Capital Budgeting Chapter 3

Chapter Nineteen CAPITAL BUDGETING TECHNIQUES In general, the capital budgeting techniques can be categorized into two groups: those that do use discounting techniques (the time value of money) and those that do not. Methods that utilize discounting techniques consist of net present value, internal rate of return, profitability index, net profitability index, uniform annual series, and equivalent annual profit or cost methods. Methods not utilizing discounting include the accounting rate of return and the payback methods. Evaluations of these methods, beginning with the non-discounting methods, follow. Accounting Rate of Return Method (ARR) There are basically four measures used to make capital budgeting decisions under this method. 1. Annual Accounting Return on Investment (AARI):
Average annual income Initial investment

2. Annual Accounting Return on Average Investment (ARAI):

Average annual income Initial investment / 2

3. Average Accounting Return on Average Investment (AARAI):

Total income ( Initial investment & Initial investment # ' life ! $ 2 % "

4. Average Annual Book Return on Weighted Investment (AABRWI):

= Total income ! Initial investment Weighted average investment

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For each measure, the decision to undertake a project will be affirmative if the measured rate of return exceeds the cost of capital chosen by firm management. These methods are seldom, if at all, used for capital budgeting decisions (given the ease of discounting with a computer algorithm), because the drawbacks are many. First, these methods use accounting income rather than the cash flow as the measure of benefits to be derived over the life of the project. This can provide very misleading results (see example 1.10). Second, these methods ignore the timing of cash flows. That is, a dollar received today has the same value as one received five years from now. That results in situations in which incomes of $100, $90, $80, $70, and $60, received in years 1 through 5, respectively, are treated the same as an income stream of $60, $70, $80, $90, and $ 100 for the five years. A third drawback of ARR methods is the reliance on book values rather than market values of the investment project. This is especially troublesome if one computes a current ARR on an existing project that was undertaken in previous years. Consider a piece of commercial property purchased five years ago for $5 million that currently is generating a net income of $500,000 per year and has a book value of $3 million. The annual accounting rate of return on the property is 500,000/3,000,000 = .1667 or 16.67 percent. However, the market value of the property might have doubled. If so, the actual ARR is 500,000/10,000,000 = .05 or 5 percent. Balance sheet items only represent the book value of investments made in the past. Seldom, if ever, does the book value represent the current fair market value. Example 19.1: Consider a project with an initial investment of $1,000 that generates a net income of $250 per year over life of eight years. Compute the four accounting rates of return. Answer: From the information in the problem, we have Average income = 8 x 250 = $250 8 Initial investment = $1,000. Applying our formulas:

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1. 2. 3.

AARI =

250 = .25 or 25 percent. 1,000 250 ARAI = = .50 or 50 percent. 1,000 / 2 2,000 " 1,000 AARAI = = 0.25 or 25 percent. 1,000 !8 2

The weighted average investment is the average of the book values of the investment over its life. Assuming straight-line depreciation, we have the book values in year 1 of $1,000, in year 2 of $850, and so on. Therefore, our last accounting rate of return is
4. AABRWI = 2,000 " 1,000 1,000 + 875 + 750 + 625 + 500 + 375 + 250 + 125 !8 8

= .2225 or 22.25 percent.

Example 19.2: Suppose the net income in the respective years is 700, 760, 820, 880, and 940, and the initial investment is $10,000., compute the four accounting rate of returns. Answer: The net income in the respective years is 700, 760, 820, 880, and 940, and the initial investment is $10,000. Usually, this information is put on a time-line diagram to illustrate the dollar flows. Net Income -10,000 Year 0 700 1 760 2 820 3 880 4 940 5

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Applying the accounting rate of return formulas, we have

700 + 760 + 820 + 880 + 940 820 5 1. AARI = = 10,000 10,000 = 0.082 or 8.2 percent 2. ARAI = 820 = .164 or 16.4 percent 10,000 / 2 4,100 ! 10,000 = !.236 or ! 23.6 percent. 10,000 "5 2 4,100 ! 10,000 10,000 + 8,000 + 6,000 + 4,000 + 2,000 "5 5 = !0.1967 or ! 19.67 percent.

3. AARAI =

4. AABRWI =

In this example, two accounting rates are negative and two are positive. Such conflicting information makes it difficult to accept or reject the project. If we were to measure the dollar benefit by cash flows rather than net income (sometimes in the ARR computation, cash flow is utilized) the four accounting rates of return would be
3,000 = .30 or 30 percent. 10,000 3,000 2. ARAI = = .60 or 60 percent. 10,000 2 5,000 3. AARAI = = .20 or 20 percent. 10,000 !5 2 5,000 4. AABRWI = = .1667 or 16.67 percent. 30,000 !5 5 AARI =

1.

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As can be seen, these returns are quite different from those obtained using net income, but they are all of the same sign. The Payback Period Method The payback period of a project is the time required to recover the initial investment Thus it can be thought of as a measure of the project's ability to recover the initial investment (i.e., capital), rather than its profitability. There are two payback period methods that are currently in use. The classic payback or simple payback method is used when management is interested in capital recovery and liquidity rather than profitability. This method measures the time required to recover the initial outlay on a project. The time required is the payback period (PB) of the project. In calculating this time period, the cash flows are added cumulatively until the original investment is recovered. The time thus obtained is the payback period. The classical payback method has been criticized on several grounds. First, the method does not pay any attention to cash flows beyond the payback period. A project could turn very unprofitable after the initial investment is recovered, and the payback method would make no adjustment for such a situation. Second, no consideration of the time value of the cash flows is given. Third, no adjustment is made for projects of differing initial investments (i.e., size). Last, there is no accounting for the cost of obtaining funds and supporting the project. The discounted payback (DPB) method, also know as the present value payback (PVPB) method, is used to overcome this last problem. To use this method, we obtain the present value of all the future cash flows at the given cost of capital and then obtain the payback based on these discounted cash flows. The discounted payback period is the time needed to make the cumulative discounted cash flow zero. The following example will clarify this method.

