Chapter

10

Capital Budgeting Techniques

Understand the key elements of the capital

budgeting process.
Calculate, interpret, and evaluate the payback
period and discounted payback period
Calculate, interpret, and evaluate the net present
value (NPV) and profitability index (PI)
Calculate, interpret, and evaluate the internal
rate of return (IRR).
Use net present value profiles to compare NPV
and IRR techniques.
Discuss NPV and IRR in terms of conflicting
rankings and the theoretical and practical
strengths of each approach.
1

Capital budgeting is the process of evaluating and

selecting long-term investments that are consistent
with the firms goal of maximizing owner wealth.

A capital expenditure is an outlay of funds by the

firm that is expected to produce benefits over a
period of time greater than 1 year.

An operating expenditure is an outlay of funds by

the firm resulting in benefits received within 1 year.

The capital budgeting process consists of five steps:

1. Proposal generation. Proposals for new investment
projects are made at all levels within a business
organization and are reviewed by finance personnel.
2. Review and analysis. Financial managers perform
formal review and analysis to assess the merits of
investment proposals
3. Decision making. Firms typically delegate capital
expenditure decision making on the basis of dollar limits.
4. Implementation. Following approval, expenditures are
made and projects implemented. Expenditures for a
large project often occur in phases.
5. Follow-up. Results are monitored and actual costs and
benefits are compared with those that were expected.
Action may be required if actual outcomes differ from
projected ones.

Independent versus Mutually Exclusive Projects

Independent projects are projects whose cash flows are
unrelated to (or independent of) one another; the acceptance
of one does not eliminate the others from further
consideration.
Mutually exclusive projects are projects that compete with
one another, so that the acceptance of one eliminates from
further consideration all other projects that serve a similar
function.

Unlimited Funds versus Capital Rationing

Unlimited funds is the financial situation in which a firm is
able to accept all independent projects that provide an
acceptable return.
Capital rationing is the financial situation in which a firm
has only a fixed number of dollars available for capital
expenditures, and numerous projects compete for these
dollars.

Accept-Reject versus Ranking Approaches

An acceptreject approach is the evaluation of capital
expenditure proposals to determine whether they meet the
firms minimum acceptance criterion.
A ranking approach is the ranking of capital expenditure
projects on the basis of some predetermined measure, such
as the rate of return.

Payback Period
Discounted Payback Period
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)

Bennett Company is a medium sized metal fabricator

that is currently contemplating two projects: Project A
requires an initial investment of $42,000, project B an
initial investment of $45,000. The relevant operating
cash flows for the two projects are presented in Table
10.1 and depicted on the time lines in Figure 10.1.

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11

The payback method is the amount of time required for

a firm to recover its initial investment in a project, as
calculated from cash inflows.
Decision criteria:
The length of the maximum acceptable payback period is
determined by management.
If the payback period is less than the maximum
acceptable payback period, accept the project.
If the payback period is greater than the maximum
acceptable payback period, reject the project.

12

We can calculate the payback period for Bennett Companys projects A

and B using the data in Table 10.1.
For project A, which is an annuity, the payback period is 3.0 years
($42,000 initial investment $14,000 annual cash inflow).
Because project B generates a mixed stream of cash inflows, the
calculation of its payback period is not as clear-cut.
In year 1, the firm will recover $28,000 of its $45,000 initial
investment.
By the end of year 2, $40,000 ($28,000 from year 1 + $12,000
from year 2) will have been recovered.
At the end of year 3, $50,000 will have been recovered.
Only 50% of the year-3 cash inflow of $10,000 is needed to
complete the payback of the initial $45,000.
The payback period for project B is therefore 2.5 years (2 years +
50% of year 3).

13

The payback method is widely used by large firms to evaluate

small projects and by small firms to evaluate most projects.
Its popularity results from its computational simplicity and
intuitive appeal.
By measuring how quickly the firm recovers its initial
investment, the payback period also gives implicit
consideration to the timing of cash flows.
Because it can be viewed as a measure of risk exposure, many
firms use the payback period as a decision criterion or as a
supplement to other decision techniques.

14

The major weakness of the payback period is that the

appropriate payback period is merely a subjectively
determined number.
It cannot be specified in light of the wealth maximization goal because it
is not based on discounting cash flows to determine whether they add to
the firms value.

A second weakness is that this approach fails to take fully into

account the time factor in the value of money.
A third weakness of payback is its failure to recognize cash
flows that occur after the payback period.

