholder wealth
maximization.
The discount rate used in calculating an investments
NPV, also called cost of capital or the required rate of
return, is the minimum acceptable rate of return on
projects of similar risk. It is determined by the required
return in the market for investments of comparable risk.
Net Present Value Formula
The formula for NPV is

Net present Initial Present value of
value outlay future cash flows








where I
0
is the initial cash outlay, CF
t
is the net cash
flow in period t, k is the cost of capital for the project,
and n is the economic life of the investment.
= +

=
+
+ =
=
+
+ +
+
+
+
+ =
n
t
t
t
n
n
k
CF
I
k
CF
k
CF
k
CF
I NPV
1
0
2
2 1
0
1
1 1 1
) (
) ( ) (

Net Present Value Formula
The initial outlay should include any investment in net
working capital. Working capital refers to the money that
firm must invest in accounts receivable, inventory, and cash
to support the sales and production of its products and
services. Initial investment in working capital must be
recovered at the termination of the project.
Net cash flow is usually calculated as profit after tax, plus
depreciation and other non-cash charges, minus (plus) any
additions to (recovery of) working capital during the period,
and minus (plus) capital expenditures (sales of fixed assets)
during the period. This measure includes all project cash
inflows and outflows and ignores non-cash items.
Depreciation is added back to net income because it is a
non-cash item.

Net CF= Profit after tax + Depreciation Change in net
working capital Capital Expenditures

Net CF = (Revenues Costs Depreciation)x(1 T) +
Depreciation NWC CapEx, where T is the tax rate
Application of NPV Rule
Example:
Company ABC is considering a five year investment
project which requires an initial investment in plant and
equipment of $6 million.
The projects estimated revenue in year 1 is $8 million and
$16 million in years 2 through 5. The projects estimated
costs in year 1 are $6.9 million and $12.1 million in years 2
through 5.
At the end of year five the plant will be scrapped and sold
for $1 million.
Depreciation charges will be equal to $1 million each year.
Initial working capital requirement is $1.2 million which will
be recovered in year 5.

If the tax rate is 40% and ABCs cost of capital is 10%,
what is the NPV of the investment project?
Application of NPV Rule
I
0
(Initial outlay) = $7.2 million
This includes the investment in plant and equipment of $6 million plus $1.2
million invested in working capital.
Next estimate net cash flows

CF = (Rev. Cost Depr.)x(1 T) + Depr. NWC + Sale of plant
CF
1
= ( 8 6.9 1 )x(1 0.4) + 1 = 1.06
CF
2-4
= (16 12.1 1 )x(1 0.4) + 1 = 2.74
CF
5
= (16 12.1 1 )x(1 0.4) + 1 + 1.2 + 1 = 4.94

Net cash flow in year 5 includes also cash received from the sale of the plant
($1 million) and the recovery of net working capital ($1.2 million).
Notice that the book value of the plant at the end of year 5 is exactly $1 million
because total depreciation amount for five years was $5 million and initial
investment was $6 million. Since the plant is sold for its book value there are no
taxes associated with taxable gains or losses.




The project should be accepted since it has a positive NPV of $3.03 million
03 3
1 0 1
94 4
1 0 1
74 2
1 0 1
74 2
1 0 1
74 2
1 0 1
06 1
2 7
5 4 3 2
.
) . (
.
) . (
.
) . (
.
) . (
.
.
.
. =
+
+
+
+
+
+
+
+
+
+ = NPV
Strengths and Weakness of NPV Rule
NPV rule is consistent with shareholder wealth maximization.
NPV obeys the value additivity principle. This means that
the NPV of a set of independent projects is just the sum of the
NPVs of the individual projects
Value additivity principle implies that the value of a firm equals
the sum of the values of its component parts. Consequently,
when a firm undertakes a series of projects, its value
increases by an amount equal to the sum of the NPVs of the
accepted projects.
This means that when confronted with mutually exclusive
projects, a firm should accept the one with the highest NPV as
it will make the largest contribution to shareholder wealth.
The weakness of NPV is that many managers and non-
technical people have hard time understanding the concept.
Time value of money and cost of capital are not intuitively
obvious to most people.
Finally, NPV requires computation of a proper discount rate,
which is not trivial as we will see later.
Alternative Investment Evaluation Criteria
Although NPV is the theoretically correct technique for
evaluating investments, there are other capital budgeting
methods
These methods can be divided into two broad categories:
non-discounted cash flow (non-DCF) methods and
discounted cash flow (DCF) methods
Non-DCF methods:
Payback
Accounting Rate of Return
DCF methods:
Discounted Payback
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Profitability Index (PI)
Payback
The payback period is the length of time
necessary to recoup the initial outlay from
net cash flows.
From the earlier example of ABC company the
initial outlay is $7.2 million (including investment
in plant and equipment and working capital).
By the end of third year the cumulative net cash
flow will be $1.06 + $2.74 + $2.74 = $6.54
million. This leaves another $7.2 - $6.54 = $0.66
million until payback. Assuming that cash flows
are spread evenly throughout the year, payback
will occur in another 0.66/2.74 = 0.24 years.
So payback period is 3.24 years.

