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CB-1
Define CAPITAL BUDGETING

It is the process of identifying, evaluating, planning and financing capital investment projects of an entity.
It is important because more than anything else, fixed asset investment decisions chart a company’s course for the
future.

CAPITAL BUDGETING PROCESS involves the:

1. generation of investment proposals
2. estimate the cash flows for the proposals
3. evaluation of cash flows
4. selection of projects based on acceptable criteria
5. continued re-evaluation of investment projects after their acceptance

Conceptually, the capital budgeting process is identical to the decision process used by individuals making
investment decisions.

Six Stages of a Capital Budgeting Project

1. Identification stage, in which a firm determines which types of capital investments are necessary to
accomplish organization objectives and strategies.
2. Search stage, in which a firm explores alternative capital investments that will achieve the firm’s objectives.
3. Information-acquisition stage in which a firm considers the expected costs and benefits of alternative capital
investments.
4. Selection stage, in which a firm chooses projects for implementation.
5. Financing stage in which a firm obtains project funding.
6. Implementation and control stage in which a firm starts the projects and monitors their performance

No business firm can survive for long without making sound capital investments. No governmental organization
can provide good services to its constituents without intelligent capital investments. Investments that involve major
technology change are more likely initiated at the top management level. In analyzing capital investments, the
primary focus is in cash flows. Cash outflows in investments occur at 3 stages:

1. Project Initiation : to acquire the investment and begin operations, to provide its working capital, and to
dispose of the replaced or discarded assets;
2. Project Operation : to cover operating expenditures and any additional investments & to provide additional
working capital; and
3. Final Project Disposal: to dispose of the investment, to restore facilities, and to provide training or relocation
for personnel whose positions have been terminated.

Basic Principles in CAPITAL BUDGETING

1. Capital investment models are focused on the future cash inflows and outflows rather than on net income.
2. Investment proposals should be evaluated according to their differential effects on the company's cash flows as
a whole.
3. Financing costs associated with the project are excluded in the analysis of incremental cash flows in order to
avoid the "double-counting" of the cost of money.
4. The concept of the time value of money recognizes that a peso of present return is worth more than a peso of
future return.
5. Choose the investments that will maximize the total NPV of the projects subject to the capital availability
constraint.

Capital budgeting decision is a key factor in the long-run profitability of a firm. This is true in situations where a firm
has only limited investment funds available but has unlimited investment opportunities to choose from. The long-
run profitability of the firm will depend on the skill of the manager in choosing those uses for limited funds that will
provide the greatest return.

Capital budgeting involves comparing and evaluating alternative projects. Financial managers assisted by cost
accountants are responsible for analyzing alternative investment opportunities. They apply quantitative criteria
(such as ARR or ROI, PP, DPP or breakeven time, NPV, IRR, PI) as well as qualitative criteria (such as employee
morale, employee safety, employee responsibility, corporate image, social responsibility, market share, growth,
strategic planning, sustainability) to evaluate the feasibility of alternative projects. Most firms evaluate projects
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using multiple criteria so that managers can be confident that they have carefully considered all project costs and
benefits.

Define a Capital Investment

A capital investment involves a current commitment of funds with the expectation of generating a satisfactory
return on these funds over a relatively extended period of time in the future.

Distinctions between physical life vs. economic life

The PHYSICAL LIFE of an asset is the length of time it will physically operate while the ECONOMIC LIFE of an
asset refers to the length of time it will provide service benefits to a given user or users. Economic life is usually
shorter than the physical life of the asset.

Characteristics of a Capital Investment Decision

1. Usually involves big capital outlay.
2. Involves long-term commitment of resources invested in a project.
3. Degree of risk is relatively high because of uncertainty.
4. Decisions are difficult to reverse once they are made.
5. In some cases, success or failure of the company may depend upon the single or relatively few investment
decision.

Financing Decision vs. Investment Decision

A financing decision involves choices regarding the method of raising capital to fund an investment. Financing is
based on an entity’s ability to issue and service debt and equity securities. Assignment of financing costs to a
specific project is often arbitrary, which causes problems in comparing projects that are acquired with different
financing sources. The company’s treasurer in conjunction with top management typically makes financing
decisions.

