Chapter 13

Introduction to Corporate
Finance
Fifth Canadian Edition
Booth, Cleary, Rakita
Chapter 13
Capital Budgeting, Risk Considerations and Other

Special Issues
Copyright ©2020 John Wiley & Sons, Inc.
Learning Objectives
13.1 Describe the capital budgeting process and explain its importance to corporate
strategy.
13.2 Identify and apply the main tools used to evaluate investments.
13.3 Analyze independent projects and explain how they differ from interdependent
projects.
13.4 Explain what capital rationing is and how it affects firms’ investment criteria.
13.5 Explain the importance of international foreign direct investment both inside and
outside Canada.
13.6 Understand how the modified internal rate of return (MIRR) is calculated and why this
represents a conceptual improvement over the way the IRR is calculated.
Copyright ©2020 John Wiley & Sons, Inc. 2

13.1 CAPITAL EXPENDITURES
• Capital expenditures are a firm’s investments in long-lived or fixed assets, which may
be:
o Tangible, such as property, plant and equipment
o Intangible, such as research and development knowledge, patents, copyrights, trademarks,
brand names and franchise agreements
• Capital expenditures decisions determine the future direction of the company and are
among the most important that a firm can make because they often:
o Involve a very significant outlay of money and managerial time
o Take many years to demonstrate their return
o Are irrevocable
o Significantly alter the risk of the entire firm because of their size and long-term nature
• Capital budgeting is the process through which a firm makes capital expenditure
decisions, and involves identifying and evaluating investment alternatives,
implementing the chosen proposals, and monitoring implemented decisions
PORTER’S FIVE FORCES MODEL
• Michael Porter’s Five Forces Model identifies five critical factors that determine the
attractiveness of an industry:
1. Entry barriers
2. Threat of substitute products
3. Bargaining power of buyers
4. Bargaining power of suppliers
5. Rivalry among existing competitors
• Companies do exert control over how they strive to create a competitive advantage within their
industry. They can strive for:
1. Cost leadership (i.e., be the lowest-cost producer)
2. Product differentiation (i.e., have products considered unique)
• Once attained, a competitive advantage is difficult to sustain and requires on-going planning and
investment
• Capital expenditure decisions must be made with a strategic focus and be subject to rigorous
financial analysis
TYPES OF ANALYSIS AND DCF METHODS (1 of 2)
• Bottom-up analysis is an investment strategy in which capital

expenditure decisions are considered in isolation without regard
for whether the firm should continue in its particular business or
for general industry and economic trends
• Top-down analysis is an investment strategy that focuses or
strategic decisions, such as which industries or products the firm
should be involved in, looking at the overall economic picture

TYPES OF ANALYSIS AND DCF METHODS (2 of 2)
• Capital expenditure decisions, like security valuation, must take

into account the timing, magnitude, and riskiness of net
incremental after-tax cash flow benefits that an initial investment
is forecast to produce
• Unlike security valuation, however, analysts can change the
underlying cash flows by changing the structure of the project to
impact its feasibility and profitability
• All discounted cash flow (DCF) methods require an estimate of the
initial investment, the net incremental after-tax cash flows, and
the required rate of return on the project for the discount rate

13.2 EVALUATING INVESTMENT ALTERNATIVES
• Figure 13.1 shows the cash flow pattern for a traditional capital
expenditure:
• Where :
o CFt = the estimated after-tax future incremental cash flow at time t
o CF0 = the initial after-tax incremental cash outlay
o We will consider four DCF methods for evaluating investment alternatives:
net present value (NPV), internal rate of return (IRR), payback period and
discounted payback period, and profitability index (PI).

COST OF CAPITAL
• The firm’s cost of capital determines the minimum rate of return that would be
acceptable for a capital project
• The weighted average cost of capital (WACC) is the discount rate (k) used in NPV
analysis, assuming the risk of the project being evaluated is similar to the risk of the
overall firm, and the hurdle rate for IRR analysis
• If the risk of the project differs from the risk of the overall firm, however, a risk-
adjusted discount rate (RADR) should be used
• RADRs can be estimated using two techniques:
1. Use the CAPM after determining the project’s beta. This approach involves forecast ROA
that must be regressed against the ROA of the market index, and estimation errors can be
significant.
2. Use a pure-play approach where you find the cost of capital of another firm operating in
the industry associated with the project. The key to this approach is that the firm must not
be diversified across industries but truly represent an investment solely in that industry.