Payback: Decision Rule
Decision rule is simple:
Projects with a payback less than a specified
cutoff period are accepted, whereas those with a
payback beyond this figure are rejected.
In our example, if ABC company has a three-
year payback requirement then the investment
project would be rejected, otherwise with a four
year cutoff period the project would be accepted.
Usually the riskier is the project the shorter is the
required payback period.
Payback: Strength and Weakness
Payback is easy to understand and simple to
apply.
However it has two major weaknesses:
It ignores the time value of money. The timing of cash
flows is of critical importance because of time value of
money. Payback assigns the same value to a dollar
received at the end of the payback period as it does to
one received in the beginning.
It ignores the cash flows beyond the payback period. In
our example the project is expected to generate $7.68
million in years 4 and 5; with a cutoff period of three
years these cash flows are ignored in evaluating the
project.
The payback method is biased against long-term
projects; if a quick payoff is not forthcoming, the
project will be rejected.
Discounted Payback Period
This is a modification of payback method which corrects one of its
weaknesses, the time value of money.
Discounted payback method is the length of time required for the
present value of cash inflows to equal the cost of initial outlay.
Again, from the example of ABC company the present values of net
cash flows are as follows:

Year CF x PV Factor = PV Cumulative PV
1 1.06 0.9091 0.96 0.96
2 2.74 0.8264 2.26 3.22
3 2.74 0.7513 2.06 5.28
4 2.74 0.6830 1.87 7.15
5 4.94 0.6209 3.07 10.22

The cumulative present value of the project at the end of year four is
$7.15 million. So the discounted cash back period is slightly over 4
years.
Again, this method ignores the cash flow in year five. If the required
cutoff period was 4 years this project would be rejected, although the
project would increase the value of ABC company by $3.03 million (its
NPV).

Accounting Rate of Return
Accounting rate of return (also known as average rate
of return or average return on book value or return
on investment) is the ratio of average after-tax profit to
average book investment.
Average book value is calculated as the average of initial
outlay (including any investment in working capital) and
the ending book value, which is initial investment less
accumulated depreciation (again including any recovery
of net working capital).
The formula is

2
value book Ending outlay Initial
n
t year in profit tax - After
return of rate Accounting
n
1 t
+
=

=
Accounting Rate of Return
After-tax profit can be calculated as
(Revenues Costs Depreciation)x(1 T)
In our example of ABC company:
After-tax profit in year 1 =
= (8 6.9 1)x(1 0.4) = $0.06 million
After-tax profits in years 2 through 5 =
= (16 12.1 1)x(1 0.4) = $1.74 million
Initial outlay (including working capital) = $7.2 million
Ending book value = $2.2 million (book value of the
plant of $1 million plus recovery of working capital of
$1.2 million)

% . .
) . . (
) . . (
9 29 299 0
2
2 2 2 7
5
74 1 4 06 0
or return of rate Accounting =
+
+
=
Accounting Rate of Return: Strengths and
Weakness
To apply this method a firm must specify a target rate of
return. Investments yielding a return greater than this
standard are accepted, whereas those falling below it
would be rejected.
The project in our example would be accepted if ABCs
target rate of return was less than 29.9%.
This method is simple to apply, but
It ignores the time value if money. It treats income derived in
year 1 the same as it treats income in year 5, though earlier
income is more valuable than later one.
It is based on accounting income instead of cash flow. Investors
value only cash provided by companies; accounting income not
associated with cash flows cannot be spent (consumed) and
therefore is of no value to investors.
Internal Rate of Return (IRR)
Internal rate of return (IRR) is the discount rate that
sets the present value of the project cash flows equal to
the initial investment outlay. In other words IRR is the
discount rate that sets NPV equal to zero.
IRR is the rate of return earned on money committed to
a capital investment and measures the profitability of the
investment.
It is calculated as the rate of return k for which