An investment decision is a judgment about which assets to acquire to accomplish an entity’s mission.
Management must justify an asset’s acquisition and use before justifying the method of financing that asset.
Divisional managers or top managers with input from divisional managers, make investment decisions.

Broad Categories of Capital Budgeting Decisions:

1. Screening Decisions are those relating to whether a proposed project meets some present standard of
acceptance.

2. Preference Decisions are those that relate to selecting from among several competing courses of action.

CATEGORIES OF CAPITAL INVESTMENTS

Three (3) general types of capital projects are:

* INDEPENDENT PROJECTS

These are the projects whose cash flows are not affected by the acceptance or non-acceptance of other projects.
Such projects are evaluated individually and reviewed against predetermined corporate standards of acceptability.
Examples are:
1) investment in LtA such as property, plant, and equipment
2) new product development
3) undertaking a large scale advertising campaign
4) introduction of a computer
5) corporate acquisitions (such as purchase of shares as subsidiaries or affiliates)

* MUTUALLY EXCLUSIVE PROJECTS

It refers to a set of projects where only one can be accepted. Such projects will require the company to choose
among competing alternatives that provide the same basic service. They must pass the criteria of acceptability set
by the company. When projects are mutually exclusive it means that they do the same job. Examples are:
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1) replacement against renovation of equipment or facilities

2) rent or lease against ownership of facilities
3) manual bookkeeping system against computerized system
4) preventive maintenance against periodic overhaul of machineries
5) purchase of machinery from an outside supplier against assembly of machinery by the company's own
staff. Research and development may be initiated to improve company methods or products.

*MUTUALLY INCLUSIVE PROJECTS

If a primary project is chosen, all related projects are also selected. Alternatively, rejection of the primary project
will dictate rejection of the others. For example: when a firm chooses to invest in new technology, investing in an
employee training program for the new technology may also be necessary.

OTHER TYPES OF CAPITAL INVESTMENTS:

 Investments mandated by law or policy

This includes investments made to comply with environmental, safety and other laws and regulations. It
also includes investments made because company policy so dictates.

 Investments made to further strategic goals

This is composed of investments made for such purposes as securing global distribution of products,
increasing quality and reducing lead time.

 Investments to increase capacity or reduce costs

These investments aim at increasing profitability.

 Investments made for non-financial reasons

Such decisions cannot show objective measures of profitability sufficient to justify such investments,
though indirect, intangible benefits might be very high. The decision revolves around how to accomplish
the desired result, for example, what equipment to purchase for the fitness center or for the cafeteria.

Major Classifications of Projects Based on Purpose:

1. REPLACEMENT PROJECTS - those involving replacements of worn-out assets to avoid disruption of normal
operations, or to improve efficiency.

2. PRODUCT or PROCESS IMPROVEMENT - projects that aim to produce additional revenue or to realize
cost savings.

3. EXPANSION - projects that enhance long-term returns due to increased profitable volume.

TYPICAL CAPITAL BUDGETING DECISIONS:

1. COST REDUCTION DECISIONS
Should new equipment be purchased in order to reduce costs?

2. PLANT EXPANSION DECISIONS

Should a new plant, warehouse, or other facility be acquired in order to increase capacity and sales?

3. EQUIPMENT SELECTION DECISIONS

Which of the 3 machines would be most cost effective?

4. LEASE OR BUY DECISIONS

Should new plant facilities be leased or purchased?

5. EQUIPMENT REPLACEMENT DECISIONS

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Should old equipment be replaced now or later?

What is the difference between investments in Working Capital and in plant assets?

At the end of its useful life, a plant asset is almost always worth less than its cost whereas, WC investments are
typically recovered in full, or nearly so, because the higher receivables and inventory will be turned into cash
during the final operating cycle in the life of the project. In the final year of a project, the expectation of reduced
sales reduces inventory, thereby reducing purchases, which in turn reduces the amount of cash needed to pay for
purchases and frees such cash for other uses.

Distinguish between a return of capital vs. a return on capital

A return of capital is the recovery of the original investment or the return of principal whereas a return on capital is
income and equals the discount rate multiplied by the investment amount.

