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10
Capital Budgeting:
Introduction and Techniques
Chapter Objectives
By the end of this chapter you should be able to:
imply put, investment
1. Introduce TVM concepts to investment analysis
decisions have a
2. Develop project evaluation models
greater impact on a
businesss future than
3. Compare NPV to IRR
any other decision it
4. Select projects under capital rationing
makes. Businesses that
invest profitably make
money and provide a fair return for their owners. Those that fail to invest
profitably are unlikely to survive in the competitive business world. Businesses must invest constantly. Vail Associates, the ski resort operator,
invested $1 million in 1996 in a snowmobile and horseback riding center. Beaver Creek ski area invested $20 million in a retail complex. Both
were hoping to attract an increasingly elusive ski customer. Were these
wise investments? No matter how sophisticated the analysis, a firm is seldom sure. However, we can develop methods that increase the chance
that investments yield more than they cost.
The purpose of this chapter is to investigate methods for evaluating
investment decisions. We will use many of the tools developed so far in
this text. For example, we must adjust an investments cash flows to take
into account the time value of money. Additionally, we must be able to
adjust for the risk of those cash flows.
We begin this discussion by defining capital budgeting.
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Finance: Investments, Institutions, and Management, Second Edition, by Stanley G. Eakins. Copyright 2002 by
Pearson Education, Inc. Published by Addison Wesley.
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262
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Computation
The calculation of the payback is very easy if the annual cash flows are annuities (remember that annuities are equal payments received at equal intervals). The payback is found
by dividing the initial investment by the annual annuity.
If the cash flows vary from year to year, they must be accumulated until the sum
equals the initial investment. Partial years can be estimated. In Example 10.1 we use payback to evaluate an annuity.
X A M P L E
10.1
In 2000 Consumer Reports listed Lindemans Bin 40 Cabernet Sauvignon as a best buy in its taste
test. If Lindemans wants to expand production to take advantage of the increased sales this report
may generate, it will have to expand its facilities. Assume that expansion of its winery will cost
$1,000,000. If this will generate after-tax cash inflows of $235,000 for 8 years, what is the payback? It will take about 4 years and 3 months for the firm to recover its initial investment.
Solution
Because the annual cash inflows are equal, simply divide them into the initial investment:
Payback = Initial investment
Annual cash inflow
$1,000,000
Payback =
= 4.25 = 4 years, 3 months
$235,000
The calculation is somewhat more complicated if the cash inflows are not equal. An
accumulation table can be constructed to compute payback in this case. We evaluate
an investment with unequal cash flows in Example 10.2.
X A M P L E
10.2
Suppose after reviewing its cash flow estimates, Lindemans decides that the publicity provided
by the Consumer Reports article will wear off over time. As a result, cash inflows would decline
10% the first year and then 15% per year thereafter. What is the payback?
Year
0
1
2
3
4
5
6
:$1,000,000
Cash Inflow
0
$235,000.00
211,500.00
179,775.00
152,808.75
129,887.44
110,404.32
Accumulated
Inflow
0
$235,000.00
446,500.00
626,275.00
779,083.75
908,971.19
1,019,375.51
Balance
:$1,000,000.00
:765,000.00
:553,500.00
:373,725.00
:220,916.25
:91,028.81
;19,375.51
The final year can be estimated by dividing the remaining balance by the cash inflow and then
multiplying the product by 12:
$91,028.81
= 0.824 12 = 9.89 months
$110 ,404.32
It will take Lindemans about 5 years and 10 months to recover its initial investment if the cash
flow estimates are correct (5 years+9.89 months).
Advantages
The principal advantage of the payback method is its simplicity. It also provides information about how long funds will be tied up in a project. The shorter the payback, the
greater the projects liquidity.
Disadvantages
There are many problems with the payback method.
No clearly defined accept/reject criteria: Is a 4-year payback good or bad? We do not
have a method to determine this. Often a payback of 2 or 3 years is required, but
clearly this is arbitrary.