In our example of ABC company IRR is calculated as

=
=
+
+ =
n
t
t
t
k
CF
I NPV
1
0
0
1 ) (
% .
) (
.
) (
.
) (
.
) (
. .
. 4 22 0
1
94 4
1
74 2
1
74 2
1
74 2
1
06 1
2 7
5 4 3 2
= =
+
+
+
+
+
+
+
+
+
+ = k
k k k k k
NPV
-2
-1
0
1
2
3
4
5
6
7
8
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30%
Discount rate
N
e
t

p
r
e
s
e
n
t

v
a
l
u
e

(
$

m
i
l
l
i
o
n
s
)
NPV Profile for ABCs Project
Net present value profile is the relationship between
the NPV of a project and the discount rate used to
calculate the NPV.
Decision Rule for Using IRR and its
Strength
If the IRR exceeds the cost of capital for the project, the
firm should undertake the project; otherwise the project
should be rejected.
The rationale for this rule is that any project yielding
more than its cost of capital will have a positive net
present value.
In our example ABC company should invest in its project
if the cost of capital is less than 22.4%.
The strength of IRR method is that many firms prefer
IRR because managers visualize and understand more
easily the concept of a rate of return than they do the
concept of a sum of discounted dollars.
IRR: Weaknesses
1. Lending or Borrowing?
IRR does not differentiate between lending- and
borrowing-type transactions.
With some borrowing-type transactions (where initial
outlay is positive while future cash flows are
negative) the NPV of the project is increasing as the
discount rate increasing.
This is contrary to the normal relationship between
NPV and discount rate.

Project CF
0
CF
1
IRR NPV (k = 10%)
A (lending) -100 +150 50% $36.36
B (borrowing) +100 -150 50% -$36.36



IRR: Weaknesses
2. Multiple rates of return.
When an investment has an initial cash outflow, a series of
positive cash inflows, and then at least one additional cash
outflow (negative cash flow), then there may be more than one
IRR!
The number of solutions may be as great as the number of sign
reversals in the stream of cash flows.
Example: The following project has three IRRs
Year 0 1 2 3 .
Cash flow -$200 +$1,200 -$2,200 +$1,200







%
) (
,
) (
, ,
100 0
1 1
200 1
1 1
200 2
1 1
200 1
200
2
3 2
2
= =
+
+
+

+
+ = IRR NPV
%
) (
,
) (
, ,
0 0
0 1
200 1
0 1
200 2
0 1
200 1
200
1
3 2
1
= =
+
+
+

+
+ = IRR NPV
%
) (
,
) (
, ,
200 0
2 1
200 1
2 1
200 2
2 1
200 1
200
3
3 2
3
= =
+
+
+

+
+ = IRR NPV
IRR: Multiple Rates of Return
NPV Profile of Previous Example: Multiple IRRs
-40
-35
-30
-25
-20
-15
-10
-5
0
5
10
0% 40% 80% 120% 160% 200% 240% 280%
Discount Rate
N
e
t

p
r
e
s
e
n
t

v
a
l
u
e

(
$
)
IRR: Weaknesses
3. Mutually exclusive projects.
In the case of mutually exclusive projects when the firm has to
choose either one project or another, NPV and IRR can favor
conflicting projects.
Example: Consider the following two projects:
Cash Flow for Project
Year A B .
0 -1,000 -1,000
1 800 100
2 300 400
3 200 500
4 100 800
NPV (k = 17%) $81.2 $116.8
IRR 22.99% 21.46%

NPV and IRR give conflicting results when discount rate is less
than the crossover rate - rate at which NPVs of mutually
exclusive projects are equal. Crossover rate in this example is
19.78%.
NPV and IRR are most likely to give conflicting results when
the mutually exclusive projects are substantially different (i) in
the timing of cash flows or (ii) in scale.
Crossover rate for Projects A and B
NPV Profiles of Projects A and B, and Crossover Rate
-400
-200
0
200
400
600
800
1000
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30%
Discount rate
N
e
t

p
r
e
s
e
n
t

v
a
l
u
e

(
$
)
Project A
Project B
.
Crossover
rate
IRR: Weaknesses
3(i). Timing of Cash Flows
The conflict in the IRR and NPV rankings of projects A
and B arises because of differences in the timing of their
cash flows, with most of As cash flows arriving in the
early years and most of Bs cash flows arriving in the
later years.
The reason for conflicting rankings is that IRR implicitly
assumes that intermediate cash flows occurring during
the life of the project can be reinvested at a rate equal to
IRR, whereas NPV implicitly assumes a reinvestment
rate equal to the projects cost of capital.
In such cases always trust NPV as it more realistically
represents the opportunity cost of funds.

