Ch13

Chapter 13 –
Support
Capital
Capital Budgeting
Budgeting
Techniques
Techniques
13b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember?
Remember? The
The Different
Different
Methods
Methods of
of Evaluation?
Evaluation?
• Payback Period (PBP)
• Internal Rate of Return (IRR)
• Net Present Value (NPV)
• Profitability Index (PI)
Let us use the ‘New Asset’ project
from Chapter 12 (VW13E-13b.xlsx)
Project
Project Evaluation:
Evaluation:
Alternative
Alternative Methods
Methods
Year Cash Flow Cumulative CF
We will start with the cash
0 $ (75,000) $ (75,000)
1 $ 33,332 $ (41,668) flows of the project and also
2 $ 36,446 $ (5,222) calculate the cumulative
3
4
$ 28,147
$ 37,075
$
$
22,925
60,000 cash flow values.
We can use Excel functions / approaches to calculate each of

the following methods from the above cash flows.
Discount rate: 16%

PBP: 2.19 Accept: Assume want payback within 3 yrs
IRR: 28.40% Accept: Exceeds discount rate
NPV: $ 19,328.69 Accept: Increase shareholder wealth
PI: 1.26 Accept: Greater than 1.00
Remember to refer to Excel spreadsheet
IRR:
IRR: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.
Project
Project Evaluation
Evaluation
IRR: 28.40% =IRR($L$24:$L$28,K31)
The Internal Rate of Return function is built into Excel!

Simply use the formula above:
• $L$24:$L$28:
$L$24:$L$ represents the cash flows from period 0
through the last period (4 in our example)
• K31:
K31 represents a “guess” as to the answer, but you
do not need to put this in the formula
Discount rate: 16%
NPV:
NPV: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.
Project
Project Evaluation
Evaluation
NPV: $ 19,328.69 =NPV($K$31, $L$25:$L$28)+$L$24
•The Net Present Value (NPV) function is built into
•Excel and we used it in the TVM chapter!
• K31:
K31 represents the rate of return investors expect to earn for the
given amount of risk (discount rate)
• $L$25:$L$28:
$L$25:$L$28 represents the cash flows from period 1 through the
last period (we do NOT use period 0)
• $L$24:
$L$24 We subtract the ICO (or add if we already assigned it a
negative sign as we did in slide 3).
• This is an important “quirk” with the Excel function
Discount rate: 16%
PI:
PI: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.
Project
Project Evaluation
Evaluation
PI: 1.26 =1+$K$34/-$L$24
PI: 1.26 =NPV($K$31, $L$25:$L$28)/-$L$24
The Profitability Index (PI) function does not exist in

Excel, but we can use a simple calculation using the NPV answer
or a second method directly using the NPV function.
• We can simply use the NPV earlier ($K$34) and divide by the ICO (-$L$24)
and add this to 1.00 – [Method #1]
• Second, we use the NPV formula and calculate the present value of cash
flows in periods 1 through 4 discounted at the $K$31 discount rate. This value
we simply divide by the ICO of -$L$24 – [Method #2]
Discount rate: 16%
PBP:
PBP: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.
Project
Project Evaluation
Evaluation
PBP: 2.19 =IF(M24<0,IF(M25<0,IF(M26<0,IF(M27<0,IF(M28<0,"Exceeds 4 Years",K27+
(-M27/L28)),K26+(-M26/L27)),K25+(-M25/L26)),K24+(-M24/L25)),K23+(-M23/L24))
The Payback Period (PBP) function does not exist in