Example: P1 investment in a project yields a 10% rate of return. This will grow to a sum of P 1.10 in one year.
Of
the P 1.10, P 1 represents the return of capital and P 0.10 represents the return on capital.

ELEMENTS OF CAPITAL BUDGETING

or 3 FACTORS IN THE EVALUATION OF INVESTMENT ALTERNATIVES

1. Net Investment or Project Cost

This is the Net Additional Cash Outlay required to obtain future returns. For decision making purposes, the NET
INVESTMENT is not necessarily the cost that would be entered in the accounting records. It is generally the
net cash outflows to support a capital project.

2. Annual Net Cash Inflows (ANCI)

These are the cash inflows expected from a project as reduced by the cash costs that can be directly attributed
to the project. In some projects, the returns are measured in the form of cost savings.

3. Cost of Capital

This is the minimum acceptable rate of return employed in the project or the return that could be earned on
such capital if invested in some other projects or profitable ventures.

SAVINGS OR CASH INFLOW:

1. Trade-in value of old asset (in case of replacement)

2. Proceeds from sale of old asset to be disposed due to the acquisition of the new project (less applicable tax in
case there is gain on sale or add tax savings in case there is loss on sale).
3. Avoidable cost of repairs net of tax.

All the quantitative criteria except the ARR, focus on cash flows. Cash returns or cash inflows include cash
revenues, savings in cash operating costs, and any cash inflow from selling the asset at the end of its useful life (or
salvage value). Cash outflows include asset acquisition expenditures, incremental or additional cash invested in
working capital and cash costs of project-related DM, DL and overhead.

Cash flows from a capital project are received and paid at different points in time over the project’s life. Some cash
flows occur at the beginning of a period, some during the period, and others at the end of the period. To simplify
capital budgeting analysis, most analysts assume that all cash flows occur at a specific, single point in time;
typically, either at the beginning or end of the time period in which they actually occur. The cash flow information
can be illustrated through the use of a time line. A time line visually illustrates the points in time when projected
cash flows are received or paid, making it a helpful tool for analyzing cash flows of an investment proposal.
Example:

End of Period 0 1 2 3 4 5 6 7
Inflows - 0 - P2,700, P2,900, P3,200, P3,900, P4,200, P2,100, P1,000,
Outflows (13,500,) (500,) (300,) (0) (0) (0) (0) (0)
Net Cash Flow (13,500,) 2,200, 2,600, 3,200, 3,900, 4,200, 2,100, 1,000,
====== ===== ===== ==== ===== ===== ===== =====
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On a time line, the date of initial investment represents time point 0, which marks the start of the cash flows
pertaining to a project. Each year after the initial investment is represented as a full time period; periods serve only
to separate the timing of cash flows. Nothing is presumed to happen during a period. For example, cash sales are
shown as occurring at the end of, rather than during, the time period. A less conservative assumption would show
the cash flows occurring at the beginning of the period.

What is the difference between normal and nonnormal cash flows?

Projects with normal cash flows have outflows, or costs, in the first year or years followed by a series of inflows.
Projects with non-normal cash flows have one or more outflows after the inflow stream has begun.

Determining Future Cash Flows

In evaluating investment alternatives, determine the future cash flows that are relevant to the decision. Relevant
cash flows are those that are expected to differ among the alternatives. Examples of relevant cash flows include:
1. the initial investment in long-term tangible or intangible assets for each investment alternative
2. any initial investment in working capital for each investment alternative
3. cash flow from the sale of any assets being replaced
4. differences in cash flows from operations under the alternatives (e.g. cash inflows from sales and/or cash
outflows for operating costs)
5. cash flows at the end of the expected life of the project:
 Terminal disposal price of any long-term tangible or intangible assets. The tax gain or loss will generate a
tax inflow or outflow.
 Recovery of any working capital investment. This investment will be recovered at the end of the project by
liquidation of inventories, accounts receivable, etc. There are generally no tax implications of this recovery
because it is assumed that the cash received will be equal to the BV of the working capital items.

