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Chapter 13

Capital Budgeting
Techniques
13-1

Pearson Education Limited 2004


Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

After studying Chapter 13,


you should be able to:

13-2

Understand the payback period (PBP) method of project evaluation and


selection, including its: (a) calculation; (b) acceptance criterion; (c)
advantages and disadvantages; and (d) focus on liquidity rather than
profitability.
Understand the three major discounted cash flow (DCF) methods of
project evaluation and selection internal rate of return (IRR), net
present value (NPV), and profitability index (PI).
Explain the calculation, acceptance criterion, and advantages (over the
PBP method) for each of the three major DCF methods.
Define, construct, and interpret a graph called an NPV profile.
Understand why ranking project proposals on the basis of IRR, NPV, and
PI methods may lead to conflicts in ranking.
Describe the situations where ranking projects may be necessary and
justify when to use either IRR, NPV, or PI rankings.
Understand how sensitivity analysis allows us to challenge the singlepoint input estimates used in traditional capital budgeting analysis.
Explain the role and process of project monitoring, including progress
reviews and post-completion audits.

Capital Budgeting
Techniques

13-3

Project Evaluation and Selection

Potential Difficulties

Capital Rationing

Project Monitoring

Post-Completion Audit

Project Evaluation:
Alternative Methods

13-4

Payback Period (PBP)

Internal Rate of Return (IRR)

Net Present Value (NPV)

Profitability Index (PI)

Proposed Project Data


Julie Miller is evaluating a new project
for her firm, Basket Wonders (BW).
She has determined that the after-tax
cash flows for the project will be
$10,000; $12,000; $15,000; $10,000;
and $7,000, respectively, for each of
the Years 1 through 5. The initial
cash outlay will be $40,000.
13-5

Independent Project
For

this project, assume that it is


independent of any other potential
projects that Basket Wonders may
undertake.
Independent -- A project whose
acceptance (or rejection) does not
prevent the acceptance of other
projects under consideration.
13-6

Payback Period (PBP)


0

-40 K

10 K

12 K

15 K

4
10 K

PBP is the period of time


required for the cumulative
expected cash flows from an
investment project to equal
the initial cash outflow.
13-7

5
7K

Payback Solution (#1)


0
-40 K(-b)

Cumulative
Inflows

13-8

10 K
10 K

12 K
22 K

PBP

3 (a)
15 K
37 K(c)

4
10 K(d)
47 K

=a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years

5
7K
54 K

Payback Solution (#2)


0

-40 K

10 K

12 K

15 K

10 K

-40 K

-30 K

-18 K

-3 K

7K

Cumulative
Cash Flows

13-9

5
7K
14 K

PBP = 3 + ( 3K ) / 10K = 3.3


Years
Note: Take absolute value of last
negative cumulative cash flow value.

PBP Acceptance Criterion


The management of Basket Wonders
has set a maximum PBP of 3.5
years for projects of this type.
Should this project be accepted?
Yes! The firm will receive back the
initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]
13-10

PBP Strengths
and Weaknesses
Strengths:

Easy to use and


understand

Can be used as a
measure of liquidity

Easier to forecast
ST than LT flows

Weaknesses:

Does not account


for TVM

Does not consider


cash flows beyond
the PBP

Cutoff period is
subjective

13-11

Internal Rate of Return (IRR)


IRR is the discount rate that equates the
present value of the future net cash
flows from an investment project with
the projects initial cash outflow.
CF1
ICO =
(1+IRR)1
13-12

CF2
(1+IRR)2

CFn
+...+
(1+IRR)n

IRR Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3 (1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.
13-13

IRR Solution (Try 10%)


$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $
7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 +
$4,347
= $41,444
[Rate is too low!!]

13-14

IRR Solution (Try 15%)


$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841
[Rate is too high!!]
13-15

IRR Solution (Interpolate)


.05

.10

IRR $40,000
.15

X
.05

13-16

$41,444
$36,841

$1,444
$4,603

$1,444

$4,603

IRR Solution (Interpolate)


.05

.10

IRR $40,000
.15

X
.05

13-17

$41,444
$36,841

$1,444
$4,603

$1,444

$4,603

IRR Solution (Interpolate)


.05

.10

$41,444

IRR $40,000
.15

$1,444

$4,603

$36,841

X = ($1,444)(0.05)
$4,603

X = .0157

IRR = .10 + .0157 = .1157 or 11.57%


13-18

IRR Acceptance Criterion


The management of Basket Wonders
has determined that the hurdle rate
is 13% for projects of this type.
Should this project be accepted?
No! The firm will receive 11.57% for
each dollar invested in this project at
a cost of 13%. [ IRR < Hurdle Rate ]
13-19

IRRs on the Calculator


We will use the
cash flow registry
to solve the IRR
for this problem
quickly and
accurately!

