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Chapter 10

Capital Investment
Decision Analysis I

Learning Objectives
1.

2.

3.
4.

Discuss the difficulty encountered in finding profitable


projects in competitive markets and the importance of the
search.
Determine whether a new project should be accepted or
rejected using the payback period, net present value, the
profitability index, and the internal rate of return.
Explain how the capital-budgeting decision process changes
when a dollar limit is placed on the capital budget.
Discuss the problems encountered when deciding among
mutually exclusive projects.

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FINDING PROFITABLE
PROJECTS

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Capital Budgeting
Meaning: The process of decision making
with respect to investments in fixed assets
that is, should a proposed project be
accepted or rejected.
It is easier to evaluate profitable projects
than to find them

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Source of Ideas for Projects


R&D: Typically, a firm has a research &
development (R&D) department that
searches for ways of improving existing
products or finding new projects.
Other sources: Employees, Competition,
Suppliers, Customers.

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CAPITAL-BUDGETING
DECISION CRITERIA

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Capital-Budgeting
Decision Criteria

The Payback Period


Net Present Value
Profitability Index
Internal Rate of Return

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The Payback Period


Meaning: Number of years needed to
recover the initial cash outlay related to an
investment.
Decision Rule: Project is considered feasible
or desirable if the payback period is less
than or equal to the firms maximum desired
payback period. In general, shorter payback
period is preferred while comparing two
projects.

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Payback Period Example


Example: Project with an initial cash outlay of $20,000 with following free cash flows for 5 years.

Payback is 4 years.

YEAR CASH
FLOW
1

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8,000

BALANCE
($ 12,000)

4,000 (

8,000)

3,000 (

5,000)

5,000

10,000

12,000

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Trade-Offs
Benefits:
Uses cash flows rather than accounting profits
Easy to compute and understand
Useful for firms that have capital constraints

Drawbacks:
Ignores the time value of money
Does not consider cash flows beyond the payback
period

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Discounted Payback Period


The discounted payback period is similar to
the traditional payback period except that it
uses discounted free cash flows rather than
actual undiscounted cash flows.
The discounted payback period is defined as
the number of years needed to recover the
initial cash outlay from the discounted free
cash flows.

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Discounted Payback Period

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Table 10-2

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Payback Period Example


Table 10-2 shows the difference between
traditional payback and discounted payback
methods.
With undiscounted free cash flows,
the payback period is only 2 years,
while with discounted free cash flows (at
17%), the discounted payback period is
3.07 years.

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10-14

Net Present Value (NPV)


NPV is equal to the present value of all
future free cash flows less the investments
initial outlay. It measures the net value of a
project in todays dollars.

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NPV Example
Example: Project with an initial cash
outlay of $60,000 with following free cash
flows for 5 years.
Year
FCF
Initial outlay 60,000
1
25,000

Year
3
4

FCF
13,000
12,000

11,000

24,000

The firm has a 15% required rate of return.

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NPV Example

PV of FCF = $60,764
Subtracting the initial cash outlay of
$60,000 leaves an NPV of $764.
Since NPV > 0, project is feasible.

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NPV in Excel
Input cash flows for initial outlay and free
cash inflows in cells A1 to A6.
In cell A7 type the following formula:
=A1+npv(0.15,A2:A6)
Excel will give the result NPV = $764.

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NPV Trade-Offs
Benefits
Considers all cash flows
Recognizes time value of money

Drawbacks
Requires detailed long-term forecast of cash
flows

NPV is generally considered to be the most


theoretically correct criterion for evaluating
capital budgeting projects.

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The Profitability Index (PI)


(Benefit-Cost Ratio)
The profitability index (PI) is the ratio of the
present value of the future free cash flows
(FCF) to the initial outlay.
It yields the same accept/reject decision as
NPV.

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Profitability Index

Decision Rule:
PI 1 = accept;
PI < 1 = reject

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Profitability Index Example


A firm with a 10% required rate of return is
considering investing in a new machine
with an expected life of six years. The
initial cash outlay is $50,000.

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Profitability Index Example


FCF

PVF @ 10%

PV

Initial
Outlay
Year 1

$50,000

1.000

$50,000

15,000

0.909

13,636

Year 2

8,000

0.826

6,612

Year 3

10,000

0.751

7,513

Year 4

12,000

0.683

8,196

Year 5

14,000

0.621

8,693

Year 6

16,000

0.564

9,032

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Profitability Index Example

PI = ($13,636 + $6,612 + $7,513 +


$8,196 + $8,693 + $9,032) / $50,000
= $53,682/$50,000
= 1.0736
Projects PI is greater than 1. Therefore,
accept.

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NPV and PI
When the present value of a projects free
cash inflows are greater than the initial cash
outlay, the project NPV will be positive. PI
will also be greater than 1.
NPV and PI will always yield the same
decision.

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10-25

Internal Rate of Return (IRR)


IRR is the discount rate that equates the
present value of a projects future net cash
flows with the projects initial cash outlay
(IO).

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Internal Rate of Return


Decision Rule:
If IRR Required Rate of Return, accept
If IRR < Required Rate of Return, reject

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Figure 10-1

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IRR and NPV


If NPV is positive, IRR will be greater than
the required rate of return
If NPV is negative, IRR will be less than
required rate of return
If NPV = 0, IRR is the required rate of
return.

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IRR Example
Initial Outlay: $3,817
Cash flows: Yr. 1 = $1,000, Yr. 2 = $2,000,
Yr. 3 = $3,000
Discount rate
NPV
15%
$4,356
20%
$3,958
22%
$3,817
IRR is 22% because the NPV equals the
initial cash outlay at that rate.