IRR: Weaknesses
3 (ii). Scale Differences
Difference in the scale of projects (or difference in the
amount of initial investment) can lead to conflicting
ranking of projects.
Example: Consider the following two projects:

Cash Flow for Project
Year X Y .
0 -100 -1,000
1 140 1,250
NPV (k = 15%) $21.8 $87.0
IRR 40% 25%

NPV and IRR rules yield conflicting results. This is
because NPV takes into account the size differences in
initial investment while IRR does not.
NPV rule in this case is correct, assuming there is no
capital rationing.
Modified IRR (MIRR)
Modified IRR solves some of the weaknesses associated
with IRR.
MIRR is a discount rate at which the present value of a
projects annual cash outflows is equal the present value
of its terminal value, where the terminal value is found as
the sum of the future values of the cash inflows,
compounded at the firms opportunity cost of capital.

where COF refers to cash outflows
(negative numbers), or the cost of
the project. And CIF refers to cash
inflows (positive numbers).

( )
t
MIRR
in FV
out PV
+
=
1
life) s project' the of end at the flows of ( Value Terminal
flows
( )
( )
( )
n
n
t
t n
t
n
t
t
t
MIRR
r CIF
r
COF
+
+
=
+

=
1
1
1
0
0
Modified IRR: Calculation
Lets go back to our old example of multiple IRRs and assume that the
cost of capital is 10%.
Example: The following project has three IRRs.

Year 0 1 2 3 .
Cash flow -$200 +$1,200 -$2,200 +$1,200

Present value at time 0 of all cash outflows is:
200 2,200/(1.10)
2
= 2,018.18
Future value (at the end of projects life at time 3) of all cash inflows is:
+1,200(1.10)
2
+ 1,200 = +2,652
We have separated all negative cash flows at time 0, and all positive
cash flows at time 3.

Year 0 1 2 3 .
Cash flow -$2,018.18 +$2,652

The MIRR for this project is found as:



MIRR = 0.0953 or 9.53% (we have only one IRR here).
( )
3
1
652 , 2
18 . 018 , 2 0
MIRR +
+ =
Modified IRR: Strengths and
Weaknesses
Advantages of MIRR over IRR are that it:
Solves the problem with borrowing-type projects (by
switching the places of negative and positive cash
flows).
Solves the problem of multiple IRRs (by guaranteeing
only one cash flow sign reversal).
Solves the problem with mutually exclusive projects
with differences in the timing of cash flows (by
assuming intermediate cash flows are reinvested at
the opportunity cost of capital).
But, it still gives conflicting results with mutually
exclusive projects with scale differences.
Incremental IRR
Since MIRR does not work with mutually exclusive projects
with scale differences, we can use incremental IRR to make
a decision with such projects.
Incremental IRR is the IRR of incremental cash flows.
If the incremental IRR exceeds the cost of capital, the firm
should undertake the larger project; otherwise the firm
should undertake the smaller project.
Example. Assume k = 15%.
Cash Flow for Project
Year X Y Incremental (Y X) .
0 -100 -1,000 -1000 - (-100) = -900
1 140 1,250 1,250 - 140 = 1,110
NPV $21.8 $87.0 $65.2
IRR 40% 25% 23.3%

Since Incremental IRR of 23.3% > 15%, accept larger
project.
Profitability Index (PI)
Profitability Index (PI), also known as the benefit-cost ratio, is the
present value of future cash flows divided by the initial cash
investment





The profitability index for ABC companys project is $10.23/$7.2 =
1.42. In other words, this project returns a present value of $1.42 for
every $1 of the initial investment.
Decision rule: As long as profitability index exceeds 1, the project
should be accepted.
Although for a given project NPV and PI give the same accept-reject
signal, they sometimes disagree in the rank ordering of acceptable
projects when there are mutually exclusive projects and when there
is capital rationing.
0
0
0
1
1
I
I NPV
I
k
CF
PI
n
t
t
t
) ( ) ( +
=
+
=