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Example 19.3: Consider a project with an initial outlay of $1,000 and yearly cash flows as follows: -200, -100, 300, 300, 400, 200, 100, 200, 500, 400, and 100. Calculate the classical payback period as well as the cost adjusted payback period, assuming a 10 percent cost of funds. Answer: To calculate these payback periods, we must set up a cash flow table for both unadjusted and cost-adjusted cumulative cash flows. Cumulative Cash Flow -1,000 -1,200 -1,300 -1,000 -700 -300 -100 0 200 700 1,100 1,200 Discounted Cash Flow @10% -1,000 -181.82 -82.64 225.39 204.90 248.37 112.89 51.32 93.30 212.05 154.22 35.05 Cumulative Discounted Cash Flow -1,000 -1,181.82 -1,264.46 -1,039.07 -834.16 -585.80 -472.90 -421.59 -328.28 -116.23 37.98 73.03

Year 0 1 2 3 4 5 6 7 8 9 10 11

Cash Flow -1,000 -200 -100 300 300 400 200 100 200 500 400 100

In column 3, the cumulative cash flow needed to determine the classical payback period has been computed. The cumulative total is 0 in year 7; hence, that is the payback period. The discounted column is the present values of all cash flows using the cost of capital as the discount rate. Computing the cumulative discounted cash flow in column 6, we obtain the cost-adjusted payback period as DPB = 9 +
116.23 = 9.75 years 154.22 116.23 = 9 years and 275.09 days. 154.22

= 9 + 365 !

After 275.09 days, the above procedure was used to obtain the discounted payback period is not in vogue anymore. Even though, the above procedure is theoretically appropriate and correct. At present, the adopted procedure to obtain the discounted payback is to obtain the present value of all the future cash flows at the given cost of capital and then

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obtain the payback based on these discounted cash flows. For example, the above problem is solved as follows:

5
400

6
200
112.89

7
100

8
200

9
500

10
400

11
100

-1000 -200 -100 300 300

Discounted Cash Flows

-1000
-181.82

-82.64 225.39

204.90 248.37

93.30 51.32 212.05

154.22 35.05

Moreover, no one makes the final decision based on the payback period method, either classical or discounted, this computation of payback should be taken as an intermediate step in making the final decision. While the payback method has been criticized for the reasons given, it does have several advantages over other capital budgeting methods. Besides being simple to use, it does concern itself with the liquidity of a project, thereby protecting against illiquidity and bankruptcy. Utilizing the cost-adjusted method also takes into account discounted cash flows and is comparable to present value analysis in that sense. We now turn our attention to methods utilizing discounted cash flows. In general, there are two discounted cash flow methods of capital budgeting - Net Present Value (NPV) and Internal Rate of Return (IRR). Other methods, such as the Profitability Index (PI), Net Profitability Index (NPI), Equivalent Annual Charge (EAC), and Uniform Annual Series (UAS), are modifications of the net present value method. The Net Present Value Method (NPV) This method of capital budgeting is the most widely accepted method of evaluating a project when the firm's objective is to maximize the wealth of its owners. It provides definite answers to project acceptance or rejection when looking at changes in shareholder wealth. The rationale behind the NPV method is quite simple and intuitive. Assume that VBP is the value of the firm before the acceptance of a project. Then, the value of a firm is just the present value of future cash flows or

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V BP = !
t =1

CFt (1 + k ) t

where k is the cost of capital and CFt is cash flows in period t. Now assume that the firm is considering a project that will cost I0 and will generate additional cash flows of Xt in period t. Assuming no change in the cost of capital, the value of the firm after the acceptance of the project, VAP, will be
n

V AP = !
t =1

X t + CFt (1 + k ) t

" I0.

Hence, the change in the value of the firm will be

VAP " VBP = " I 0 + ! Xt . t 1+ k ) t =1 (
n

(19.1)

The objective of the firm is assumed to be the maximizing of the value of the firm. This can be achieved by maximizing VAP - VBP. Thus the right-hand side of equation (19.1) provides a tool for capital budgeting decisions. This is known as net present value method. In general, we have the following: NPV = PV of all cash inflows - PV of all cash outflows and can be written as
n

NPV = " I 0 + !
t =1

CF , (1 + k ) t

where CF is the net cash flow and k is the cost of capital. The project should be accepted if NPV > 0 and rejected if NPV < 0. If the net present value equals 0, the project will earn a rate of return exactly equal to the cost of the funds, and management (or other considerations) will dictate the accept/reject decision. There are also several variants of NPV to take into account for

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different situations, such as even versus uneven cash flows, perpetual cash flows, and the changing cost of capital. Projects with Level Cash Flows: Consider a project that requires an investment of I0 today and will generate cash inflow, CF, at the end of each year for n years. The NPV, assuming the same cost of capital, k, in each period, will be
NPV = " I 0 + ! CF . t t =1 (1 + k )
n

