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Chapter 13

Capital Budgeting
Techniques

13.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 13,
you should be able to:
1. Understand the payback period (PBP) method of project evaluation and
selection, including its: (a) calculation; (b) acceptance criterion; (c)
advantages and disadvantages; and (d) focus on liquidity rather than
profitability.
2. Understand the three major discounted cash flow (DCF) methods of
project evaluation and selection – internal rate of return (IRR), net
present value (NPV), and profitability index (PI).
3. Explain the calculation, acceptance criterion, and advantages (over the
PBP method) for each of the three major DCF methods.
4. Define, construct, and interpret a graph called an “NPV profile.”
5. Understand why ranking project proposals on the basis of IRR, NPV, and
PI methods “may” lead to conflicts in rankings.
6. Describe the situations where ranking projects may be necessary and
justify when to use either IRR, NPV, or PI rankings.
7. Understand how “sensitivity analysis” allows us to challenge the single-
point input estimates used in traditional capital budgeting analysis.
8. Explain the role and process of project monitoring, including “progress
reviews” and “post-completion audits.”
13.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Budgeting
Techniques
• Project Evaluation and Selection
• Potential Difficulties
• Capital Rationing
• Project Monitoring
• Post-Completion Audit

13.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Project Evaluation:
Alternative Methods
• Payback Period (PBP)
• Internal Rate of Return (IRR)
• Net Present Value (NPV)
• Profitability Index (PI)
• Refer to the additional PowerPoint slides and the Excel
spreadsheet “VW13E-13b.xlsx” for computer-based
solutions.

13.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Proposed Project Data

Julie Miller is evaluating a new project


for her firm, Basket Wonders (BW).
She has determined that the after-tax
cash flows for the project will be
$10,000; $12,000; $15,000; $10,000;
and $7,000, respectively, for each of
the Years 1 through 5. The initial
cash outlay will be $40,000.
13.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Independent Project

• For this project, assume that it is


independent of any other potential
projects that Basket Wonders may
undertake.
• Independent – A project whose
acceptance (or rejection) does not
prevent the acceptance of other
projects under consideration.
13.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Payback Period (PBP)
0 1 2 3 4 5

–40 K 10 K 12 K 15 K 10 K 7K

PBP is the period of time


required for the cumulative
expected cash flows from an
investment project to equal the
initial cash outflow.
13.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Payback Solution (#1)

0 1 2 3 (a) 4 5

–40 K (-b) 10 K 12 K 15 K 10 K (d) 7 K


10 K 22 K 37 K(c) 47 K 54 K

Cumulative
Inflows PBP =a+(b–c)/d
= 3 + (40 – 37) / 10
= 3 + (3) / 10
= 3.3 Years
13.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Payback Solution (#2)

0 1 2 3 4 5

–40 K 10 K 12 K 15 K 10 K 7K
–40 K –30 K –18 K –3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows Note: Take absolute value of last
negative cumulative cash flow value.
13.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PBP Acceptance Criterion

The management of Basket Wonders


has set a maximum PBP of 3.5
years for projects of this type.
Should this project be accepted?
Yes!(We Accept the project) The firm
will receive back the initial cash
outlay in less than 3.5 years. [3.3
Years < 3.5 Year Max.]
13.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PBP Strengths
and Weaknesses
Strengths: Weaknesses:
• Easy to use and • Does not account
understand for TVM(time value
• Can be used as a of money)
measure of • Does not consider
liquidity cash flows beyond
• Easier to forecast the PBP
ST than LT flows • Cutoff period is
13.11
subjective
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Internal Rate of Return (IRR)

IRR is the discount rate that equates the


present value of the future net cash
flows from an investment project with
the project’s initial cash outflow.

CF1 CF2 CFn


ICO = (1 + IRR)1 +
(1 + IRR)2
+...+
(1 + IRR)n

13.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution

$40,000 = $10,000 $12,000


+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the


discounted cash flows to equal $40,000.

