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A B C D E F G H I J K
1/1/2012
Capital Budgeting Decisions
Situation
Franchise S
Year (t) Franchise S Franchise L 0 1 2 3
0 ($100) ($100) (100) 70 50 20
1 70 10
2 50 60 Franchise L
3 20 80
0 1 2 3
(100) 10 60 80
Net Present Value (NPV)
WACC = 10%
Franchise S
Time period: 0 1 2 3
Cash flow: (100) 70 50 20
Disc. cash flow: (100) 64 41 15
NPV(S) = $19.98 = Sum disc. CF's. or $19.98 = Uses NPV function.
b. What is the difference between independent and mutually exclusive projects? Answer: See Chapter 10 Mini Case Show
Chapter 10. Mini Case
Expected
Net Cash Flows
You have narrowed your selection down to two choices: (1) Franchise L, Lisa's Soups, Salads, & Stuff, and (2) Franchise S,
Sam's Fabulous Fried Chicken. The net cash flows shown below include the price you would receive for selling the franchise in
Year 3 and the forecast of how each franchise will do over the 3-year period. Franchise L's cash flows will start off slowly but
will increase rather quickly as people become more health conscious, while Franchise S's cash flows will start off high but will
trail off as other chicken competitors enter the marketplace and as people become more health conscious and avoid fried foods.
Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for you to invest in both
franchises. You see these franchises as perfect complements to one another: You could attract both the lunch and dinner
crowds and the health conscious and not so health conscious crowds without the franchises directly competing against one
another.
Here are the net cash flows (in thousands of dollars):
You have just graduated from the MBA program of a large university, and one of your favorite courses was "Today's
Entrepreneurs." In fact, you enjoyed it so much you have decided you want to "be your own boss." While you were in the
master's program, your grandfather died and left you $1 million to do with as you please. You are not an inventor, and you do
not have a trade skill that you can market; however, you have decided that you would like to purchase at least one established
franchise in the fast-foods area, maybe two (if profitable). The problem is that you have never been one to stay with any project
for too long, so you figure that your time frame is three years. After three years you will go on to something else.
Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.
You also have made subjective risk assessments of each franchise and concluded that both franchises have risk characteristics
that require a return of 10%. You must now determine whether one or both of the franchises should be accepted.
c. (1.) Define the term net present value (NPV). What is each franchise's NPV?
To calculate the NPV, we find the present value of the individual cash flows and find the sum of those discounted cash flows.
This value represents the value the project add to shareholder wealth.
a. What is capital budgeting? Answer: See Chapter 10 Mini Case Show
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A B C D E F G H I J K
Franchise L
Time period: 0 1 2 3
Cash flow: (100) 10 60 80
Disc. cash flow: (100) 9 50 60
NPV(L) = $18.78 $18.78 = Uses NPV function.
Internal Rate of Return (IRR)
Year (t) Franchise S Franchise L
0 ($100) ($100)
1 70 10 IRR
S
= 23.56%
2 50 60 IRR
L
= 18.13%
3 20 80
Constant Cash Flows
Year (t) Cash Flow
0 ($100) 0 1 2 3
1 40 (100) 40 40 40
2 40
3 40
IRR = 9.70% Note: You can use the Rate function if
payments are constant.
Similarity to a bond:
0 1 2 3 4 5 6 7 8 9 10
(1,134) 90 90 90 90 90 90 90 90 90 1,090
IRR = 7.08%
The NPV method of capital budgeting dictates that all independent projects that have positive NPV should accepted. The
rationale behind that assertion arises from the idea that all such projects add wealth, and that should be the overall goal of the
manager in all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you would want to accept
the project that adds the most value (i.e. the project with the higher NPV). Hence, if considering the above two projects, you
would accept both projects if they are independent, and you would only accept Project S if they are mutually exclusive.