13-20

Actual IRR Solution Using


Your Financial Calculator
Steps in the Process
Step 1:
Press CF
Step 2:
Press 2nd
Step 3: For CF0 Press

key
CLR Work keys
-40000 Enter

keys

Step 4:
Step 5:
Step 6:
Step 7:

For C01 Press


For F01 Press
For C02 Press
For F02 Press

10000
1
12000
1

Enter
Enter
Enter
Enter

keys
keys
keys
keys

Step 8: For C03 Press


13-21 Step 9: For F03 Press

15000
1

Enter
Enter

keys
keys

Actual IRR Solution Using


Your Financial Calculator
Steps in the Process (Part II)
Step 10:For C04 Press
Step 11:For F04 Press
Step 12:For C05 Press
Step 13:For F05 Press

13-22

10000
1
7000
1

Enter
Enter
Enter
Enter

keys
keys
keys
keys

Step 14:
Step 15:

Press
Press IRR

Step 16:

Press CPT

Result:

Internal Rate of Return = 11.47%

keys

key
key

IRR Strengths
and Weaknesses
Strengths:
Accounts for
TVM

Weaknesses:

Considers all
cash flows

Assumes all cash


flows reinvested at
the IRR

Difficulties with
project rankings and
Multiple IRRs

Less
subjectivity

13-23

Net Present Value (NPV)


NPV is the present value of an
investment projects net cash
flows minus the projects initial
cash outflow.
CF1
NPV =
(1+k)1
13-24

CF2
+
(1+k)2

CFn
ICO
+...+
(1+k)n

NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
$40,000
4 +
5
(1.13)
(1.13)
13-25

NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428
13-26

NPV Acceptance Criterion


The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?
No! The NPV is negative. This means
that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
13-27

NPV on the Calculator


We will use the cash
flow registry to solve
the NPV for this
problem quickly and
accurately!
Hint: If you have not
cleared the cash flows
from your calculator, then
you may skip to Step 15.
13-28

Actual NPV Solution Using


Your Financial Calculator
Steps in the Process
Step 1:
Press CF
Step 2:
Press 2nd
Step 3: For CF0 Press

key
CLR Work keys
-40000 Enter

keys

Step 4:
Step 5:
Step 6:
Step 7:

For C01 Press


For F01 Press
For C02 Press
For F02 Press

10000
1
12000
1

Enter
Enter
Enter
Enter

keys
keys
keys
keys

Step 8: For C03 Press


13-29 Step 9: For F03 Press

15000
1

Enter
Enter

keys
keys

Actual NPV Solution Using


Your Financial Calculator
Steps in the Process (Part II)
Step 10:For C04 Press
Step 11:For F04 Press
Step 12:For C05 Press
Step 13:For F05 Press

10000
1
7000
1

Step 14:
Step 15:

Press
Press NPV

Step 16: For I=, Enter

13-30

Enter
Enter
Enter
Enter

keys
keys
keys
keys

keys

key
13

Enter

keys

Step 17:

Press CPT

key

Result:

Net Present Value = -$1,424.42

NPV Strengths
and Weaknesses
Weaknesses:

Strengths:

Cash flows
assumed to be
reinvested at the
hurdle rate.

Accounts for TVM.

Considers all
cash flows.

13-31

May not include


managerial
options embedded
in the project. See
Chapter 14.

Net Present Value Profile


Net Present Value

$000s
15

Thre
e

10
5

Plot NPV for each


discount rate.
of th
e

se p
oint

IRR

s ar

6
9
12
Discount Rate (%)

e ea
sy n

NPV@13%

0
-4

13-32

Sum of CFs

15

ow!

Creating NPV Profiles


Using the Calculator
Hint: As long as you
do not clear the
cash flows from the
registry, simply start
at Step 15 and enter
a different discount
rate. Each resulting
NPV will provide a
point for your NPV
Profile!
13-33

Profitability Index (PI)


PI is the ratio of the present value of
a projects future net cash flows to
the projects initial cash outflow.
Method #1:

CF1
PI =
(1+k)1

CF2
+
(1+k)2

+...+

CFn
(1+k)n

<< OR >>
Method #2:
13-34

PI = 1 + [ NPV / ICO ]

ICO

PI Acceptance Criterion
PI

= $38,572 / $40,000
= .9643 (Method #1, 13-34)

Should this project be accepted?


No! The PI is less than 1.00. This
means that the project is not profitable.
[Reject as PI < 1.00 ]
13-35

PI Strengths
and Weaknesses
Strengths:

Weaknesses:

Same as NPV

Same as NPV

Allows
comparison of
different scale
projects

Provides only
relative profitability

Potential Ranking
Problems

13-36

Evaluation Summary
Basket Wonders Independent Project

Method Project Comparison Decision

13-37

PBP

3.3

3.5

Accept

IRR

11.47%

13%

Reject

NPV

-$1,424

$0

Reject

PI

.96

1.00

Reject

Other Project
Relationships
Dependent -- A project whose
acceptance depends on the
acceptance of one or more other
projects.
Mutually Exclusive -- A project
whose acceptance precludes the
acceptance of one or more
alternative projects.