13.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Try 10%)
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(0.909) + $12,000(0.826) +
$15,000(0.751) + $10,000(0.683) +
$ 7,000(0.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
13.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(0.870) + $12,000(0.756) +
$15,000(0.658) + $10,000(0.572) +
$ 7,000(0.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
13.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Interpolate)

0.10 $41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15 $36,841

X $1,444
0.05 = $4,603

13.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Interpolate)

0.10 $41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15 $36,841

X $1,444
0.05 = $4,603

13.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Interpolate)

0.10 $41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15 $36,841

X = ($1,444)(0.05) X = 0.0157
$4,603
IRR = 0.10 + 0.0157 = 0.1157 or 11.57%
13.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Acceptance Criterion
The management of Basket Wonders
has determined that the hurdle rate
is 13% for projects of this type.
Should this project be accepted?

No! (WE REJECT the project) The


firm will receive 11.57% for each
dollar invested in this project at a
cost of 13%. [ IRR < Hurdle Rate ]
13.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRRs on the Calculator

We will use the


cash flow registry
to solve the IRR
for this problem
quickly and
accurately!

13.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Actual IRR Solution Using
Your Financial Calculator
Steps in the Process
Step 1: Press CF key
Step 2: Press 2nd CLR Work keys
Step 3: For CF0 Press -40000 Enter  keys

Step 4: For C01 Press 10000 Enter  keys


Step 5: For F01 Press 1 Enter  keys
Step 6: For C02 Press 12000 Enter  keys
Step 7: For F02 Press 1 Enter  keys
Step 8: For C03 Press 15000 Enter  keys
Step 9: For F03 Press 1 Enter  keys
13.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Actual IRR Solution Using
Your Financial Calculator
Steps in the Process (Part II)
Step 10:For C04 Press 10000 Enter  keys
Step 11:For F04 Press 1 Enter  keys
Step 12:For C05 Press 7000 Enter  keys
Step 13:For F05 Press 1 Enter  keys
Step 14: Press   keys
Step 15: Press IRR key
Step 16: Press CPT key

Result: Internal Rate of Return = 11.47%


13.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Strengths
and Weaknesses
Strengths: Weaknesses:
• Accounts for • Assumes all cash
TVM flows reinvested at
• Considers all the IRR
cash flows • Difficulties with
• Less project rankings and
subjectivity Multiple IRRs

13.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Net Present Value (NPV)

NPV is the present value of an


investment project’s net cash
flows minus the project’s initial
cash outflow.

CF1 CF2 CFn


NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k) n

13.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV =net present value
Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)

13.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) – $40,000
NPV = $10,000(0.885) + $12,000(0.783) +
$15,000(0.693) + $10,000(0.613) +
$ 7,000(0.543) – $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 – $40,000
= - $1,428
13.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Acceptance Criterion
The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?

No!(WE REJECT) The NPV is negative.


This means that the project is reducing
shareholder wealth. [Reject as NPV < 0 ]

13.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV on the Calculator

We will use the cash


flow registry to solve
the NPV for this
problem quickly and
accurately!

Hint: If you have not


cleared the cash flows
from your calculator, then
you may skip to Step 15.
13.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Actual NPV Solution Using
Your Financial Calculator
Steps in the Process
Step 1: Press CF key
Step 2: Press 2nd CLR Work keys
Step 3: For CF0 Press -40000 Enter  keys

Step 4: For C01 Press 10000 Enter  keys


Step 5: For F01 Press 1 Enter  keys
Step 6: For C02 Press 12000 Enter  keys
Step 7: For F02 Press 1 Enter  keys
Step 8: For C03 Press 15000 Enter  keys
Step 9: For F03 Press 1 Enter  keys
13.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Actual NPV Solution Using
Your Financial Calculator
Steps in the Process (Part II)
Step 10:For C04 Press 10000 Enter  keys
Step 11:For F04 Press 1 Enter  keys
Step 12:For C05 Press 7000 Enter  keys
Step 13:For F05 Press 1 Enter  keys
Step 14: Press   keys
Step 15: Press NPV key
Step 16: For I=, Enter 13 Enter  keys
Step 17: Press CPT key
Result: Net Present Value = -$1,424.42
13.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Strengths
and Weaknesses
Strengths: Weaknesses:
• Cash flows •
May not include
assumed to be managerial
reinvested at the options embedded
hurdle rate. in the project. See
• Accounts for TVM. Chapter 14.
• Considers all
13.31
cash flows.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Net Present Value Profile
$000s Sum of CF’s Plot NPV for each
15 discount rate.
Net Present Value