No risk adjustment: Risky cash flows are treated the same way as low-risk cash flows.
The required payback period could be lengthened for low-risk projects, but the exact
adjustment is still arbitrary.
265
*$10,000/$3,000=3.33. This means it will take 3.33 years to recover the initial investment. One-third of a
year is 4 months. The payback is then 3 years and 4 months.
266
Cash Inflow A
Cash Inflow B
0
1
2
3
0
$500,000
300,000
200,000
0
$200,000
300,000
500,000
Balance
$1,000,000
Ignores cash flows beyond the payback period: Any cash inflows that occur after the
payback period are excluded from the analysis. This is clearly a short-sighted way
to view investments.
Ignores time value of money: Consider Table 10.1. The payback is the same, 3 years,
but cash inflow A is clearly preferred because of the time value of money.
To properly evaluate investment projects we need a method that does not suffer from
the above problems. One such method is the net present value. One reason for learning
the payback method was to demonstrate a poor method of analysis so that you will be
able to appreciate a theoretically sophisticated method. Pay attention to how the net present value approach differs from the payback method.
The net present value (NPV) is the most popular and theoretically sound evaluation
tool available to analysts. NPV has grown in use among corporations as more students
are exposed to the method in their finance or MBA coursework. Its interpretation
requires a fundamental understanding of the time value of money. Surveys of large
national corporations find that over 70% now apply NPV to project evaluation, although
most companies continue to use other methods as well.
Theory
Most investments have some funds being spent today in the hope that greater amounts
will be received in the future. Because the cash inflows and the cash outflows occur at
different times, they cannot be compared directly. Instead, they must be translated into
a common time period. It is usually easiest to convert all of the cash flows into current
dollars because at least some expenditure is probably made at time zero. After the conversion into present values, the cash inflows are compared with the cash outflows. If
inflows exceed outflows, the project is acceptable. The difference between the cash outflows and the cash inflows is the NPV.
Computation
The formula for calculating NPV can be written several ways. Equation 10.1 uses summation notation:
n
NPV =
t =1
CFt
(1 + i)
Initial investment
(10.1)
(10.2)
You can interpret a positive NPV as meaning that the current value of the income
exceeds the current value of the expenditure, so the project should be accepted. A negative NPV means the project costs more than it will bring in and so should be rejected.
The decision criteria for NPV can then be summarized as follows: Accept the project if
NPV is positive or equal to 0; reject the project if NPV is negative.
X A M P L E
10.3
The owner of a Texaco gas station in Nevada is considering buying a slot machine to put in his
small convenience store. The slot machine will sell for $6,000 and is expected to bring in about
$10 per day after expenses. Slot machines in casinos have an average take of about $150 per
day after expenses, so the owner believes his cash flow estimate is conservative. If the average
cost of funds to the gas station is 15%, should the slot machine be installed? The machine is
expected to last 3 years before a newer model will be needed to attract gamblers.
Solution
We can simplify the calculations by using the annual projected cash inflow rather than
the daily cash inflow ($10!365=$3,650). Putting the numbers into Equation 10.1 yields
the following:
n
NPV =
NPV =
1 + ti t
t =1 (
)
CF
$3,650
(1.15)
Initial investment
$3,650
(1.15)
$3,650
(1.15)3
$6 ,000 = $2 ,333.77
Because the NPV is positive, the gas station owner should install the slot machine. The problem could also have been worked using the annuity tables to find the present value of the equal
cash inflows.1
How would you explain what an NPV of $2,333.77 means to someone who has not
taken an introductory finance course? One accurate interpretation is that the project has
returned the cost of capital (15%) plus $2,333.77. In other words, the value of the firm
will increase by $2,333.77 as a result of accepting the project.
Suppose that you had completed the analysis of an investment for a very large firm.
