Capital Budgeting

Capital Budgeting
 The process of evaluating and ranking
alternative long-range projects for the
purpose of allocating limited resources
– Plan and prepare the capital budget
– Review past investments
• assess success of past decisions and
• enhance the decision process in the future

2
 Investment vs. Financing
Investment Decision Financing Decision
 Which assets to  Debt or equity
acquire

 Made by divisional  Made by Treasurer

managers and top and top
management management
 Interest is a
financing decision

3
True or False?
 Project funding is an investing decision.
-False

 The decision concerning which assets to

acquire to achieve an organization’s
objectives is an investing decision.
-True

4
 Capital Budgeting:
Part of the Financial Budget
Statement of
Cash Budget
Cash Flows

Capital
Statement of Budget
Comprehensive Operating Budget
Income

Statement of
Retained Earnings Balance Sheet
5
 Capital Budgeting Process

 Identification – MOGS and SWOT

 Development
 Selection
 Implementation
 Follow-up

6
True or False?
 Capital budgeting uses financial criteria
exclusively when evaluating projects.
-False

7
Selection

 Compare and evaluate alternative

projects
– nonfinancial (qualitative) and
– financial (quantitative) criteria
• short and long-term benefits
• usually multiple criteria

-- consider all significant stakeholders

8
Selection: financial and nonfinancial criteria

9
Capital Budgeting --Qualitative

 Employee morale, safety, and responsibility

 Corporate image
 Social responsibility
 Market share
 Growth

10
Capital Budgeting --Quantitative

 Accounting rate of return

Undiscounted
 Payback period Cash Flow Focus
 Net present value
Discounted
 Profitability index Cash Flow Focus
 Internal rate of return

11
 1. Accounting Rate of Return

 Measures rate of return on earnings for

average capital investment over
project’s life
 Uses profits shown on accrual-based
financial statements
 Not based on cash flows

Accounting = Average Annual Profits

Rate of Return Average Investment
12
True or False?
 The accounting rate of return considers
the salvage value of an asset.
-True

13
Example
 OfficePro Industries is considering the
purchase of a P100,000 machine that is
expected to result in a decrease of P15,000
per year in expenses. This machine, which
has no residual value, has an estimated
useful life of 10 years and will be
depreciated on a straight-line basis. For this
machine, the accounting rate of return
would be
P15,000/(P100,000/2) = 30%

14
Example
 Allen’s Retail is considering an investment in a
delivery truck. Allen has found a used truck that
he can purchase for P8,000. He estimates the
truck would last six years and increase his
store's net revenues by P2,000 per year. At the
end of six years, the truck would have no
salvage value and would be discarded. Allen
will depreciate the truck using the straight-line
method. What is the accounting rate of return
on the truck investment (based on average
profit and average investment)?
 P2,000/P4,000 = 50%
15
Average Investment = (P8,000 + 0)/2 = P4,000
 Cash Flow
 Cash Receipts
1. Revenues earned and collected
2. Savings generated by reducing opex
3. Proceeds from sale of assets

 Cash Disbursements
1. Expenditures for asset acquisition
2. Working capital investments
3. Costs for DM, DL, and FOH
16
 2. A popular, but flawed,
measure...
 Payback period
– number of years until the cash flows from a
project equal the project’s cost
 Decision rule: Accept project if payback
period is less than a maximum desired
time period

17
 Payback Period
Original Investment
= Payback Period
Annual Cash Inflows
(assuming equal cash flows)

Example:
Original Investment P25,000
Annual Cash Inflows P10,000
Payback Period 2.5 years

18
Example:
Cost of Investment needed: P20,000
Cash Cumulative Amount
YR Flow Cash flow Needed
1 5,800 5,800 14,200
2 5,800 11,600 8,400
3 5,800 17,400 2,600
4 5,800
Fraction of year: 2,600/5,800 = 0.45
Payback = 3.45 years
19
 Payback’s Drawbacks

 Ignores time value of money

 It ignores the cash flows beyond the
payback period
 Any relationship between the payback,
the decision rule, and shareholder
wealth maximization is purely
coincidental

20
 Discounted Cash Flow Methods

3. Net Present Value

4. Profitability Index
5. Internal Rate of Return

21
 Discount Rate %
 Discount rate should equal or exceed
the cost of capital

 Cost of Capital - weighted average cost

for the debt and equity that comprise a
firm’s financial structure

22
 3. Net Present Value

PV of expected cash flows

- Cost of project
= Net Present Value

23
 Net Present Value

Minus Investment made currently

Plus PV of future cash inflows or
cost savings
Minus PV of future cash outflows
Equals Net present value