10

5 IRR
NPV@13%
0
-4
0 3 6 9 12 15
Discount Rate (%)
13.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Creating NPV Profiles
Using the Calculator

Hint: As long as you


do not “clear” the
cash flows from the
registry, simply start
at Step 15 and enter
a different discount
rate. Each resulting
NPV will provide a
“point” for your NPV
Profile!
13.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Profitability Index (PI)
PI is the ratio of the present value of
a project’s future net cash flows to
the project’s initial cash outflow.
Method #1:
CF1 CF2 CFn
PI = + +...+ ICO
(1+k)1 (1+k) 2 (1+k)n
<< OR >>
Method #2:
PI = 1 + [ NPV / ICO ]
13.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PI Acceptance Criterion
PI = $38,572 / $40,000
= .9643 (Method #1, previous slide)

Should this project be accepted?

No(REJECT)! The PI is less than 1.00.


This means that the project is not
profitable. [Reject as PI < 1.00 ]

13.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PI Strengths
and Weaknesses
Strengths: Weaknesses:
• Same as NPV • Same as NPV
• Allows • Provides only
comparison of relative profitability
different scale
• Potential Ranking
projects(the
Problems
higher the PI ,the
better)
13.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Evaluation Summary

Basket Wonders Independent Project


Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
13.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Project Evaluation: Remember
Chapter 12 ‘New Asset’ project?
We will start with the cash
flows of the project and also
calculate the cumulative
cash flow values.

We can use Excel functions / approaches to calculate each of


the following methods from the above cash flows.

13.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Other Project
Relationships
• Dependent – A project whose
acceptance depends on the
acceptance of one or more other
projects.
• Mutually Exclusive ‫قبول االول يعني رفض‬
‫ –الثاني‬A project whose acceptance
precludes‫ يستثني‬the acceptance of one
or more alternative projects.
13.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life

13.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A. Scale Differences
Compare a small (S) and a
large (L) project.

NET CASH FLOWS


END OF YEAR Project S Project L
0 -$100 -$100,000
1 0 0
2 $400 $156,250
13.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A. Scale Differences
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?
Project IRR NPV PI

S 100% $ 231 3.31


L 25% $29,132 1.29
13.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember to refer to Excel spreadsheet
‘VW13E-13b.xlsx’ and the ‘Scale’ tab.

A. Scale Differences

Refer to VW13E-13b.xlsx on the ‘Scale’ tab.


13.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
B. Cash Flow Pattern
Let us compare a decreasing cash-flow (D)
project and an increasing cash-flow (I) project.

NET CASH FLOWS


END OF YEAR Project D Project I
0 -$1,200 -$1,200
1 1,000 100
2 500 600
3 100 1,080
13.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cash Flow Pattern
Calculate the IRR, NPV@10%,
and PI@10%.
Which project is preferred?

Project IRR NPV PI


D 23% $198 1.17
I 17% $198 1.17
13.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
600 Examine NPV Profiles
Plot NPV for each
Net Present Value ($)

project at various
Project I discount rates.
400

NPV@10%
200

IRR

Project D
0
-200

0 5 10 15 20 25
Discount Rate (%)
13.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
600
Net Present Value ($)
Fisher’s Rate of Intersection

At k<10%, I is best! Fisher’s Rate of


-200 0 200 400

Intersection

At k>10%, D is best!

0 5 10 15 20 25
Discount Rate ($)
13.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember to refer to Excel spreadsheet
‘VW13E-13b.xlsx’ and the ‘Pattern’ tab.

B. Cash Flow Pattern

Refer to VW13E-13b.xlsx on the ‘Pattern’ tab.


13.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
C. Project Life Differences
Let us compare a long life (X) project
and a short life (Y) project.