This can be simplified by applying the present value of an annuity formula, equation (5.2), to get
&1 ' (1 + k ) ' n # NPV = ' I 0 + CF $ !. k % "

(19.2)

If the cost of capital is different in different periods, say k1, k2, . . ., kn in periods 1, 2, . . ., n, the NPV will be calculated as
NPV = # I 0 + CF CF CF + + +!+ (1 + k1 ) (1 + k1 )(1 + k 2 ) (1 + k1 )!(1 + k n )
n

= # I 0 + CF !
t =1

1
t

.
i

(19.3)

" (1 + k )
i =1

The net present value (NPV) of a project with an n-year life, equal cost of capital, and even cash flow in each period is
&1 ' (1 + k ) ' n # NPV = ' I 0 + CF $ !. k % "

With different costs of capital in each period, it is given by

NPV = # I 0 + CF !
t =1 n

1
t

,
i

" (1 + k )
i =1

where ki is the cost of capital in period i.

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The following examples illustrate the use of these formulas. Example 19.4: Consider a project with initial investment of $10,000 and a level cash flow of $3,000 per year (at the end of year) for five years. Assume k = .12, compute the NPV of the project. Answer: We have, by equation (19.2),
&1 ' (1.12) '5 # NPV = '10,000 + 3,000$ ! .12 % " = $814.33.

Since NPV >0, the project should be accepted. Example 19.5: Consider the above example, but assume that the costs of funds will be 12, 15, 17, 20, and 25 percent in years 1, 2, 3, 4, and 5. Compute its NPV. Answer: We have the cash flows of the project as CF Year ki -10,000 0 0 3,000 1 .12 3,000 2 .15 3,000 3 .17 3,000 4 .20 3,000 5 .25

NPV = !10,000 +

3,000 3,000 3,000 + + 1.12 (1.12)(1.15) (1.12)(1.15)(1.17 ) 3,000 3,000 + + (1.12)(1.15)(1.17 )(1.20) (1.12)(1.15)(1.17 )(1.20)(1.25) = !15.33.

Hence, the project should be rejected. Projects with Perpetual Cash Flows: Consider a project that will require an investment of I0 today and will return a perpetual cash flow of CF. The net present value of this project will be
NPV = " I 0 + CF CF CF + +!+ . 2 (1 + k ) (1 + k ) (1 + k ) !

This is just a perpetual annuity of $CF. By equation (5.2A), this can be written as

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NPV = ! I 0 +

CF k

(19.4)

Projects having perpetual cash flow, CF, and an initial investment of I0 will have an NPV of
NPV = ! I 0 + CF . k

In practice, these kinds of projects are hard to find. However, some British bonds (called consols) return perpetual cash flow to the holders because they have no term to maturity. Projects having a very long life (at least 30 years), with level cash flows, can be treated as perpetual cashflow. The following example illustrates the degree of error associated with using this rule of thumb. Example 19.6: Jarstrom, Inc., is considering a project that will require an initial investment of $10,000 and will return level cash inflows of $1,200 for 35 years. Compute its NPV assuming k = .10. Answer: Using equation (19.2), we have
&1 ' (1 + .10) '35 # NPV = '10,000 + 1,200$ ! .10 % " = $1,572.99.

Hence, the project should be accepted. If we assume this project to be perpetual, then using equation (19.4), we have
NPV = !10,000 + = $2,000, 1,200 .10

a difference of $427 in the NPV. As can be seen, assuming perpetual cash flows caused overestimation of the true net present value. Projects with Level Cash Flows Plus a Liquidation Value at the End. This type of projects is a combination of an annuity and a lump-sum cash flow at the end. Let S be the

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liquidation value, also known as the salvage value or the scrap value, which occurs at the end of the project. The NPV will be determined by
&1 ' (1 + k ) ' n # S NPV = ' I 0 + CF $ . !+ n k % " (1 + k )

(19.5)

Note that the present value of the cash flows in equation (19.5) is the sum of the PV of an annuity and the PV of a lump-sum liquidation value. The sum of these two present values can be calculated easily using a financial calculator:
BA II + k I/Y n N CF PMT S FV CPT PV HB-10B k I/Y n N CF PMT S FV PV

Then NPV = -I0 + PV (obtained from calculator).

The net present value (NPV) of a project with an n-year life, cost of capital k, and even cash flow CF in each period, and a liquidation value S at the end of project is

Example 19.7: Suppose you are considering a project with $10,000 initial investment. You estimate that the project will generate a level cash flow of $1,200 per year for 15 years. At the end of the 15th year, the project will be liquidated for $3,000. Find the NPV if cost of capital is 12 percent. Answer: Using equation (19.5), the NPV is
'1 ! (1 + .12) !15 $ 3,000 NPV = !10,000 + 1,200% + " 15 .12 & # (1 + .12 ) = !10,000 + 8,173.04 + 548.09 = !1,278.87

Or, using a financial calculator,

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BA II +

HB-10B

12 I/Y 15 N -1200 PMT -3000 FV CPT PV 8,721.13 Therefore, the NPV = -10,000 + 8,721.13 = -1,278.87.

12 I/Y 15 N -1200 PMT -3000 FV PV 8,721.13

Project with Continuous Cash Flows: Consider a project that will require an investment of I0 today and will return a continuous cash flow of CF per year. If the term of the project is n years and continuously compounded discount rate is k, the net present value of this project, using the present value of a continuous annuity formula in equation (7.7), will be
NPV = ! I 0 + CF 1 ! e ! nk k