24
 True or False

 Because “present value” refers to the value of

cash flows that occur at different points in
time, a series of present values of cash flows
should not be summed to determine the value
of a capital budgeting project.
 F

25
 Cash Flow Data

YEAR PROJECT A PROJECT B

0 (today) -20,000 -25,000
1 5,800 4,000
2 5,800 4,000
3 5,800 8,000
4 5,800 10,000
5 5,800 10,000
(using 10%, round off PV factor to two decimal places)
Which has the higher NPV? 26
 NPV of Project A
CASH 10% PRESENT
YR FLOW x PVIF = VALUE
0 –P20,000 1.000 –P20,000
PV (P5,800 x 3.79) 21,982

Net Present Value =P 1,982

27
28
 NPV of Project B
CASH 10% PRESENT
YR FLOW x PVIF = VALUE
0 -P25,000 1.000 -P25,000
1 4,000 0.909 3,636
2 4,000 0.826 3,304
3 8,000 0.751 6,008
4 10,000 0.683 6,830
5 10,000 0.621 6,210
Net Present Value = P 988
29
(round off PV factors to three decimal places)
Example
 Jolie Productions is considering the purchase of a
new movie camera, which will be used for major
motion pictures. The new camera will cost P30,000,
have an eight-year life, and create cost savings of
P5,000 per year. The new camera will require P700
of maintenance each year. Jolie Productions uses a
discount rate of 9 percent. Compute NPV. Round off
PV factors to the nearest four decimal places.

30
 Reminder: Cash Flow

 Cash Receipts
1. Revenues earned and collected
2. Savings generated by reducing opex
3. Proceeds from sale of assets

 Cash Disbursements
1. Expenditures for asset acquisition
2. Working capital investments
3. Costs for DM, DL, and FOH 31
 NPV: Decision Rule

 NPV represents the peso gain in

shareholder wealth from undertaking
the project
 If NPV ≥ 0, do the project
-shareholder wealth increases
 If NPV <0, do not undertake
-shareholder wealth decreases
32
 Net Present Value
 Two potential sources of positive
economic profits:
– Entry barriers that keep out/reduce
competition
• Economies of scale
• Product differentiation
• Absolute cost advantages
• Differences in access to distribution channels
• Government policy (patents, quotas)
– Cost savings projects
33
 NPV Profile
Figure 13.1 Relationship Between NPV and Discount Rates: NPV Profile

10000.00

8000.00

6000.00
NPV ($)

4000.00

2000.00

0.00
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12 0.13 0.14 0.15 0.16 0.17

-2000.00
Discount Rate (in decim al)

34
 True or False

 Assuming that their NPVs based on the firm's

cost of capital are equal, the NPV of a project
whose cash flows accrue relatively rapidly will
be more sensitive to changes in the discount
rate than the NPV of a project whose cash
flows come in later in its life.
 F

35
 4. Profitability Index
 Compares present value of net cash
flows to net investment
 Measures efficiency of the use of capital
 Does not calculate the rate of return

Profitability = PV of Net Cash Flows

Index Net Investment

36
 Profitability Index
Project 1 2
PV of net cash flows P900,000 P580,000
Net investment 720,000 425,000
Net presentNPV
Compute valueand PI. P180,000 P155,000
Profitability Index
P900,000/P720,000 1.25
P580,000/P425,000 1.36

Assuming limited funds,

which project would you choose? 37
 PI: Decision Rule

 Accept project if PI ≥ 1.0

 Reject project if PI < 1.0

38
 5. Internal Rate of Return

 Discount rate where

PV of cash inflows = PV of cash outflows
NPV = 0

39
 What Does the IRR Measure?

IRR measures the return earned on

funds that remain internally
invested in the project

40
 Solution Methods

 Compute the IRR by:

– Trial and error
– Financial calculator
– Spreadsheet software

41
Example
Houston Corporation is considering an investment in a
labor-saving machine. Information on this machine
follows:

•Cost, P30,000
•Salvage value in five years, P0
•Estimated life, 5 years
•Annual depreciation, P6,000
•Annual reduction in existing costs, P8,000