15

The discounted payback method is the amount of time

required for a firm to recover its initial investment in a
project, as calculated from present value of the cash
inflows.
Decision criteria:
The length of the maximum acceptable payback period is
determined by management.

If the discounted payback period is less than the

maximum acceptable payback period, accept the project.
If the discounted payback period is greater than the
maximum acceptable payback period, reject the project.

16

Advantages
Includes time value of
money
Easy to understand
Biased towards liquidity

Disadvantages
Requires an arbitrary
cutoff point
Ignores cash flows
beyond the cutoff point
Biased against long-term
projects, such as R&D
and new products

17

Net present value (NPV) is a sophisticated capital

budgeting technique; found by subtracting a projects
initial investment from the present value of its cash
inflows discounted at a rate equal to the firms cost of
capital.
NPV = Present value of cash inflows Initial investment

18

Decision criteria:

If the NPV is greater than $0, accept the project.

If the NPV is less than $0, reject the project.

If the NPV is greater than $0, the firm will earn a return
greater than its cost of capital. Such action should
increase the market value of the firm, and therefore the
wealth of its owners by an amount equal to the NPV.

19

20

For a project that has an initial cash outflow followed

by cash inflows, the profitability index (PI) is simply
equal to the present value of cash inflows divided by the
initial cash outflow:

When companies evaluate investment opportunities

using the PI, the decision rule they follow is to invest in
the project when the index is greater than 1.0.
21

We can refer back to Figure 10.2, which shows the present

value of cash inflows for projects A and B, to calculate the
PI for each of Bennetts investment options:
PIA = $53,071 $42,000 = 1.26
PIB = $55,924 $45,000 = 1.24

22

The Internal Rate of Return (IRR) is a sophisticated

capital budgeting technique; the discount rate that equates
the NPV of an investment opportunity with $0 (because the
present value of cash inflows equals the initial investment);
it is the rate of return that the firm will earn if it invests in
the project and receives the given cash inflows.

23

Decision criteria:
If the IRR is greater than the cost of capital, accept the
project.
If the IRR is less than the cost of capital, reject the
project.

These criteria guarantee that the firm will earn at least

its required return. Such an outcome should increase the
market value of the firm and, therefore, the wealth of its
owners.

24

25

26

Comparing

the IRRs of projects A and B given in Figure 10.3

to Bennett Companys 10% cost of capital, we can see that both
projects are acceptable because
IRRA = 19.9% > 10.0% cost of capital
IRRB = 21.7% > 10.0% cost of capital
Comparing

the two projects IRRs, we would prefer project B

over project A because IRRB = 21.7% > IRRA = 19.9%.

27

It is interesting to note in the preceding example that

the IRR suggests that project B, which has an IRR of
21.7%, is preferable to project A, which has an IRR
of 19.9%.
This conflicts with the NPV rankings obtained in an
earlier example.
Such conflicts are not unusual.
There is no guarantee that NPV and IRR will rank
projects in the same order. However, both methods
should reach the same conclusion about the
acceptability or nonacceptability of projects.

28

Which Methods Do Companies Actually Use?

A recent survey asked Chief Financial Officers (CFOs) what
methods they used to evaluate capital investment projects.
The most popular approaches by far were IRR and NPV,
used by 76% and 75% (respectively) of the CFOs
responding to the survey.
These techniques enjoy wider use in larger firms, with the
payback approach being more common in smaller firms.

29

NPV and IRR will generally give us the same

decision

Exceptions:
Non-conventional cash flows cash flow signs
change more than once
Mutually exclusive projects
Initial investments (i.e. size) are substantially
different
Timing of cash flows is substantially different

30

Project A
year cash flow
0
(135,000)
1
60,000
2
60,000
3
60,000
required return = 12%
IRR = 15.89%
NPV = RM9,110
PI = 1.07

Project B
year cash flow
0
(30,000)
1
15,000
2
15,000
3
15,000
required return = 12%
IRR = 23.38%
NPV = RM6,027
PI = 1.20

31

Project A
year cash flow
0
(48,000)
1
1,200
2
2,400
3
39,000
4
42,000
required return = 12%

Project B
year cash flow
0
(46,500)
1
36,500
2
24,000
3
2,400
4
2,400
required return = 12%

IRR = 18.10%
NPV = RM9,436
PI = 1.20

IRR = 25.51%
NPV =RM8,455
PI = 1.18

32

IRR is a good decision-making tool as long as cash

flows are conventional. (- + + + + +)

Problem: If there are multiple sign changes in the cash

flow stream, we could get multiple IRRs. (- + + - + +)
When the cash flows change sign more than once, there is
more than one IRR

If you have more than one IRR, which one do you use
to make your decision?