(19.6)

Consider a project that will require an investment of I0 today and will return a continuous cash flow of CF per year. If the term of the project is n years and continuously compounded discount rate is k, the net present value of this project is

Example 19.8: Suppose you are considering a project with $10,000 initial investment. You estimate that the project will generate a continuous cash flow of $1,200 per year for 15 years. At the end of the 15th year, the project will be liquidated for $3,000. Find the NPV if cost of capital is 12 percent. Answer: Recall that the discount rate k in equation (7.7) is the nominal continuously compounded rate of interest, therefore, we need to convert the cost of capital, which is an effective rate, to the nominal rate. We have
k = ln(1 + .12) = .113329

Using equation (19.6), we have

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NPV = !10,000 + = !797.75

1,200 1 ! e ! (15)(.113329 ) 3,000 + .113329 (1.12 )15

Project with Cash Flows Growing at a Constant Rate: Consider a project that will require an investment of I0 today and will return a finite cash flow stream. The cash flow at the end of first year is CF1, and then the cash flow grows at a constant rate g from year to year. If the term of the project is n years and cost of capital is k, the net present value of this project, using equation (8.3), will be
& - 1+ g *n # ( ! $1 ' + 1+ k ) ! , $ NPV = ' I 0 + CF1 $ k'g ! $ ! % "

(19.7)

If the cash flows grow at a constant rate forever, then the NPV will be computed using equation (8.4):
NPV = ! I 0 + CF1 k!g

(19.8)

Consider a project that will require an investment of I0 today and will return a finite cash flow stream. The cash flow at the end of first year is CF1, and then the cash flow grows at a constant rate g from year to year. If the term of the project is n years and cost of capital is k, the net present value of this project will be

If the cash flows grow at a constant rate forever, then the NPV will be

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Projects with Uneven Cash Flows. Consider a project with initial investment, I0, and cash flowing of CF1, CF2, . . . , CFn at the end of each year for n years. If the cost of capital (or the discount) rate is k, the NPV of the project will be
NPV = " I 0 + ! CFt . t t =1 (1 + k )
n

(19.8)

In cases where the discount rates are different, the NPV will be
NPV = # I 0 + !
t =1 n

CF t
t

.
i

(19.9)

" (1 + k )
i =1

where ki is the discount rate during period i, The NPV of an n year project with uneven cash flows, CFt, and cost of capital, k, is given by
NPV = " I 0 + ! CFt . t t =1 (1 + k )
n

n cases where the discount rates are different in different periods, the NPV will be
NPV = # I 0 + !
t =1 n

CFt
t

,
i

" (1 + k )
i =1

where ki is the discount rate during period i. In the derivations presented previously, it appears that the initial investment will always occur today and the cash flows will always be received in the subsequent years. In practice, this is not the case, as positive and negative cash flows can occur at any time during the life of this project. For example, if CF0, CF1, CF2, . . . , CFn are cash flows at 0, 1, 2, . . . , n, respectively, the NPV is simply

NPV = !
t =0

CFt (1 + k ) n

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If CFt, for any t is negative, then it is an outflow rather than an inflow. Also, note that in all of the previous discussions CF0 = I0, This is illustrated in the example that follows. Example 19.9: HQB, Inc., the developer of commercial property in Miramar, Florida is contemplating development of a shopping mall. Because of the highly desirable location, HQB was able, before construction, to lease out the land for billboard space. The actual construction will begin in the second year and will be completed by the end of the third year, and will open at that time. HQB feels that it will be a profitable venture for 25 years from the day of the opening. The lease and rental amount received can be invested at the rate of 15 percent in other profitable ventures by HQB, and the firm can borrow the money for actual construction at 12 percent. If the cash flow pattern is as follows, obtain the NPV of this project. Anticipated cash flows to HBQ, Inc: Billboard payment amount received at 0 Billboard rental amount received at 1 Construction cost at 2 Construction cost at 3 Level cash inflows from 4 to 28 = $ 500,000 = $1,500,000 = $2,000,000 = $3,000,000 =$200,000 per year.

Answer: We have the pattern of cash flows (in millions of dollars) as follows: Cash flow Year k +0.5 0 .15 +1.5 1 .12 -2.0 2 .12 -3.0 3 .15 0.2 4 .15 0.2 5 ... 0.2 29 .15 0.2 30

Noting that years 4 to 28 represent a project with even cash flows, we can apply equation (19.9) to that portion of the flows to get
NPV = 0.5 + '1 ! (1.15) !25 $ 1 .5 2.0 3.0 0.2 ! ! + " 1.15 (1.15)(1.12) (1.15)(1.12) 2 (1.15)(1.12) 2 % .15 & # = 0.5 + 1.30 ! 1.55 ! 2.08 + 0.90 = $ ! 0.93 million.

This project should not be undertaken.