NET CASH FLOWS


END OF YEAR Project X Project Y
0 -$1,000 -$1,000
1 0 2,000
2 0 0
3 3,375 0
13.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Project Life Differences

Calculate the PBP, IRR, NPV@10%,


and PI@10%.
Which project is preferred? Why?
Project IRR NPV PI

X 50% $1,536 2.54


Y 100% $ 818 1.82

13.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember to refer to Excel spreadsheet
‘VW13E-13b.xlsx’ and the ‘Life’ tab.

C. Project Life Differences

13.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Another Way to
Look at Things
1. Adjust cash flows to a common terminal
year if project “Y” will NOT be replaced.
Compound Project Y, Year 1 @10% for 2 years.

Year 0 1 2 3
CF –$1,000 $0 $0 $2,420

Results: IRR* = 34.26% NPV = $818


*Lower IRR from adjusted cash-flow stream. X is still Best.
13.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Replacing Projects
with Identical Projects
2. Use Replacement Chain Approach (Appendix B)
when project “Y” will be replaced.
0 1 2 3

–$1,000 $2,000
–1,000 $2,000
–1,000 $2,000
–$1,000 $1,000 $1,000 $2,000
Results: IRR = 100% NPV* = $2,238.17
*Higher NPV, but the same IRR. Y is Best.
13.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember to refer to Excel spreadsheet
‘VW13E-13b.xlsx’ and the ‘Life2’ tab.

C. Project Life Differences

13.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for
this capital budgeting period.
13.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Available Projects for BW
Project ICO IRR NPV PI
A $ 500 18% $ 50 1.10
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
E 12,500 26 500 1.04
F 15,000 28 21,000 2.40
G 17,500 19 7,500 1.43
H 25,000 15 6,000 1.24
13.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Choosing by IRRs for BW
Project ICO IRR NPV PI
C $ 5,000 37% $ 5,500 2.10
F 15,000 28 21,000 2.40
E 12,500 26 500 1.04
B 5,000 25 6,500 2.30
Projects C, F, and E have the
three largest IRRs.
The resulting increase in shareholder wealth
is $27,000 with a $32,500 outlay.
13.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Choosing by NPVs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40
G 17,500 19 7,500 1.43
B 5,000 25 6,500 2.30
Projects F and G have the
two largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
13.58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Choosing by PIs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
G 17,500 19 7,500 1.43
Projects F, B, C, and D have the four largest PIs.
The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
13.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of Comparison
Method Projects Accepted Value Added
PI F, B, C, and D $38,000
NPV F and G $28,500
IRR C, F, and E $27,000

PI generates the greatest increase in


shareholder wealth when a limited capital
budget exists for a single period.
13.60 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Single-Point Estimate
and Sensitivity Analysis
Sensitivity Analysis: A type of “what-if”
uncertainty analysis in which variables or
assumptions are changed from a base case in
order to determine their impact on a project’s
measured results (such as NPV or IRR).
• Allows us to change from “single-point” (i.e.,
revenue, installation cost, salvage, etc.) estimates
to a “what if” analysis
• Utilize a “base-case” to compare the impact of
individual variable changes
• E.g., Change forecasted sales units to see
impact on the project’s NPV
13.61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and
benefits of a project with original estimates.

• Identify any project weaknesses


• Develop a possible set of corrective actions
• Provide appropriate feedback
Result: Making better future decisions!
13.62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Multiple IRR Problem*
Let us assume the following cash flow
pattern for a project for Years 0 to 4:
–$100 +$100 +$900 –$1,000
How many potential IRRs could this
project have?
Two!! There are as many potential
IRRs as there are sign changes.
* Refer to Appendix A
13.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Profile – Multiple IRRs
75 Multiple IRRs at
Net Present Value

k = 12.95% and 191.15%


50
($000s)

25

–100
0 40 80 120 160 200
Discount Rate (%)
13.64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Profile – Multiple IRRs

Hint: Your calculator


will only find ONE
IRR – even if there
are multiple IRRs. It
will give you the
lowest IRR. In this
case, 12.95%.

13.65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.