Excel either, but this complicated formula is one way to write a set of if
functions to determine PBP.
• The IF statements attempt to find when the cumulative cash flows change from a
negative sign to a positive sign.
• Once that occurs, we know the core number of years and we can then calculate the
portion of the next year to get payback
• To make this work for a longer project life, you need to add additional imbedded if
statements Discount rate: 16%
Asset
Asset Replacement?
Replacement?
• Now go back to Chapter 12 and the cash
flows we developed for the ‘Asset
Replacement’ project and calculate the PBP,
IRR, NPV and PI.
• Hint: The answers are shown in ‘VW13E-
13b.xlsx’ file on the ‘Asset Replacement’ tab.
• Given are assumptions, would you want to
replace the project? Why or why not?
Remember?
Remember? Potential
Potential Problems
Problems
Under
Under Mutual
Mutual Exclusivity
Exclusivity
Ranking of project proposals may

create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
Remember?
Remember?
A.
A. Scale
Scale Differences
Differences
Compare a small (S) and a
large (L) project.
NET CASH FLOWS

END OF YEAR Project S Project L
0 –$100 –$100,000
1 0 0
2 $400 $156,250
‘VW13E-13b.xlsx’ and the ‘Scale’ tab.
A.
A. Scale
Scale Differences
Differences
Year CF - Small CF - Large
0 $ (100) $ (100,000)
1 $ - $ - Graph the NPV Profiles for 'Small' and 'Large'
2 $ 400 $ 156,250
projects
$350.00 $60,000.00
Discount rate: 10%
IRR: 100.00% 25.00%
$300.00
NPV: $ 230.58 $ 29,132.23 $50,000.00
PI: 3.31 1.29
$250.00
 $40,000.00
BEST!!
Greatest NPV $200.00
$30,000.00
$150.00 NPV - Small
Rate NPV - Small NPV Large NPV Large

$20,000.00
0% $300.00 $56,250.00 $100.00
2% $284.47 $50,182.62
$10,000.00
4% $269.82 $44,461.91 $50.00
6% $256.00 $39,061.94
8% $242.94 $33,959.19 $0.00 $0.00
10% $230.58 $29,132.23 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
12% $218.88 $24,561.54
Axis Title
14% $207.79 $20,229.30
16% $197.27 $16,119.20
18% $187.27 $12,216.32
20% $177.78 $8,506.94
22%
24%
$168.74
$160.15
$4,978.50
$1,619.41
Refer to VW13E-13b.xlsx on the ‘Scale’ tab.
A.
A. Scale
Scale Differences
Differences
• Remember that we evaluate the projects
based on maximizing shareholder wealth
• So we choose the ‘Large’ project even
though the other evaluation methods seem
better!
• In Excel, we can use the functions or
alternatively ‘Data Tables’
Tables to create the
chart on the previous slide which allows us
to easily graph the NPV Profiles.
Remember?
Remember?
B.
B. Cash
Cash Flow
Flow Pattern
Pattern
Let us compare a decreasing cash-flow (D)
project and an increasing cash-flow (I) project.
NET CASH FLOWS

END OF YEAR Project D Project I
0 –$1,200 –$1,200
1 1,000 100
2 500 600
3 100 1,080
‘VW13E-13b.xlsx’ and the ‘Pattern’ tab.
B.
B. Cash
Cash Flow
Flow Pattern
Pattern
Year CF - Decrease CF - Increase
0 $ (1,200) $ (1,200)
1 $ 1,000 $ 100
2 $ 500 $ 600
3 $ 100 $ 1,080
NPV Profiles for two similar projects

Discount rate: 10%
$700.00
IRR: 22.79% 16.93%
NPV: $ 197.45 $ 198.20
$600.00
PI: 1.16 1.17
 $500.00
BEST??
Greatest NPV
$400.00
$300.00
Rate NPV - Decrease NPV Increase NPV - Decrease
0% $400.00 $580.00 NPV Increase
$200.00
2% $355.21 $492.45
4% $312.72 $411.00 $100.00
6% $272.36 $335.13
8% $233.98 $264.33 $0.00
10% $197.45 $198.20 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
12% $162.63 $136.32 ($100.00)
14% $129.42 $78.37
16% $97.72 $24.01 ($200.00)
18% $67.41 ($27.02)
20% $38.43 ($75.00)
22% $10.67 ($120.15)
24% ($15.92) ($162.69) Refer to VW13E-13b.xlsx on the ‘Pattern’ tab.
B.
B. Cash
Cash Flow
Flow Pattern
Pattern
• Remember that we evaluate the projects based on
maximizing shareholder wealth,
wealth but in this case they have
essentially the SAME NPVs.
• So we evaluate the uncertainty … to the left of the
intersection the increasing CF pattern is best and to the
right it is decreasing
• Both are acceptable projects, but if we must choose only
one, the “decreasing” pattern might be better
• It generates cash quicker which has less risk
• It has a positive NPV as long as the discount rate is less
than about 23%
• Again, we can use the functions or ‘Data Tables’ to create
the chart on the previous slide.
Remember?
Remember?
C.
C. Project
Project Life
Life Differences
Differences
Let us compare a long life (X) project
and a short life (Y) project.
NET CASH FLOWS