13-38

Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
13-39

A. Scale Differences
Compare a small (S) and a
large (L) project.
END OF YEAR

13-40

NET CASH FLOWS


Project S
Project L

-$100

-$100,000

$400

$156,250

Scale Differences
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?
Project

IRR

100%

25%

13-41

NPV

PI

231

3.31

$29,132

1.29

B. Cash Flow Pattern


Let us compare a decreasing cash-flow (D)
project and an increasing cash-flow (I) project.
END OF YEAR
0
1
2
3
13-42

NET CASH FLOWS


Project D
Project I
-$1,200
-$1,200
1,000
100
500
600
100
1,080

Cash Flow Pattern


Calculate the IRR, NPV@10%, and
PI@10%.
Which project is preferred?
Project

13-43

IRR

NPV

PI

23%

$198

1.17

17%

$198

1.17

13-44

600

Plot NPV for each


project at various
discount rates.

400

Project I

200

NPV@10%
IRR
Project D

0
-200

Net Present Value ($)

Examine NPV Profiles

10
15
20
Discount Rate (%)

25

Net Present Value ($)


-200 0 200 400
600

Fishers Rate of Intersection

13-45

At k<10%, I is best!

Fishers Rate of
Intersection
At k>10%, D is best!

10
15
20
Discount Rate ($)

25

C. Project Life Differences


Let us compare a long life (X) project
and a short life (Y) project.
END OF YEAR
0
1
2
3
13-46

NET CASH FLOWS


Project X
Project Y
-$1,000
-$1,000
0
2,000
0
0
3,375
0

Project Life Differences


Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?

13-47

Project

IRR

NPV

PI

50%

$1,536

2.54

100%

$ 818

1.82

Another Way to
Look at Things
1.

Adjust cash flows to a common terminal


year if project Y will NOT be replaced.
Compound Project Y, Year 1 @10% for 2 years.

Year
CF

-$1,000

$0

$0

$2,420

Results:

IRR* = 34.26%

NPV = $818

*Lower IRR from adjusted cash-flow stream. X is still Best.


13-48

Replacing Projects
with Identical Projects
2.

Use Replacement Chain Approach (Appendix B)


when project Y will be replaced.
0

-$1,000

-$1,000
Results:
13-49

$2,000
-1,000
$1,000
IRR = 100%

$2,000
-1,000

$2,000

$1,000

$2,000

NPV* = $2,238.17

*Higher NPV, but the same IRR. Y is Best.


Best

Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for
this capital budgeting period.
13-50

Available Projects for BW


Project
A
B
C
D
E
F
G
H
13-51

ICO
$

500
5,000
5,000
7,500
12,500
15,000
17,500
25,000

IRR
18%
25
37
20
26
28
19
15

NPV

PI

50
6,500
5,500
5,000
500
21,000
7,500
6,000

1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24

Choosing by IRRs for BW


Project
C
F
E
B

ICO

IRR

NPV

PI

$ 5,000
15,000
12,500
5,000

37%
28
26
25

$ 5,500
21,000
500
6,500

2.10
2.40
1.04
2.30

Projects C, F, and E have the


three largest IRRs.
The resulting increase in shareholder wealth
is $27,000 with a $32,500 outlay.
13-52

Choosing by NPVs for BW


Project
F
G
B

ICO
$15,000
17,500
5,000

IRR

NPV

PI

28%
19
25

$21,000
7,500
6,500

2.40
1.43
2.30

Projects F and G have the


two largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
13-53

Choosing by PIs for BW


Project
F
B
C
D
G

ICO

IRR

NPV

PI

$15,000
5,000
5,000
7,500
17,500

28%
25
37
20
19

$21,000
6,500
5,500
5,000
7,500

2.40
2.30
2.10
1.67
1.43

Projects F, B, C, and D have the four largest PIs.


The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
13-54

Summary of Comparison
Method Projects Accepted
PI

F, B, C, and D

Value Added
$38,000

NPV

F and G

$28,500

IRR

C, F, and E

$27,000

PI generates the greatest increase in


shareholder wealth when a limited capital
budget exists for a single period.
13-55

Single-Point Estimate
and Sensitivity Analysis
Sensitivity Analysis:
Analysis A type of what-if
uncertainty analysis in which variables or
assumptions are changed from a base case in
order to determine their impact on a projects
measured results (such as NPV or IRR).

13-56

Allows us to change from single-point (i.e.,


revenue, installation cost, salvage, etc.) estimates
to a what if analysis
Utilize a base-case to compare the impact of
individual variable changes
E.g., Change forecasted sales units to see
impact on the projects NPV

Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and
benefits of a project with original estimates.

Identify any project weaknesses

Develop a possible set of corrective actions

Provide appropriate feedback

Result: Making better future decisions!


13-57

Multiple IRR Problem*


Let us assume the following cash flow
pattern for a project for Years 0 to 4:
-$100 +$100 +$900 -$1,000
How many potential IRRs could this
project have?
Two!! There are as many potential
IRRs as there are sign changes.
13-58

* Refer to Appendix A

NPV Profile -- Multiple IRRs


Net Present Value
($000s)

75
50
25
0

-100
13-59

Multiple IRRs at
k = 12.95% and 191.15%

40

80
120
160
Discount Rate (%)

200

NPV Profile -- Multiple IRRs


Hint: Your calculator
will only find ONE
IRR even if there
are multiple IRRs. It
will give you the
lowest IRR. In this
case, 12.95%.

13-60