In case of replacement projects, the book value of asset to be replaced is not included in the computation of NET
INVESTMENT because it is a sunk cost, therefore irrelevant. It is the responsibility of the management accountant
and the consultant to see to it that management is presented with the most useful information about each project,
so decisions are based not on guess work but on justifiable calculations. In practice it is usual to apply more than
one technique in calculating the profitability of individual projects. Intangible benefits are sometimes difficult or
impossible to quantify or even to estimate. But estimation of benefits and costs often help in selecting from among
the alternatives.

TIME VALUE OF MONEY

Money received today is worth more than the same amount of money received at a future date such as a year from
now. This principle is known as the TIME VALUE OF MONEY. Money has a time value because of investment
opportunities not because of inflation. Consider the time value of money because of the lag between spending cash
and receiving cash. The time value of money is an opportunity cost; by making a particular investment now, we
give up the opportunity to make other investments.

Future value (FV) refers to the amount to which one or more sums of money invested at a specified interest rate
will grow over a specified number of time periods.

Present value (PV) is the amount that one or more future cash flows are worth currently, given a specified rate of
interest. Thus, future and present values depend on three things: (1) amount of the cash flows, (2) rate of interest,
and (3) timing of the cash flow.

In computing future and present values, simple or compound interest can be used. Simple interest means that
interest is earned only on the original investment or principal amount. Compound interest means that interest
earned in prior periods is added to the original investment so that in each successive period, interest is earned on
both principal and earned interest. The time between each interest computation is called the compounding period.
The more often interest is compounded, the higher the actual rate of interest being received relative to the stated
rate.

Interest rates are typically stated in annual terms. To compensate for compounding periods occurring
more often, multiply the number of years to the number of compounding periods per year. For example,
if 14% interest is to received each year for five years and the compounding period is semiannually,
the effective rate per compounding period is 7% and the number of interest periods would be ten.

PRESENT VALUE CONCEPT

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The process of computing the present value of future cash flows is referred to as Discounting. Discounting means
reducing future cash flows by removing the portion of the future values representing interest. After discounting, all
future values associated with a project are stated in a common base of current peso amounts known as present
value. Cash receipts and disbursements occurring at the beginning of a project (time 0) are already stated in their
present values and are not discounted.

Future and present values are distinctly related. A present value amount is simply a future value discounted back
the same number of periods at the same rate of interest. The rate of return used in present value computations is
called the discount rate.

In theory, if future cash flows are known with certainty, the correct discount rate is a firm's cost of capital. In
practice, future cash flows are uncertain, and managers often choose a discount rate higher than the cost of capital
to deal with that uncertainty.

An annuity is a series of equal payments over a specified number of periods. The difference between an
"ORDINARY ANNUITY" and a " ANNUITY DUE" is that the ordinary annuity assumes that the payments are made
at the end of the period (or in arrears), and an annuity due assumes that the payments are made at the beginning
of the period (or in advance).

Assume that Mr. Edu Yan knows that his bank pays interest at 12% per year compounded semiannually. He wants
to have P1,418 in three years and wants to know what amount to invest now. The following formula is used to
solve for the present value:

PV = FV/(1+i) n
PV = present value of a future amount
Where FV = future of a current investment
n = number of compounding period
i = interest rate per compounding period

Substituting known-value into the formula gives the following:

PV = P1,418 [1/(1+0.06)6]
PV = P1,418 [1/(1.4180)]
PV = P1,000

A distinction must be made between cash flows representing a return of capital and those representing a return on
capital. A return of capital is the recovery of the original investment or the return of principal while a return on
capital is income and equals the discount rate multiplied by the investment amount. For example, P1.00 invested
in a project that yields a 10% rate of return will grow to a sum of P1.10 in 1 year. Of the P1.10, P1.00 represents
the return of capital and P0.10 represents the return on capital. The return on capital is computed for each period
of the investment life.

CAPITAL RATIONING

Refers to the process by which management allocates available investment funds among competing capital
investment proposals. When capital rationing exists, the selection of investment projects must fall within the capital
budget limit.

In capital rationing, an initial screening of alternative proposals is usually done by establishing minimum standards
for the payback and the average rate of return methods. The proposals that survive this initial screening are
subjected to the more rigorous net present value and internal rate of return methods of analysis. The proposals
that survive this final screening are evaluated in terms of qualitative factors, such as employee morale.