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The Internal Rate of Return The second discounted cash flow method is the internal rate of return. Here, we seek to obtain the rate of return the project is expected to earn over its life. In other words, the IRR is that rate of return that makes the net present value of a project zero. If the calculated internal rate of return exceeds the cost of capital, the project should be undertaken. If it is less than the cost of capital, the project should be rejected. When the two are equal, the decision must be based on other factors. The computation of the IRR is slightly more difficult than the NPV. To illustrate, suppose a project with an initial investment of I0, will generate a cash flow of CF1, CF2, . . . , CFn at the end of each year for n years. The IRR, denoted by r, will be the solution to the following equation:
0 = NPV = " I 0 + !
t =1 n

CFT . (1 + r ) k

(19.10)

Thus, if the life is more than two years, no explicit solution to r can be obtained in terms of I0 and CF because we have a higher order polynomial. The programmed procedures available in many calculators usually provide a solution for internal rate of return problems. The answer obtained will be correct in all situations except when there is a possibility of two or more positive rates of return or when no positive IRR exists. Sometimes, the recognition of the problem and its particular solution methods may save a great deal of time. The various types of problems and their possible solution procedures are as follows. Type 1 - One-period case: In this case, an amount, I0, is invested and a single cash flow, CF1, is realized one period later. The time-line diagram is as follows: -I0 0 If r is the internal rate of return, then
I0 = CF1 1+ r

CF1 1

or
r=

CF1 ! I 0 . I0

(19.11)

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In this case, you obtain the exact IRR. Example 19.10: A project costs $50 today and will generate a cash flow of $56 in one year. What is the IRR of this project? Answer: From equation (19.11), we have
r= 56 ! 50 = .12 or 12 percent. 50

Type 2 - Two-period case: Problems of this type generate cash flow in two consecutive periods. For example, CF1 , -I0 The IRR would be calculated from
I0 = CF1 CF + . 1 + r (1 + r ) 2

CF2

The exact IRR can be calculated as follows. Multiplying the previous equation by (1 + r)2, we have I0(1 + r)2 - (CF1)(1 + r) - CF2 = 0. Using the solution for the quadratic equation

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ax 2 + bx + c = 0, where x = (1 + r ), we have (1 + r ) = or r= CF1 (CF1 ) 2 + 4( I 0 )(CF2 ) 2I 0 ! 1. (19.12) (+CF1 ) (CF1 ) 2 ! 4( I 0 )(!CF2 ) 2I 0

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The solution can yield 0, 1, or 2 positive internal rates. Example 19.11: If I0 = 100, CF1 = 150, and CF2 = 20, calculate the IRR. Answer: From equation (19.12),
150 (150) 2 + 4(100)(20) r= !1 2 " 100 = 150 174.64 ! 1. 200

Thus
r= 150 + 174.64 ! 1 = 1.62 ! 1 = .62 or 62 percent 200

or

150 ! 174.64 ! 1 = !.1232 ! 1 = !1.1232 or ! 112.32 percent. 200

Type 3 - The Perpetual Annuity Case: In this case, an amount, I0, is invested in the beginning, and a level cash flow of CF is expected at the end of each period. See the following time-line diagram. CF -I0 Since CF is a perpetual annuity, we can write
I0 = CF r

CF

CF infinity

or
r=

CF I0

(19.13)

Example 19.12: A project is expected to produce a cash flow of $25 each period through infinity. If it costs $1,000 what is its IRR? Answer: Applying equation (19.13),
r=
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Sometimes it is possible to combine type 1 or type 2 with type 3. In these situations, the solution can be obtained in two stages. Example 19.13: A project is expected to produce cash flow of $100 in period 1 and $25 thereafter. If it costs $1,000, what is the IRR? Answer: Note that the PV of the perpetuity at the end of period 1 will be 25/r. Thus we can treat this as a one-period case with two independent cash flows. Therefore,
1,000 = 100 25 + 1 + r r (1 + r )

or

1,000r 2 + 900r ! 25 = 0

Applying equation (19.12), we have

r= ! 900 (900) 2 ! 4(1,000)(!25) ! 1, 2 " 1000

so either
r= ! 900 + 953.94 = 2.697 percent 2,000 ! 900 ! 953.94 = !92.697 percent. 2,000

or
r=

Discarding the negative r, we have our internal rate of return of 2.697 percent. Type 4 - The Reversible Project Case: A project is said to be reversible if it generates: (a) a fixed level of CF at the end of each period, and (b) the initial investment can be recouped at the end of any period. Let a project costing I0 generate a level cash flow, CF, at the end of each period, and at the termination of the project I0 can be recouped. In this case, the project's IRR is equal to
r= CF I0

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exactly the same as type 3. Note that in the case of reversible projects, it is not necessary to know the life of the project. To see why this formula holds, consider a project that costs I0 today and generates cash inflows of CF at the end of each period. When the project is terminated, the cash, CF, as well as the initial amount, I0, is recouped. That is, the CF stream looks like CF -IO Therefore, we can make use of the formula for the present value of an annuity to get CF CF .......... CF + I0,

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&1 ' (1 + r ) ' n # I0 0 = NPV = ' I 0 + CF $ + ! n r % " (1 + r ) or &1 ' (1 + r ) 'n # I 0 1 ' (1 + r ) 'n = CF $ ! r % "

or I0 = or r= CF I0 CF r

In practice, firms use this method to budget for inventories and working capital. Type 5 - The Lump Sum Case: These types of projects can be identified by the fact that they generate a one-time cash flow, CF, at the end of n periods. No other cash flow is generated. The IRR in this case is given by
' CF $ r =% % I " " & 0 #
1/ n

!1

(19.14)

Example 19.14: A project costs $200 today. If a cash flow of $250 will be received at the end of seven years, what is its IRR? Answer: Applying equation (19.14), we have
' 250 $ r =% " & 200 #
1/ 7

! 1 = 0.0324 or 3.24 percent.

