Capital Budgeting Techniques

© 2007 Thomson/South-Western 1
Essentials of
Chapter 9
How do firms make decisions about whether to
invest in costly, long-lived assets?
How does a firm make a choice between two
acceptable investments when only one can be
purchased?
How are different capital budgeting techniques
related?
Which capital budgeting methods do firms
actually use?

2
What is Capital Budgeting?
The process of planning and evaluating
expenditures on assets whose cash flows are
expected to extend beyond one year
Analysis of potential additions to fixed assets
Long-term decisions; involve large expenditures
Very important to firm’s future

3
Generating Ideas for Capital
Projects
A firm’s growth and its ability to remain
competitive depend on a constant flow
of ideas for new products, ways to make
existing products better, and ways to
produce output at a lower cost.
Procedures must be established for
evaluating the worth of such projects.

4
Project Classifications
Replacement Decisions: whether to purchase capital
assets to take the place of existing assets to maintain or
improve existing operations
Expansion Decisions: whether to purchase capital
projects and add them to existing assets to increase
existing operations
Independent Projects: Projects whose cash flows are not
affected by decisions made about other projects
Mutually Exclusive Projects: A set of projects where the
acceptance of one project means the others cannot be
accepted

5
Similarities between Capital
Budgeting and Asset Valuation
Determine the cost, or purchase price, of the asset.
Estimate the cash flows expected from the project.
Assess the riskiness of cash flows.
Compute the present value of the expected cash flows to
obtain as estimate of the asset’s value to the firm.
Compare the present value of the future expected cash flows
with the initial investment.

6
Net Cash Flows for
Project S and Project L
Expected Afte r-Tax
^
Net Cash Flows, CF t
Year (T) Project S Project L
0 $(3,000) $(3,000)
1 1,500 400
2 1,200 900
3 800 1,300
4 300 1,500

7
What is the Payback Period?
The length of time before the original cost
of an investment is recovered from the
expected cash flows or . . .
How long it takes to get our money back.
 Unrecovered cost at start 
 Number of years before   
   of full - recovery year 
Payback = PB =  full recovery of  +  Total cash flow during 
 original investment  
   full - recovery year 
 

8
Payback Period for Project S
0 1 2 PBS 3 4

Net
Cash Flow -3,000 1,500 1,200 800 300
Cumulative
Net CF
-3,000 -1,500 -300 500 800

PaybackS = 2 + 300/800 = 2.375 years

9
Payback Period for Project L
0 1 2 3 PB 4
L

Net
Cash Flow - 3,000 400 900 1,300 1,500
Cumulative
Net CF
- 3,000 - 2,600 - 1,700 - 400 1,100

PaybackL = 3 + 400/1,500 = 3.3 years

10
Strengths and Weaknesses
of Payback:
Strengths of Payback:
• Provides an indication of a project’s
risk and liquidity
• Easy to calculate and understand

Weaknesses of Payback:
• Ignores TVM
• Ignores CFs occurring after the payback
period

11
Net Present Value:
Sum of the PVs of Inflows and
Outflows
n ^
CFt
NPV = ∑ t
t=0
(1+ r)
Cost is CF0 and is generally negative.
^
CFt
n
PV =∑
^
N t −CF0 .
t=0 (
1+r)

12
What is Project S’s NPV?
0 r = 10% 1 2 3 4

(3,000) 1,500 1,200 800 300

1,363.64

991.74

601.05

204.90

NPVS = 161.33
13
What is Project L’s NPV?
0 1 2 3 4
r = 10%

(3,000) 400 900 1300 1500

363.64

743.80

976.71

1024.52

NPVL = 108.67
14
Calculator Solution, NPV for L
Enter in CF for L:
-3,000 CF0

400 CF1

900 CF2

1,300 CF3

1,500 CF4

10% I NPVL = 108.67 = NPVL

15
Rationale for the NPV method:
NPV = PV inflows - Cost
= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually exclusive

projects on basis of higher NPV.
Which adds most value?

16
Using NPV method,
which project(s) should be
accepted?
If Projects S and L are mutually
exclusive, accept S because NPVS
> NPVL.

If S & L are independent,

accept both; NPV > 0.

17
Internal Rate of Return: IRR
0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = cost.
This is the same as forcing NPV = 0.

