Capital Budgeting

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CHAPTER 11
The Basics of Capital Budgeting
Should we
build this
plant?
Copyright © 2002 by Harcourt, Inc. All rights reserved.

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What is Capital Budgeting?
 Capital refers the long-term assets used
in the firm
 Budget is a plan that details the
projected cash flows during some future
period
 Capital budget is the outline of planned
investment in the fixed assets
 Capital budgeting is the whole process
of analyzing the proposed projects and
decide which one to include in the firm’s
capital budget
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Significance of capital budgeting?
 Analysis of potential additions to

fixed assets.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.

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Steps of Capital Budgeting:
 Review the goals/objectives of firm
 Search various proposals
 Estimate the Cash flows of each
 Ranking proposals using tools
 Selection of projects based on
ranking
 Implementation of selected one(s)
 Post audit for controlling
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Steps
1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine k = WACC (adj.).
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >
WACC.
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What is the difference between
independent and mutually exclusive
projects?
Projects are:
independent, if the cash flows of one
are unaffected by the acceptance of
the other.
mutually exclusive, if the cash flows
of one can be adversely impacted by
the acceptance of the other.
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An Example of Mutually Exclusive

Projects
BRIDGE vs. BOAT to get

products across a river.
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Normal
NormalCash
CashFlow
FlowProject:
Project
Cost (negative CF) followed by a
series of positive cash inflows.
One change of signs.
Nonnormal Cash Flow Project
Two or more changes of signs.
Most common: Cost (negative
CF), then string of positive CFs,
then cost to close project.
Nuclear power
Copyright © 2002 by Harcourt, Inc.
plant, strip mine.
All rights reserved.
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Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
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Common Capital Budgeting Tools:
 Payback period(Discounted Payback)

 Net present Value (NPV)
 Internal Rate of Return(IRR) /
 (Modified IRR or MIRR)
 Profitability Index (PI)
 Accounting Rate of Return (ARR)
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What is the payback period?
The number of years required to

recover a project’s cost,
or how long does it take to get our

money back?

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Payback for Project L

(Long: Large CFs in later years)
0 1 2 2.4 3
CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50
PaybackL = 2 + 30/80 = 2.375 years

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Project S (Short: CFs come quickly)
0 1 1.6 2 3
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40
PaybackS = 1 + 30/50 = 1.6 years

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Strengths of Payback
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.
Weaknesses of Payback
1. Ignores the TVM.

2. Ignores CFs occurring after the
payback period.
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Discounted Payback: Uses discounted

rather than raw CFs.
0 1 2 3
10%
CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
= 2 + 41.32/ 60.11 = 2.7 years
payback
Recover invest. + cap. costs in 2.7 years.
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NPV: Sum of the PVs of inflows and

outflows.
CFt
n
NPV   t .
t 0 1  k 

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What is Project L’s NPV?
Project L:
0 1 2 3
10%
-100.00 10 60 80
9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
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What is Project L’s NPV?
Project L:
0 1 2 3
20%
-100.00 10 60 80
8.333
41.664
46.296
-3.71 = NPVL
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Calculator Solution
Enter in CFLO for L:

-100 CF0
10 CF1
60 CF2
80 CF3
10 I NPV = 18.78 = NPVL

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Rationale for the NPV Method
NPV = PV inflows – Cost

= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually

exclusive projects on basis of
higher NPV. Adds most value.
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Using NPV method, which project(s)

should be accepted?
 If Projects S and L are mutually

exclusive, accept S because
NPVs > NPVL .
 If S & L are independent,
accept both; NPV > 0.

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Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3

Cost Inflows
IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.
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NPV: Enter k, solve for NPV.

n
CFt

t 0 1  k 
t  NPV .
IRR: Enter NPV = 0, solve for IRR.

n
CFt

t 0 1  IRR 
t  0.