The initial investment is $1 billion and the NPV is $1. Assuming you are absolutely
1For
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X A M P L E
10.4
Not all investments are made in one lump sum. Sometimes the initiation of the project takes
several years. For example, the Trans-Alaska Pipeline took 4 years to complete, at a total cost
of $8 billion. Suppose $1 billion was spent the first year, $1 billion the second year, $2 billion
the third year, and $4 billion the last year (assume all investments are made at the beginning
of the year). If the revenues are expected to be $1 billion per year for 20 years and the discount
rate is 15%, should the pipeline have been built (assume all cash inflows occur at the end of
the year and begin at the end of year 1)?
Solution
We will first compute the present value of the cash outflows, and then we will compute the
present value of the cash inflows. Finally, we will compute NPV by subtracting the present value
of the outflows from the present value of the inflows.
Step 1: PV(outflows ) = $1 billion + $1 billion
+ $2 billion
+ $4 billion
1
2
1
(1.15)
(1.15)
(1.15)3
Advantages
The net present value method solves the problems listed with the payback period
approach.
Uses time value of money concept: The cash flows are discounted back to the present
so that all cash flows are compared on an equal basis.
Clear decision criterion: Accept the project if the NPV is zero or greater. Reject if less
than zero.
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Discount rate adjusts for risk: By increasing or decreasing the discount rate, the firm can
adjust for the riskiness of the cash flows. We will investigate how to do this in a later
section. The discount rate used to evaluate capital budgeting projects is the firms cost
of capital, which is the average cost of its debt and equity. The cost of capital reflects
the risk of the firm and the firms average required rate of return on its investments. In
Chapter 12 we will learn how to compute the cost of capital. For now it is best described
as the return the firm must earn on its investments to satisfy investors.
Disadvantages
The primary disadvantage to NPV is that it may be difficult for someone without a background in financial theory to understand. This problem sustains the popularity of other
methods we will study.
A second problem with NPV is that it can be difficult to use when available capital
or resources are limited. If a company must select among a group of positive-NPV projects, it may want to know which projects provide the highest return for the amount
invested. NPV does not provide this information. We will point out alternative methods
that can be helpful when the firm must rank projects.
NPV Profile
An NPV profile graphs the NPV at a variety of discount rates. The NPV profile demonstrates how sensitive the NPV is to changes in the discount rate. We will learn in Chapter 12 that it is very difficult to accurately and confidently estimate the cost of capital for
a firm. At best we can determine an approximate value. Before we recommend that a firm
accept or reject a project, we should determine whether a small error in our cost of capital estimate is important. We can do this by preparing an NPV profile. Once the profile
is prepared, we can note whether small changes in the cost of capital will result in major
changes to the NPV.
Let us prepare an NPV profile for the cash flows given in Table 10.2.
TABLE 10.2
Year
Cash Flow
0
1
2
3
4
5
:$1,000
250
250
250
250
250
Study Tip
Many students get confused about which discount rates should be used
to construct an NPV profile. Any interest rate
works. Simply pick ones
that are above and below
the crossover point. You
will not know where this
occurs until you begin
computing some NPVs.
*No; NPV=$2,483.82-$2,500=:16.18. Because the NPV is negative, do not buy the machine.
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FIGURE 10.1
NPV Profile
$300
NPV
$200
$100
$0
($100)
($200)
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
Discount Rate
To compute the NPV profile, select a number of different discount rates and compute the NPV for each. You may use any discount rates you choose, although it is usually easiest to begin at 0% because the NPV is found simply by summing the cash flows.
Continue using increasingly larger discount rates until the NPV turns negative. The
NPVs for five interest rates using the cash flows from Table 10.2 are reported below.
Discount Rate
0%
5
7.5
10
12
NPV
$250.00
82.37
11.47
:52.30
:98.81
These numbers are graphed in Figure 10.1. We can read the point where the graph
crosses the horizontal axis. This occurs at about 8%. This is where NPV=0. To the left of
this point NPV is positive and the project is acceptable. To the right of this point NPV is
negative and the project should be rejected. If you are confident that the cost of capital (the
average cost of funds to the firm) is less than the crossover point, accept the project.