What is the internal rate of return on this project

(round to the nearest 1/2%)?
a. 37.5% b. 25.0% c. 10.5% d. 13.5%
IRR factor or PV factor = P30,000 / P8,000 = 3.75 42
The constant of 3.75 corresponds to a rate of 10.5%
 IRR: Decision Rule
 Hurdle rate is the lowest acceptable return on
investment (at least equal to the cost of capital)
– If Internal Rate of Return = Hurdle Rate; Accept
– If Internal Rate of Return > Hurdle Rate; Accept
– If Internal Rate of Return < Hurdle Rate; Reject

43
 IRR: Issue

 A project may have more than one IRR

 Can occur if project has alternative
positive and negative cash flows.
 Most likely to occur if project requires
substantial renovations or maintenance
during its life or if end-of-life shut-down
costs are high.

44
 Relationships

 PI, NPV, IRR will always agree on the

Accept/Reject decision
 If NPV > 0
– IRR > minimum required return and
– PI > 1

45
 NPV vs. IRR
 They may rank projects differently

 What if projects are mutually exclusive and

the rankings conflict?
 Answer: Use NPV as it measures the change
in shareholder wealth occurring because of
the project.

46
Modified Internal Rate of Return

 MIRR developed to solve some of the issues

associated with IRR.
 MIRR will agree with NPV on the
accept/reject decision
 MIRR gives a single answer—there is only
one MIRR
 MIRR agrees with NPV rankings when the
initial investments are of comparable size.

47
 Modified Internal Rate of Return:
Three step process
1. Find the present value of all cash outflows
2. Find the future value of all cash inflows at
the end of the project’s life at year n. This
lump sum is called the terminal value.
3. MIRR is the discount rate which equates the
present value of the outflows and the future
value of the inflows:
FV at year n = PV (1 + MIRR)n

48
 MIRR for Project A
1. Present value of outflows = 20,000 (no
additional calculation needed)
2. Find FV as of year 5 for cash inflows from
years 1-5 if cash inflow per year = P5,800:
5800 (1.10)4 = 8491.78
5800 (1.10)3 = 7719.80
5800 (1.10)2 = 7018.00
5800 (1.10)1 = 6380.00
5800 (1.10)0 = 5800.00
Terminal value (sum of FV) = 35,409.58

49
 MIRR for Project A
 PV of outflows: 20,000
 Terminal value (sum of FV of inflows) =
35,409.58

3. FV = PV(1 + MIRR)n
= P35,409.58= P20,000(1 + MIRR)5
 Solving, we find the MIRR is 12.10
percent
 Accept project as MIRR>10% required
return 50
 Capital Budgeting: Limitations

 Management preferences regarding

timing of cash flows are not included
 Single, deterministic measures of cash
flow are used rather than probabilities

51
 Payback

Assumptions Limitations
 Speedy recovery of  Ignores cash flows
investment is key after payback
 Cash flows can be  Ignores time value
accurately predicted of money
 Risk is lower for the
shorter payback
project

52
 Net Present Value
Assumptions Limitations
• Discount rate is valid • Alternative project
• Timing and size of cash rates of return are
flows can be predicted not known
• Life of project can be • Internal rate of
predicted return on project is
not reflected

53
 Profitability Index
Assumptions Limitations
• Measures efficient use of • A relative answer is
capital given but pesos of NPV
• Discount rate is valid are not reflected
• Timing and size of cash • Alternative project rates N
N flows can be predicted of return are not known
P• P
Life of project can be • Internal rate of return on
V project is not reflected V
predicted
 Internal Rate of Return (IRR)
Assumptions Limitations
• Hurdle rate is valid • Projects are ranked by
• Timing and size of cash IRR and not peso size
flows can be predicted • Net present value
• Project life can be pesos are not reflected
predicted • Multiple rates of return
• If shorter project can be calculated on
selected, proceeds of the same project
shorter project will
continue to earn the
IRR through theoretical
completion of longer
project
 Comparing Techniques
Payback NPV PI IRR
 Uses time value money N Y N? Y
Y or Y
 Provides specific rate of return N N N? N
Y or Y
 Uses cash flows Y Y N? Y
Y or Y
 Considers all returns N Y N? Y
Y or Y
 Uses discount rate N Y N? Y
Y or N

56
problem solving: ARR

 The Arrival, Inc., is planning to spend

P600,000 for a machine that it will depreciate
on a straight-line basis over a ten-year period
with no terminal disposal price. The machine
will generate cash flow from operations of
P120,000 a year. Ignoring income taxes, what
is the accounting rate of return?