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What’s Project L’s IRR?
0 1 2 3
IRR = ?
-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
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Find IRR if CFs are constant:
0 1 2 3
IRR = ?
-100 40 40 40
INPUTS 3 -100 40 0
N I/YR PV PMT FV
OUTPUT 9.70%
Or, with CFLO, enter CFs and press

IRR = 9.70%.
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IRR of single Cash Inflow and Outflow:

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IRR of Uneven Cash Flows

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Q. How is a project’s IRR
related to a bond’s YTM?
A. They are the same thing.
A bond’s YTM is the IRR
if you invest in the bond.
0 1 2 10
IRR = ? ...
-1134.2 90 90 1090
IRR = 7.08% (use TVM or CFLO).

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YTM on BOND?
 Let discount rate is 5%,
 NPV= {(90x7.7217)+(1000x.6139)}-
1134.20 =174.653
 Let discount rate is 10%
 NPV={(90x6.1446)+(1000x.3855)}-
1134.20= -195.686
 IRR=7.358 Appx.(Using Trial and
Error Method)
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Rationale for the IRR Method
If IRR > WACC, then the project’s

rate of return is greater than its
cost--some return is left over to
boost stockholders’ returns.
Example: WACC = 10%, IRR = 15%.

Profitable.
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IRR Acceptance Criteria
 If IRR > k, accept project.
 If IRR < k, reject project.

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Decisions on Projects S and L per IRR
 If S and L are independent, accept

both. IRRs > k = 10%.
 If S and L are mutually exclusive,
accept S because IRRS > IRRL .

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Construct NPV Profiles
Enter CFs in CFLO and find NPVL and

NPVS at different discount rates:
k NPVL NPVS
0 50 40
5 29
10 33 20
15 19 12
20 7
(4) 5
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NPV ($) k NPVL NPVS
60
0 50 40
50 . 5 33 29
40 .
Crossover 10 19 20
. Point = 8.7%
15 7 12
30 . 20 (4) 5
20 . S
. IRRS = 23.6%
10 L . .
0
.20 . Discount Rate (%)
5 10 15 23.6
-10
IRRL = 18.1%
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NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > k k > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.
k (%)
IRR
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Mutually Exclusive Projects
NPV
k < 8.7: NPVL> NPVS , IRRS > IRRL
CONFLICT
L k > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
S IRRS
%
k 8.7 k IRR
L
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To Find the Crossover Rate
1. Find cash flow differences between

the projects. See data at beginning
of the case.
2. Enter these differences in CFLO
register, then press IRR. Crossover
rate = 8.68%, rounded to 8.7%.
3. Can subtract S from L or vice versa,
but better to have first CF negative.
4. If profiles don’t cross, one project
dominates the other.
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Two Reasons NPV Profiles Cross
1. Size (scale) differences. Smaller project

frees up funds at t = 0 for investment.
The higher the opportunity cost, the
more valuable these funds, so high k
favors small projects.
2. Timing differences. Project with faster
payback provides more CF in early
years for reinvestment. If k is high,
early CF especially good, NPVS > NPVL.
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Reinvestment Rate Assumptions
 NPV assumes reinvest at k (opportunity

cost of capital).
 IRR assumes reinvest at IRR.
 Reinvest at opportunity cost, k, is more
realistic, so NPV method is best. NPV
should be used to choose between
mutually exclusive projects.

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Managers like rates--prefer IRR to NPV
comparisons. Can we give them a
better IRR?
Yes, MIRR is the discount rate that

causes the PV of a project’s terminal
value (TV) to equal the PV of costs.
TV is found by compounding inflows
at WACC.
Thus, MIRR assumes cash inflows are

reinvested at WACC.
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MIRR for Project L (k = 10%)

0 1 2 3
10%
-100.0 10.0 60.0 80.0

10%
66.0
10%
12.1
MIRR =
158.1
16.5%
-100.0 $158.1
$100 = TV inflows
(1 + MIRRL)3
PV outflows
MIRRL = 16.5%
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To find TV with HP 10B, enter in CFLO:
CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

I = 10
NPV = 118.78 = PV of inflows.
Enter PV = -118.78, N = 3, I = 10, PMT = 0.
Press FV = 158.10 = FV of inflows.
Enter FV = 158.10, PV = -100, PMT = 0,
N = 3.
Press I = 16.50% = MIRR.
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Why use MIRR versus IRR?
MIRR correctly assumes reinvestment

at opportunity cost = WACC. MIRR
also avoids the problem of multiple
IRRs.
Managers like rate of return
comparisons, and MIRR is better for
this than IRR.
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Pavilion Project: NPV and IRR?
0 1 2
k = 10%
-800 5,000 -5,000
Enter CFs in CFLO, enter I = 10.