18
Calculating IRR
NPV: Enter r, solve for NPV.
n
CFt
∑( )t
= NPV .
t =0 1 + r
IRR: Enter NPV = 0, solve for IRR.
n
CFt
∑ (1 + IRR) t = 0
t= 0

19
What is Project S’s IRR?

0 IRR = ? 1 2 3 4

(3,000) 1,500 1,200 800 300

Sum of
PVs
for CF1-4 = 3,000

Enter CFs in CF register, then

NPVS = 0 press IRR: IRRS = 13.1%
20
What is Project L’s IRR?
0 1 2 3 4
IRR = ?

(3,000) 400 900 1300 1500

Sum of
PVs
for CF1-4 = 3,000

Enter CFs in CF register, then

NPVL = 0 press IRR: IRRL = 11.4%
21
How is a Project’s IRR
Related to a Bond’s YTM?
They are the same thing.
A bond’s YTM is the IRR
if you invest in the bond.
0 1 2 10
IRR = ?

-1134.20 90 90 1090

IRR = 7.08% (use TVM or CF register)

22
Rationale for the IRR Method
If IRR (project’s rate of return) > the
firm’s required rate of return, r, then
some return is left over to boost
stockholders’ returns.

Example: r = 10%,
IRR = 15%. Profitable.

23
IRR Acceptance Criteria

If IRR > r, accept project.

If IRR < r, reject project.

24
Decisions on Projects S and L per
IRR
If S and L are independent,
accept both. IRRs > r = 10%.

If S and L are mutually exclusive,

accept S because IRRS > IRRL .

25
Construct NPV Profiles
Enter CFs in your calculator and find NPVL and
NPVS at several discount rates (r):
r NPVL NPVS
0 1,100 800
5 554 455
10 109 161
15 (259) ( 91)
20 (566) (309)

26
 NPV Profiles for Project S and Project
L
k NPVL NPVS
0 1,100 800
1,200 5 554 455
1,000 Project L
10 109 161
800
Crossover (259) ( 91)
600 15
Point = 8.1%
400
20 (566) (309)
200
Project S
0 IRRS = 13.1%
(200) 0 2 4 6 8 10 12 14 16 18 20
(400)
(600)
(800) IRRL = 11.4%

27
NPV and IRR always lead to the same
accept/reject decision for independent
projects

NPV ($)
IRR > r IRR < r
and NPV > 0 and NPV < 0.
Accept. Reject.

r (%)
IRR

28
Mutually Exclusive Projects
r < 8.1: NPVL> NPVS , IRRL < IRRS
NPV CONFLICT

r > 8.1: NPVS> NPVL , IRRS > IRRL

NO CONFLICT
L
S
IRRs

%
8.1
IRRL

29
To Find the Crossover Rate:

1. Find cash flow differences between the

projects. See data at beginning of the case.

2. Enter these differences in CF register, then

press IRR. Crossover rate = 8.11, rounded to
8.1%.

3. Can subtract S from L or vice versa.

4. If profiles don’t cross, one project dominates

the other.

30
Two Reasons NPV Profiles Cross:
1) Size (scale) differences. Smaller project frees up
funds at t = 0 for investment. The higher the
opportunity cost, the more valuable these funds, so
high r favors small projects.

2) Timing differences. Project with faster payback

provides more CF in early years for reinvestment.
If r is high, early CF especially good, NPVS> NPVL.

31
Reinvestment Rate Assumptions

NPV assumes reinvest at r.

IRR assumes reinvest at IRR.

Reinvest at opportunity cost, r, is more

realistic, so NPV method is best. NPV
should be used to choose between
mutually exclusive projects.

32
Modified Internal Rate of Return
A better indicator of relative profitability
Better for use in capital budgeting
TV
PV of cash outflows =
(1+ MIRR)n
n

n
COFt
∑ CIF (1 + r)
t n −t

∑ (1 + r) t = t =0
(1 + MIRR ) n
t =0

33
Chapter 9 Essentials
How do firms make decisions about whether
to invest in costly, long-lived assets?
Firms use decision-making methods that are
based on fundamental valuation concepts
How does a firm make a choice between two
acceptable investments when only one can
be purchased?
The decision should be consistent with the goal of
maximizing the value of the firm

34
Chapter 9 Essentials
How are different capital budgeting
techniques related?
All techniques except traditional payback period
(PB) are based on time value of money
Which capital budgeting methods do firms
actually use?
Most firms rely heavily on NPV and IRR to make
investment decisions

35
The End

36