NET PRESENT VALUE (NPV) (1 of 4)
• Use Equation 13.1 to calculate NPV:
CF1 CF2 CF3 n
CFt
NPV   
1  k 1  k  1  k 
2 3
 ...  CF0  
t 1 1  k 
t
 CF0
• Essentially, the net present value (NPV) is the present value of all benefits (net cash
inflows) minus the present value of costs (net cash outflows)
• If PV(benefits) > PV(costs), then NPV > 0 and the project is acceptable because it will
add value
• If PV(benefits) < PV(costs), then NPV < 0 and the project should not be accepted
because it will destroy value
• NPV is an absolute measure, expressed in present dollars, of the net incremental
benefit the project is forecast to bring shareholders
• In a perfectly efficient market, the total value of the firm should rise by the value of
the NPV if the project is undertaken
• Example: Suppose a company has an investment that requires an after-

tax incremental cash outlay of $12,000 today. It estimates that the
expected future after-tax cash flows associated with this investment are
$5,000 in years 1 and 2, and $8,000 in year 3. Using a 15% discount rate,
determine the project’s NPV.
• Solution by Formula:
CF1 CF2 CF3
NPV     CF0
1  k 1  k  1  k 
2 3
5,000 5,000 8,000

    12,000  $1,388.67
1.15 1.15 1.15
2 3

• Solution Using a Financial Calculator:
• Solution Using Excel:

• =NPV(rate, value 1, value 2, …, value n)
• =NPV(0.15, 5000, 5000, 8000) = $13,388.67, the present value of future cash flows
• Then, subtract the initial outlay of $12,000 to find NPV

• An NPV profile is a set of NPVs for a project created by varying the

discount rate used to find the present value of the cash flows
• An NPV profile is also the slope of the line created when the
results are graphed; the longer the life of a project, the steeper
the slope of the NPV profile.

INTERNAL RATE OF RETURN (IRR) (1 of 3)
• The internal rate of return (IRR) is the discount rate that causes the NPV
of the project to equal zero:
n
CFt
NPV    CF0  0
1  IRR 
t
t 1
• If the IRR > WACC, then the project is acceptable because it is forecast
to yield a rate of return on invested capital that is greater than the
cost of the fund invested in the project
• If the IRR < WACC, the project should not be accepted because the
investment will not earn its cost of capital

• Example: Suppose a company has an investment that requires an after-

tax incremental cash outlay of $12,000 today. It estimates that the
expected future after-tax cash flows associated with this investment are
$5,000 in years 1 and 2, and $8,000 in year 3. The cost of capital is 15%.
Determine the project’s IRR.
• There is no closed-form formula solution for IRR. It can be solved
iteratively, but technology expedites the process significantly.
CF1 CF2 CF3
NPV     CF0  0
1  k 1  k 2 1  k 3
5,000 5,000 8,000
    12,000  0
1  IRR 1  IRR  1  IRR 
2 3

• Solution Using a Financial Calculator:
• Solution Using Excel:

o =IRR(value 0, value 1, value 2, …, guess), guess can be blank
o =IRR(-12000, 5000, 5000, 8000) = 21.31282726%

NPV VERSUS IRR (1 of 4)
• Both methods use the same basic decision inputs

• The difference is the assumed discount rate: the IRR assumes
intermediate cash flows are reinvested at the IRR while the NPV
assumes that they are reinvested at the WACC
• This difference can produce conflicting decision results under specific
conditions (see Table 13.1, next slide):
1. Evaluating two or more mutually exclusive investment proposals
2. NPV profiles of the projects have different slopes and cross at a positive
NPV
3. The cost of capital (relevant discount rate) is lower than the crossover
discount rate

TABLE 13.1 NPV versus IRR

Issue NPV IRR
1. Future cash flows change NPV works the same way for both Multiple IRRs may result—in this case, the IRR
sign accept/reject and ranking decisions. cannot be used for either accept/reject or ranking
decisions.
2. Ranking projects Higher NPV implies greater contribution to The higher IRR project may have a lower NPV, and
firm wealth—it is an absolute measure of vice versa, depending on the appropriate discount
wealth. rate and the size of the project. For example,
would analysts prefer an IRR of 100 percent on
$1,000 or 20 percent on $1 million?
3. Reinvestment rate assumed Assumes all future cash flows are Assumes cash flows from each project are
for future cash flows reinvested at the discount rate. This is reinvested at that project’s IRR.
received appropriate because it treats the This is inappropriate, particularly when the IRR is
reinvestment of all future cash flows high.
consistently, and k is the investor’s
opportunity cost.

• In Figure 13.2 the IRR of B is 15% while the IRR of A is only 12%, so IRR
would suggest that B is better than A
• But, notice that the NPV of A is greater when the discount rate is lower
than the 9% crossover rate.

