6-1

CHAPTER
6
Capital Budgeting

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6-2

Chapter Outline
6.1 Why Use Net Present Value?
6.2 The Payback Period Rule
6.3 The Discounted Payback Period Rule
6.4 The Average Accounting Return
6.5 The Internal Rate of Return
6.6 Problems with the IRR Approach
6.7 The Profitability Index
6.8 The Practice of Capital Budgeting
6.9 Summary and Conclusions
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 Capital Budgeting: The process
of planning for purchases of long-
term assets.
For example: Suppose our firm must
decide whether to purchase a new plastic
molding machine for $125,000. How do
we decide?
Will the machine be profitable?
Will our firm earn a high rate of return
on the investment?
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 Decision-making Criteria
in Capital Budgeting

How do we decide
if a capital
investment
project should
be accepted or
rejected?
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 Decision-making Criteria in
Capital Budgeting

The ideal evaluation method should:

a) include all cash flows that occur during
the life of the project,
b) consider the time value of money, and
c) incorporate the required rate of return
on the project.
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6-6

6.1 Why Use Net Present Value?

Accepting positive NPV projects benefits
shareholders.
 NPV uses cash flows
 NPV uses all the cash flows of the project
 NPV discounts the cash flows properly

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6-7

The Net Present Value (NPV) Rule

Net Present Value (NPV) =
Total PV of future CF’s - Initial Investment

Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV
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 Net Present Value
 NPV = the total PV of the annual net
cash flows - the initial outlay.


FCFt
NPV = - IO
(1 + k) t
t=1
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 NPV Example

Suppose we are considering a capital

investment that costs $250,000 and
provides annual net cash flows of
$100,000 for five years. The firm’s
required rate of return is 15%.

(250,000) 100,000 100,000 100,000 100,000 100,000

0
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 Net Present Value
NPV is just the PV of the annual cash
flows minus the initial outflow.
Using TVM:
P/Y = 1 N = 5 I = 15
PMT = 100,000

PV of cash flows = $335,216

- Initial outflow: ($250,000)
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= Net PV $85,216
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11

Good Attributes of the NPV Rule

1. Uses cash flows
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly

Reinvestment assumption: the NPV rule assumes

that all cash flows can be reinvested at the
discount rate.

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12

6.2 The Payback Period Rule

How long does it take the project to “pay back”
its initial investment?
Payback Period = number of years to recover
initial costs
Minimum Acceptance Criteria:
set by management
Ranking Criteria:
set by management
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 Payback Period

How long will it take for the project

to generate enough cash to pay for
itself?

(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

Payback period = 3.33 years

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 Payback Period

Is a 3.33 year payback period good?

Is it acceptable?
Firms that use this method will compare
the payback calculation to some
standard set by the firm.
If our senior management had set a cut-
off of 5 years for projects like ours, what
would be our decision?
Accept the project.
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15

The Payback Period Rule (continued)

Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback criteria may
not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity
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16

6.3 The Discounted Payback

Period Rule
How long does it take the project to “pay back”
its initial investment taking the time value of
money into account?
By the time you have discounted the cash flows,
you might as well calculate the NPV.

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 Discounted Payback

Discounts the cash flows at the firm’s

required rate of return.
Payback period is calculated using these
discounted net cash flows.
Problems:
Cutoffs are still subjective.
Still does not examine all cash flows.
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 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.37 2 years
88.33
3
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250 168.74 .52 years
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19

6.4 The Average Accounting Return Rule

Average Net Income
AAR 
Average Book Value of Investent
Another attractive but fatally flawed approach.
Ranking Criteria and Minimum Acceptance Criteria set by
management
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values
Advantages:
The accounting information is usually available
Easy to calculate
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20

6.5 The Internal Rate of Return (IRR) Rule

IRR: the discount that sets NPV to zero
Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return.
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.
Disadvantages:
Does not distinguish between investing and borrowing.
IRR may not exist or there may be multiple IRR
Problems with mutually exclusive investments
Advantages:
Easy to understand and communicate