These are the only cases for which exact solution methods can be developed using algebraic procedures. In all other cases, either trial or error or present value profile (graphical) methods must be used. Type 6 - Projects Having Level Cash Flows: An initial investment of I0 generates a level cash flow CF at the end of each year for n years. The IRR can be obtained by noting that such a problem involves an annuity of CF for n years. Applying equation (5.2), we have

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&1 ' (1 + r ) ' n # I 0 = CF $ ! r % "

(19.15)

The value r that solves equation (19.15) is the IRR. Since equation (19.15) is a non-liners function of r, it can only be solve using trail and error method or approximation numerical algorithm. Fortunately, the latter method is pre-programmed in financial calculators. Therefore, the IRR in equation (19.15) is:
BA II + - I0 PV n N CF PMT CPT I/Y HB-10B - I0 PV n N CF PMT I/Y

Example 19.15: A project costs $1,000 and generates $200 in cash flow at the end of each year for six years. What is its IRR? Answer: Using financial calculator:
BA II + -1,000 PV 6 N 200 PMT CPT I/Y 5.4718 HB-10B -1,000 PV 6 N 200 PMT I/Y 5.4718

Therefore, the IRR is 5.4718 percent. Type 7 - Projects with Level Cash Rows and Scrap Value: Consider a project with initial cost $10 and level cash payments of $CF at the end of each of the (n - 1) periods and $CF + S at n. S represent the market value of the project when sold at the completion of its useful life. The time-line diagram is as follows: CF -I0 The internal rate of return, r, will be that value which satisfies the equation
&1 ' (1 + r ) ' n # S I 0 = CF $ . !+ n r % " (1 + r )

CF

CF

... CF + S

(19.16)

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Note that equation (19.16) is very similar to equation (18.1), therefore the discount rate r can be solved the same ways. The easiest way to calculate r is using a financial calculator as the following:
BA II + - I0 PV n N CF PMT S FV CPT I/Y HB-10B - I0 PV n N CF PMT S FV I/Y

In addition, an approximate value of the internal rate of return, ra, can be obtained as
CF + S ! I0 n S + I0 2

ra =

(19.17)

If 10 does not differ from CF by more than 25 percent, the exact r will be within 0.01 (or 1 percent) of the approximate r. Having obtained an approximate r, the exact r can be obtained as follows: 1. If I0 < S, the exact r will be between approximate r and approximate r + .01. 2. If I > S, the exact r will be between approximate r and approximate r - 0.01. 3. If I0 = S, the exact r = approximate r = CF/I0. Below, we illustrate this with the help of an example. Example 19.16: Let a project costing $100,000 generate level cash flows of $10,000 at the end of each year for 20 years. If the scrap value of the project is $90,000, calculate the IRR on the project. Answer: Using financial calculator:
BA II + HB-10B

-100,000 PV 20 N 10,000 PMT 90,000 FV CPT I/Y 9.8218

-100,000 PV 20 N 10,000 PMT 90,000 FV I/Y 9.8218

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Therefore, the IRR is 9.8218 percent. Or, using equation (19.17), the approximate r is equal to
10,000 + ra = 90,000 ! 100,000 20 = 0.10. 90,000 + 100,000 2

Since I0 > S, according to rule 2, the exact r should be ra and ra - .01. Trying various values between .09 to 10 in the exact formula, we find that r = .0982. Type 8 - Projects with Uneven Cash Flows: The IRR for these kinds of projects can be obtained by trial and error using the present value formula. That is, let CFt represent the cash flow in year t and I0 the initial investment. The internal rate of return is the value of r that satisfies
I0 = ! CFt t 1+ r ) t =1 (
n

(19.18)

An approximate value of r can be obtained by employing the net present value profile of a project. The NPV profile is a graph of various discount rates and NPVs of the given cash flows at these discount rates. If the plotting is done with discount rates on the horizontal axis and corresponding NPVs on the vertical axis, the NPV where the curve crosses the horizontal axis yields the internal rate of return. The following example illustrates this. Example 19.17: Consider a project with an initial investment of $500 and cash flows of $200, $200, and $307 at the end of years 1, 2, and 3. Find the IRR using the NPV profile method. Answer: The NPVs at various discount rates are: Discount Rate 0 .05 .10 .15 .20 NPV 207.00 137.08 77.76 27.70 -16.78

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The NPV changes sign from positive to negative between discount rates of .15 and .20. Hence, IRR must be between these two rates. Plotting the points, we have NPV 207

137.08 77.76 27.70

0.0 -16.18

0.5

.10

.15

.20

Discount Rate

FIGURE 19.1

NPV Profile

Estimating the point where the NPV line crosses the horizontal axis, we have an IRR of 18 percent. Type 8 - Projects with infinite Cash Flows Growing at a constant Rate. Consider a project with initial investment I0. The project will receive an end-of-year cash flow CF1 in year 1, the cash flow will increase at a fixed-rate g thereafter. From equation (19.8), we have the following:
I0 = CF1 r!g

By rearranging the above equation, the IRR will be:

r= CF1 +g I0

(19.19)

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Example 19.18: Suppose the project requires initial investment of $10,000 and expects to receive annual end-of-year perpetual payments. The first payment is estimated to be $800 and we expect the payment to grow at a constant rate of 3 percent annually. Find the IRR of this project. Answer: Using equation (19.19), the IRR will be
r= 800 + .03 = 0.11 10,000