• Both NPV and IRR use the same inputs

• NPV measures in absolute terms the estimated increase in the value of the firm today
that the project is forecast to produce, and assumes that cash flows are reinvested at
WACC
• IRR estimates the project’s rate of return and assumes that cash flows produced by the
project are reinvested by the firm at the project’s IRR
• The reason for the different accept/reject decisions is the different reinvestment rate
assumptions used by the two techniques
• Which method should be relied upon?
o It depends which reinvestment assumption is more realistic
o Most often, the NPV assumption of reinvestment at WACC is the most realistic because no
rational manager would reinvest cash flows at rates lower than the firm’s cost of capital
o If projects with high IRRs are rare, then reinvestment may not be possible

CFO PREFERENCES
• Despite the inherent superiority of the NPV approach, chief financial officers
continue to use other approaches and do not necessarily favour NPV over IRR
• Perhaps the reason for this is that it is difficult for people to understanding
what a positive NPV really means

PAYBACK PERIOD (1 of 2)
• The payback period is a simple approach to capital budgeting that is designed to tell
you how many years it will take to recover the initial investment
• The payback period is often used by financial managers as one of a set of investment
screens, because it gives the manager an intuitive sense of the project’s risk
• The discounted payback period overcomes the lack of consideration of time value of
money that is problematic with the simple payback period
• Graphing the cumulative present value of cash flows can help identify the pattern of
cash flows beyond the payback point
• If carried to the end of the project’s useful life, it will tell us the project’s NPV if the
WACC is used as the discount rate

PAYBACK PERIOD (2 of 2)
• Example: Determine the payback and discounted payback for a project that
costs $100,000 to implement and gives $60,000 after-tax cash flows for six
years
• Solution: the payback period is 1.7 years and the discounted payback period is
1.9 years
Year CF Discounted CF Cumulative CF Cumulative Discounted CF
0 -$100,000 −$100,000 −$100,000 −$100,000
1 $60,000 $54,545 −$40,000 −$45,455
2 $60,000 $49,587 $20,000 $4,132
3 $60,000 $45,079
4 $60,000 $40,981
5 $60,000 $37,255
6 $60,000 $33,868

DISCOUNTED PAYBACK PERIOD GRAPHED

PROFITABILITY INDEX (PI)
• The profitability index (PI) uses exactly the same decision inputs as the
NPV
• The PI simply expresses the relative profitability of the project’s
incremental after-tax cash flow benefits as a ratio to the project’s initial
cost:
PV Cash Inflows 
PI 
PV Cash Outflows 
• If PI > 1, accept the project because the PV(Benefits) > PV(Costs)
• If PI < 1, do not accept the project because the PV(Benefits) < PV
(Costs)

13.3 INDEPENDENT & INTERDEPENDENT
PROJECTS
• Independent projects have no relationship with one another; therefore, the decision
to implement one project has no impact on the decision to implement another
project.
• Example: Building a store in Ottawa is independent of building a store in Edmonton.
• Contingent projects, on the other hand, are projects where the acceptance of one
requires the acceptance of another, either as a prerequisite or simultaneously
• Example: Building a retail outlet in Edmonton requires warehouse space in Edmonton.
• Mutually exclusive projects are substitutes where the decision to accept one project
automatically means all other substitute proposals are rejected
• Example: A commercial development on a parcel of land in Edmonton means an
apartment building will not be built there

EVALUATING MUTUALLY EXCLUSIVE PROJECTS WITH
UNEQUAL LIVES
• There are two approaches to adjust for unequal lives among mutually exclusive
projects:
1. The chain replication approach finds a time horizon into which all the project lives under
consideration will divide equally (i.e., their lowest common multiple) and then assumes
each project repeats until it reaches this horizon. This implicitly assumes the projects are
repeatable on the same terms into the future.
2. The equivalent annual NPV (EANPV) approach compares projects by finding the NPV of the
individual projects and then determining the amount of an annuity that is economically
equivalent to the NPV generated by each project over its respective time horizon. Equation
13-4:
Project NPV
EANPV 
1 1 
1  
k  1  k n 

13.4 CAPTIAL RATIONING
• Capital rationing is the corporate practice of limiting the amount of funds dedicated to capital
investments in any one year
• It is academically illogical: why would a manager not invest in a project that will offer a greater
return than the cost of capital used to finance it?
• In the long-run, it could threaten a firm’s continuing existence through the erosion of its
competitive position
• But the firm may have owners who do not want to raise additional external equity because it
will mean ownership dilution of their share
• The firm may also have so many worthy investment projects that taking advantage of all of them
exceeds the firm’s short-term managerial capacity
• Under capital rationing the cost of capital is no longer the appropriate opportunity cost
• IRR may have more validity because the firm may be able to reinvest its cash flows at rates that
are higher than the cost of capital