For example, the acquisition of new, more efficient equipment which eliminates several jobs could lower employee
morale to a level that could decrease overall plant productivity.

The final step in the capital rationing process is to rank the proposals according to management's criteria, and to
compare the proposals, with the funds available to determine which proposals will be funded. The unfunded
proposals are reconsidered if funds subsequently become available.

Distinguish between SOFT RATIONING and HARD RATIONING

Soft Rationing is the situation that occurs when units in a business are allocated a certain amount of financing
for capital budgeting. If we face soft rationing, the first thing to do is try and get a larger allocation. So within the
existing budget, choose those projects with the largest benefit-cost ratio or PI.
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Hard Rationing is the situation that occurs when a business cannot raise financing for a project under any
circumstances. If we face hard rationing, then we are not going to take a new project. Hard rationing can occur
when a company experiences financial distress, meaning that bankruptcy is a possibility.

POSTAUDIT OF INVESTMENT PROJECTS

This means a follow-up after the project has been approved to see whether or not expected results are actually
realized. This should be conducted after the project has stabilized rather than shortly after start-up. This is a key
part of the capital budgeting process as it provides management with an opportunity, over time, to see how realistic
the proposals are that are being submitted and approved. It also provides an opportunity to reinforce successful
projects as needed, to strengthen or perhaps salvage projects that are encountering difficulty, to terminate
unsuccessful projects before losses become too great, and to improve the overall quality of future investment
proposals.

In performing a post audit, the same technique should be used as was used in the original approval process. So if
a project was approved based on NPV analysis, then the same procedure should be used in performing the post
audit. However, the data going into the analysis should be actual data. This will provide management to make a
side-by-side comparison to see how well the project has worked out. It also helps assure that estimated data
received on future proposals will be carefully prepared, since the persons submitting the data will know that their
estimates will be given careful scrutiny in the post audit process. Actual results that are far out of line with original
estimates should be carefully reviewed by management, and corrective action taken as necessary. In accordance
with the management by exception principle, those responsible for the original estimates should be required to
provide a full explanation of any major differences between estimated and actual results.

To summarize, postinvestment audit is conducted to compare actual project performance against

expected performance to:
 evaluate the accuracy of original projections;
 diagnose problems with implementation
 assess credibility of project sponsors’ information.
They should be done in greater depth for high-value investment projects using the same technique/s
originally used to determine project acceptance.

Basic Concepts of Capital Budgeting Techniques

PP NPV PI IRR ARR

Uses time value of money? No Yes Yes Yes No

Indicates a specific rate of return? No No No Yes Yes

Uses cash flow? Yes Yes Yes Yes No

Considers returns during life of the project? No Yes Yes Yes Yes

Uses discount rate in calculation? No Yes Yes No* No*

*Discount rate is not used in the calculation, but it can be used as the hurdle rate.

RETURN ON INVESTMENT (ROI)

Advantages
1. It is simple to operate and easy to understand.
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2. It considers the profit of a project throughout its working life.

3. It acts as a yardstick when comparing the profitability of two or more projects or it is used as a rough
preliminary screening device of investment proposals.
Disadvantages
1. It ignores the fact that profits from different projects may accrue at an uneven rate or it does not consider the
timing component of cash inflows.
2. It is difficult to assess a fair rate of return on capital employed. It does not consider the timing component of
cash inflows.
3. Different averaging techniques may yield inaccurate answers.
4. It ignores the time value of money by failing to discount the future cash inflows and outflows.

PAYBACK PERIOD (PP)

We calculate the payback by developing the cumulative cash flows. Payback represents a type of breakeven
analysis. It tells us when the project will breakeven in a cash flow sense. Whether the two projects are
independent or mutually exclusive makes no difference in this case.

PP evaluates only the rapidity with which an investment will be recovered. A project would not be acceptable if the
PP exceeded the life of the project. A firm may set a limit on the PP beyond which an investment will not be
made. The payback method does not indicate the profitability of the investment. If 2 investments promise equal
total returns, so the one that generates the returns more quickly is more desirable.