END OF YEAR Project X Project Y
0 –$1,000 –$1,000
1 0 2,000
2 0 0
3 3,375 0
‘VW13E-13b.xlsx’ and the ‘Life’ tab.
C.
C. Project
Project Life
Life Differences
Differences
Year CF - X CF - Y
0 $ (1,000) $ (1,000)
1 $ - $ 2,000
2 $ - $ -
3 $ 3,375 $ -
NPV Profiles for X and Y - neither repeated

Discount rate: 10%
$2,500.00
IRR: 50.00% 100.00%
NPV: $ 1,535.69 $ 818.18
PI: 2.54 1.82
$2,000.00

BEST??
Greatest NPV
$1,500.00
Rate NPV - X NPV - Y NPV - X

0% $2,375.00 $1,000.00 $1,000.00 NPV - Y
2% $2,180.34 $960.78
4% $2,000.36 $923.08
6% $1,833.72 $886.79
$500.00
8% $1,679.18 $851.85
10% $1,535.69 $818.18
12% $1,402.26 $785.71
$0.00
14% $1,278.03 $754.39
16% $1,162.22 $724.14 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
18% $1,054.13 $694.92
20% $953.13 $666.67
22% $858.64 $639.34
24% $770.14 $612.90
B.
B. Cash
Cash Flow
Flow Pattern
Pattern
(NOT
(NOT renewing
renewing project)
project)
• Remember that we evaluate the projects based on
maximizing shareholder wealth,
wealth but in this case we have an
overriding question – what happens at the end of the first
year if we choose project “Y”?
• We do indeed choose Project “X” (see previous slide)
because the NPV is greatest if, and only if, this is a project
that won’t be repeated or renewed. With the discount rates
we used, X is superior to Y in every scenario shown.
• If this project is repeated, then we need to re-evaluate the
cash flows as follows.
‘VW13E-13b.xlsx’ and the ‘Life2’ tab.
C.
C. Project
Project Life
Life Differences
Differences
Year 0 Year 1 Year 2 Year 3
Year CF - X CF - Y
-1000 2000
0 $ (1,000) $ (1,000) -1000 2000
1 $ - $ 1,000 -1000 2000
2 $ - $ 1,000 -1000 1000 1000 2000
3 $ 3,375 $ 2,000
NPV Profiles for X and Y-repeated

Discount rate: 10%
$3,500.00
IRR: 50.00% 100.00%
NPV: $ 1,535.69 $ 2,238.17
PI: 2.54 3.24 $3,000.00