CAPITAL RATIONING
• The profitability index may also be a useful starting point because it ranks
projects on PV per unit of investment
• In the absence of capital rationing, NPV, IRR and PI will select value-maximizing
projects.
• Figure 13.4 shows CP’s investment opportunity schedule:

INVESTMENT OPPORTUNITY SCHEDULES (1 of 3)
• An investment opportunity schedule (IOS) is a prioritized list of capital projects, ranked

from highest to lowest with the cumulative investment required also listed
• Investments can be ranked according to any metric, but only NPV ensures
maximization of shareholder wealth
• Example: Suppose a firm has a 10% cost of capital and six projects from which it can
choose to allocate $6 million in capital investment.
Project Initial Cost ($) Annual ATCF ($) Useful Life NPV ($) IRR (%) PI
A 1,500,000 290,000 7 -88,159 8.19 0.94
B 3,000,000 700,000 6 48,682 10.55 1.02
C 4,000,000 1,040,000 6 529,471 14.40 1.13
D 70,000 20,000 7 27,368 21.08 1.39
E 1,000,000 290,000 5 99,328 13.82 1.10
F 960,000 200,000 8 106,985 12.99 1.11

• Example: Suppose a firm has a 10% cost of capital and six projects from which
it can choose to allocate $6 million in capital investment
• In the absence of capital rationing, all three methods choose value maximizing
project and reject value destroying projects
Rank NPV IRR PI

1st C D D
2nd F C C
3rd E E F
4th B F E
5th D B B
Rejected A A A

• Example: Suppose a firm has a 10% cost of capital and six projects from
which it can choose to allocate $6 million in capital investment
• With only $6 million to allocate only NPV ensures maximization of
shareholder wealth:
Rank NPV IRR PI
1st C D D
2nd F C C
3rd E E n/a
Capital Budget $5,960,000 $5,070,000 $4,070,000
Total NPV $735,785 $656,168 $556,840

13.5 INTERNATIONAL CONSIDERATIONS
• Capital investment decisions that involve foreign investment should taking into account
additional factors:
o Political risk
o Potential legal and regulatory issues
o Adjustments for foreign exchange risk
o Adjustments for foreign taxation
o Sources of financing if local capital markets are poorly developed or unsuitable
• Export Development Canada (EDC) is a federal crown corporation that helps Canadian firms
export and make foreign direct investment (FDI)
• EDC provides insurance products to mitigate some risks of FDI
• FDI outside of Canada is a growing phenomenon as Canadian companies are increasing seeking
international investment opportunities
• EDC encourages Canadian companies to look beyond the U.S. for FDI

13.6 The Modified Internal Rate of Return (MIRR)
• IRR assumes that all cash flows are reinvested at the same rate.
This is not realistic; in some cases there may be no opportunity for
reinvestment available; in others, the return may be higher than
the IRR.
• MIRR is a variation of the IRR that allows for adjustments for the
reinvestment rates on cash flows that are generated during the life
of the project
• The accept/reject criteria for the MIRR is similar to that of the IRR:
if a project has an MIRR greater than its cost of capital, it is
acceptable; if a project’s MIRR is less than its cost of capital, it is
not acceptable.
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Copyright © 2020 John Wiley & Sons, Canada, Ltd.

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Introduction to Corporate

Capital Budgeting, Risk Considerations and Other

Copyright ©2020 John Wiley & Sons, Inc. 2

• Bottom-up analysis is an investment strategy in which capital

Copyright ©2020 John Wiley & Sons, Inc. 5

• Capital expenditure decisions, like security valuation, must take

Copyright ©2020 John Wiley & Sons, Inc. 6

Copyright ©2020 John Wiley & Sons, Inc. 7

Copyright ©2020 John Wiley & Sons, Inc. 8

• Example: Suppose a company has an investment that requires an after-

5,000 5,000 8,000

Copyright ©2020 John Wiley & Sons, Inc. 10

• Solution Using Excel:

Copyright ©2020 John Wiley & Sons, Inc. 11

• An NPV profile is a set of NPVs for a project created by varying the

Copyright ©2020 John Wiley & Sons, Inc. 12

Copyright ©2020 John Wiley & Sons, Inc. 13

• Example: Suppose a company has an investment that requires an after-

Copyright ©2020 John Wiley & Sons, Inc. 14

• Solution Using a Financial Calculator:

• Solution Using Excel:

Copyright ©2020 John Wiley & Sons, Inc. 15

• Both methods use the same basic decision inputs

Copyright ©2020 John Wiley & Sons, Inc. 16

TABLE 13.1 NPV versus IRR

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• Both NPV and IRR use the same inputs

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• An investment opportunity schedule (IOS) is a prioritized list of capital projects, ranked

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Rank NPV IRR PI

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Copyright © 2020 John Wiley & Sons, Canada, Ltd.

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