PP can be a rough screening device for investment proposals because a relatively long payback period will usually
mean a low rate of return. It is also useful as a measure of risk because in general, the longer it takes to get your
money back, the more risky that the money will not be returned. As the time horizon lengthens, more uncertainties
arise. Inflation might ease, or it might get worse; interest rates could rise, or they could fall; new techniques might
be developed that would make the investment obsolete. The faster that capital is returned from an investment, the
more rapidly it can be invested in other projects.
Advantages:
1. It is simple to compute and easy to understand.
2. It shows how soon the purchase cost on assets will be recovered or it is used to select projects which provide a
quick return of invested funds or cash, thus placing an emphasis on liquidity.
3. Because the method considers only the years in which cost is recovered, estimates are not based on very long
periods of time and so, tend to be relatively more accurate than other method in which the total life of the asset
is considered.
4. This short term approach reduces the loss through obsolescence.
5. It offers a possible indicator of the degree of risk of each investment. It is used to measure the degree of risk
associated with a project. Generally, the longer the PP, the higher the risk.
6. It acts as a yardstick in comparing the profitability of two or more projects.
7. It is a widely used method that is certainly an improvement over a hunch, rule of thumb, or intuitive method.

Disadvantages
1. It considers only the recovery of purchase costs, not profits earned during the working life of the asset.
2. It ignores the fact that profits from different projects may accrue at an uneven rate. Thus a project which earns
profit quickly, early in its life, may be considered a more profitable investment than another machine which
earns profit slowly at first but at an accelerated rate later in its working life.
3. It does not recognize the time value of money.
4. It ignores the impact of cash inflows after the payback period.
5. The conventional payback computation fails to consider salvage value, if any.
6. It does not measure profitability-only the relative liquidity of the investment.
7. It does not distinguish between alternatives having different economic lives.
8. It stresses the importance of converting capital into cash which may be unimportant in assets with a long
working life.
DISCOUNTED CASH FLOW (DCF) METHOD
Advantages
1. The discounted cash flow calculations reveal not only the payback period, but also the profit accruing from
the project. Income over the entire life of the project is considered.
2. It reveals the estimated cash flow during the life of the asset and related the discounted value of future proceeds
in terms of current periods. It is more reliable because the value of money is taken into account.
3. It serves as a guide to management in its decisions as to how much capital may be invested profitably in a
project.

4. It considers the net cash flow as representing the recovery of the original investment plus a return on capital
employed.
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5. It overcomes the disadvantages of the payback and ROI methods. It is more objective and relevant because
it focuses on cash flow.

Disadvantages
1. It is difficult to determine a reasonable rate of interest. It is not easily understood.
2. The period during which the asset is expected to earn revenue is included in the discounted cash flow
calculation, but it is difficult to forecast the life of an asset with any degree of accuracy.
4. Too many refinements are introduced into what must necessarily be an exercise which includes numerous
uncertainties. It is more complex and difficult to apply.
4. It requires detailed long-term forecasts of incremental cash flow data.
5. It requires pre-determination of the cost of capital or the discounted rate to be used.

Net Present Value (NPV) Method

Advantages:
1. It is easy to apply even when the cash inflows are not uniform.
2. Due recognition is given to risk and uncertainty and their corollary the fact that money due in the future is not
worth its face value in the present.
3. It shows the true relative profitability by comparing the present value of the accumulated profit in "n" years,
with the capital employed.
4. It considers the time value of money.
5. It considers cash flow over the entire life of the project.
Disadvantages:
1. It requires the selection of an interest rate to be used in calculating the present value of the inflows.
2. No general agreement on how the rate should be set has been reached, and no simple rules can be laid down.
3. The rate tends to be highly subjective and is generally a matter of judgment rather than a mathematical formula.
4. It does not provide a clear means of ranking investments in the order of their profitability if different
investments are being considered.
5. Some argue that this method is too difficult to compute and to understand.