BEST?? $2,500.00
Greatest NPV
$2,000.00
Rate NPV - X NPV - Y NPV - X

0% $2,375.00 $3,000.00 $1,500.00 NPV - Y
2% $2,180.34 $2,826.21
4% $2,000.36 $2,664.09 $1,000.00
6% $1,833.72 $2,512.63
8% $1,679.18 $2,370.93 $500.00
10% $1,535.69 $2,238.17
12% $1,402.26 $2,113.61
$0.00
14% $1,278.03 $1,996.60
16% $1,162.22 $1,886.55 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
18% $1,054.13 $1,782.90
20% $953.13 $1,685.19
22% $858.64 $1,592.95
24% $770.14 $1,505.79
B.
B. Cash
Cash Flow
Flow Pattern
Pattern
(NOT
(NOT renewing
renewing project)
project)
• Notice on the previous slide that we created the repeated
cash flows for the project assuming no change in cash
flows.
• We are still evaluating projects based on maximizing
shareholder wealth.
• We now choose Project “Y” (see previous slide) because the
NPV is greatest!
• In fact, Y is greatly superior to X in all of the scenarios
shown.
Remember?
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.
Remember?
Capital Rationing
We can use the “Solver” Add-in for Excel to find the
optimal mix EASILY!!! First make sure you have it
available on your computer by:
•Click the round Microsoft Office button (upper left corner of
screen) when Excel is open, click “Excel Options” at the
bottom, and then click the “Add-ins” category on the left side.
•In the “Manage” box at the bottom, choose “Excel Add-ins”,
and then click the “Go” button.
•In the pop-up box of Add-ins available, check the “Solver
Add-in” box, and then click OK.
Remember?
Available Projects for BW
Project ICO IRR NPV PI
A $ 500 18% $ 50 1.10
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
E 12,500 26 500 1.04
F 15,000 28 21,000 2.40
G 17,500 19 7,500 1.43
H 25,000 15 6,000 1.24
Capital Rationing
• We are going to use this data that can be found in VW13E-13b.xlsx
or you can enter the data yourself.
• Your data should look something like below in the yellow section.
• The “Yes/No” box is a binary variable that determines if we want to
keep that project as being optimal.
Project ICO IRR NPV Yes/No ICO NPV
A $ 500.00 18% $ 50.00 1 $ 500.00 $ 50.00
B $ 5,000.00 25% $ 6,500.00 1 $ 5,000.00 $ 6,500.00
C $ 5,000.00 37% $ 5,500.00 1 $ 5,000.00 $ 5,500.00
D $ 7,500.00 20% $ 5,000.00 1 $ 7,500.00 $ 5,000.00
E $ 12,500.00 26% $ 500.00 1 $ 12,500.00 $ 500.00
F $ 15,000.00 28% $ 21,000.00 1 $ 15,000.00 $ 21,000.00
G $ 17,500.00 19% $ 7,500.00 1 $ 17,500.00 $ 7,500.00
H $ 25,000.00 15% $ 6,000.00 1 $ 25,000.00 $ 6,000.00
$ 88,000.00 $ 52,050.00
Capital Rationing
• Let us open
Solver. Click
on the ‘Data’
tab and then in
the ‘Analysis’
ribbon choose
‘Solver’.
• The box should
open like the
following
example:
Capital Rationing
• “Set Target
Cell” equal to
the box that
sums the NPVs
and click on the
“Max” option
• In the “By
Changing
Cells” area, set
it to the binary
‘Yes / No’
values (F3:F10
in this case)
Capital Rationing
• Now we need to
add our
constraints.
• We want the
values of
F3:F10 to be
ONLY a “0” or a
“1” value
• We want G11,
sum of the ICOs
to be $32,500 or
less
Capital Rationing
Now we solve by clicking the ‘SOLVE’ button! Look, only projects
B, C, D and F are chosen!!
If you look at the Excel

formulas for columns
‘G’ and ‘H’ you will see
that the values are set
to the “Yes/No”
variable value (either 0
or 1) multiplied by the
original value in
columns ‘C’ and ‘E’.
This is a nifty way to

find the optimal
decision!

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Ch13

Uploaded by

Copyright:

Available Formats

Chapter 13 –

We can use Excel functions / approaches to calculate each of

Discount rate: 16%

The Internal Rate of Return function is built into Excel!

The Profitability Index (PI) function does not exist in

The Payback Period (PBP) function does not exist in

Ranking of project proposals may

NET CASH FLOWS

Rate NPV - Small NPV Large NPV Large

NET CASH FLOWS

NPV Profiles for two similar projects

NET CASH FLOWS

NPV Profiles for X and Y - neither repeated

Rate NPV - X NPV - Y NPV - X

NPV Profiles for X and Y-repeated

Rate NPV - X NPV - Y NPV - X

If you look at the Excel

This is a nifty way to

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