33

Suppose an investment will cost RM90,000 initially

and will generate the following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000

The required return is 15%.

Should we accept or reject the project?

34

IRR = 10.11% and 42.66%

35

Mutually exclusive projects

If you choose one, you cant choose the other
Example: You can choose either Project A or B, but
not both

Intuitively you would use the following decision

rules:
NPV choose the project with the higher NPV
IRR choose the project with the higher IRR

36

Period

Project A Project B

-500

-400

325

325

325

200

IRR

19.43%

22.17%

NPV

64.05

60.74

The required return

for both projects is
10%.

Which project
should you accept
and why?
37

IRR for A = 19.43%

IRR for B = 22.17%
Crossover Point = 11.8%

43

NPV directly measures the increase in value to the

firm

Whenever there is a conflict between NPV and

another decision rule, you should always use NPV

IRR is unreliable in the following situations

Non-conventional cash flows
Mutually exclusive projects

39

 IRR

assumes that all cash flows are

reinvested at the IRR.

MIRR

provides a rate of return measure

that assumes cash flows are reinvested at
the required rate of return.

40

Calculate the PV of the cash outflows.

Using the required rate of return.
Calculate the FV of the cash inflows at the last
year of the projects time line. This is called the
terminal value (TV).
Using the required rate of return.
MIRR: the discount rate that equates the PV of
the cash outflows with the PV of the terminal
value, ie, that makes:
PVoutflows = PVinflows or
FVinflows = PVoutflows (1+MIRR)n

41

From previous example

Suppose an investment will cost RM90,000 initially and will

generate the following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000

The required return is 15%.

Should we accept or reject the project?

42

(90,000) 132,000

100,000

(150,000)

0
1
2
3
RM90,000
RM98,627
RM174,570
RM115,000
RM188,627 (1 + MIRR)3 = RM 289,570
MIRR = 15.36% (> 15 %.... ACCEPT)

43

Capital rationing occurs when a firm or division has

limited resources.

Because of this limited resources, some of the positive

NPV projects may have to be rejected.

The profitability index is a useful tool when a manager

is faced with capital rationing.

44

1. Equivalent Annual Annuities (EAA)

2. Replacement Chain Analysis

45

Suppose our firm is planning to expand and we

have to select one of two machines.

They differ in terms of economic life and capacity.

How do we decide which machine to select?

46

The after-tax cash flows are:

Year
0
1
2
3
4
5
6

Machine 1
(45,000)
20,000
20,000
20,000

Machine 2
(45,000)
12,000
12,000
12,000
12,000
12,000
12,000

Assume a required return of 14%.

47

 NPV1

= RM1,433
NPV2 = RM1,664
So,

does this mean Machine 2 is better?

NO!

The two NPVs cant be compared!

48

If we assume that each project will be replaced an

infinite number of times in the future, we can
convert each NPV to an annuity.

The projects EAAs can be compared to determine

which is the best project!

EAA: Simply annuitize the NPV over the projects

life.
49

Simply spread the NPV over the life of the

project

Machine 1:
PV = EAA 1 (PVIFA 3, 14)
RM1433 = EAA 1 (2.3216)
EAA 1 = RM617

Machine 2:
PV = EAA 2 (PVIFA 6, 14)
RM1664 = EAA 2 (3.8887)
EAA 2 = RM428
50

EAA1 = RM617
EAA2 = RM428

This tells us that:

NPV1 is equivalent to receiving annuity of RM617 per year.
NPV2 is equivalent to receiving annuity of RM428 per year.

So, weve reduced a problem with different time

horizons to a couple of annuities.

51

Assuming infinite replacement, the EAAs are

actually perpetuities. Get the PV by dividing the
EAA by the required rate of return.

NPV 1 = 617/.14 = RM4,407

NPV 2 = 428/.14 = RM3,057

Which machine should be selected?

52

Machine 1
RM1433
0

RM1433
1

Machine 2
RM1664
0

53

Then find the total NPV over the life of the project

Machine 1: (Invest twice)

Total NPV = RM1433 + RM1433/(1.14)3
= RM1433 + RM967
= RM2400

Machine 2: (Invest once)

Total NPV = RM1664
Which machine should be selected?

54