Multiple Projects

The NPV method evaluates investment proposals in peso amounts while the IRR method evaluates investment
projects in percentages or rates. The NPVs from multiple projects can be added to arrive at a single total NPV for
all investments that a firm will invest as a package while percentages or rates of return on multiple projects cannot
be added. The total NPV of independent projects is the simple sum of these projects’ NPVs. If the NPV of a P
120,000 investment is P 35,000 and the NPV of a P 50,000 investment in another independent project is P 20,000,
the total NPV of investing P 170,000 in these 2 projects is P 55,000, the sum of the 2 net present values. The
additivity of net present values makes evaluating multiple investments easy.

IRR of different investments cannot be added to determine the overall IRR of the multiple projects. Investments of
P 120,000 in one project that earns a 10% rate of return and P 50,000 in another project that earns a 15% rate of
return do not make 25% the rate of return from the entire P 170,000 investment. A change in the composition of
projects being considered requires a complete recalculation of the overall IRR. IRR is likely to favor projects with
long useful lives.
Comparison of NPV and IRR Methods
NPV IRR
* Not meaningful for comparing projects with different * Easy to compare projects with different amounts
amounts of initial investments of initial investments
----------------------------------------------------------------------------------------------------------------------------------------------
* NPVs of multiple projects are additive * IRRs of multiple projects are not additive
----------------------------------------------------------------------------------------------------------------------------------------------
* Assumes that cash proceeds can be reinvested to earn * Assumes that cash proceeds can be reinvested to
the same rate of return used in the computation of the NPV earn the same rate as the IRR on that particular
project
----------------------------------------------------------------------------------------------------------------------------------------------
* Allows for multiple discount rates over the years * Allows for only one discount rate for the entire
period

The NPV of a project is dependent on the COC used. So if the COC changed, the NPV of each project would
change. The NPV method assumes reinvestment at the COC while the IRR method assumes reinvestment at the
IRR. The IRR is that discount rate which forces the NPV of a project to equal zero.
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The NPV and IRR methods result in conflicts only if mutually exclusive projects are being considered since the
NPV is positive if and only if the IRR is greater than the COC. A change in the COC or in the cash flow streams
would not lead to conflicts if the projects were independent. Therefore, the IRR method can be used in lieu of the
NPV if the projects being considered are independent.

If both projects are mutually exclusive, only one can be chosen. As long as the COC is greater than the crossover
rate, both the NPV and IRR methods will lead to the same project selection. However, if the COC is less than the
crossover rate, the two methods lead to different project selections—a ranking conflict exists. When a conflict
exists, the NPV method must be used. At the crossover rate, the 2 project NPVs are equal. Thus, other criteria
such as the IRR must be used to evaluate the projects.

Calculate the crossover rate by:

1. going back to the data on the problem, finding the cash flow differences for each year;
2. entering those differences into the cash flow register, and
3. pressing the IRR button to get the crossover rate.

NPV Profile is a plot of a project’s NPV @ different discount rates. The NPV is plotted on the vertical axis and
the rate of return (k) on the horizontal axis. The NPV profile can be of great practical use to managers trying to
make investment decisions. It gives the manager a clear insight into the following questions:
1. At what interest rates is an investment project still a profitable opportunity?
2. How sensitive is a project’s profitability to changes in the discount rates?
NPV Profiles for Projects A and B
Net Present Value
_
12,000 *

8,000 -- Investment A

4,000 -- Investment B *
| Investment B
| * IRR = 22.51%
| B
| Investment A
| * *
5% | 10%
|
8.7% IRR = 14.33
Crossover point A

How is the IRR on a project related to the YTM on a bond?

The IRR is to a capital project what the YTM is to a bond. It is the expected rate of return on the project, just as
the YTM is the promised rate of return on a bond. IRR measures a project’s profitability in the rate of return sense.
If a project’s IRR = its COC, then its cash flows are just sufficient to provide investors with their required rates of
return. An IRR greater than its COC implies an economic profit, which accrues to the firm’s shareholders, while an
IRR less than its COC indicates an economic loss, or a project that will not earn enough to cover its COC. If IRR
is greater than the hurdle rate, both projects should be accepted if they are independent. However, if they are
mutually exclusive, then choose a project with a higher IRR.

Would the projects’ IRRs change if the COC changed?

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IRRs are independent of the COC. However, the acceptability of the projects could change.