 Answer: 40%

57
problem solving: ARR and payback
 Ellis & Associates operates a rehabilitation center for individuals
with physical disabilities. The company is considering the
purchase of a P1,200,000 piece of equipment that has a five-
year life and no salvage value. The company depreciates assets
on a straight-line basis. The expected annual cash flow on a
before-tax basis for this equipment is P400,000. Ellis requires
that an investment be recouped in less than five years and have
a pre-tax accounting rate of return of at least 18 percent.
a. Compute the accounting rate of return.

b. Compute the payback period.

c. Accept or reject?

 Answers:
a. ARR = P160,000 ÷ (P1,200,000 ÷ 2) = 26.67%
b. Payback = P1,200,000 ÷ P400,000 per year = 3 years
c. Accept.
58
problem solving: ARR and payback
 Fashion Foto is evaluating the purchase of a state-of-the-art desktop
publishing system that costs P40,000, has six-year life, and has no
salvage value at the end of its life. The company’s controller estimates
that the system will annually generate P14,000 of cash receipts and
create P2,000 of cash operating costs. The company’s tax rate is
expected to be 30 percent during the life of the asset, and the company
uses straight-line depreciation.
a. Determine the annual after-tax cash flows from the project.
b. Determine the after-tax payback period for the project.
c. Determine the after-tax ARR for the project.
 Answers:
a. Annual cash receipts P14,000
Cash expenses (2,000)
Net cash flow before taxes 12,000
Depreciation (6,667)
Income before tax 5,333
Taxes (1,600)
Net income 3,733
Depreciation 6,667 59

Annual after-tax cash flow P10,400

problem solving: ARR and payback
 Fashion Foto is evaluating the purchase of a state-of-the-art desktop
publishing system that costs P40,000, has six-year life, and has no
salvage value at the end of its life. The company’s controller estimates
that the system will annually generate P14,000 of cash receipts and
create P2,000 of cash operating costs. The company’s tax rate is
expected to be 30 percent during the life of the asset, and the company
uses straight-line depreciation.
a. Determine the annual after-tax cash flows from the project.
b. Determine the after-tax payback period for the project.
c. Determine the after-tax ARR for the project.

 Answers:
b. Payback = P40,000 ÷ P10,400 per year = 3.85 years
c. ARR = P3,733 ÷ (P40,000 ÷ 2) = 18.66%

60
problem solving: ARR and payback
 The Mais Company has invested in a machine that
cost P70,000, that has a useful life of seven years,
and that has no salvage value at the end of its useful
life. The machine is being depreciated by the straight-
line method, based on its useful life. It will have a
payback period of four years. Given these data, the
simple rate of return based on initial investment (to
the nearest tenth of a percent) on the machine will be
(ignore taxes)

Answer: 10.7%

61
problem solving: Payback
Resnick Inc. is considering a project that has the
following cash flow data. What is the project's
payback?

Year 0 1 2 3
Cash flows -$350 $200 $200 $200

a. 1.42 years
b. 1.58 years
c. 1.75 years
d. 1.93 years
e. 2.12 years

62
problem solving: Payback
Susmel Inc. is considering a project that has the
following cash flow data. What is the project's
payback?

Year 0 1 2 3
Cash flows -$500 $150 $200 $300

a. 2.03 years
b. 2.25 years
c. 2.50 years
d. 2.75 years
e. 3.03 years

63
problem solving: Payback
Fernando Designs is considering a project that has the
following cash flow and WACC data. What is the
project's discounted payback?

WACC: 10.00%
Year 0 1 2 3
Cash flows -$900 $500 $500 $500

a. 1.88 years
b. 2.09 years
c. 2.29 years
d. 2.52 years
e. 2.78 years

64
problem solving: Payback
Masulis Inc. is considering a project that has the
following cash flow and WACC data. What is the
project's discounted payback?

WACC: 10.00%
Year 0 1 2 3 4
Cash flows -$950 $525 $485 $445 $405

a. 1.61 years
b. 1.79 years
c. 1.99 years
d. 2.22 years
e. 2.44 years

65
problem solving: NPV
Anderson Systems is considering a project that has the
following cash flow and WACC data. What is the
project's NPV? Note that if a project's projected NPV is
negative, it should be rejected.

WACC: 9.00%
Year 0 1 2 3
Cash flows -$1,000 $500 $500 $500

Answer: P265.65

66
problem solving: NPV
Tuttle Enterprises is considering a project that has the
following cash flow and WACC data. What is the
project's NPV? Note that if a project's projected NPV is
negative, it should be rejected.