(3.) Would the NPVs change if the cost of capital changed? Answer: See Chapter 10 Mini Case Show
The internal rate of return is defined as the discount rate that equates the present value of a project's cash inflows to its
outflows. It is the discount rate that forces the PV of the inflows to equal the initial cost. In other words, the internal rate of
return is the interest rate that forces NPV to zero. The calculation for IRR can be tedious, but Excel provides an IRR function
that merely requires you to access the function and enter the array of cash flows. The IRR's for Franchises S and L are shown
below, along with the data entry for Franchise S.
d. (1.) Define the term internal rate of return (IRR). What is each franchise's IRR?
(2.) How is the IRR on a project related to the YTM on a bond?
net cash flows
(2.) What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if
they
The IRR function
assumes payments occur
at end of periods, so that
function does not have to
be adjusted.
Expected
Notice that for IRR you must
specify all cash flows,
including the time zero cash
flow. This is in contrast to
the NPV function, in which
you specify only the future
cash flows.
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A B C D E F G H I J K
NPV Profiles
e. Draw NPV profiles for Franchises L and S. At what discount rate do the profiles cross?
Franchise S Franchise L
WACC $19.98 WACC $18.78
0% 40.00 0% 50.00
2% 35.53 2% 42.86
4% 31.32 4% 36.21
6% 27.33 6% 30.00
8% 23.56 8% 24.21
10% 19.98 10% 18.78
12% 16.60 12% 13.70
14% 13.38 14% 8.94
16% 10.32 16% 4.46
18% 7.40 18% 0.26
20% 4.63 20% (3.70)
22% 1.98 22% (7.43)
24% (0.54) 24% (10.95)

f. (1.) What is the underlying cause of ranking conflicts between NPV and IRR?
(2.) What is the "reinvestment rate assumption," and how does it affect the NPV versus IRR conflict? Answer: See
Chapter
The IRR method of capital budgeting maintains that projects should be accepted if their IRR is greater than the cost of capital.
Strict adherence to the IRR method would further dictate that mutually exclusive projects should be chosen on the basis of the
greatest IRR. In this scenario, both franchises have IRRs that exceed the cost of capital (10%) and both should be accepted, if
they are independent. If, however, the franchises are mutually exclusive, we would choose Franchise S. Recall, that this was
our determination using the NPV method as well. The question that naturally arises is whether or not the NPV and IRR
methods will always arrive at the same conclusion.
Previously, we had discussed that in some instances the NPV and IRR methods can give conflicting results. First, we should
attempt to define what we see in this graph. Notice, that the two franchises' profiles (S and L) intersect the X-axis at costs of
capital of 18.13% and 23.56%, respectively. Not coincidently, those are the IRRs of the franchises. If we think about the
definition of IRR, we remember that the internal rate of return is the cost of capital at which a project will have an NPV of
zero. Looking at our graph, it is a logical conclusion that the project IRR is defined as the point at which its profile intersects
the
(4.) Would the franchises' IRRs change if the cost of capital changed?
(2.) Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which franchise or franchises should
be
accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less
When dealing with independent projects, the NPV and IRR methods will always yield the same accept/reject result. However,
in the case of mutually exclusive projects, NPV and IRR can give conflicting results. One shortcoming of the internal rate of
return is that it assumes that cash flows received are reinvested at the project's internal rate of return, which is not usually
true. The nature of the congruence of the NPV and IRR methods is further detailed in a latter section of this model.
(3.) What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are
independent?