X A M P L E
10.5
You are contemplating an investment in a Putt-Putt miniature golf course. If you invest $50,000
today, you expect to receive annual cash flows of $15,000 for the next 5 years. You are not certain of your cost of capital but expect it to be around 15%. Prepare an NPV profile and discuss
whether the investment should be made.
Solution
We will need to compute the NPV at a variety of different discount rates. We do not know which
ones until we actually begin computing a few to see how the NPV profile develops. We will
begin with the discount rate equal to zero and will compute the NPV using increasingly large
discount rates until the NPV is negative. The formula for computing NPV is
NPV=$15,000!(PVIFA5 yr,i)-$50,000
NPV
0%
5
10
15
20
$25,000
14,935
6,862
282
(5,141)
NPV
$20,000.00
$10,000.00
$0.00
($10,000.00)
0%
5%
10%
15%
20%
Discount Rate
From the NPV profile we see that we would accept the project as long as the cost of capital was
less than about 1514% because the NPV is positive in that range. Alternatively, we would reject
the project if the cost of capital was greater than about 1514%. In this example, since the cost
of capital is 15%, you would make the investment.
In the next section we will introduce a method that converts NPV into a ratio that
is easier for some to interpret.
PI =
(
)
PV (Cash outflows)
PV (Cash inflows)
PV Cash inflows
Initial investment
(10.3)
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272
Computation
To compute PI simply find the present value of the cash inflows and divide by the PV of
the cash outflows. If you are also computing an NPV, these values should be readily available. We can use the figures provided by Example 10.3 to illustrate the process.
X A M P L E
10.6
Profitability Index
Suppose that a $6,000 investment will yield three cash inflows of $3,650 each. With a discount
rate of 15%, what is the PI?
Solution
The PV of the cash outflow is $6,000 because the entire investment is made today. The PV of
the cash inflows is $3,650(PVIFA15%,3 yr), which is $3,650(2.2832)=$8,333.68. Put these figures into Equation 10.3:
PI =
PV (Cash inflows )
PV (Cash outflows )
$8,333.68
$6,000
PI = 1.39
PI =
The profitability index is 1.39. Because it is greater than 1, we would accept the project. Notice
that this is the same decision we reached in Example 10.3. In fact, PI and NPV will always
provide the same answer to the accept/reject question.
Advantages
The PI is useful as an aid in ranking projects from best to worst. It may be necessary to
rank projects if the firm does not have sufficient funds or capacity to accept all positiveNPV projects. Consider two positive-NPV projects, one small and one large. The large
one may have the largest NPV even though the smaller one has a greater return on the
dollars invested. The profitability index will highlight this difference by computing the
return per dollar invested, on a present value basis. The firm may be better off taking
several small high-PI projects instead of one large positive-NPV project.
Study Tip
Because PI gives the return
per dollar invested, it is
said to give the bang per
buck.
X A M P L E
10.7
Suppose that you have collected the following data on four possible projects. Rank the projects
using PI. If your capital budget was $1,000, which project(s) would you select?
Project
Net Investment
A
B
C
D
PV (cash inflows)
$ 500
100
1,000
20
$ 550
90
1,052
25
NPV
$50
:10
52
5
Solution
Begin by computing the profitability index for each project:
Project
Net Investment
A
B
C
D
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$500
100
1,000
20
PV (cash inflows)
$550
90
1,052
25
PI
$550$500=1.1
$90$100=.9
$1,052$1,000=1.052
$25$20=1.25
Now review the PI ratios to see which projects are acceptable. Because project B has a PI less
than 1, it is immediately rejected. Next, rank the projects in order from highest PI to lowest.
Project D has the highest PI, A is next, and C is third. This analysis suggests we should accept
projects A and D, for a total capital budget of $520. The combined NPV of these two projects
is $55, which is greater than the NPV of project C by itself.2
Disadvantages
Although there are no theoretical problems with PI, it should not replace NPV. Ultimately,
the goal of the financial manager is to maximize shareholder wealth. PI may be used as
a supplement to NPV, but not as a replacement.