NPV and IRR always give the same accept/reject decisions for independent projects. NPV versus IRR conflict
arises only if mutually exclusive projects are involved.

Why is it important for managers to be able to rank multiple projects?

 Managers need to select the best project from a set of projects that are directly competing with each other
particularly in the case of mutually exclusive projects. Even when projects are not directly competing with
each other, managers may have a limited supply of capital that has to be allocated to the most worthy of the
projects.

Why is the Profitability Index (PI) a better basis than NPV to compare projects that require different levels of
investment?

The PI relates the magnitude of the NPV to the magnitude of the initial investment. Thus, the PI gives some
indication of relative profitability. The NPV itself provides no direct indication of the level of investment that is
required to generate the NPV and therefore provides no indication of relative profitability. PI gauges the efficiency
of the firm’s use of capital. The higher the index, the more efficient is the capital investment.

Does a project that generates a positive IRR also have a positive NPV?

 No. A positive IRR does not necessarily mean that a project will also have a positive NPV. Only if the IRR >
discount rate that is used in the NPV calculation will the NPV be positive.

Why is it important for an entity to conduct post-investment audit of capital projects?

 The post-investment audit provides management with an opportunity to evaluate the actual performance of the
investment relative to expected performance. If possible, management can take corrective action when actual
performance is poor relative to the expected performance. Management can also use the post-investment audit
to evaluate the performance of those who provided the original information about the investment and those
who are in charge of the investment. In addition, management may use the information from the post-
investment audit to improve the evaluation process of future capital projects.

What is the difference between the regular and discounted payback periods?

Discounted payback is similar to payback except that discounted rather than raw cash flows are used. Regular
payback has 2 critical deficiencies:
1. It ignores the time value of money and
2. It ignores the cash flows that occur after the payback period.

Discounted payback considers the time value of money but it still fails to consider cash flows after the PP, hence it
has a basic flaw. Payback is not generally used as the primary decision tool. Rather, it is used as a rough measure
of a project’s liquidity and riskiness. If the NPV is zero, then the project generates exactly enough cash flows (1) to
recover the cost of the investment and (2) to enable investors to earn their required rates of return (the OC of
capital). In a financial sense, the project breaks even.

Sensitivity Analysis

Sensitivity Analysis is a process of determining the amount of change that must occur in a variable before a
different decision would be made. Sensitivity analysis is a statistical tool that determines how much a change in an
input will affect the output. It can be conducted for the discount rate, annual net cash flows, or project life.

Many firms have simulation capabilities available to test “ what if” scenarios. If sales volume were to drop by 10%
from the forecast level, what is the impact on ROR or NPV? If because of technological advances, a particular
machine’s life is cut from 6 years to 4 years, how badly will losing Yr. 5 and 6 cash flows hurt the proposal?
Obviously, “what ifs” of many variable changes can be analyzed. Spreadsheet capabilities now make these
simulations routine and a normal part of project evaluation.
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Example: Assume that the NPV of Project 52 is P80,000. Project 52 will add 10,000 units of productive capacity.
A P10 UCM and the expanded capacity will last for 5 years. Desired rate of return is 15%. Ignoring taxes, the
value of 1 unit of sales per year for 5 years is P33.52 (3.352 x P10).

1. What if sales only reach 80% of new capacity?\

PV of the lost CM 2,000 u x P33.52 = P67,040
NPV of project if sales equal 8,000 units = P80,000 – P67,040 = P12,960
The project still earns better than a 15% return.

2. What unit sales are needed to earn at least 15%?

Units of allowed lost sales P80,000 ÷ P33.52 = 2,386 units
Units of sales to have a 15% rate of return 10,000 -2,386 = 7,614 units
This means that a 23.86% drop in expected new sales will cause the project to have a zero NPV, a return of
15%. A drop of 3.000 units would cause the project to have a negative NPV and to be rejected.

3. What if the project lasted only 4 years, not five years?

PV of Year 5 sales ……………………………..10,000 x P10 x 0.497 = P 49,700
NPV of Project 52 if Year 5 is eliminated P80,000 – P49,700 = P 30,300

The project is still acceptable. Cutting years off the end of a project’s life is a common method of reducing
uncertainty.