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 Internal Rate of Return (IRR)
n


FCFt
NPV = - IO
(1 + k) t
t=1

n
FCFt
IRR:

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
t=1
(1 + IRR) t = IO

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22

The Internal Rate of Return: Example

Consider the following project:
$50 $100 $150

0 1 2 3
-$200
The internal rate of return for this project is 19.44%
$50 $100 $150
NPV  0   
(1  IRR) (1  IRR) (1  IRR)3
2

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23

The NPV Payoff Profile for This Example

If we graph NPV versus discount rate, we can see the
IRR as the x-axis intercept.

Discount Rate NPV

0% $100.00
4% $71.04
8% $47.32
12% $27.79
16% $11.65
20% ($1.74) IRR = 19.44%
24% ($12.88)
28% ($22.17)
32% ($29.93)
36% ($36.43)
40% ($41.86)

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24

6.6 Problems with the IRR Approach

Multiple IRRs.
Are We Borrowing or Lending?
The Scale Problem
The Timing Problem

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25

Multiple IRRs
There are two IRRs for this project:
$200 $800
Which one
0 1 2 3 should we use?
-$200 - $800
NPV

$100.00
100% = IRR2
$50.00

$0.00
-50% 0% 50% 100% 150% 200%
($50.00)
0% = IRR1 Discount rate
($100.00)

($150.00)
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26

The Scale Problem

Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment
while the 50% return is on a $1,000 investment?

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27

The Timing Problem

$10,000 $1,000 $1,000
Project A
0 1 2 3
-$10,000
$1,000 $1,000 $12,000
Project B
0 1 2 3
-$10,000
The preferred project in this case depends on the discount rate, not
the IRR.
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28

The Timing Problem

$5,000.00
$4,000.00
Project A
$3,000.00
Project B
$2,000.00
10.55% = crossover rate
NPV

$1,000.00
$0.00
($1,000.00) 0% 10% 20% 30% 40%

($2,000.00)
($3,000.00)
($4,000.00)
12.94% = IRRB 16.04% = IRRA
Discount rate
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29

Calculating the Crossover Rate

Compute the IRR for either project “A-B” or
“B-A”
Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000) $0 $0
1 $10,000 $1,000 $9,000 ($9,000)
2 $1,000 $1,000 $0 $0
3 $1,000 $12,000 ($11,000) $11,000

$3,000.00
$2,000.00
10.55% = IRR
$1,000.00
A-B
NPV

$0.00
B-A
($1,000.00) 0% 5% 10% 15% 20%
($2,000.00)
($3,000.00)
Discount rate

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Mutually Exclusive vs.

Independent Project
Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring an
accounting system.

RANK all alternatives and select the best one.

Independent Projects: accepting or rejecting one project

does not affect the decision of the other projects.

Must exceed a MINIMUM acceptance criteria.

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31

6.7 The Profitability Index (PI) Rule

Total PV of Future Cash Flows
PI 
Initial Investent
Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects

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 Profitability Index
n


FCFt
NPV = t - IO
(1 + k)
t=1


FCFt
PI = IO
(1 + k) t
t=1
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33

6.8 The Practice of Capital Budgeting

Varies by industry:
Some firms use payback, others use accounting rate of
return.
The most frequently used technique for large
corporations is IRR or NPV.

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34

Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.

Year Project A Project B

0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
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35

Example of Investment Rules

Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
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36

Example of Investment Rules

Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?
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37

Relationship Between NPV and IRR

Discount rate NPV for A NPV for B
-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
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38

NPV Profiles
$400
NPV
$300
IRR 1(A) IRR (B) IRR 2(A)
$200

$100

$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)

($200)
Project A
Discount rates
Cross-over Rate Project B
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39

6.9 Summary and Conclusions

This chapter evaluates the most popular
alternatives to NPV:
Payback period
Accounting rate of return
Internal rate of return
Profitability index
When it is all said and done, they are not the
NPV rule; for those of us in finance, it makes
them decidedly second-rate.
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