In the next section we will discuss the most frequently used alternative to the net
present value: the internal rate of return.
Study Tip
NPV and PI will always
give the same accept/reject
decision because all of the
inputs to both models are
exactly the same. The value
of PI is to help rank projects by showing which
provide the greatest return
per dollar invested.
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Theory
Suppose that your roommate offers you an opportunity to invest in his mail-order computer parts business. If you invest $100 today, you will receive $110 in 1 year. What is
the return on this investment? You probably answered 10% without needing paper and
pencil. The return on this investment is independent of what else is happening to market returns, so we call it an internal return.
Would you accept your roommates offer? That depends on what your required rate
of return is. If your cost of capital is 12%, you would reject the proposal.
Let us continue with this example by demonstrating how we would compute the
NPV. The figures are initially put into Equation 10.3:
NPV = $110 $100
1+ i
If we know the discount rate (i), we can compute NPV. The IRR approaches the
problem from a slightly different angle. Rather than inputting a discount rate and computing NPV, we ask how high the discount rate can be before NPV becomes negative and
the project is unacceptable. We find this breakeven discount rate by setting NPV equal
to zero and solving for i. For example,
NPV = 0 = $110 $100
1+i
$100 = $110
1+i
1 + i = $110 = 1.10
$100
i = 0.10 = 10%
The 10% interest rate is the value of the discount rate that sets the present
value of the cash inflows equal to the present value of the cash outflows. If the
10% return is acceptable, the project should be taken. In this example, because
capital cost 12%, we reject the project. Thus, the decision criterion for IRR can be
summarized as follows: Accept the project if the IRR is greater than or equal to the
cost of capital.3
Review Figure 10.1. We can read the IRR directly off the NPV profile. The IRR is
the discount rate where NPV=0. This is where the profile crosses the horizontal axis.
Computation
In the preceding example we saw that the calculation of the IRR was fairly straightforward when there was a single cash inflow. It becomes much more complicated when
there are multiple cash flows. There are three methods to use depending on the nature
of the cash flows and the availability of a financial calculator. They involve using financial tables, trial and error, and a calculator. We will discuss each of the methods below
and illustrate them with examples.
3When
used in this context, the cost of capital is often referred to as the hurdle rate. It is the rate the IRR must
exceed to be acceptable.
X A M P L E
10.8
If the initial investment is $500 and the cash inflows are $200 for 3 years, what is the IRR?
Solution
NPV = 0 = $200(PVIFAIRR,3 yr) $500
$500 = $200(PVIFAIRR,3 yr)
$500/$200 = PVIFAIRR,3 yr
2.500 = PVIFAIRR,3 yr
Look in the PVIFA table for the factor equal to 2.5 with 3 periods. We find that the interest rate
falls between 9% and 10%. We could estimate the IRR to be 9.5%.
The second method involves trial and error. This method is used if the cash flows
are not equal. The problem is again set up as if you were setting NPV equal to zero. Select
an interest rate and determine whether NPV computes to zero. If not, try another. (If the
computed NPV was positive, try a higher interest rate; if it was negative, try a lower rate.)
Keep trying interest rates until NPV is equal to zero.
X A M P L E
10.9
Use the cash flows from Example 10.8 and compute the IRR by trial and error.
Solution
To solve this example by trial and error we would set it up using Equation 10.3:
NPV = 0 =
If the discount rate is set equal to 9%, NPV=6.26. If the discount rate is set equal to 10%,
NPV=:2.63. The internal rate of return is between 9% and 10%.
The third method involves using a financial calculator. Many financial calculators have
built-in IRR formulas. The cash flows must be entered before the IRR can be calculated.
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276
Advantages
The primary advantage of the IRR method of investment analysis is that it is easy to interpret and explain. Investors like to speak in terms of annual interest rates when evaluating
investment options. For this reason, many firms that use NPV also compute IRR.