(20)
(10)
0
10
20
30
40
50
60
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
NPV ($)
Cost of Capital
NPV Profile of Franchises S and L
Project L
Project S
Franchise L- IRR
Franchise
S- IRR
Crossover Rate =
8.7%
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A B C D E F G H I J K
Cash Flow
Year (t) Franchise S Franchise L Differential
0 ($100) ($100) 0
1 70 10 60
2 50 60 (10)
3 20 80 (60)
IRR = Crossover rate = 8.68%
Modified Internal Rate of Return (MIRR)
WACC = 10% MIRR
S =
16.89%
Franchise S MIRR
L = 16.50%
10%
0 1 2 3
(100) 70 50 20
Franchise L
0 1 2 3
(100) 10 60 80
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12.1
P V : (100) TV = 158.1
(3.) Which method is the best? Why? Answer: See Chapter 10 Mini Case Show
The advantage of using the MIRR, relative to the IRR, is that the MIRR assumes that cash flows received are reinvested at the
cost of capital, not the IRR. Since reinvestment at the cost of capital is more likely, the MIRR is a better indicator of a project's
profitability. Moreover, it solves the multiple IRR problem, as a set of cash flows can have but one MIRR .
Also note that Excel's MIRR function allows for discounting and reinvestment to occur at different rates. Generally, MIRR is
defined as reinvestment at the WACC, though Excel allows the calculation of a special MIRR where reinvestment occurs at a
different rate than WACC.
The modified internal rate of return is the discount rate that causes a project's cost (or cash outflows) to equal the present
value of the project's terminal value. The terminal value is defined as the sum of the future values of the project's cash inflows,
compounded at the project's cost of capital. To find MIRR, calculate the PV of the outflows and the FV of the inflows and then
find the discount rate that equates the two. Or, you can solve using Excel's MIRR function.
g. (1.) Define the term modified IRR (MIRR). Find the MIRRs for Franchises L and S.
Expected
Net Cash Flows
Note that if negative cash flows occur in years beyond Year 1, those cash flows would be discounted at the cost of capital and
added to the Year 0 cost to find the total PV of costs. If both positive and negative flows occurred in some year, the negative
flow should be discounted, and the positive one compounded, rather than just dealing with the net cash flow. This makes a
difference.
The intuition behind the relationship between the NPV profile and the crossover rate is as follows: (1) Distant cash flows are
heavily penalized by high discount rates--the denominator is (1 + r)
t
, and it increases geometrically; hence, it gets very large at
high values of t. (2) Long-term projects like L have most of their cash flows coming in the later years, when the discount
penalty is largest; hence, they are most severely impacted by high capital costs. (3) Therefore, Franchise L's NPV profile is
steeper than that of S. (4) Since the two profiles have different slopes, they cross one another.
Finally, it is stated in the text, when the IRR versus the NPV is discussed, that the NPV is superior because (1) the NPV
assumes that cash flows are reinvested at the cost of capital whereas the IRR assumes reinvestment at the IRR, and (2) it is
more likely, in a competitive world, that the actual reinvestment rate is more likely to be the cost of capital than the IRR,
especially if the IRR is quite high. The MIRR setup can be used to prove that NPV indeed does assume reinvestment at the
WACC, and IRR at the IRR.
Looking further at the NPV profiles, we see that the two franchises profiles intersect at a point we shall call the crossover rate.
We observe that at costs of capital greater than the crossover rate, the franchise with the greater IRR (Franchise S, in this case)
also has the greater NPV. But at costs of capital less than the crossover rate, the franchise with the lesser IRR has the greater
NPV. This relationship is the source of discrepancy between the NPV and IRR methods. By looking at the graph, we see that
the crossover rate appears to occur at approximately 8.7%. Luckily, there is a more precise way of determining the crossover
rate. To find the crossover rate, we will find the difference between the two franchises' cash flows in each year, and then find
the IRR of this series of differential cash flows. This IRR is the crossover rate.
(2.) What are the MIRR's advantages and disadvantages vis-a-vis the regular IRR? What are the MIRR's advantages and
disadvantages vis-a-vis the NPV?
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A B C D E F G H I J K
PROFITABILITY INDEX
h. What does the profitability index (PI) measure? What are the PI's for Franchises S and L?
For Franchise S:
PI(S) = PV of future cash flows Initial cost
PI(S) = $119.98 $100
PI(S) = 1.1998
For Franchise L:
PI(L) = PV of future cash flows Initial cost
PI(L) = $118.78 $100
PI(L) = 1.1878
i. (1.) What is the payback period? Find the paybacks for Franchises L and S.