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10-30

IRR in Excel
IRR can be easily computed in Excel.
In the previous example, input cash outflow
and three yearly cash inflows in cells A1:A4.
In cell A5 input
=IRR(A1:A4)
Excel will give the result IRR = 22%.

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Multiple IRRs
A normal cash flow pattern for project is
negative initial outlay followed by positive
cash flows (, +, +, + )
However, if the cash flow pattern is not
normal (such as , +, ) there can be more
than one IRR.
Figure 10-2 is based on cash flows of
1,600, +10,000, 10,000 in years 0, 1, 2.

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Multiple IRRs (Figure 10-2)

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Modified IRR (MIRR)


Primary drawback of the IRR relative to the
net present value is the reinvestment rate
assumption made by the internal rate of
return. Modified IRR allows the decision
maker to directly specify the appropriate
reinvestment rate.

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Modified IRR
Accept if MIRR required rate of return
Reject if MIRR < required rate of return

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MIRR Example
Project having a 3-year life and a required
rate of return of 10% with the following free
cash flows:

FCFs
Initial
Outlay

$6,000

Year 1

FCFs
Year 2
Year 3

$3,000
$4,000

$2,000
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MIRR Example
Step 1: Determine the PV of the projects
free cash outflows. $6,000 is already at the
present.
Step 2: Determine the terminal value of the
projects free cash inflows. To do this use
the projects required rate of return to
calculate the FV of the projects three cash
inflows. They turn out to be $2,420 +
$3,300 + $4,000 = $9,720 for the terminal
value.

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MIRR Example
Step 3: Determine the discount rate that
equates the PV of the terminal value
and the PV of the projects cash outflows.
MIRR = 17.446%.
Decision: MIRR is greater than required rate
of return, so accept.

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MIRR in Excel
= MIRR(values,finance rate,reinvestment
rate)
where values is the range of cells where the cash
flows are stored, and k is entered for both the
finance rate and the reinvestment rate.

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10-39

CAPITAL RATIONING

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Capital Rationing
Capital rationing refers to situation where
there is a limit on the dollar size of the
capital budget. This may be due to:
a) temporary adverse conditions in the market;
b) shortage of qualified personnel to direct new
projects; and/or
c) other factors such as not being willing to take
on excess debt to finance new projects.

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Capital Rationing
How to select? Select a set of projects with
the highest NPVsubject to the capital
constraint.
Note, using NPV may preclude accepting the
highest ranked project in terms of PI or IRR.

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Figure 10-4

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Table 10-7

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RANKING MUTUALLY
EXCLUSIVE PROJECTS

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Ranking Mutually
Exclusive Projects
Size Disparity
Time Disparity
Unequal Life

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Size Disparity
This occurs when we examine mutually
exclusive projects of unequal size.
Example: Consider the following cash flows
for one-year Project A and B, with required
rates of return of 10%.
Initial Outlay: A = $200; B = $1,500
Inflow:A = $300; B = $1,900

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Table 10-8

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Size-Disparity
Ranking Problem
Project A

Project B

NPV

72.73

227.28

PI

1.36

1.15

IRR

50%

27%

Ranking Conflict:
Using NPV, Project B is better;
Using PI and IRR, Project A is better.

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10-49

Size-Disparity
Ranking Problem
Which technique to use to select the
project?
Use NPV whenever there is size disparity. If
there is no capital rationing, project with the
largest NPV will be selected. When capital
rationing exists, rank and select set of
projects based on NPV.

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10-50

The Time-Disparity Problem


Time-disparity problem arises because of
differing reinvestment assumptions made by
the NPV and IRR decision criteria.
How are cash flows reinvested?
According to NPV: Required rate of return
According to IRR: IRR

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The Time-Disparity Problem


Example: Consider two projects, A and B,
with initial outlay of $1,000, cost of capital
of 10%, and following cash flows in years 1,
2, and 3:
A: $100
$200
$2,000
B: $650
$650
$650

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The Time-Disparity Problem

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The Time-Disparity Problem

Project A

Project B

758.83

616.45

1.759

1.616

35%

43%

NPV
PI
IRR
Ranking Conflict:

Using NPV or PI, A is better


Using IRR, B is better

Which technique to use to select the superior


project?
Use NPV
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Unequal-Lives Problem
This occurs when we are comparing two
mutually exclusive projects with different life
spans.
To compare projects, we compute the
Equivalent Annual Annuity (EAA).

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Unequal-Lives Problem
Example: If you have two projects, A and B,
with equal investment of $1,000, required
rate of return of 10%, and following cash
flows in years 1-3 (for project A) and 1-6
(for project B)
Project A = $500 each in years 1-3
Project B = $300 each in years 1-6

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10-56

Computing EAA
Calculate the projects NPV:
A = $243.43 and B = $306.58
Calculate EAA = NPV/annual annuity factor
A = $97.89
B = $70.39
Project A is better

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Figure 10-5

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Figure 10-6

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Key Terms

Capital budgeting
Capital rationing
Discounted payback period
Equivalent annual annuity (EAA)
Internal rate of return (IRR)
Modified internal rate of return (MIRR)
Mutually exclusive projects
Net present value (NPV)
Net present value profile
Payback period
Profitability index (PI) or benefit-cost ratio

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Table 10-1

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Table 10-3

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Table 10-4

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Table 10-5

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Table 10-6

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Table 10-10

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Table 10-10 (cont.)

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Figure 10-3

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