NPV = -386.78
IRR = ERROR. Why?
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We got IRR = ERROR because there
are 2 IRRs. Nonnormal CFs--two sign
changes. Here’s a picture:
NPV NPV Profile
IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
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Logic of Multiple IRRs
1. At very low discount rates, the PV of

CF2 is large & negative, so NPV < 0.
2. At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
3. In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
4. Result: 2 IRRs.
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Could find IRR with calculator:
1. Enter CFs as before.
2. Enter a “guess” as to IRR by
storing the guess. Try 10%:
10 STO
IRR = 25% = lower IRR
Now guess large IRR, say, 200:
200 STO
IRR = 400% = upper IRR
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When there are nonnormal CFs and

more than one IRR, use MIRR:
0 1 2
-800,000 5,000,000 -5,000,000
PV outflows @ 10% = -4,932,231.40.

TV inflows @ 10% = 5,500,000.00.
MIRR = 5.6%
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Accept Project P?
NO. Reject because MIRR =

5.6% < k = 10%.
Also, if MIRR < k, NPV will be

negative: NPV = -$386,777.

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Profitability Index (PI):
 PI is the ratio between PV of cash in

flows and PV of cash out flows
 PI (L) = $118.79/$100=1.18
 PI (s) = $120/$100=1.20
 PI>1=Accepted
 PI<1= Rejected

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Accounting Rate of Return (ARR):
 ARR is calculated by dividing the

average income with average
investment
 ARR (L) = ($50/$100)x100=50%
 ARR (s) = ($46.67/$100)x100=46.67%
 ARR>k=Accepted
 ARR<k=Rejected
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Study Work:
 Self-Test problems: ST-1,2

 Starter Problems: 10-1,2,3,4,5,6
 Exam-Type Problems:
10-7,8,9,11,13,16
 Problems: 10-19,23

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11 - 1

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Significance of capital budgeting?

 Analysis of potential additions to

Copyright © 2002 by Harcourt, Inc. All rights reserved.

1. Estimate CFs (inflows & outflows).

An Example of Mutually Exclusive

BRIDGE vs. BOAT to get

Inflow (+) or Outflow (-) in Year

Common Capital Budgeting Tools:

 Payback period(Discounted Payback)

What is the payback period?

The number of years required to

or how long does it take to get our

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Payback for Project L

CFt -100 10 60 100 80

PaybackL = 2 + 30/80 = 2.375 years

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Project S (Short: CFs come quickly)

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

Copyright © 2002 by Harcourt, Inc. All rights reserved.

1. Ignores the TVM.

Discounted Payback: Uses discounted

NPV: Sum of the PVs of inflows and

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What is Project L’s NPV?

What is Project L’s NPV?

Enter in CFLO for L:

10 I NPV = 18.78 = NPVL

Rationale for the NPV Method

NPV = PV inflows – Cost

Accept project if NPV > 0.

Choose between mutually

Using NPV method, which project(s)

 If Projects S and L are mutually

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Internal Rate of Return: IRR

CF0 CF1 CF2 CF3

IRR is the discount rate that forces

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What’s Project L’s IRR?

Or, with CFLO, enter CFs and press

IRR of single Cash Inflow and Outflow:

Copyright © 2002 by Harcourt, Inc. All rights reserved.

IRR of Uneven Cash Flows

Copyright © 2002 by Harcourt, Inc. All rights reserved.

IRR = 7.08% (use TVM or CFLO).

Rationale for the IRR Method

If IRR > WACC, then the project’s

Example: WACC = 10%, IRR = 15%.

IRR Acceptance Criteria

 If IRR > k, accept project.

 If IRR < k, reject project.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Decisions on Projects S and L per IRR