Therefore, the IRR is 11 percent. Problems with the Internal Rate of Return In evaluating independent projects for a firm, the IRR criterion suffers from two major problems. First is the algebraic problem of multiple or zero solutions to the problem. The second problem is the implicit assumption used in calculating the internal rate of return that the cash flows can be reinvested at the rate of return earned on the project. That is, if the project generated $100,000 of cash flow in the first year at a rate of return of 20 percent, there is an implicit assumption that the $100,000 will continue to earn 20 percent for the life of the project. This is not realistic. These two problems are interrelated. By choosing a more realistic assumption that past cash flows only earn the cost of capital, we can also solve the problem of multiple roots. Before employing the more realistic assumption as to the earning on cash flows, let us first examine some methods for recognizing multiple-root problems. The existence of multiple roots or the nonexistence oF an internal rate of return is purely an algebraic phenomenon. The number of roots of (or solutions to) a polynomial equation can be determined by Descartes' rule of signs. This rule states that the number of positive solutions will be either: (a) the number of sign changes or (b) the number of sign changes minus an even number, where the equation is written in either ascending or descending order of the power of its unknown variables. To illustrate this rule, consider a project with the following cash flows: CF1 I0 If r is its internal rate of return, then this can be expressed in equation form as: CF2 -CF3 -CF4 CF5 -CF6

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0 = !I 0 +

CF3 CF5 CF6 CF1 CF2 CF4 + ! ! + ! 2 3 4 5 (1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r ) 6

Multiplying both sides of this expression by (1 + r)6, we have

0 = ! I 0 (1 + r ) 6 + CF1 (1 + r ) 5 + CF2 (1 + r ) 4 ! CF3 (1 + r ) 3 ! CF4 (1 + r ) 2 + CF5 (1 + r ) ! CF6

The variable of interest in the above equation is (1 + r). The number of positive solutions of (1 + r) will depend on the number of sign changes in the equation. In the preceding equation, the sign on the term in front of the exponent term changes four times. Thus (1 + r) will have either 4 positive solutions or 4 - 2 (an even number) or 4 -4 (another even number) solutions. In other words, the number of positive, "one plus" internal rates of return is either 4 or 2 or 0. The selection of the even number is guided by the number of sign changes and will be the even numbers less than the number of sign changes. Note that the equation is written in terms of 1 + r and not r for convenience. However, a positive solution to 1 + r does not necessarily imply a positive r. That is, if 1 + r = .9, then r = -.10. It should also be obvious that if the number of sign changes is odd (instead of even), at least one positive 1 + r is guaranteed. This is the reason why in the usual textbook examples the initial investment is in the current period and the positive cash flows occur throughout the life of the project. Hence, only one sign change occurs, and a positive solution to 1 + r is always guaranteed. The following example illustrates this discussion. Example 19.19: Consider a project with cash flows of -2,000, +10,400, and -9,600 at the end of years 5, 6, and 7. Obtain the IRR. Will the IRR change if the cash flows are instead received in periods 0, 1, and 2? Answer: By equation (19.18), we have
0 = NPV = ! 2,000 10,400 9,600 + ! . (1 + r ) 5 (1 + r ) 6 (1 + r ) 7

Multiplying both sides by (1 + r)7, we have

! 2,000(1 + r ) 2 + 10,400(1 + r ) ! 9,600 = 0.

There are two changes of sign in the equation; hence, two or zero solutions exist. Using the quadratic formula, we obtain 1 + r = 1.20 or 4.00

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Thus, r = 20 or 300 percent. Changing the periods on the cash flows, we have -2,000(1 + r)2 + 10,400(1 + r) - 9,600 = 0. Again, we have the same number of sign changes and get the same equation. Hence r = 20 or 300 percent. In the above example, we notice the solution does not change when the time periods change. The IRR is determined by the pattern of cash flows from the inception to the end point of the project. It does not matter whether the project starts today or ten years from now. Also, changing the signs of all cash flows throughout the project will not change the IRR. For example, whether the cash flows are -2,000, 10,400, -9,600, or 2,000, - 10,400, and 9,600, in periods 0, 1, and 2, respectively, the IRR solutions will always be 20 and 300 percent. The solution to the problem of multiple roots lies in the premise that one should reduce the multiple solutions to a single solution in the case of multiple IRR and force a solution in the case of no solution. Both of these problems can be solved if we assume that the project will earn a rate of return during only one period of its life. The choice of the one period is arbitrary. For the other periods, we assume the project earns a known rate of return. This known rate of return is either the firm's cost of capital or a reinvestment rate determined by management. This procedure is known as Teichroew's procedure or the financial manager rate of return (FMRR) method in the real estate literature. Firms often prefer this approach, even if a single IRR solution for a project exists on the notion that the implicit reinvestment assumption of IRR is not always satisfied. Algebraically, the procedure is as follows. Let CF0, CF1, . . . , CFn be the cash flows of a project. Its IRR will be the solution to the equation (19.18). If we assume instead that the project earns the IRR only in some period j - 1 to j ( j = 2, 3, . . . , n), the modified IRR, rm, will be the solution to the following equation:
0 = CF0 + CF j !1 CF1 CF2 + +!+ 2 1 + k (1 + k ) (1 + k ) j !1 CF j CF j +1 + + j !1 (1 + k ) (1 + rm ) (1 + k ) j (1 + rm ) +!+ CFn , (1 + k ) n!1 (1 + rm ) (19.19)