Disadvantages
Study Tip
Note that we also make an
assumption about reinvestment of periodic cash
flows when computing
NPV. We assume that those
cash flows are reinvested at
the firms cost of capital.
There are several serious problems with IRR that must be understood. They do not necessarily invalidate the model, but must be considered before its application.
Reinvestment Rate Assumption The IRR assumes that the cash flows are reinvested at the internal rate of return when they are received. In Example 10.8, three payments of $200 are received. The first payment is reinvested for two periods and the second
payment is reinvested for one period. IRR assumes that these payments earn 9.70% when
reinvested until the project is over. We consider this reinvestment rate assumption to be a
disadvantage because there may not be any other investments available with returns equal
to high-IRR projects, so it may not be possible to reinvest at the IRR.
The reinvestment rate assumption is a problem only when you are attempting to rank
mutually exclusive projects. If you are just attempting to reach an accept/reject decision
on a project, the reinvestment rate assumption is not relevant. On the other hand, it may
cause incorrect ranking of projects. If you depend on IRR to select among projects, you
may select the wrong one. Review Table 10.3. The initial investment is $1,000 for projects A and B, but we get conflicting rankings from NPV and IRR. NPV is higher for project A, but IRR is greater for project B. Which project do we accept? Because the NPV is
computed using the firms cost of capital, we can assume that other projects are available
at that rate. We do not know whether any more investments are available that yield 20%.
For this reason, we favor NPV when ranking projects. Note that both methods gave the
same accept/reject decision. This will always be true. A project that is found acceptable
with NPV will also be acceptable with IRR.
To better understand the ranking problem, review Figure 10.2, which graphs the
NPV profiles of projects A and B. Project A has the highest NPV for all discount rates
TABLE 10.3
Cash Flows
Year
Project A
Project B
0
1
2
3
NPV@5%
IRR
:$1,000
0
0
$1,500
$295.76
14.47%
:$1,000
$1,200
0
0
$142.86
20%
Project A
Project B
500
Project A has
greatest NPV at
a 5% discount rate.
400
300
NPV
200
Project B has
greatest NPV at
a 25% discount rate.
100
0
100
200
300
400
0%
5%
10%
15%
20%
25%
30%
Discount Rate
less than 12%. Project B is superior for all discount rates greater than 12%. The projects rank depends on the discount rate. Because the IRR method does not evaluate
the project at a particular discount rate, it cannot be used for ranking mutually exclusive projects.
277
FIGURE 10.2
IRR Ranking Problem
278
FIGURE 10.3
Multiple IRRs
NPV
0
2
4
6
8
10
0%
15%
25%
30%
33.30%
40%
Discount Rate
IRR Ignores Differences in Scale Suppose you had the choice of buying the
Kinston Indians (a small-town baseball team) or the Atlanta Braves. You can buy the
Indians for $10,000. The Atlanta Braves cost $10 million, but contractual provisions limit
you to owning only one baseball team of any kind. If both have an IRR of 25%, which
would you take if you could afford either? The IRR does not give you any help because
it converts the cash flows to percentages and ignores differences in the size or scale of
projects being considered. Clearly anyone of sound mind would go with the Braves.
EXTENSION 10.1
Modified Internal Rate of Return (MIRR)
Because of the problems listed above for the internal rate of return, analysts have developed an alternative evaluation technique that is similar to IRR, but attempts to improve on
it. The cash outflows are discounted back to the present at the cost of capital and the cash
inflows are compounded at the cost of capital to the end of the projects life. The future
value of the cash inflows is called the terminal value. The modified internal rate of return
(MIRR) is the interest rate that sets the PV of outflows equal to the terminal value.
The calculation of MIRR, though it takes several steps, is not difficult.
1. Find the present value of all cash outflows at the firms cost of capital. Often the only
cash outflow is the initial investment. If any subsequent cash outflows are required,
such as a future modification, compute the present value of these outflows as well.
2. Find the future value of all cash inflows at the firms cost of capital. All positive cash
flows are compounded to the point in time at which the last cash inflow is received.