WACC: 11.00%
Year 0 1 2 3 4
Cash flows -$1,000 $350 $350 $350 $350

Answer: P85.86

67
problem solving: NPV
Last month, Lloyd's Systems analyzed the project whose cash
flows are shown below. However, before the decision to accept or
reject the project, the Federal Reserve took actions that changed
interest rates and therefore the firm's WACC. The Fed's action did
not affect the forecasted cash flows. By how much did the change
in the WACC affect the project's forecasted NPV? Note that a
project's projected NPV can be negative, in which case it should be
rejected.

Old WACC: 10.00% New WACC: 11.25%

Year 0 1 2 3
Cash flows -$1,000 $410 $410 $410

a. -$18.89
b. -$19.88
c. -$20.93
d. -$22.03
e. -$23.13
68
problem solving: NPV
Lasik Vision Inc. recently analyzed the project whose cash flows
are shown below. However, before Lasik decided to accept or
reject the project, the Federal Reserve took actions that changed
interest rates and therefore the firm's WACC. The Fed's action did
not affect the forecasted cash flows. By how much did the change
in the WACC affect the project's forecasted NPV? Note that a
project's projected NPV can be negative, in which case it should be
rejected.

Old WACC: 8.00% New WACC: 11.25%

Year 0 1 2 3
Cash flows -$1,000 $410 $410 $410

a. -$59.03
b. -$56.08
c. -$53.27
d. -$50.61
e. -$48.08
69
problem solving: IRR
Simms Corp. is considering a project that has the
following cash flow data. What is the project's IRR?
Note that a project's projected IRR can be less than the
WACC or negative, in both cases it will be rejected.

Year 0 1 2 3
Cash flows -$1,000 $425 $425 $425

a. 12.55%
b. 13.21%
c. 13.87%
d. 14.56%
e. 15.29%

70
problem solving: IRR
Warr Company is considering a project that has the
following cash flow data. What is the project's IRR?
Note that a project's projected IRR can be less than the
WACC or negative, in both cases it will be rejected.

Year 0 1 2 3 4
Cash flows -$1,050 $400 $400 $400 $400

a. 14.05%
b. 15.61%
c. 17.34%
d. 19.27%
e. 21.20%

71
problem solving: comprehensive
A firm is considering two projects, A and B. Both have the same initial cash
outlay and the same payback period. Project A is expected to generate
after-tax cash flows for 10 years, while Project B is expected to generate
after-tax cash flows for 15 years. Given that payback is the same for both
projects, will the firm be indifferent between these two projects? Explain
why or why not.

Answer:

According to the payback period, both projects are equal in terms of

breaking even at the same point in time. However, Project B would be the
preferred project as it has cash inflows for five years beyond the payback
period. Thus, Project B will have a higher NPV than Project A.

72
problem solving: comprehensive
A company is reviewing an investment proposal whose initial cost and
related data for each year, are presented in the following schedule. All
cash flows are assumed to take place at the end of the year. The salvage
value of the investment at the end of each year is equal to its net book
value, and there will be no salvage value at the end of the investment’s life.

Annual
Initial Cost Net After-Tax Annual
Year and Book Value Cash Flows Net Income
0 P105,000 P -0- P -0-
1 70,000 50,000 15,000
2 42,000 45,000 17,000
3 21,000 40,000 19,000
4 7,000 35,000 21,000
5 -0- 30,000 23,000

The company uses a 24% after-tax target rate of return for new investment
proposals. Round off PV factors to two decimal places.

The traditional payback period for the investment proposal is

Answer: 2.25 73
problem solving: comprehensive
A company is reviewing an investment proposal whose initial cost and
related data for each year, are presented in the following schedule. All
cash flows are assumed to take place at the end of the year. The salvage
value of the investment at the end of each year is equal to its net book
value, and there will be no salvage value at the end of the investment’s life.

Annual
Initial Cost Net After-Tax Annual
Year and Book Value Cash Flows Net Income
0 P105,000 P -0- P -0-
1 70,000 50,000 15,000
2 42,000 45,000 17,000
3 21,000 40,000 19,000
4 7,000 35,000 21,000
5 -0- 30,000 23,000

The company uses a 24% after-tax target rate of return for new investment
proposals. (Round off PV factors to two decimal places.)