=
Profitability Index: Mutually Exclusive
Projects
We already saw that when scale differences exist, NPV
and IRR may give conflicting signals. The same is true for
PI.
Example: Consider again our old example with following
two projects:
Cash Flow for Project
Year X Y .
0 -100 -1,000
1 140 1,250
NPV (k = 15%) $21.8 $87.
PI 1.22 1.09

Though both NPV and PI give accept decision for both
projects, they disagree about the ranking of these projects.
When there is a conflict of ranking the firm should select
the project with the higher NPV (unless there is capital
rationing)!
Profitability Index: Capital Rationing
Capital rationing is a situation when firms constrain the
size of their capital budgets. Capital rationing may be
self-imposed or externally imposed.
When constraints prevent the firm from undertaking all
acceptable projects, it must select among them the
subset of projects that gives the highest net present
value.
When all the initial outlays occur in the first period, a
simple approach using PI is as follows:
Calculate PI for each project,
Rank all projects in terms of their PIs, from the highest to the
lowest,
Starting with the project having the highest PI, go down the list
and select all projects having PI>1 until the capital budget is
exhausted.
Profitability Index: Capital Rationing
Example: A firm has a capital budget of $5,000 and the following
projects

Project Initial Outlay NPV Rank PI Rank
A 500 100 5 1.20 2
B 500 70 6 1.14 6
C 2,000 300 2 1.15 5
D 3,000 480 1 1.16 4
E 1,000 170 3 1.17 3
F 500 125 4 1.25 1

The projects selected under NPV rule are C and D with a combined
NPV of $780. Alternatively, PI selects projects F, A, E, and D with a
total NPV of $875.
NPV method does not necessarily select the best combination of
projects under capital rationing.
PI method will select the optimal combination of projects if the entire
budget can be consumed by accepting projects in descending order
of PI. Projects are usually indivisible and applying the PI approach
may lead to an underutilized budget because the next available
project might be too large. In this case PI method cannot be used.
Mutually Exclusive Projects with Different
Economic Lives
Example: Finance Department has to choose between two copying
machines. Xerox costs $1,200, will last 5 years, and will require
$300 of annual maintenance costs. Alternatively, Canon costs $750,
will last only 4 years, and annual maintenance costs are $400.
Which one should Finance Department choose?
One way to choose between these two machines is to compare the
present values (NPVs) of their costs. Assuming 8% discount rate we
have:

Year Xerox Canon
0 $1,200 $750
1 300 400
2 300 400
3 300 400
4 300 400
5 300
NPV at 8% $2,398 $2,074

It looks like Canon is more preferable since it has higher NPV. But
these two investments are not directly comparable because they
have different economic lives.
Mutually Exclusive Projects with Different
Economic Lives
One way to handle mutually exclusive investments with
unequal lives is to assume that at the expiration of the
economic life of each asset, the firm will invest in new
asset with identical characteristics. E.g., if we buy Xerox
today, we will replace it by Xerox again in 5 years. Thus
department will buy chains of Xeroxes or Canons.
Then we need to calculate equivalent annual cash flow
of using mutually exclusive assets.
Equivalent annual cash flow (EACF) of an asset is an
annuity that has the same life as the asset with present
value equal to the NPV of the asset.
It is calculated as:
EACF = NPV/Present value annuity factor






( )
(

=
n
k 1
1
1
k
1
NPV
EACF
Mutually Exclusive Projects with Different
Economic Lives









Buying a chain of Xeroxes is equivalent to paying $600 a
year, whereas a chain of Canons costs $626 a year.
Xerox is the preferred asset as its EACF is higher by $26.
The rule for comparing mutually exclusive assets with
unequal economic lives is: Compute the equivalent
annual cash flow of each asset. Select the asset with the
highest equivalent annual cash flow.
( )
600 $
08 . 0 1
1
1
08 . 0
1
398 , 2
EACF
5
Xerox
=
(

=
( )
626 $
08 . 0 1
1
1
08 . 0
1
074 , 2
EACF
4
Canon
=
(

=
Surveys of Capital Budgeting Techniques
Used in Practice
Source: J. Graham and C. Harvey, How Do CFOs Make Capital Budgeting AND
Capital Structure Decisions? Journal of Applied Corporate Finance, Spring 2002