3. Compute the yield that sets the present value of the inflows equal to the present
value of the outflows. This yield is the modified internal rate of return.
An example will help explain this method.
X A M P L E
10.10
Compute the MIRR for the following cash flow stream. Assume a cost of capital of 10%. The
initial investment is $500. The cash inflows are $300 per year for 2 years, followed by a $200
expenditure and then one more $300 inflow.
Solution
Prepare a time line to better visualize the process:
0
1
2
$500
$300
$300
$200
$300
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280
FV=$1,062.30,
N=4,
PMT=0,
compute I=13.05%
PV = FV(PVIFn,i)
650.26 = 1,062.30(PVIFn,i)
PVIFn,i =
650.26 = 0.6121
1,062.30
Now go to the PVIF table and find the factor closest to 0.6121 in the row corresponding to four
periods. We find that the factor falls close to 13%, so we estimate the MIRR as about 13%.
The MIRR solves the reinvestment rate assumption problem because all cash flows
are compounded at the cost of capital. It also solves the problem of changing cash flow
signs resulting in multiple IRRs. It still suffers from scale problems. Remember that one
problem with IRR is that it does not distinguish between large and small projects effectively. MIRR suffers from this same limitation. As a result, it cannot be used to rank projects. Hence, it can only be used to make the accept/reject decision, which is accurately
done by IRR. Again we reach the same conclusion: Because NPV is easy to calculate and
provides a correct wealth-maximizing decision, it is the preferred method.
Careers in Finance
Large corporations employ financial analysts
whose primary responsibility is to evaluate capital spending projects of interest to the firm. A
financial analyst collects information from
throughout the firm to prepare cash flow estimates. These
estimates are then analyzed to determine whether the firm
should pursue the projects. The financial analyst is often
also employed in reviewing projects as they are implemented and post completion.
Financial Analyst
Financial analysts salaries range from
$23,000$27,000 for new hires by small firms
to $50,000 or $60,000 for seasoned analysts
employed by larger firms. Many financial analysts use the skills they learn analyzing individual projects
to advance into into positions of chief financial officer,
where salaries can reach several hundred thousand dollars per year.
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CHAPTER SUMMARY
Capital budgeting is the process of evaluating the cash flows
from investment opportunities and deciding which investments should be accepted or rejected by the firm. The capital
budgeting process requires two distinct steps. First, the cash
flows from the project must be accurately estimated. Second,
the cash flows must be evaluated to determine whether they
provide a return sufficient to cover the firms cost of capital.
This chapter introduced five methods to evaluate potential
investment opportunities. In Chapter 11 we will investigate
how cash flows are estimated.
The payback period method simply computes the number of years required to recapture the initial cash outflows.
This method is used primarily because of its simplicity. It can
also provide an indication of the projects liquidity because it
tells the analyst how long the firms funds will be tied up in
the project. However, it fails to adjust for risk or for the time
value of money. Additionally, any cash flows that occur after
the payback period are ignored.
The net present value (NPV) method is the preferred way
of evaluating cash flows. It adjusts for risk and for the time
value of money by evaluating all cash flows in the present. It
is theoretically accurate and is easy to compute. Accepting all
positive-NPV projects will lead to maximizing the value of the
firm. It can also be used to rank projects if the firm is unable
to accept all positive-NPV opportunities.
The profitability index (PI) is the ratio of the present value
of the cash inflows to the present value of the cash outflows
KEY WORDS
capital budgeting 261
cost of capital 269
internal rate of return
(IRR) 273
DISCUSSION QUESTIONS
1. Why is capital an appropriate word to use to describe the
process of evaluating possible investment projects?
2. What steps should a firm take to maximize its chance
of successfully identifying and implementing investment projects?
3. What is the purpose of the post audit?
4. What are the advantages and disadvantages of the
payback method, NPV, IRR, PI, and MIRR?
5. What is the decision criterion for NPV, PI, IRR, and
MIRR?