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where k is the given reinvestment rate or the firm's cost of capital. Since k is known, there will be only one solution to rm. Of course, the solution will be different depending on which period is chosen for the return to equal the project's IRR. The following example illustrates the procedure. Example 19.20: Suppose we have the cash flows as in example 19.19. Assuming k = .30 in period 2, what is the project's modified IRR? Answer: By equation (19.19), we have
0 = !2,000 + 10,400 9,600 ! (1 + rm ) (1 + rm )(1 + .30)

or rm = 50.76 percent

If the cost of capital is less than 50.76 percent, the project should be accepted. If we, instead, assume k = .30 in the first period, we would calculate rm as
0 = !2,000 + 10,400 9,600 ! 1.30 (1 + rm )(1.30)

rm = 23.07 percent.

Other Capital Budgeting Methods As previously mentioned, there are several commonly used methods of capital budgeting that employ variants of the net present value method. Two of the simplest are the Profitability Index (PI) and the Net Profitability Index (NPI). Their use yields the same investment decision as the net present value method for single projects. Specifically, we define these methods as follows:

PI =

Present value of all cash inflows Present value of all cash outflows Net present value Present value of all cash outflows

NPI =

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Example for PI: Consider a project with the following cash flows -200, 440 and -242 at time 0, 1 and 2, respectively. Obtain the PI (Profitability Index) of the project if the cost of capital is 10%. Solution:

!! !

!!" ! ! ! !! !"! !""! ! ! ! !! !

Example for NPI: Consider a project with the following cash flows -190, 440 and -242 at time 0, 1 and 2, respectively. Obtain the NPI (Net Profitability Index) of the project if the cost of capital is 10%. Solution:

!! ! ! !

!!"#!

!!" !"! ! ! ! ! !! ! ! ! !! ! !"! !"#! ! ! ! !! !

A project would be accepted if PI > 1 or NPI > 0. The use of these methods is typically employed when evaluating several independent projects with differing initial investment costs. When investment funds need to be rationed, the indexes provide a helpful ranking procedure. Two more complicated procedures are the Equivalent Annual Charge (EAC) and the Uniform Annual Series (UAS). The EAC method is useful in cases where the emphasis is placed on the initial investment and subsequent operating costs. Public utility companies are the biggest users of this method. Since the operating costs for public utilities are charged to the customers and because the initial investment and future cash outflows may not be level over the life of the project, an equivalent charge is obtained over the life of the project. Revenue needs can then be determined so that the appropriate rate structure can be set. The method consists of annualizing the cash flows over the life of the project. In most cases, the pattern of cash flows will be smooth if the project requires working capital that can be recouped at the end of its life or if the equipment has salvage value. To obtain the EAC, compute the present value of all the cash flows, including the initial investment, and annualize this present value over the life of the project. Algebraically, if CFt is the cash flow (positive or negative) for any period t = 0, 1 2, . . . , n, then the equivalent annual change can be written as follows:

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& n CFt # & # k EAC = $( . t !$ 'n ! % t =0 (1 + k ) " %1 ' (1 + k ) "

(19.20)

The method is demonstrated in the following example. Example 19.21: TI Utility Company is considering a project that will require an initial investment of $10 million and will also require an annual operating cost of $700,000 per year for 30 years. The working capital requirement will be $500,000, and the equipment can be sold for $1 million at the end of the project. When TI presented its case to the Public Utility Commission, the commission wanted TI to sell one of the existing plants at the end of year 3 and distribute the proceeds to its customers. The commission felt that the project would be able to generate enough power by the end of year 3 so that selling the old plant would not adversely affect its customers. If the required rate of return is 10 percent, obtain the EAC assuming that the old plant can be sold for $2 million. Answer: We have the following pattern of cash flows (in millions of dollars): Year 0 1 -.7 I0 = -10 WC = -.5 The present value of the cash flows is
'1 ! (1.10) !30 $ 2 1.5 PV = !10.5 ! .7 % + + " 3 30 .10 & # (1.10) (1.10) = !15.510248.

2 -.7

3 -.7 +2.0

4 -.7

... ............ 29 -.7 Recapture of WC = +.5 Salvage value = + 1.0

30 -.7

Applying equation (19.20), we have

' $ .10 EAC = !15.510248% !30 " &1 ! (1.10) # = !1.6453154

or $1,645,315.40 of equivalent annual charges per year. The uniform annual series method is essentially the same as the EAC method, except this method is used when the interest lies in annualizing revenues rather than

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costs. If CFt's are cash inflows, this method is sometimes referred to as the Equivalent Annual Profit (EAP) method. The formula for the EAC method thus applies to the UAS method. This method is very useful in evaluating mutually exclusive projects with unequal project lives. So far, we have presented the various methods used to evaluate a single project Generally, the most widely used methods are the payback, the NPV, and the IRR methods. From a theoretical viewpoint, the net present value criteria represent the appropriate method. However, the usual IRR will yield similar results provided there is exactly one IRR to the problem. The payback method, by far the easiest to use, can be shown to be equivalent to the NPV method if care is used in selecting the payback period used for acceptance or rejection of the project. Next, we examine the relationship between the NPV and payback methods for several different cash flow profiles.

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