The ARR using the initial investment is

Answer: 18.1% 74
problem solving: comprehensive
A company is reviewing an investment proposal whose initial cost and
related data for each year, are presented in the following schedule. All
cash flows are assumed to take place at the end of the year. The salvage
value of the investment at the end of each year is equal to its net book
value, and there will be no salvage value at the end of the investment’s life.

Annual
Initial Cost Net After-Tax Annual
Year and Book Value Cash Flows Net Income
0 P105,000 P -0- P -0-
1 70,000 50,000 15,000
2 42,000 45,000 17,000
3 21,000 40,000 19,000
4 7,000 35,000 21,000
5 -0- 30,000 23,000

The company uses a 24% after-tax target rate of return for new investment
proposals. (Round off PV factors to two decimal places.)

The NPV of the investment proposal is

Answer: P10,450 75
 The Investment Decision

 Is the activity worthy of an investment?

 Which assets can be used for the activity?
 Of the available assets for each activity,
which is the best investment?
 Of the “best investments” for all worthwhile
activities, in which ones should the company
invest?

Consider Quantitative and Qualitative Factors

76
 True or False

 A firm should never accept a project if its

acceptance would lead to an increase in the
firm's cost of capital (its WACC).
 F

77
problem solving: project ranking
Automobile Corp. is contemplating four projects: A, B, C, and D. The capital costs
for the initiation of each mutually-exclusive project and its estimated after-tax, net
cash flows are listed below. The company’s desired after-tax opportunity costs is
12%. It has P900,000 capital budget for the year. Idle funds cannot be reinvested at
greater than 12%.
In Thousand Pesos
A B C D
Initial cost 400 470 380 420
Annual cash flows
Year 1 113 180 90 80
Year 2 113 170 110 100
Year 3 113 150 130 120
Year 4 113 110 140 130
Year 5 113 100 150 150
Net present value P7,540 P59,654 P54,666 P(15,708)
IRR 12.7% 17.6% 17.2% 10.6%
Excess present value index 1.02 1.13 1.14 0.96
78
The company will choose
 True or False

 Conflicts between two mutually exclusive

projects occasionally occur, where the NPV
method ranks one project higher but the IRR
method puts the other one first. In theory,
such conflicts should be resolved in favor of
the project with the higher NPV.
 T

79
Conflicts Between NPV, IRR, MIRR,
Profitability Index

 Different rankings may occur if projects

are mutually exclusive.
 Most likely happens when projects have
different cash flow patterns
– Projects with larger and earlier cash flows
may have higher IRR rankings than those
with larger later cash flows

80
Conflicts Between NPV, IRR, MIRR,
Profitability Index
 Different time horizons
– Project Long and Project Short require
P100 investment
– Short: returns P200 in 2 years
• IRR = 41.42%
• NPV (at 10% required return) = P65.29
– Long: returns P2,000 in 20 years
• IRR =16.16%
• NPV (at 10% required return) = P197.29

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 Conflicts Between NPV, IRR, MIRR,
Profitability Index
 Different Sizes
– Projects with smaller initial investments may have
higher IRR and higher PI and smaller NPV than
projects with larger initial investments.

Initial PV of Cash Profitability

Project Outlay Cash Flows NPV Index
Small P100 P150 P50 1.5
Large 1,000 1,100 P100 1.1
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Conflicts Between NPV, IRR, MIRR,
Profitability Index
 NPV is the best measure as it measures the
absolute peso change in shareholder wealth.
 The others are relative measures of project
attractiveness.

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 What Managers Use

 75% of CFOs used NPV, IRR or both to

evaluate projects
 IRR is most popular
 Over half still use payback as a
secondary or supplementary method of
analysis

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 Risk-related Considerations

 Expected return/risk tradeoff

 Higher (lower) than average risk

projects should have a higher (lower)
than average discount rate

85
 Risk-related Considerations

 Required return on average risk project

= firm’s cost of capital, or cost of
financing
 For average risk projects, use this
number as the discount rate (NPV, PI)
or the minimum required rate of return
(IRR)

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 Risk-adjusted Discount Rate

Adjust the project’s discount rate up or

down from the firm’s cost of capital for
projects of above-average or below-
average risk

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 An Example
Average risk:
Discount rate = cost of capital
Below-average risk:
Discount rate = cost of capital –2%
Above-average risk:
Discount rate = cost of capital + 2%
High risk:
Discount rate = cost of capital + 5%
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End