282
PROBLEMS
1. Consider the cash flows for the following two
investments:
Year
0
1
2
3
4
Investment 1
:$150
20
50
70
120
Investment 2
:$150
30
40
100
110
Project 1
Project 2
:$200
0
50
100
150
:$300
100
100
100
100
5.
6.
7.
8.
Cash Flow
0
1
2
3
4
5
:$2,500
1,500
1,700
1,000
1,000
1,000
Project A
Project B
0
1
2
3
:$75,000
30,000
18,000
50,000
:$55,000
22,000
13,200
37,000
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13. The Renn project cost $55,000 and its expected net cash
inflows are $12,000 per year for 8 years.
a. What is the projects payback period?
b. The cost of capital is 12%. What is the projects
NPV?
c. What is the projects IRR?
d. Calculate the projects MIRR assuming a 12%
cost of capital. (Extension 10.1)
14. Lacey Industries Co. has been evaluating a project with
a cost of $700,000. Estimated net cash flows of $180,000
are expected for a 7-year period. The cost of capital is
14%. Find the NPV and IRR.
15. The Fitness Center is considering including two pieces
of equipment, a treadmill and a step machine, in
this years capital budget. The projects are independent.
The cash outlay for the treadmill is $1,700 and for
the step machine it is $2,200. The firms cost of capital
is 14%. After-tax cash flows, including depreciation,
are as shown in the following table. Calculate the NPV,
the IRR, and the MIRR (Extension 10.1) for each
project, and indicate the correct accept/reject decision
for each.
Years
Treadmill
Step Machine
1
2
3
4
5
$510
510
510
510
510
$750
750
750
750
750
Rivergate
Treywood
Net Cash Flows Net Cash Flows
$160,000
160,000
160,000
95,000
95,000
$275,000
275,000
600,000
600,000
600,000
SELF-TEST PROBLEMS
1. XYZ Company wants to know the payback period for
a project with an initial investment of $4 million and
annual cash flows of $800,000. What is it?
2. Suppose the annual cash flows listed for problem 1
start at $800,000 and then decrease by 15% each year.
What is the payback period?
284
Net
Investment
$ 400
700
150
1,000
250
PV (cash
inflows)
$480
735
225
950
275
NPV
$80
35
75
(50)
25
WEB EXPLORATION
1. The concepts behind NPV and IRR apply equally to
investing in capital projects or in securities. Go to
www.financenter.com/calculate/all_calculate.fcs and
choose the calculator titled What Selling Price Provides
My Desired Return? This site allows you to input a variety of variables and to look at the rate of return the
investment provides. It also allows you to view graphs of
the answers. Relate the results you find using this calculator to IRR and NPV.
285
MINI CASE
ou have recently gone to work for a development/construction firm. This company does contract and bid
construction work as well as real estate development. You
work on the development side helping to select projects that
will be profitable. The development company is organized
as a separate entity from the construction firm. This requires
that both firms be independently profitable.
The company founder, Jerry Hammer, is primarily
responsible for identifying development opportunities. Once
an opportunity is identified, Hammer turns it over to his staff
for analysis. Jerry began as a carpenter and has built the firm
into a multimillion dollar enterprise mostly based on good
intuition and street smarts. He has no college education.
Last week Jerry called the staff of the development firm
together to discuss his latest idea. He would like to build a
new strip mall on a corner of property near the university.
He visualizes a group of tenets that would service the needs
of college students. He directed you to let him know if the
project was feasible.
Your first step was to collect cost and revenue estimates. The proposed mall is a duplicate of one built last year
for $3,750,000 with minor cosmetic changes. The mall will
have 30,000 square feet, all of which can be leased. You contact the owner of the property and find it can be purchased
for $500,000.
The revenues are more difficult to estimate. You decide
the most practical approach is to assume the mall will lease
for $2.75 per square foot per month. The mall will take about
10 months to build and you think the mall will be 10%
leased by the end of the first year. You will get 10% of the