Payback Period
Franchise S
Time period: 0 1 2 3
Cash flow: (100) 70 50 20
Cumulative cash flow: (100) (30) 20 40
Payback: 1.600
Franchise L
Time period: 0 1 2 3
Cash flow: (100) 10 60 80
Cumulative cash flow: (100) (90) (30) 50
Payback: 2.375
Discounted Payback Period
WACC = 10%
Franchise S
Time period: 0 1 2 3
Cash flow: (100) 70 50 20
Disc. cash flow: (100) 64 41 15 Cash Flows Discounted back at 10%.
Disc. cum. cash flow: (100) (36) 5 20
Discounted Payback: 1.9
(2.) What is the rationale for the payback method? According to the payback criterion, which franchise or franchises
should
be accepted if the firm's maximum acceptable payback is 2 years, and if Franchise L and S are independent? If they
The profitability index is the present value of all future cash flows divided by the intial cost. It measures the PV per dollar of
investment.
Discounted payback period uses the project's cost of capital to discount the expected cash flows. The calculation of discounted
payback period is identical to the calculation of regular payback period, except you must base the calculation on a new row of
discounted cash flows. Note that both projects have a cost of capital of 10%.
(3.) What is the difference between the regular and discounted payback periods?
The payback period is defined as the expected number of years required to recover the investment, and it was the first formal
method used to evaluate capital budgeting projects. First, we identify the year in which the cumulative cash inflows exceed the
initial cash outflows. That is the payback year. Then we take the previous year and add to it the fraction calculated as the
unrecovered balance at the end of that year divided by the following year's cash flow. Generally speaking, the shorter the
payback period, the better the investment.
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A B C D E F G H I J K
Franchise L
Time period: 0 1 2 3 4
Cash flow: (100) 10 60 80 0
Disc. cash flow: (100) 9 50 60 0
Disc. cum. cash flow: (100) (91) (41) 19 19
Discounted Payback: 2.7
Multiple IRRs
Project M: 0 1 2
(800) 5,000 (5,000)
The project is estimated to be of average risk, so its cost of capital is 10%.
(2.) What is Project P's NPV? What is its IRR? Its MIRR?
NPV
M
= ($386.78)
IRR
M
1
= 25.0% MIRR = 5.6%
IRR
M
2
= 400%
0 1 2
(800.0) 5,000 (5,000)
j. As a separate project (Project P), you are considering sponsoring a pavilion at the upcoming World's Fair. The pavilion
would
cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However,
it
We will solve this IRR twice, the first time using the default guess of 10%, and the second time we will enter a guess of 200%.
Notice, that the first IRR calculation is exactly as it was above.
The two solutions to this problem tell us that this project will have a positive NPV for all costs of capital between 25% and
400%. We illustrate this point by creating a data table and a graph of the project NPVs.
(4.) What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting
decisions?
The inherent problem with both paybacks is that they ignore cash flows that occur after the payback period mark and neither
provides a specific acceptance rule. While the discounted method accounts for timing issues (to some extent), it still falls short
of fully analyzing projects. However, all else equal, these two methods do provide some information about projects' liquidity
and risk.
(1.) What are normal and nonnormal cash flows? Answer: See Chapter 10 Mini Case Show
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A B C D E F G H I J K
r = 25.0%
NPV = 0.00
NPV
r $0.0
0% (800.00)
25% 0.00
50% 311.11
75% 424.49
100% 450.00 Max.
125% 434.57
150% 400.00
175% 357.02
200% 311.11
225% 265.09
250% 220.41
275% 177.78
300% 137.50
325% 99.65
350% 64.20
375% 31.02
400% 0.00
425% (29.02)
450% (56.20)
475% (81.66)
500% (105.56)
525% (128.00)
550% (149.11)
PROJECTS WITH UNEQUAL LIVES
k. In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects:
Year Project S Project L
0 ($100,000) ($100,000)
1 60,000 33,500
2 60,000 33,500
3 33,500
4 33,500
Project L WACC: 10.0%
0 1 2 3 4
($100) $33.5 $33.5 $33.5 $33.5
NPV $6.19
Project S
0 1 2 3 4
($100) $60 $60
NPV $4.13
End of Period:
End of Period:
The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future.
Both projects have a 10% cost of capital.
(3.) Draw Project P's NPV profile. Does Project P have normal or nonnormal cash flows? Should this project be accepted?
(1.) What is each projects initial NPV without replication?
-1,000
-800
-600
-400
-200
0
200
400
600
-100% 0% 100% 200% 300% 400% 500%
NPV ($)
Cost of Capital
Multiple Rates of Return
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A B C D E F G H I J K
Equivalent Annual Annuity (EAA) Approach
Here are the steps in the EAA approach.
1. Find the NPV of each project over its initial life (we already did this in our previous analysis).
NPV
L
= $6.19
NPV
S
= $4.13
2. Convert the NPV into an annuity payment with a life equal to the life of the project.
EAA
L
= $1.95 Note: we used Excel's PMT function by using the function wizard.
EAA
S
= $2.38
Project S
0 1 2 3
($100) $60 $60
($100) $60 $60
($100) $60 ($40) $60 $60
NPV $7.55
Project S
0 1 2 3
($100) $60 $60
($105) $60 $60
($100) $60 ($45) $60 $60
NPV $3.42
ECONOMIC LIFE VS. PHYSICAL LIFE
Year
Operating
Cash Flow
Salvage
Value
0 ($5,000) $5,000
1 $2,100 $3,100
2 $2,000 $2,000
3 $1,750 $0
3-Year NPV = Initial Cost +
PV of
Operating
Cash Flow
+
PV of
Salvage
Value
= ($5,000.00) + $4,876.78 + $0.00
3-Year NPV = ($123.22)
2-Year NPV = Initial Cost +
PV of
Operating
Cash Flow
+
PV of
Salvage
Value
= ($5,000.00) + $3,561.98 + $1,652.89
2-Year NPV = $214.88
l. You are also considering another project which has a physical life of 3 years; that is, the machinery will be totally worn out
after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive
salvage
The asset has a negative NPV if it is kept for three years. But even though the asset will last three years, it might be better to
operate the asset for either one or two years, and then salvage it.
(1.) Using the 10% cost of capital, what is the project's NPV If it is operated for the full 3 years?
End of Period:
End of Period:
(2.) What is each projects equivalent annual annuity?
(4.) Now assume that the cost to replicate Project S in 2 years will increase to $105,000 because of inflationary pressures.
How should the analysis be handled now, and which project should be chosen?
(3.) Now apply the replacement chain approach to determine the projects extended NPVs. Which project should be chosen?
(2.) Would the NPV change if the company planned to terminate the project at the end of Year 2?
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A B C D E F G H I J K
1-Year NPV = Initial Cost +
PV of
Operating
+
PV of
Salvage
= ($5,000.00) + $1,909.09 + $2,818.18
1-Year NPV = ($272.73)
The project's NPV will only be positive when it is operated for 2 years. Therefore, the project's economic life is 2 years.
m. After examining all the potential projects, you discover that there are many more projects this year with positive NPVs
than in
a normal year. What two problems might this extra large capital budget cause? Answer: S ee Chapter 10 Mini Case Show
(4.) What is the projects optimal (economic) life?
(3.) At the end of Year 1?
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L M N O P Q R S T U
Notice that the NPV function isn't really a Net present value.
Instead, it is the present value of future cash flows. Thus, you
specify only the future cash flows in the NPV function. To find the
true NPV, you must add the time zero cash flow to the result of the
NPV function.
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L M N O P Q R S T U


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L M N O P Q R S T U
Cash Flows Discounted back at 10%.